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

EUR: Deflation Macro Hedge Via Options
• The probability of a Japan-style collapse in
forward rates and the term structure has
increased in line with a 75bp drop in 5Y5Y since
the start of this year.
• STRATEGY: Buy 2.9%-2.0% 5Y5Y receiver
spreads at zero cost and positive carry.
The process of adjustment towards a lower
equilibrium long-term rate has been ongoing since
the start of this year. We have made the case for
lower 5Y5Y rates in a series of research notes (e.g.
“EUR: Long-Term Equilibrium Rates”, 5 March, and
“EUR: Equilibrium Rates Revisited”, 4 June). Here,
we provide ways to play this theme with controlled
downside risk.
Since the start of this year, EUR 5Y5Y has declined
by 75bp, reflecting a combination of rallying Bunds
and flatter term structure. Outright bullish strategies
such as 2.50% 5Y5Y receivers have performed very
well on the back of this underlying dynamic (+75%).
The main argument for such a strategy is based on
long-term fundamental projections (Table 1). Our
macro scenario implies another 50-55bp of decline in
5Y5Y rates (based on long-term average growth,
inflation and term premium). However, if we
substitute our forecast with realised inflation and
growth in Japan from the 1992-2002 sample, the
argument for receiving 5Y5Y rates is even more
compelling, as the equilibrium rate declines to around
1.4%. Note that JPY 5Y5Y ended 2002 at around
1.5%.
Chart 1: ECB and Long-Term Rates
4.50
5.50
4.00
ECB (LHS)
EUR 5Y5Y
5.25
3.50
5.00
3.00
4.75
2.50
4.50
2.00
4.25
1.50
1.00
4.00
0.50
3.75
0.00
3.50
2003 2004 2005 2006 2007 2008 2009 2010
Source: BNP Paribas
Table 1: Estimating Equilibrium Rates
Equilibrium Rates - BNP Paribas Scenario
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Average
GDP 1.2 0.6 1.0 2.2 1.0 1.5 1.5 1.5 1.2 1.2 1.3
CPI 1.6 1.4 0.7 1.8 1.5 1.5 1.5 1.5 1.5 1.5 1.5
Term premium 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5
Long term rate equilibrium 3.24
EUR 5Y5Y live 3.83
Equilibrium Rates - Japan 1992-2002 Scenario
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Average
GDP 0.3 0.1 2.4 3.2 -0.3 -1.5 -0.2 2.6 -1.6 1.7 0.7
CPI 1.0 0.7 -0.3 0.6 1.8 0.6 -1.1 -0.1 -1.1 -0.3 0.2
Term premium 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5 0.5
Long term rate equilibrium 1.35
EUR 5Y5Y live 3.83
JPY 5Y5Y End 2002 1.50
Source: BNP Paribas
Chart 2: EUR 5Y5Y volatility
90.0
0.50
EUR 5Y5Y ATM normal vol
85.0 EUR 5Y5Y SABR Alpha (RHS)
0.45
80.0
0.40
Strategy: We propose two investment ideas based
on the same underlying philosophy, i.e. a controlled
downside macro deflation hedge:
75.0
70.0
65.0
0.35
0.30
0.25
1) Buy EUR 5Y5Y 3.00% – 2.00% 1x1 receiver
spread at the cost of 80 cents. Buying
outright receivers is quite expensive due to
the strong performance of 5Y5Y forwards.
Also, the still-elevated level of ATMF vol and
alpha (vol of vol) makes outright solutions
relatively expensive (Chart 2).
60.0
0.20
55.0
0.15
50.0
0.10
2003 2004 2005 2006 2007 2008 2009 2010
Source: BNP Paribas
2) Buy EUR 5Y5Y 2.90% – 2.00% 1x2 receiver
spread at zero cost. Strategy delivers
negative P&L only below 1.1% at expiry.
Strategy has positive carry of 8 cents after
one year and 30 cents after two years.
Alessandro Tentori 16 July 2010
Market Mover, Non-Objective Research Section
29
www.GlobalMarkets.bnpparibas.com