Trade #1: Positioning for Fed: Pay 2s5s in swaps (pay 5y point).
Rationale: After the latest minutes release from FOMC last week, we have seen a huge positioning for a rate normalization (we discussed this before). But in some sense, normalization in dollar rates already started a while back. Although the policy rate is still stuck at very low level, the shadow rate (Wu Xia shadow rate), a representation of effective policy rate has tightened a lot since late 2014. Also in nominal space, although the rates levels are historically low, we have seen considerable normalization in slopes and curvature.
As the charts show (the left: range since 2000; right chart: range of average rates through different rates cycle - hike, cut and neutral, red triangles mark the current values; data from FRED and Bloomberg), in most measures of higher orders, the current yield curve is not far from normal. There is little scope for a further significant flattening of the curve to price in further rate hikes expectation. Add to this, there has been a large increase in short euro dollar positioning lately for FOMC. Given this, the best way forward is not to position for the next hike, but rather the ones that may follow. The next round of normalization (if at all) will be in rates levels and especially in long term equilibrium rates (terminal rate). The ideal way to position for this to take advantage of the historically tight 2s5s. The spread difference prices roughly only one rate hike between 2 year and 5 year. This levels are usually seen around recession time - or a scenario of "few and done" as some may argue. If you do not believe we have a recession around the corner, this is arguably mis-priced. On top this can benefit asymmetrically for a much more dovish Fed than expected, as the front end positioning unwinds.
Trade #2: ECB on Thursday : Long Euro vs GBP in FX
On Thursday, ECB is little expected to surprise the market. Euro area inflation print continues to print in the negative territory. However, given the recent recovery in commodities, with all probabilities the ECB economic forecasts on Thursday will not paint a dire picture requiring immediate further policy measure. This should put technical pressure on Euro for a tactical leg upwards. This is best expressed against GBP whose recent strength and technicals make it poised for a corrective move. Alternative positioning is on the long end of the Euro rates as discussed above.
Rationale: After the latest minutes release from FOMC last week, we have seen a huge positioning for a rate normalization (we discussed this before). But in some sense, normalization in dollar rates already started a while back. Although the policy rate is still stuck at very low level, the shadow rate (Wu Xia shadow rate), a representation of effective policy rate has tightened a lot since late 2014. Also in nominal space, although the rates levels are historically low, we have seen considerable normalization in slopes and curvature.
As the charts show (the left: range since 2000; right chart: range of average rates through different rates cycle - hike, cut and neutral, red triangles mark the current values; data from FRED and Bloomberg), in most measures of higher orders, the current yield curve is not far from normal. There is little scope for a further significant flattening of the curve to price in further rate hikes expectation. Add to this, there has been a large increase in short euro dollar positioning lately for FOMC. Given this, the best way forward is not to position for the next hike, but rather the ones that may follow. The next round of normalization (if at all) will be in rates levels and especially in long term equilibrium rates (terminal rate). The ideal way to position for this to take advantage of the historically tight 2s5s. The spread difference prices roughly only one rate hike between 2 year and 5 year. This levels are usually seen around recession time - or a scenario of "few and done" as some may argue. If you do not believe we have a recession around the corner, this is arguably mis-priced. On top this can benefit asymmetrically for a much more dovish Fed than expected, as the front end positioning unwinds.
Trade #2: ECB on Thursday : Long Euro vs GBP in FX
Rationale: The latest balance of payments data (released end of May for March 2016) from ECB points to continued net outflow from Euro area fixed income markets (chart below; data from ECB database). This flow is massive. The Euro area has seen a net outflow of almost €580B since 2015 in debt instruments. This is roughly at $40B per month, a pace higher than the FX reserve depletion of PBoC of China. This, from pure flow point of view, puts upward pressure on long end yields. However, the QE from ECB has been more than effective to counter that. But on one hand, as this exports the downward pressure on yields to international bond market (similar to Japan), it also makes the long end yields vulnerable to technical sell-off from time to time. However, with FOMC around the corner and the negatively carry, it may not be the perfect timing now to position for such a move.
On Thursday, ECB is little expected to surprise the market. Euro area inflation print continues to print in the negative territory. However, given the recent recovery in commodities, with all probabilities the ECB economic forecasts on Thursday will not paint a dire picture requiring immediate further policy measure. This should put technical pressure on Euro for a tactical leg upwards. This is best expressed against GBP whose recent strength and technicals make it poised for a corrective move. Alternative positioning is on the long end of the Euro rates as discussed above.
Trade #3: Brexit hedge: Buy EUR/USD calendar vol spread in straddle
Rationale: The basic idea for this hedge is to avoid directionality and buy gamma instead. Since the cross-asset vol spiked early this year, we have witnessed most vols across asset classes getting cheaper (the chart shows 3m rolling average of number of 2σ moves in each asset class for one-to-one comparison; data from Bloomberg). Also, rates and equities vols are much cheaper than FX and commodities in general. Still it makes sense to express this hedge in FX. The relative performance of FTSE (compared to DAX, Euro Stoxx or even S&P) has been quite impervious to Brexit hopes and fears, and there are few reasons to assume we will see an effective hedge in the equity space.
However, in FX space, there appears to be a mis-pricing: Given a Brexit outcome, it is hard to believe we see a large move in the cable, without any commensurate move in EUR/USD. And EUR/USD vol, especially the calendar spread at flat log-normal vol points, is a much cheaper option to position for a hedge.
Trade #4: Brexit upside: USD 5s10s steepener vs GBP
Rationale: The spread between USD and GBP swap curve slopes, e.g. 5s10s, is at historical low. 5s10s in dollar rates flattened a lot since last year pricing in an expectation of rates normalization (as discussed above). But what is still quite a bit away from "normal" (apart from the rates levels of course) is the level of curve risk premia - for example the ACM term premium - at historical low. Yield curve slope (adjusted for the level of rates) captures a large component of this term premeia. And it appears even conditional on the much lower term premium, we have some parts of the yield curve relatively flatter, like 5s10s vs 10s30s in dollar rates.
On the sterling rates side, however, all these actions have been missing - partly because of softer economic data, and partly because of the risk of a Brexit. This has led to a historical level of the 5s10s spread in dollar vs sterling rates. The USD leg has little further room to flatten, while a remain outcome in Brexit may lead to some bear flattening of the sterling rates. This can further be supported by better than recent prints for UK economic data once the Brexit is over.
This is also an asymmetric positioning. Even if we have a Brexit outcome, there is a good chance of dollar spread sharply steepening in a risk-off mood, and sterling undergoes a panic bull flattening. The structure above will be benefit from that.
The ideal structure is at least the GBP leg through swaptions, i.e. conditional bear flattener (sell the payer on 10s). Even though it is themed around Brexit, longer expiry is preferred. to take advantage of bull flattening in adverse outcome and better economic data in favorable outcome as discussed above.
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