Trade Idea: 2015 Top Trade Ideas To Start (Rates only)

This is exclusively rates only piece. Others may follow soon.

Trade Idea #1: Buy EUR 10y30y 2% payer vs 10y5y 4% payer (Macro)

Rational: The Euro long end is ridiculously low. Lower than even Japan. Even the long-dated real rates are trading negative. This is a great trade to position for any correction whenever that happens. The extreme bottom right of the vol surface has developed fantastic vol carry vs. other points on the surface. The forwards are near-about the same (and historically they have been same). The spread has moved in negative correlation to 10y swap rates in post-Lehman era. Now it is near historical average. Given current level of rates, we will see a break-down of this correlation in a rally (i.e. the spread does not move much, the trade benefits from carry). In a sell-off the trade benefits from delta. The trade also benefits in a steepening scenario if Euro area moves further close to Japan. The adverse scenario is a bull flattening. Given the current levels, a large move in that direction is unlikely except a) another euro crisis b) strong yield chasing flows in to the longer part pushing 10s30s down. The trade will be net long gamma in any case. So a strong convex pay-out which costs nothing to carry.

Trade Idea #2: GBP 5s10s steepeners against  USD 5s10s (Cross market)

Rational: The convergence and the relative rally of GBP rates compared to USD last year was mostly a correction of the over-optimistic inflation pricing in GBP. However the underlying growth numbers for the UK has remain quite solid in terms of private consumption and capital formation, apart from a few misses in PMIs. This year, notwithstanding the election, this should continue or even pick up in speed. However, given the influence of the Euro area economies (largest trade partner for UK) , the pressure on inflation will remain on the lower side. Also the sensitivity of UK inflation to oil prices are comparatively low. This will keep front end rate hike pricings in check and may lead to a steepening in 5s10s on the back of solid economic growth. On the other leg, the US is more closer to a hike and the Fed may indeed go ahead with policy rate hike mid this year. This will lead a solid performance of this trade.

Trade Idea #3: 20y1y vs 4y1y steepener in swaps (Carry)

Rational: Unless we have something really surprising, Europe is potentially in the area of low-for-long for a while. That makes having a carry trade in the portfolio an absolute necessity. This combination is one of the sweetest spot, in terms of the carry generated per unit of risk taken. This spread in particular has also seen a sharp flattening from around 150+ bps to 85 bps area. This brings it back to about the same levels of the pre-crisis average. This presents an opportune timing to enter this trade.

Trade Idea #4: EUR Long-end ASW (Macro)

Rational: The long end ASW in Euro (swaps vs. Germany) has recently shown excellent correlation to vols, not only in rates, with equity and FX vols as well. Given the massive QE from ECB compared to Germany supply, and given the positioning in the market, the long end ASW should widen from here. In a rally, Germany long bonds have still room for yield compression and flows should work for the trade. In a sell-off, given the strong long positioning in rates, the hedging pressure will force ASW widening across maturities. Therefore the long-end offers a convex bet. Plus the correlation to vol, if continues, gives excellent way to position for long vol, as the trade will carry positive.

Trade Idea #5: Pay EUR in 10s30s (steepeners) vs USD (Cross-market)

Rational: The EUR 5s10s30s fly is too cheap, primarily driven by the too flat 10s30s leg. With the Japanification of Europe, the front-end of EUR and JPY swap curves have settled in to similar patterns. The anomaly lies in the long end. Any normalization from here will support this steepener on the EUR leg. On the USD leg, a possible re-pricing of rates (terminal rate) will keep the flattening pressure. Over the latter half of the past year, the major changes in the rate hikes pricing has been a front-loaded timing along with a lowered terminal rate. Any surprise in wage will impact the terminal rate upwards and will help the trade. On top, any long end carry related flows in to treasuries, buoyed by liquidity from ECB, BOJ and other central banks, will add to further flattening pressure even in a rally. The package can be done either through payer swaptions or through swaps. The swaps version carries better. A more efficient version will be expressing the views through the 5s10s30s fly (instead of 10s30s), which is almost flat to carry. However, the better carry comes at an increased risk of a 5y led sell-off in the US.

Trade Idea #6: Buy USD 2y1y 2%/ 2.5% payer spread (Macro)

Rational: The current ATMF is 50 bps cheaper than the minimum policy rate from the FOMC committee projection for 2017 as of Dec 14 (last available projection). This trade attempts to capture the good chance that the market is behind the curve from the FOMC. The structure takes advantage of the high payer skews to make a 4:1 pay-out ratio (max) if the view realizes. The carry is negative but tolerable.

Trade Idea #7: Buy 6m30y straddle in EUR vs 6m5y5y midcurve (Tactical)

Rational: The recent uptick in vols in most asset classes can extend its scope and bring back the missing vols in rates. Given the rates level, most of the action will be in the long end, in either direction. This trade presents an efficient structure to get long gamma on the long end while selling the expensive midcurve vol on 5y5y. The ratio of 10y to 5y vol is near historic high, making the midcurve attractive to sell. A premium neutral trade will be net flat vega, carries flat initially, and long gamma on the slope (and significantly long gamma on rates levels on the rally side). In recent time the 10s30s slope has been dominated by 30y (than 10y) and this presents an effective long gamma trade with little cost to carry. The downside is of course flipping correlation and 10y whipping around instead of 30y. The main scenario under which this can happen is an exogenous (led by the US perhaps) general sell-off in rates.

Trade Idea #8: Global Commodity Slump trade - Buy AUD receivers Vs USD (Macro)

Rational: The global commodity slump will stay here for a while. This is not helped by a Chinese slow-down, which may grow even lower than 7% depending on how the policy makers steer ahead with liquidity. The result is a global glut of liquidity and rally pressure on all commodity currency economies. The ones affected most will be ones with starting higher level of rates and large and relatively free economies. Australia is in the preferred choice. The sweetest spot in terms of carry should be in intermediate left. However even 10y or belly receivers should work. Outright, or against the USD rates (or GBP rates, i.e. economies in general poised to gain from lower commodity prices and higher liquidity).

Trade Idea #9: Currency Peg Trade - Buy DKK belly receivers against EUR (Macro)

Rational: The massive QE will put pressure on all currencies pegged to EUR. Unlike SNB, the Danish central bank has been maintaining peg since the Deutsche mark era. So it is indeed a tail event to remove the peg. However, the more plausible way to fight pressure from Euro is even more depressed rates. We have not yet seen the pressure on DKK in scale, evident in the FX reserve change in Nationalbank balance sheet vs SNB. When that does build up we will see further rate cuts, possibly into deep negative territory.

Trade Idea #10: Sell forward Euro HICP floor spread, strike 0% and -1% (Tactical)

Rational: The recent deflation fear made the Euro HICP 0% floor to blow out with a large spike in inflation vol. Given the ECB action and the still positive core inflation (and the downward price + wage rigidity), this is an opportunity to cash in on the panic dislocation. The risk is that we get stuck in policy inaction in case of further deterioration of the situation. The spread makes positive PnL till about -0.5% (note: ball-park pricing here). Even for Japan the average inflation prints between 2000 till before the 2008 financial crisis was -0.5% (and much better post crisis). The upside also includes a sharp correction in energy prices. Alternatively, the trade can be structured as a real rate trade, by buying matching floors on the Euribors.

Trade Idea: Long End ASW Widener vs. Long Vol

The  ECB QE in Europe can play out through either expectation channel (inflation expectation leading to long-end sell off) or portfolio re-balancing channel (leading to a general rally). Based on the numbers from my last blog on this, at least for Germany I expect the portfolio re-balancing to be stronger. So we can expect a rally or status quo in near future.

Given  the short end Germany already near zero there is little room left to push it down further compared to swap. In pricing in any uncertainties, there is bigger room on the long end. The negative carry rolling to the 2 year point (which is even more negative on yields) clearly indicates that. This is the same reason that we will have less of a steepening pressure on euro curves from QE (as opposed to what happened in the US). 

Add to this, the interesting relationship of the long end ASW to vols, in rates and across asset classes.Since turn of the last year, the Euro ASW spreads (spread to Germany vs. interest rates swaps) has shown remarkable correlation to volatility in levels. If the correlation is maintained this implies a possible way of trading convexity through this spread going forward. On the long end, 10y shows similar characteristics, but less pronounced.

30 year ASW already widened quite a bit, but given the uncertainties around Greece, there is good chance for further move. This is a fantastic opportunity to proxy a long vol trade, with positive carry!!

The 30 year ASW actually narrowed in 2008 blow-out, but that was presumably driven mostly by receiving pressure from exotics and ALM desks. This time that pressure should be absent, at least given the level of rates.

[UPDATE] The updated numbers and charts on ECB QE

Till Sep 16 (19 months from Mar 15)
Total purchase @60 B/ month) : EUR 1140 B
Total ABS (@~12 B/ month): EUR 230 B
Total EU Inst. (@12% of Addl Purchase): EUR 110 B
Implied Sov Purchase (remaining): EUR 800 B

Total Risk Sharing @12% (EU Inst, purchase by NCBs) + 8% (Sovs, purchase by ECB) = 20%. Rest sov to be purchased by NCBs
Sov Risk Sharing EUR 72 B out of 800 B

Tenor: Min 2 year, Max 30 year

Updated chart above(based on approximate current O/S and assumption of no net new issuance). In the US, QEs had generally had selling off pressure for yields. However, MBS yield generally lowered, and according to Fed research, the Fed QE resulted in holding substantial market share in MBS that explains the impact beyond expectation channel (through portfolio re-balancing effect). Given the high share of core for proposed ECB purchase, this might generate net rallying pressure for rates.

1. QE2 size of 600 B, calculated on current O/S debt
2. QE3 size of 45 B/per month assuming 19 months of purchase on current O/S debt

ECB QE: Finally The Credit Impulse Is Here?

European business is typically more dependent on bank credit than other developed economies. And in this regard, 2014 has been a study in contrast. While the loan demands from both businesses and consumers turned a corner start of the year, the banking system was stubbornly tight with supply. One can assume, among other things, one reason of that was the Asset Quality Review (AQR), that incentivized the banks to keep balance sheets in checks, perhaps at the cost of new business.

Now that the AQR is over. With the newly announced QE, and improving credit demand, Euro area is finally seems poised to realized the much expected creditimpulse economists have been talking about for years.  The January survey already shows signs of that. The QE could not have come with a better timing.

This present a big upside to Euro area economy as whole and particularly for European equities.

ECB: The Trillion Euro "Leak"

The last ECB "leak" we had was back in October I think, about a large corporate bond QE program that never happened. Actually could not, as there was not enough to buy!

The latest 1.2 trillion-ish "leak" also sounds a bit like that. The total market size I think around eight and a half trillion for euro area sovereigns. That is roughly 14% of outstanding amount, more if we exclude outstanding interests. On top the distribution is fairly skewed towards lower maturity. That can mean a much higher percentage for eligible securities. All depends on the details. On GDP basis at 10% is similar to US QE though. 

But the sell-off in rates and the moves in EUR/USD today, both cannot be right simultaneously. One of them has to correct. The late rally in European equities also interesting. Reports say energy stocks rallied most. Sounds more like short covering than optimistic rally.

We will know tomorrow.

ECB Meeting Primer: The Wise Men At The Table

The big ECB meeting on Thursday. It seems Draghi has almost managed to pull it off with QE with most of the stake holders. But I do no think it is signed sealed and delivered yet. The voting on the particular day can still have some fireworks left.

Personally Mr Draghi has all the incentives to go all in, irrespective of whether he ever runs for  the President of Italy. The question is about the rest. Below is the table showing the voting rights on 22nd Jan (the voting rights are changed since 2015 after Lithuania's accession to EU).

On the numbers, 1 signifies strong yes, -1 a strong no, and 0 is the nutral. This is based on recent news bytes.

On paper, it seems QE should go through. At least in some form. The real question is how it will look like? Full metal jacket or a run-down version. In rates, the best way to position for this event is pretty much tilted to longs. If QE happens there is a chance of selling off, but should be limited. In fact it may rally as well. But if no QE, rates are definitely going to rally out of deflation fear.

On EUR/USD it is a bit tricky. It is anybody's guess to what extent the recent euro weakness has been driven by QE expectation. If you look at the sharp drop in recent time from the 1.25 levels, it seems most of it is QE driven. So if no QE, at least the knee-jerk reaction to rally will be large. If we do have a QE, for a strong sell-off in EUR/USD we would really need a pleasant surprise from ECB, not the run-down version already priced in. So best path is to go long with sizes where you can take the pain. If it does rally, reverse the position on Greece election coming Sunday.

Macro: Europe Leaking, A Rate Hike to Fight Deflation

Things you must not miss reading this week

1) From the ever-impressive Flow team from JPM (via FTAlphaville) on how Europe is Leaking...
2) A brilliant observation from Michael Pettis on why PBoC should hike rates to fight deflation...

ECB QE: What to Expect When You Are Expecting!

Some quick charts on the expected QE from ECB

The first chart shows the maturity distribution of sovereign debts across euro are countries as well the US and the UK. Except Greece, most of the other countries in Euro area are front-loaded. However, Germany, with the highest capital contribution to the ECB has the least amount in the near maturity bucket.

Source: Bloomberg

The second chart shows the holding patterns across different sovereigns, split in to MFIs (monetary financial institutions including banks and central banks), Other FIs (insurance, pension funds etc), Other residents (individuals, non-fin corporates and governments social securities holdings etc) and finally non-residents. Note for Euro area countries, non-residents may include residents from other euro zone countries. Except for Spain, domestic banks holdings are comparatively low, given they are the primary player for QE auctions. Which is potentially significant especially if the other holders are sticky (held till maturity)

Source: Bruegel data base

The third chart shows a scenario of possible pressure from ECB QE. This assumes a EUR 500b size and focus on less than or equal to 3 year maturities (as indicated in previous similar policies, including OMTs), and ECB buys according to capital contribution. Also assumes incremental net new issuance will be small. The chart shows target purchase for each country as a percentage of total outstanding of the within target maturity bucket, as well as percentage of bonds held by MFIs (assuming, conservatively, 50% of the non-resident is held by other euro area MFIs). Note the significant pressure on Germany as well as France, Netherlands and Portugal. (Greece may not be in chart as ECB already holds significant amount).

We opened the year with continued sell off in EUR and flows in to bonds. The broader question on the long end rates is now NOT about Europe anymore, but about US. How much of the flows we have seen in to long end US in 2014 will continue. Will we see carry flows from Europe in US rates. And more fundamentally, what drove the US long end down? An expectation of subdued inflation in spite of improving economy (i.e. risk neutral rates remaining down) or is it purely flow driven compressing the term premium?

I hope to have a model to look in to this sometime. The answer will guide what kind of rates transmission on the long end we will see when the eventual lift-off happens. Will we see a sharp sell-off in the long end from reversing flows? Or will we continue to have a subdued transmission to the long end from Fed hikes, as we have seen in past hiking cycles progressively since mid 80s?