MARKET MOVER - BNP PARIBAS - Investment Services India

US: Belly of the Curve is Rich, but…
• The flattening rally extended the richness
in the belly of the curve. As a result, 2s5s10s is
at an all-time low while 10s30s is close to its
steepest ever.
• These valuations could become even more
extended if rates briskly drop further but a
correction should ensue once rates begin to
stabilise as investors move out along the curve
to grab yield.
• STRATEGY: Once the rally shows signs of
running out of steam, consider the following
trades either in swap or Treasuries: (i) long the
2s5s10s fly (short the belly) and (ii) 10s30s
flattener. Alternatively, initiate conditional bullflatteners,
struck OTM, to ensure that they kick
in only if rates drop further and stay there.
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Chart 1: 2s5s10s Is at an All-Time Low, and
10s30s (Almost) as Steep as Ever
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-0.2
-0.4
Oct-09 Jan-10 Apr-10 Jul-10 Oct-10
Source: BNP Paribas
2s5s10s swap
10s30s swap (RHS)
Chart 2: The 5y Is Rich, but Not to the Same
Extent as in August
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1
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-0.2
The FOMC articulated its intention to provide further
accommodation if needed, laying the groundwork for
a new round of asset purchases. First, in anticipation
of the Fed’s nod toward easing, and later in response
to the confirmation of it, the Treasury market rallied,
at times even in the face of stronger equities. With
this rally, and the attendant flattening, the 5y rate has
made a new low and the 10y is within shouting
distance of one.
bps
30
20
10
0
-10
Current 6m ago 6w ago
Cheap
Rich
The belly of the curve has come out as the clear
outperformer in the rally, with 2s5s10s reaching a
new all-time low (see Chart 1). However, despite all
appearances, the belly has not eclipsed the wings to
the same extent it did in the August rally. We say this
because PCA indicates that the rich/cheap signals
are nowhere near the levels seen at the time. For
example the 5y, while rich on the curve, is only about
12bp rich and the 10y actually looks fair (see Chart
2), whereas six weeks ago they were rich by as
much as 25bp and 10bp, respectively. Therefore, it
would not be unprecedented for the 5y and 10y
sectors to extend their valuations in the event of a
further rally. In other words, if we get a brisk rally
from here, there is the risk that 2s5s10s could
tighten, and 5s10s as well as 10s30s could steepen
further.
So, what’s one to do? Our take on this is the
following: 2s5s10s and 10s30s would start to
“correct” once rates find a new (lower) range and
begin to stabilise. This is because investors will likely
extend out the curve in their search for yield once 5s
runs out of juice, similar to what happened with 2s.
-20
-30
1y 2y 3y 5y 7y 10y 15y 20y 30y
Source: BNP Paribas
Table 1: Cost of Carry is Not Punitive in Long
2s5s10s Fly and 5s10s/10s30s Flatteners
SWAP TSY
Source: BNP Paribas
2s5s10s 5s10s 10s30s
1m -0.9 0.0 -0.8
3m -1.5 0.6 -2.2
6m -2.5 1.2 -4.5
1m -0.7 -0.1 -0.9
3m -2.5 -0.3 -2.5
6m -5.2 -0.7 -5.1
With the 5y Treasury yielding somewhere around
1.3% already, we may not be too far from levels that
would prompt this move out on the curve anyway.
Indeed, the 5s10s curve has been flattening since
last Friday. Given that 2s and to a lesser extent 5s
Bulent Baygun 23 September 2010
Market Mover, Non-Objective Research Section
19
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