FxWirePro: UST’s downside risks from hawkish Fed but low-cost hedges on political risks

This week saw a significant shift in Fed rhetoric, seemingly on growing concerns over an overshoot of full employment, leading markets to price in a significantly higher probability of a hike in the next meeting in March and an underperformance in US bonds.

We update our regular positioning indicators and find that investor positioning appears significantly cleaner since end-Jan, suggesting a reduced risk of position unwinds exacerbating market moves in the near term.

In the Euro area, we retain a bias for higher yields and steeper curves in Germany but stay tactically neutral given the speed of the sell-off.

Hold 2Yx2Y/15Yx15Y swap curve steepeners, and 2s/10s weighted bear steepeners. Enter 1Y swap/ Jun17 Bobl bull flatteners. Receive Jun18 ECB OIS. Keep reds/blues weighted bear steepeners and Bund/Buxl swap spread curve flattener.

Enter Jun17 Bund swap spread bear widener. In vol, hold Schatz/Bund vol curve steepener, stay long Jun17 bund gamma via OTM calls, but stop out of long 3Mx10Y gamma.

Intra-Euro area, spreads are tighter on reduced political risk, though we continue to see the tail risk of a Le Pen presidency warranting cheap downside protection. Add short 3Y Netherlands vs. Finland and 2s/10s Italy flattener vs. Germany.

In the UK, We see valuations too rich, and stick with a bearish view: stay short 10Y gilts and hold 1Yx1Y/15Y GBP swap curve steepeners. Enter Jun17/Sep17 Short Sterling steepener boxed against Jun17/Sep17 Euribor flattener and keep reds/greens SONIA curve steepener.

Hold paying 10Yx10Y GBP vs. EUR swaps.

In Japan, receive 1Y USD/JPY cross currency basis, hold longs in the 5s/10s/20s JGB curve fly.

Next week’ key events: ECB, RBA; UK Spring Budget, US nonfarm payrolls.