FxWirePro: Intricacies of UST and US Interest Rate Derivatives after FOMC

Although the US dollar and the US bond yields jumped after the Fed hiked by 25bp to 1.875% and indicated few more hikes this year, the reactions were inverted during the press conference, as Fed Chair Powell’s tone didn’t quite match the statements. The US 10yr treasury yield jumped from 2.95% to 3.01% immediately after the FOMC statement was released, but during the ensuing press conference, it fell to 2.97%.

Markets sustained to normalize as last week’s fireworks faded but options markets don’t seem to be pricing in the full divergence, with risk premia in EUR curve volatility still cheap on a relative basis; buy 3-month caps on 2s/10s in EUR versus USD.

The US Fed’s monetary policymakers foresee the projections for the longer-term neutral fed funds rate at 2.9%. The lowest estimate among meeting participants is 2.3%. With today’s step and the next one, which is highly likely to be announced in September, the Fed would approach the lower end of the neutral area. Here, they will have to switch off the autopilot.

The main perplexity is that rate hiking cycle is going to be stopped, and it would be determined by the data flow. Hence, the Fed would be extra cautious when the data flows in weak (in the autopilot mode their tendency was to see through soft spots and expect a return to satisfactory growth). In contrast, stronger data will be an incentive to deliver more. Of course, this policy also carries its risks. Monetary policy works with significant lags. Knowing when to stop thus has to rely more on forecasts and less on current data. The Fed’s task will thus be more difficult next year.

Implied volatility ratios in EUR versus USD are trading at a discount to realized and fair value, and the risk of a hawkish shift at the ECB is greater than near-term event risks in the U.S. This combined with our flattening bias in the U.S. and steepening bias in Europe argues for buying curve caps in EUR versus USD.

Hence, Buying of 3m single look 2s/10s CMS curve caps is recommended (observation date 9/10/18, ATMF strike @ 1.119%, premium 7.6c) versus shorting 40-45% more than buying notional of 3m single look 2s/10s CMS curve caps (observation date 9/10/18, ATMF strike @ 0.165%, premium 6.3c), premium neutral at inception. Courtesy: JPM & Westpac

Currency Strength Index: FxWirePro's hourly EUR spot index is inching towards 80 levels (which is bullish) while USD spot flashes at -108 (highly bearish ahead of today’s US retail sales data announcement) while articulating at 09:20 GMT.

For more details on the index, please refer below weblink: http://www.fxwirepro.com/currencyindex

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