Bund Scarcity Boosting 30Y Swaptions as Curve Flattens: Analysis
(Bloomberg) -- Bund scarcity is eroding and enhancing returns from EUR rates markets at the same time.
- While the shrinking pool of bonds Bundesbank can buy has driven the 10s30s curve to the flattest in over a year, squeezing bank margins and forcing pension funds further out the curve, it is also fueling the outperformance of 30Y swaption gamma, Bloomberg strategist Tanvir Sandhu writes
- Spread between implied volatilities on EUR 3m30y and 3m10y swaptions has widened to 21bp/annual vs ~10bp/annual at the start of the year; the 10s30s curve is now 49bp, flattest since April 2015; see chart here vs bund 10s30s
- Abundant post-Brexit uncertainty may have shifted EUR rate vol equilibrium higher while top-left gamma will be driven by ECB policy shifts
- Eonia currently pricing 100% odds of a 10bps ECB deposit rate cut in Dec. vs 54% on U.K.’s EU referendum day, assuming 6.4bps Eonia-depo rate corridor
- Levels in EUR inflation markets are historically low and reflect little inflation risk premium
- Forward inflation swaps show ECB inflation target isn’t in sight in the next 50 years
- Any ECB move to relax QE rules amid the diminishing asset pool could put bund ASW at risk of repricing lower in summer
- ECB is considering loosening of QE rules to ensure enough debt is available to buy, euro-area officials familiar with discussions said, while Reuters reported any proposal to remove the capital key for allocating QE purchases isn’t currently under discussion
- Technical changes to ECB QE parameters have been inevitable and is nothing new as bund curve pushes further negative, nearing the 33% issue limit
- Bund scarcity concerns are most directly expressed in ASW which are inversely correlated to SX7P; see chart here for European bank selloff vs bund ASW widening
- Negative convexity dynamics is taking hold in the bund market, where the pool of bonds Bundesbank can buy is shrinking and increased purchases of what remains amplifies a bullish flattening of the yield curve
- That’s squeezing banks margins as existing higher-rate loans mature and new ones are issued at ultra-low rates
- With funding markets relatively stable and central bank backstops in place, short-term Brexit shock has been contained; however, margin squeeze and weaker euro-area GDP growth with ECB forecast cut by 0.5% pose operating risks for banks
- As returns get pushed out of curves and pension funds’ funding ratio deteriorates, organizations with large liabilities are being forced to increase their DV01 further out the curve; that’s driving incremental 10s30s flattening and in turn, 30Y gamma may continue to outperform
- Widening duration gap between liabilities vs assets amid falling yields spurs demand for duration for asset- liability matching
- NOTE: Tanvir Sandhu is an interest-rate and derivatives strategist who writes for First Word. The observations he makes are his own and are not intended as investment advice.
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