MARKET MOVER - BNP PARIBAS - Investment Services India

are more or less hitting a brick wall, 5s10s will dictate
what happens with 2s5s10s, i.e. a flatter 5s10s will
likely widen 2s5s10s.
Applying a similar thought process, we expect the
back end of the curve to flatten as rates settle down.
Treasury 10s30s is trading at 118bp, some 6bp shy
of the all-time high of 124bp in August. In swaps, the
corresponding figures are 79bp (current) vs 89bp,
respectively.
Table 1 shows the carry of these positions. The
2s5s10s fly and 10s30s flatteners carry negatively
but not excessively so. For example, the Treasury
10s30s has a 2bp cost of carry over three months.
On the other hand, 5s10s has positive carry for
Treasuries and negligible carry for swaps.
So, just wait until rates settle down and then act?
Easier said than done, we know. What should we
take as the signal that the rally is running out of
steam and a new range is being established?
Unfortunately, there is no magic formula here. To
circumvent that rather inconvenient challenge, we
make these trades contingent on rates remaining low
for some time (i.e. stability). More specifically, we
recommend conditional bull-flatteners using receivers
struck OTM, indeed below spot levels. This ensures
that we get into the flatteners if rates drop further and
stay there for some time. To state the obvious, the
conditional trade does not protect against a
steepening scenario at low rates.
5s10s is trading at 103bp spot, and 99bp 3m forward
as of this writing, indicating that the carry/rolldown
effect is 4bp against a flattener. Furthermore, ATMF
gamma vol on 10y tails is more expensive than 5y
tails, and receiver skew on 10s is higher, which
means that there is an additional cost to be paid for
doing the trade in conditional form. As an example,
let’s suppose we choose the 5y and 10y strikes 30bp
below the forwards for a 3m bull-flattener. The
breakeven in this case is about 4bp below the
forwards, i.e. the curve has to flatten by 4bp relative
to the current forwards (8bp in total, relative to spot)
to recoup the premium paid upfront. This translates
to a 5s10s spread of around 95bp. For reference, at
the end of August, 5s10s traded in the 91-95bp area
for a brief period once 5s stuck around their lows.
In other words, the conditional flattener lends itself to
the scenario we are depicting in which rates drop and
stay low, establishing a new range and prompting
duration extension trades.
Bulent Baygun 23 September 2010
Market Mover, Non-Objective Research Section
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