Choppy Trades

I expect the yields to be choppy. On one hand, the Fed has clearly determined to keep private sector borrowing costs low though a combination of quantitative easing and on the other hand, US dollar hoarding is bidding up the rates. If the rates are inching up, I do entertain the possibility of the Fed to increase the size and the pace of the Treasury purchase program beyond the initially announced $300bn over the course of six months.

That, I believe will put a temporary ‘cap’ on how high the Fed will allow yields to rise, but it will raise the upward pressure on implied volatility. Falling employment is gathering momentum in the US and Europe, now at 8.5% compared to 4.8% in the US and 7.2% in the Eurozone a year ago.

Over the past week, we had seen continued sell off on rates, but now the equity markets have done in consolidating the recovery and going forward, we will be able to make clearer assessment of what I call ‘second derivative’ of economic data. It would an interesting weeks to look forward to as most US banks will report in the second half of the month and the US Treasury should release the results of the ‘stress test’ on the banking system. The equity market has taken heart form the recent change in accounting rules and it would be good if some of the investment banks to post relatively good set of results, or if the announcement to exit TARP made. Let us keep the fingers cross.

It remains a big question if Fed will respond to 10y yields rising above 3% and that will lead us to the issue of credibility that could come back to haunt the Fed once the excitement about the start of a sharp economic recovery fades. The potential rise in implied volatility argues for a good delta hedging position, rather than buy-and-hold options. Volatility looks on the expensive side because yields are likely to be highly volatile not within the range. In response to this scenario, I like trades that have underlying in the 5-7 year maturity sector of the curve with relatively shorter expiry options, especially if the Fed’s Treasury purchase program slows or nears the end.

The situation could be far severe across the Atlantic. The ECB disappointed once again, easing its official refi rate by just 25bps. It is a missed opportunity to get ahead of the curve as it is continuing to buy time as it approaches the end of the traditional monetary policy easing cycle. I begin to see similar widening has already taken place in long dated BOR-OIS spreads with the sport three month differentials rising above 8bps last few days. Given this scenario, I disregard long-end euro rates to be attractive and any further rally in riskier assets would have positive effect on bond yields.