Market Mover - BNP PARIBAS - Investment Services India

Ramifications for Rates, Swap Spreads and Vol
The magnitude of losses implies that this could turn
into a mini crisis. Depending on the interaction of the
bearish effect of mortgages and some flight-to-quality
flows, the net effect could be neutral to mildly bearish
for duration. However, due to mortgage selling as
well as a crisis-like situation, swap spreads should
widen. In the event of a flight to quality, Treasuries
should be the primary beneficiary with 2-5y swap
spreads leading spread widening in the process. On
the other hand, if the selling of mortgages brings with
it selling/paying in Tsys and swaps, that could turn
into a self-feeding cycle with most of the flows
happening in the 5-10y part of the swap curve,
thereby widening spreads in that sector. Historically
episodes of MBS OAS widening have coincided with
5y swap spread widening, supporting our intuition
(Chart 1). In short, we advocate being long 5y swap
spreads.
In the immediate aftermath of the FNM/FRE
announcements, vol and payer skew were slightly
better bid but the impact has been very mild, and not
out of line with what one would expect in a sell-off
(recall that the rise in rates on Wednesday was
triggered by a strong performance in equities in
response to the Greek rescue discussions, as well as
the tail in the 10y Treasury auction). In contrast, with
rates virtually unchanged on the day after, vol has
been easing off. However, given its already low
levels relative to the range during the crisis (Chart 2),
we expect any slide in vol to be rather muted,
whereas any uptick should be more pronounced if/as
mortgage selling gives rise to a self-feeding backup
in rates, steepening the curve and widening swap
spreads. In view of this expected asymmetric
behaviour, we like being long gamma vol on 5y and
10y tails.
Anish Lohokare / Bulent Baygun 12 February 2010
Market Mover, Non-Objective Research Section
19
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