Risk reversals
January 14, 2021
–Yields retraced a bit of the recent surge, with tens down 5 bps at 108.8. The combination of a strong 30-yr auction and Brainard’s comments provided midday support into the close. Key from Brainard:
The economy is far away from our goals in terms of both employment and inflation, and even under an optimistic outlook, it will take time to achieve substantial further progress. Given my baseline outlook, I expect that the current pace of purchases will remain appropriate for quite some time.
The important voices have dismissed the idea of the Fed tapering buys. Brainard, Clarida, and certainly Powell today. One other important snippet from her speech indicates the Fed is prepared to look past upcoming higher inflation data:
Inflation may temporarily rise to or above 2 percent on a 12-month basis in a few months when the low March and April price readings from last year fall out of the 12-month calculation, but it will be important to see sustained improvement to meet our average inflation goal.
–Powell’s term as chair ends Feb, 2022. Whether his term is extended or not, employment has been elevated to the prime mandate of the Fed.
–Implied vol declined yesterday. In dollars, the seller of EDU3 9950c added with 20k more at 16.5, bringing his total to 70k (settled 18.25 vs 9944.5). Long dated straddles lost 2.5 to 3.5 bps. Vol on the US contract slipped to a recent low as the cash bond yield retraced 6.7 to 181.8. USH 169 straddle settled 3’18 or 7.6 vs 169-12. One bond (USH1) point is worth about 4.75 bps. Given recent strength in grains, copper, oil, etc, bond vol seems quite low, even if the Fed is willing to look past price hikes. BBG noted a new high in the 5y 5y inflation forward in Europe. And of course there are pockets of rampant speculation in equities reminiscent of the late 1990’s. See PLUG, GME, etc. In dollars, the hedge against inflation is taking place through midcurve risk reversals. Art Main of TJM summarizes:
We also continued to see interest in downside via risk reversals in midcurves as follows:
+10k 3EH1 99.00/99.625 risk reversal at 2.5 (+p -c) position add ~ 30k
+10k 3EM1 98.875/99.625 risk reversal at 5 (+p -c) position add ~ 32k
So this brings total positions across all structures to greater than 180k as we saw similar flows over the last two weeks via the following structures:
+40k 0EM1 99.25/100.25 risk reversal at 2.5 (+p -c)
+50k 2EH1 99.25/100.25 risk reversal covered 99.71/99.805 delta .05/.04 between 0.25 and 0.5 (+p -c)
+30k 3EH1 98.875/99.625 risk reversal covered 99.305 delta .10 at 1 (+p -.c)
