Monday, September 16, 2013

Past Sell-Off Dynamics

Beta during the sell-off for different swap tenors, fixing the dynamics of the 10y point as pure normal (BETA = 1) - for past selloff episodes in EUR and USD.

Different swap tenor reponse to a 1BP move in 10Y during these sell-offs (in BPS MOVE), as implied by the above BETAs.

Historically, the front end for USD has shown much lower beta (meaning more log-nomrality w.r.t. 10y rate) compared to Euro, perhaps due to a better pricing of fed expectation and less surprises in rate hikes (Notice how the Mid 08 oil shock was surprise for both the markets but for EUR was considerably stronger). In fact the strong and persistent correlation between front end slope for EUR we have now is only a recent phenomenon in the sell-off in 2013 (one of the major difference between the 2010 sell-off and the current sell-off). Whereas this has been common in USD in 2013 of course, and also during most of the past sell-off.

Projecting this in to future, the recent correlation of front end slopes with the belly (e.g. 1s3s vs 5y) will be stronger in USD than EUR, and I expect EUR to lead the first reversal of this correlation (provided we are not heading towards very different rates levels in EUR and USD) For directional trades this provides a good way to position for bearish (bullish) rates, by going long (short) the slope in USD vs EUR. Also for a contrarian trade, an OTM flattener in EUR vs USD in a good hedge for inflation suprises, (assuming ECB's reaction function is unchanged)

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