Gamma steadies as liquidity wanes
Gamma implieds steadied today after coming under selling pressure earlier in the week. Most pieces finished the session near unchanged or slightly higher.
In the background, Bunds proved resilient during the morning session after Euro PMIs printed stronger than consensus. Since then, global fixed income has rallied after softer US PMI and ahead of the Thanksgiving holiday. The 10y Bund future was last up 65 ticks while the 10y yield was down by -4bp at 1.94%.
“There isn’t so much activity in the US market and that’s feeding into euro vol,” said one trader. "The recent flows have been probably been biased towards selling... Probably much of today's flows is more position squaring than new trades," he reckoned.
Trades included 2m3y at 119bps, 1y2y at 190bps, 1y5y at 468bps, 2y5y at 637bps, 2m30y at 764bps, 3y30y at 2974bps, 4y10y at 1475bps and 5y10y at 1556bps.
Short top left; Bearish vega - JPM
Strategists at JP Morgan have published their IR 2023 rates outlook and include a comprehensive analysis of the euro vol market. Among its findings, it writes that normalisation of the implied vol surface has already begun and expects the move to continue through 2023. In its conclusion, the bank recommends shorting top left gamma and possible shorts in vega.
Short top-left gamma: “We favour shorts in top-left of the gamma surface in 1H23 and would recommend short gamma positions when there is a clear indication of a turn in Euro area inflation which will elicit a greater degree of confidence in the ECB reaction function. However, we are cautious in entering outright short gamma positions currently despite supportive medium-term macro backdrop. First, implieds appear cheap on valuations versus fundamental and may dissuade investors from short positions. Second, jump risk remains elevated, especially as market depth continues to hover towards the low-end of its historical ranges. With approaching year-end which will be associated with decline in liquidity and an expectation of headline driven market moves, jump risk is likely to increase.”
Bearish bias in vega: “We are bearish on gamma and expect the 10s/30s curve to steepen which should be supportive of lower vega implieds. Volatility of callable issuance around year-end is likely to impart some volatility to vega implieds, all else equal. Historically, callable issuance tends to remain elevated in 4Q and 1Q, on average while declining around the middle of the year. On absolute levels, callable issuances are currently well below historical averages. This could reflect illiquid market conditions, lack of duration demand, and potentially the fact that investors would prefer the simplicity of vanilla bonds given that yields are high even though high volatility makes callable bonds relatively cheap (or attractive in yield for investors). We believe that callable issuance is likely to remain low over the coming weeks as current macro fundamentals are unlikely to alter significantly. Thus, for now, we stay neutral on vega and would consider entering outright short vega positions in 1Q23.”
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