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We are starting to see signs of pushback on overly dovish central bank expectations after global bond yields hit record lows in early September. While US-China trade tensions continue to wax and wane, with the latest headlines suggesting that China may be willing to buy more US agricultural goods ahead of the upcoming trade walks in Washington, and Brexit uncertainties continue to wreak havoc in the UK Parliament, nevertheless, market players have been paring back expectations for the upcoming ECB and FOMC meetings on 12 and 19 September respectively.
The latest escalation in US-China retaliatory tariffs on 1 September suggests the negotiation road ahead remains fraught with challenges. While the Fed is likely to deliver more rate cuts, it will increasingly fade as a salve for nervous financial markets. We could foresee a 25bps rate cut in September, one more 25bp cut by December and another cut in 1Q’20.
Well, with downside risks elevated, the premium-priced into US Treasuries is unlikely to abate quickly, though intermediate yields are 24bp too low, and a deterioration in market liquidity has likely contributed to the move: stay neutral on duration.
The curve appears flat even after adjusting for the rise in negative-yielding sovereign debt.
We discuss the June TIC data. Unwind longs in 5yx5y inflation swaps and turn neutral on inflation. Lognormality is imminent in a further rally. Sell delta-neutral strangles in 1Yx1Y and buy 1Yx1Y vs 6Mx30Y 25-delta receivers.
Convexity hedging continues spread directionality and has perhaps influenced the curve.
Trade tips:
Sell 25-delta strangles in 1Yx1Y
Positive vol/rate directionality is likely to emerge as lognormality re-asserts itself, most acutely at shorter rates.
Sell $500mn notional 1Yx1Y 25-delta swaption strangles (notification 8/17/20, maturity 8/19/21, strikes receiver @ 0.775% and payer @ 1.785%, premium 23.3bp). This trade requires frequent delta hedging.
Sell 25-delta 1Yx1Y vs 6Mx30Y receivers, duration weighted.
As a means of positioning for log-normality we also like conditional bull flatteners
constructed with mismatched expiries.
Sell $500mn notional 1Yx1Y 25-delta receiver swaptions (notification 8/17/20, maturity 8/19/21, strike @ 0.775% premium 13.6bp) versus $20mn notional 6Mx30Y 25-delta receiver swaptions (notification 2/18/20, maturity 2/20/50, strike @ 1.23%, premium 205.9c). Courtesy: JPM & OCBC
