Fed's repricing likely to expand €/$ swap rates spreads

Although two-year yields in the US have come back from their lows last week, the pricing of near-term Fed hikes remain subdued. A full 25 bps rate hike is not priced until the January FOMC meeting next year and the probability placed on a hike in September is only around 30%. Markets are currently placing a 65% probability of a first hike this year, which stands in contrast to the message from key FOMC members that a first hike is likely to come this year.

In our opinion, upcoming data to set off a modification in this pricing and continue to look for a first rate hike in September gives opportunities for investors to position for higher rates in the US over the coming three to four months. We want to be short in the medium to long term segment (let's say 2-5 years) of the US curve, as this part is strongly correlated with market pricing of Fed hikes over the coming two years, but prefer to do this via a spread to EUR rates. This reduces the roll-down costs of the position markedly compared with being outright short in US rates.

On a three-month horizon, the roll-down cost in a long EUR5Y swap versus short USD5Y swap is half that of an outright short position in a five-year USD swap. We expect the short end of the EUR swap curve to continue to be broadly shielded from rising US rates in coming months, as has been the case over the past year.

Labour market slack to shrink faster than Fed projections, the driving force as to why the expectations of Fed's rate hike decision in September rather than holding on until December is developments in the labour market. The June summary of economic projections showed that the Fed sees the unemployment rate falling to 5.2-5.3% on average in Q4 this year.

Further, we see the recent decline in commodity prices further supporting low rates in the euro area over the summer. Thus, we expect a significant euro-US spread widening. In addition, the spread trade offers some protection against a blow-up in Greece and the ECB scaling up its QE programme.