FxWirePro: U.S. treasury yields and swaps recommendation

US yields sold off modestly over the week, with 10y yields rising to 2.23%, as risk assets stabilized amid little economic data. The Fed will also be updating its fed funds rate forecasts and adding one for YE 18, which at 3.25-3.5% for most participants should be close to the long-run projections. We believe the price action following the FOMC meeting will be driven largely by changes to forecasts for 2015 and, to some extent 2016.

We maintain our recommendation to sell 3m5y straddles; in our view, the current implied volatility at 80 bpv is too high, given expectations of a gradual hiking cycle. The trade should be profitable as long as three months from now 5y swap rates are 1.4-2.0%, which should hold as long as the Fed continues to emphasize that we are getting closer to the point of lift-off, followed by a gradual path of short rates.

Swap spreads: We are neutral on swap spreads in the front end and the belly of the curve. We believe that current levels are largely justified by dealer balance sheet constraints. Long-end spreads remain susceptible to sharp risk-off moves because of the potential for insurance receiving. Over the medium term, we continue to expect them to drift wider. However, we would not recommend outright wideners over the near term.