Draghi's Master Plan Keeps Summer Rates Volatility Suppressed

  • Positive carry trades in vogue, with peripherals favored
  • Hedging via swap spreads may increase as consensus builds

The European Central Bank has given the green light to summer carry trades as volatility remains contained and the policy meetings in September and October are likely reserved to outline further details on quantitative easing, buying more time for carry, Bloomberg strategist Tanvir Sandhu writes.

Italian bonds offer one of the most attractive carry and rolldown across European government bonds, with the five-year bucket three-month carry and roll at 16 basis points and one-year at 70 basis points. That compares with one-year of 30 basis points for 10-year bunds and 42 basis points for bonos. 

Given that carry trades are implicitly short volatility, two-year Italy stands out as the most attractive on a vol-adjusted basis. Since earning the full carry and rolldown assumes an unchanged yield curve, adjusting for volatility will provide a more realistic indicator of profitability.

As the hunt for carry grows and becomes the consensus trade on the assumption of low volatility, hedging with German 10-year swap spreads may increase given the correlation to risk-off markets, while long EUR rates volatility suffers negative carry and remains sluggish.

  • EUR rates gamma is approaching all-time lows, with 3m10y at 2.58bp/day (straddle priced indicatively at 155bps versus 170bps prior to ECB)
  • Near-term, bund futures may temporarily rally (with 162.93 the 50% of the June/July sell-off) but ultimately be a bull trap with the Sintra speech sell-off a wake-up call to already reduced QE purchases in Germany
  • While the fair value for bunds was only modestly rich prior to Sintra (versus extreme valuations prior to 2015 bund VaR shock), a further selloff toward 70bps area may see bunds cheapness stretched given diminishing inflation risk
  • The probability of persistently low headline inflation priced in the options markets remains a coin toss, while the risk of deflation has been effectively priced out, which will be likely used as one of the main reasons for paring back of QE
  • President Mario Draghi mentioned at the ECB press conference on July 20 that monetary stimulus would come under review in the autumn, but failed to specify a date in order to prevent market pricing being focused around exact dates
  • NOTE: Tanvir Sandhu is an interest-rate and derivatives strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice
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