Market Economics | Interest Rate Strategy - BNP PARIBAS ...

US: Could the Short End Have a Pulse?
• With inflation concerns gaining more
attention in Europe and UK, more investors are
asking if the US could follow suit, sooner or
later, despite lacklustre growth and high
unemployment so far.
• While an inflation-induced selloff is not our
base case, the market could nonetheless get
jittery – as it is prone to do – in response to any
sign of a pick-up in headline inflation, pushing
rates higher.
• STRATEGY: Consider defensive bearish
strategies using mid-curve puts on red
Eurodollars. We recommend buying mid June
9875/9825 put spread @ around 12 as an
effective strategy with a 4:1 payout.
With the ECB officially turning more hawkish in view
of better-than-expected data (especially in Germany)
and inflation becoming a more pressing concern in
the UK, the question we are hearing more and more
is, could the US be far behind? We are all familiar
with the counter arguments: high unemployment,
absence of wage pressures, still-deleveraging
consumers, depressed home prices and housing
activity, a core inflation reading a far cry from being
anything that smells of inflation, and on and on. Yet,
the market does sometimes get very fickle, and
responds disproportionately if signs of a nonconsensus
scenario begin to emerge. This is
especially true after a period of relatively limited rate
movements, as has been the case since mid-
December. So, even though we are firmly in the
camp that inflation is a non-issue in the US for the
time being for all the reasons cited above, we should
still be cognizant of the risk of an abrupt selloff.
With that in mind, we canvas the spectrum of bearish
trades. In the risk scenario we depict, where market
sentiment moves toward inflation and prices in
potentially aggressive Fed action against it down the
road, we expect the 18mo to 3y part of the curve to
take the brunt of the selloff, depending on how soon
the market perceives the beginning of any potential
tightening. We want limited downside, so our focus is
on option strategies. The most obvious choice is to
simply buy a put on red Eurodollars, but we do not
necessarily want to spend too high a premium to
cover a really long period to expiry. This leads us to
mid-curve options.
We will illustrate the idea using mid June puts. The
red June is currently trading at 98.77. The rolldown
Chart 1: Spread between 5 th ED and Fed Funds
4
3.5
3
2.5
2
1.5
1
0.5
0
-0.5
-1
-1.5
Nov-90
Nov-91
Nov-92
Nov-93
Nov-94
Nov-95
Nov-96
Nov-97
Nov-98
Nov-99
Nov-00
Nov-01
Nov-02
Nov-03
Nov-04
Nov-05
Nov-06
Nov-07
Nov-08
Nov-09
Nov-10
Source: BNP Paribas
1200
1000
800
600
400
200
0
-200
-400
Chart 2: PnL Chart of the Put Spread
96.0
96.2
Source: BNP Paribas, Bloomberg
1/20/2011
3/8/2011
4/24/2011
6/10/2011
96.4
96.6
96.8
97.1
97.3
97.5
97.7
97.9
98.1
98.3
98.5
98.7
98.9
99.2
99.4
99.6
99.8
100.0
over three months is 28bp. While hefty, this level is
close to the median of the history of the rolldown
over the past year. One would not gain anything in
terms of rolldown by moving the trade to the March
or September contract.
We select strikes in such a way to increase the odds
of the trade making money in a reasonable selloff.
Chart 1 shows the historical spread between the 5 th
Eurodollar contract and fed funds. By June 2011, at
the expiry of the option, targeting a spread above
100bp seems reasonable in the event of a selloff.
This suggests that the Jun 2012 contract should be
priced below 98.75. We prefer a put spread, rather
than a put at 98.75, for better % returns on the
premium spent. Specifically, we recommend buying
the 9875/9825 put spread, paying around 12 ticks. At
or below 98.25, the maximum payout is 4.2:1 for this
trade. For comparison, an outright 9875 put would
have a 2.3:1 payout ratio at the same level. To reach
4.2:1 payout ratio with the single put, the June 2012
should trade at 97.9 in June 2011, close to a 200bp
spread over fed funds, which is clearly a higher
hurdle to clear.
Bulent Baygun 20 January 2011
Market Mover, Non-Objective Research Section
33
www.GlobalMarkets.bnpparibas.com