Trade Idea: How To Play the Fed Hike in the Short End

In case you have missed the latest piece from the very useful IMFDirect blog , I suggest you pay a visit.

 

The basic argument is what I have been pointing out. The data driven stance of the FOMC for future rate hikes DOES NOT guarantee a given lift-off date, and more importantly not a steady 25bps per quarter hikes we have seen in past hike cycles. Fed will perhaps hate to reverse hiking once it starts, but I do not think they will hesitate to hold (with proper communication). And that makes the case more important. From the piece above:

The paper finds that—under conditions of still recovering demand, low inflation, and the policy interest rate near zero—the balance of risks favors more patience to start interest rate increases. The consequence of such a policy would still mean gradual, albeit slightly steeper, path of subsequent rate increases and a modest planned overshooting of inflation.

 

See the chart below (from IMF blog)

 

 

 

In case you accept this, that means, we may have some interesting move in the short end of curve once market stop obsessing about the lift-off date and start pricing in the reality. I suggest trading a 3y2y vs. 2y2y steepener in the midcurve space. Buy 1y2y2y payer vs. selling 1y1y2y. This has a fantastic carry (around 6 times the delta risks) mostly coming from the curve roll down. The market prices a large hike in 2y between Dec 16 to Dec17 than between Dec17 to Dec18. If the above theory holds this is going to correct. The trade is mostly flattish on parallel moves.

 

The 3y2y vs. 2y2y slope bottomed out at around 25bps back in Jan and rising since then, currently 40ish. The recent peak was 108 just after the sell-off during 2013 Taper tantrum.