Thursday, April 9, 2015

Trade Idea: The Short Story of the Long End (USD/GBP/EUR)

Post FOMC minutes, here is a quick look at the current levels of the yield curves across USD, GBP and EUR. Below table gives a snap of how the market currently prices the start of the rate hike cycles (lift-off), the pace of hiking, and the terminal equilibrium policy rates.

As we can see the terminal rate, as well as the pace of hike is highest in case of the US, followed by the UK and the Euro area. This is interesting, esp the change in these since start of 2014. The repricing of lift-off has been large for Euro, by 11 quarters (which is mostly explained by ECB commitment of 2 years worth of QE). For others the lift-off re-pricing has been rather small (almost none for the US and 3 quarters for GBP). What has been remarkably massive is the re-pricing of the terminal rate. Around 190bps for Euro, 145bps for the US and 120bps for the UK. Also note the large re-pricing of the UK pace of hikes, Which is evident in the large push-out of the peak rate timing for (this may be influenced by mismatching supply demand of long end gilts).

I further took these current curves and applied some scenarios on the base case. The scenarios are 1) a 50bps sell-off in terminal rates with faster than expected rate path (the optimistic scenario) 2) a 50bps sell-off in terminal rates with slower pace of hikes (growth with subdued inflation) 3) a 25bps downward revision of terminal rates (a recession scenario) and 4) global convergence - the large global economies converge to a common overall long term rate based on GDP weighted long term nominal trend growth (which turns out to be around 2%).

Overall, the market seems to agree with the secular stagnation theorists more than ever. It also prices in a convergence of global inflation. We indeed have a core inflation convergence (somewhat) for UK and US already. And given UK imports a lot more from Euro area than exports, the case of imported disinflation is strong. The US is more likely to have a higher potential growth than the UK, and is less burdened with Euro area disinflation. Add these up and we may have more that 50bps that is currently priced in, room for long end divergence.

On a relative basis, I think the pricing of terminal rates are okay, except may be a bit too pessimistic. The pace looks balanced too, with an upside risks to faster hike if inflation picks up unexpectedly. Individually, the lift-off for UK is perhaps too early and the pace is too low. I would rather imagine BoE avoiding hiking unless they must. There has been much less talk about bubbles in the UK. And even the London house prices seems to be on course correction. For the US, the lift off seems more or less fine, and the pace possibly as well. But the terminal rates a bit too pessimistic. Given post crisis average nominal GDP in excess of 3.7%, a terminal rates around 2.5% denotes upside around 100bps. On Euro area, well we have QE. It is still not clear the long end has found a support at the current levels. Not to mention Greece and other distraction. And if we have QE extended beyond what is currently promised then everything looks pretty much fair there. Except we have very little downside to go short rates at these levels.

Trade #1: USD 10s30s steepener vs GBP - rationale: see the point on imported disinflation. Also the tight supply and natural long end gilt demand, and a historically tight spread all support this trade. Also historical market rates over the policy rates has been higher for USD than GBP. I prefer 10s30s than other points for this steepener trade. 

Trade #2: Buy USD 1y30y payers vs GBP - rationale: Similar as above, structured through 30y rates, selling the GBP 30y payers. The USD vs. GBP 1y30y vol spread is historically near the tightest levels seen. The election perhaps does not justify all of it.

Trade #3: Long end upside in EUR - rationale: Well we can't go much lower than this and NOT have a prolonged recession. On the brighter side, we can go up quite a bit. The best way to express is outright on the long end. As this has the most asymmetric upside. Can be structured as positive carry trade through bottom right payer spreads. Else through mid-curves at zero cost to carry through 2y in to bottom right forward payer spreads. The vols are relatively cheaper beyond 2y expiries.

Trade #4: Pay UK 2s5s vs US 2s5s - rationale: in case the lift-off date and the pace gets corrected in the UK after the election. And by that time US gets nearer to the lift-off date, leading to relative under-performance of 2y to 5y.

Trade #5: Pay EUR 5s30s vs US - rationale: Euro normalization, vs. downside protection in US for a recession. It is more efficient to express this view via spread options than outright swaps, with chances of large adverse surprise

Finally a brief history of significant sell off in US rates since the 90s. Table below shows change in rates and spreads in bps (Equity is change in S&P in percentage points) over the period of the sell off. The rows highlighted shows cases where long end rates sold off while the policy rate was actually lowered.

All data from Bloomberg.

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