Friday, April 17, 2015

Widow Maker : The Latest Avatar?

Ever since Draghi declared "whatever it takes" in 2012, traders have constantly put their bets on euro rates long end normalization. The arguments were many - take your picks from below 

1) a pick up in credit situation (touted since 2012, there are early signs appearing this year)
2) resolution of debt crisis (it is perhaps not a "crisis" any more, but certainly not resolved either)
3) pick up in growth (we have seen consumption recovered a bit, but not enough) and general good feeling/ green shoots
4) add your custom reason here ... (bond vigilantes, anyone?)

Since then, the euro long end rallied a 170-180bps (swaps and Germany long dated papers). To be fair the rally started in full throttle in 2014. But even then, the euro long end normalization trades have hardly paid off. This year itself, the euro long end rallied another 70+ bps, with no sign of a reversal. The question is will the inflation and QE chase each other out and make the long end "normalized" sometimes in near future, or are the long ends already normalized at current levels and we do not know it yet.

In Japan the 30y swap trades around 1.3% area, whereas in Europe it is down to around 0.70%. The 5s30s yield curve spread at 110bps for Japan vs a meager 55bps for Euro. And the reason is as below

Japan and Euro area has similar amount around 10y and more, but Euro area is more skewed towards long dated. On top, ECB QE has had a much stronger impact than BoJ, partly because initial BoJ QEs were weak in comparison. In a yield chasing environment, 10y point on JPY curve sounds a more suitable comparison point for 30y euro swaps. And to get there, we have some ways to go. The JPY 10y swaps trade at 0.50%, and the JPY 5s10s at 25bps. To do a Euro long end normalization trade two things are required. A stop loss large enough to see the bottom, and patience. 

So the message is simple: if you are not in a downside protected positive carry trade with a longer term trading horizon, you probably should not be in it.

And for this same reason (economies aside), UK long end is more vulnerable to further rally than the US.

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