Market Economics | Interest Rate Strategy - BNP PARIBAS ...

US: Supply Could Affect Swap Spread Curve
• The Treasury followed through with the
cuts in issuance sizes that were widely
expected by the market. It has given explicit
guidance as to how/where/when further cuts
will come.
• Expect 2y, 3y and 5y auction sizes to go
down USD 10bn by September (USD 2bn cut at
each auction), and the 7y by USD 5bn.
Treasury expects to change little the 10y and
30y sizes.
• We explore the relative issuance between
the front end and back end, and its possible
effect on the 2s10s swap spread curve. We
also recap the overall effect on outright
spreads, and how supply explains the
cheapening in the 10y and 30y benchmark
points versus the hump of the curve.
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Chart 1: Spread Curve Inverting More than
Implied by the Move in OIS/Bor
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2s10s Spread Curve
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Model (using OIS/Bor)
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Jan-10 Feb-10 Mar-10 Apr-10 May-10
Source: BNP Paribas
Chart 2: Longer-Term Model of Spread Curve
• STRATEGY: In the short term, fading the
inversion in 2s10s spread-of-spreads is risky
and should be hedged with OIS/Bor. In the long
term, expect the supply factor to work against
you. Also, continue to position for wider swap
spreads and expect the hump of the Tsy curve
to stay historically rich vs 10s and 30s.
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40
20
0
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2s10s Spread Curve
Model (Using OIS/Bor and 10y Rates)
Summary of quarterly refunding announcement
Supply was cut USD 2bn in the 3-year, USD 1bn in
the 10-year and left unchanged in the 30-year. This
highlights how the cuts will be skewed toward the
front end, because Treasury still wants to extend the
average maturity of the debt, although "any further
extension will likely occur at a slower pace than what
has been observed over the past year".
The guidance it gives is that "cuts in the offering
amounts in shorter-term securities could be in the
range of 25 percent by the end of the [current] fiscal
year. Reductions in the intermediate portion of the
curve could be as much as 15 percent”. In its supply
calendar, it specifically forecasts 2y, 3y and 5y
auction sizes to go down USD 10bn by September
(USD 2bn cut at each auction), and the 7y by USD
5bn. Treasury expects to make little change to the
10y and 30y sizes.
There seems to be a desire to keep the share of bills
in the debt universe to 24% and coupons to 68%
(TIPS being at 8%). This backs up our forecast that,
despite Treasury's previous desire to cut bills, this
will not prove likely since the artificially increased
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Sep-00 Mar-03 Aug-05 Feb-08 Jul-10
Source: BNP Paribas
demand in bills (due to money market holding rules)
will need to be met with adequate supply.
Impact on the 2s10s swap spread curve
The recent risk-aversion trade has widened OIS/Bor
and inverted the spread curve further. The link
between the two is shown in Chart 1, and it seems
that the spread curve has flattened more than implied
by 1y OIS/Bor. This is not to say that one should step
in front of the Greek tragedy that is unfolding,
although for those who do see an opportunity, one
possible RV play would be to trade the spread curve
steepener and hedge this with 40% of the DV01 risk
in 1y OIS/Bor spreads (as implied by the model beta
of 0.4).
Looking at the spread curve from a longer-term
perspective (Chart 2), we find that the main factors
driving this are the level of 10y rates and OIS/Bor.
Suvrat Prakash 7 May 2010
Market Mover, Non-Objective Research Section
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