FxWirePro: Hunt for relative betas in Fed hiking cycle - Buy ATMF straddle 3Mx5Y versus 3Mx30Y volatility

Although the Fed hiking is expected to drive price action, with a March hike now essentially priced in, speculation regarding the near-term pace of tightening is likely to take center stage.

Along those lines, our Treasury strategists note that though at this point the bar to pricing in four hikes this year is rather high, this week’s events evidence a committee uneasy with the risk of overshooting full employment and generating longer-run inflation risks. 

At the same time, the underlying dynamics driving low terminal rates have not changed materially.

With the market likely to focus on the pace of rate hikes rather than the March meeting going forward, we move our long gamma bias to 5-year tails and our short gamma bias to 30s.

To estimate fair value for the tail curve, we consider the relative partial betas of daily changes in various swap rates with next meeting hike odds, the medium-term pace of hikes, and terminal Fed funds. Each represents the rough shape of the tail curve under the limiting case where just that component of policy expectations drives daily price action.

Buy $100mn 3Mx5Y ATMF straddles (notification date 6/5/2017, maturity date 6/7/2022, ATMF and strike @ 2.214%, premium 149c) versus selling $22mn 3Mx30Y ATMF straddles (notification date 6/5/2017, maturity date 6/7/2047, ATMF and strike @ 2.721%, premium 639c). 

This trade requires frequent delta-hedging and is vega-neutral at inception.