Receive belly in 2/5/10 (3M fwd) fly in USD swaps versus paying the belly in a similar fly in EUR swaps.
Open ½ position at 54bp with the possibility of another ½ position at 64bp.
Levels: target at 20bp, stop at 79bp, roll down +2bp in the first three months.
Attractive entry now as relative fly is at stretched levels
In US swaps, the belly of the curve (5Y segment) has underperformed significantly since the Fed started signalling its exit last spring. Meanwhile, in Europe, the belly outperformed as deflation risks have increased. Overall, this has left the relative 2/5/10 USD/EUR fly at stretched levels in historical terms.
Breaking down the fly into a 2/5 box and a 5/10 box shows that the widening of the relative fly since spring 2013 has mainly been driven by a relative steepening of the 2/5 slope in USD swaps versus EUR swaps. Therefore, going against the widening of the flies is another way of receiving the 2/5 USD-EUR box, being positioned for a flatter 2/5 curve in the US or just receiving the 5Y USD-EUR swap spread.
We believe risk-reward for going against the relative underperformance of the US fly is attractive. We would be cautious about fading the move outright as we see a risk that a less dovish Fed could give way for higher rates in the near term. First, money market rates are trading with a significant gap to the median Fed funds projections. Secondly, the negative weather impact is about to fade, which could lead to a near-term bounce in data. The economic surprise index is low, providing room for a positive surprise in the near term. In 2005 the 5Y USD-EUR swap spread was 100bp wider, however, given the attractive valuation in the relative fly, we see limited risks should the US sell-off continue. In the case of the expected weather rebound being shorter and weaker than generally anticipated by the markets and the Fed there is plenty of potential for performance.
We still have a positive outlook on Europe and we expect the deflation scare, which is the key driver behind the rally in the 5Y segment in Europe, to fade, as we expect the spot inflation rate to trough out in March and then gradually rise. There is also a chance that the ECB will step up its actions to avoid a further drag in inflation expectations.
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