Halister News

(Bloomberg) -- Rates volatility skew shows bond yields in Europe and the U.S. could decline from record lows; deep out-of-money swaptions remain flat, indicating no turnaround is imminent, Bloomberg strategist Tanvir Sandhu writes.

• During last year’s bund tantrum, the spread between OTM payer and receiver vols proved to be a leading indicator of where bond yields are headed
  • The spread ticked lower before the yields reversed course from near zero during that period, described by Bill Gross as “short of a lifetime”
  • See chart here for spread against EUR 1y10y 100bp OTM receiver vol vs 1y10y 100bp OTM payer vol and 10Y swap rate

BUND SCARCITY

• In Europe, scarcity of bunds eligible for QE purchases are driving yields further down amid the disinflationary backdrop
  • German bonds maturing up to and including May 2024 yield less than ECB’s deposit rate of -40bps, disqualifying them for purchases
• Short-tail EUR gamma may be boosted in anticipation of ECB revisions to QE parameters, which is required for the ECB to extend purchases beyond current end-date of March 2017
  • Inflation markets show very little inflation risk premia with forward inflation swaps showing ECB inflation target of 2% may not be reached even in 50 years
• Tweak to ECB QE parameters will be necessary as bund curve pushes further negative, closing in on 33% issue limit
• Imminent move away from the capital key toward market- weighted purchases is unlikely as could face political opposition in core countries

U.S. RATES

• Steepening positions on the swaptions grid may accelerate on dovish Fed repricing; click here for spreadsheet showing change of normalized swaption implied vols (bp/day)
• See chart here for spread against USD 1y10y 100bp OTM receiver vol vs 1y10y 100bp OTM payer vol and 10Y swap rate
• U.S. OIS curve currently assigns 29% probability of 25bps rate increase in March 2017 vs 79% on U.K. EU referendum vote; EUR, GBP and JPY OIS curves pricing rate cuts over the next few months
  • Although June NFP at 287k was higher than expected, repricing in yield immediately after couldn’t hold as 2- mo. average is just 149k and 6-mo. 172k
• U.S. 2y fwd 1m rate has fallen ~24bps since the Brexit result retracing more than 61.8% from the post ’taper tantrum’ highs of 2013
• NOTE: Prices as of ~4pm BST on Friday

• 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.