Tuesday, 8 October 2013

Market update 8th October 2013

So today was interesting, at least on the very short end of the yield curve, 1-month T-Bills rocketed as high as as 0.355%, while many are saying this is a rather insignificant move (and it kinda is) it shows how quickly the front end can move, the 1 month benchmark has been stuck to 0% since 2009, and barely budged throughout the European Crisis (ofc) and were only a little weaker during the "fiscal cliff" so in contrast it is quite big.

MTD US 1 month Benchmark yield. Reuters

Notably, the front end of the curve inverted up until about 1Y 9M (the 2yr-1m reached 2bps at one point though!)

US yield curve - Tradeweb

Here we can see the bills yields, the benchmark was up 17bps when this screenshot was taken

UST bills Quote screen. Bloomberg

Furthermore, for the first time, the yield on the US 1 month was > than the 1 Month LIBOR

US 1M TED spread

But these moves higher in US interest rates should be impacting the USD after all interest rate differentials have widened and the 2 Year Soverign spread has moved to 20bps from 12 or so a few days ago. To consider this, the last time the 2 yr spread was at 20 bps the EURUSD traded at 1.3150

EURUSD vs US-DE 2 YR spread

Divergences like this don't tend to last long, and either the US yield is going to drop suddenly(tightening the spread), or the EURUSD is going to drop. Hard.

So here is another look but considering the 2 Yr futures so we can see trade potential

EURUSD vs Bond futures

So here we have the US 2 YR futures contract and the German Schatz future (2yr ish) nominal spread overlayed in green. below we can see a visual representation of the spread by having them overlayed on the same axis.

At a current nominal spread of 0.38 points we are looking to buy US 2's and Short DE 2's. This sythetically puts us "long" the green line.

Simultaneously by shorting the EURUSD we would be hedged against interest rate risk and we would then need to wait for them to converge.

In terms of my weighting I haven't made it a perfect hedge as I have a personal downside bias in the EURUSD. So lets consider how to enter this trade.

Long  1000 TUc1 (US 2 YR) at 110.015

Short 1000 FGBSc1 (DE 2yr) at 110.395

Short EURUSD 1.3595 (Yellen just hit the wires)

Positioned like this, a tightening to 0.20 points would result in profit ~ £201.71 (at GBPUSD 1.6083 and EURGBP 0.8438) , at 0.30 points it would be £128.21

Now we need to consider the EURUSD position at this point a €10,000 notional short from mkt (#spot ref 1.3570) , yielding $1 (0.62.2p) per pip would result in a profit of $300 (~£190) if/when the EURUSD dropped to 1.3295.

If the trade worked perfectly then I believe as opposed to a simple meet-in-the-middle idea the EURUSD drops to catch up with yields then the rough area of conjoining would be ~ 1.327 or 0.30 points at this scale. 

Resulting in a profit or £390 or so depending on GBPUSD fx rate. This is a simple look using 1 contract in the future and a 10k short in the EURUSD but can easily be scaled up and adjusted depending on bias.

Worst case, the spread between the EUR and the 2Yr sov spread widens. 

Roughly speaking if it widens to 0.5 points then the potential loss is ~£150 although this would imply a EURUSD of 1.2970, the EURUSD needs to be below 1.3345 for the trade to BE, so it can be seen that I've quite substantially weighted towards the EURUSD as opposed to the spread. 

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