Vols dip ahead of CPI; Legacy LIBOR conversions
Treasury yields have pivoted into a bull flattening mode with long end yields up to 6.2bps lower on the day. The $32bn 10y reopening came 0.5bps through the 1pm bid side, further adding momentum to the bid. The vol surface has softened back in, with gamma expiries down anywhere from 1-3 normals in short expiries and 0.5 to 2 normals in longer expiries. 1y1y traded down to a low of 97.25bps today or around 7.8bp/day.
“It is all about if the Fed can continue to hike” and vols “are softer after the employment cost picture looked better in last Friday’s report,” a source explained, noting that “it is a correlation not a causality though.”
1y1y started off the day trading at 98bps, then traded down at 97.375bps and then 97.25bps last. 1y10y traded at 741bps and then at 739.5bps while 3m30y traded at 758bps and 755bps, 6m10y dealt at 531bps and 6m30y traded at 1029bps and 1027bps, according to the SDR. In longer expiries, 3y10y traded at 1186bps, 7y10y dealt at 1519bps and 10y2y traded at 419bps. For more, please see SDR trades.
Elsewhere, although the dealer community and new business has all transferred over to SOFR and the fallbacks set, one frequent user of options and swaps noted that “everyone still has legacy LIBOR on their books.”
The source pointed out that for their firm, they have been actively seeking to “convert their legacy LIBOR positions into SOFR” but have found that some dealers have been less equipped and ready to quote conversions than other dealers who are more set up to handle the process. “It seemed like a couple of months ago some dealers were not prepared,” he noted. Moreover, in seeking to convert to legacy LIBOR to SOFR, it appeared they were select minority of clients that were seeking to actively convert legacy LIBOR into SOFR.
Deutsche – Elevated rates vol is anomalous, excessive
Analysts at Deutsche highlight that rates vol has been the “best performer” in the current cycle and “although it has declined from its highs, it remains elevated both historically and relative to other measures of risk premia, which have been either declining or rising more slowly than rates vol.”
“Given the logic of tightening cycles as periods of decelerated growth, the explosion of (rates) volatility was last year’s most outstanding anomaly,” Deutsche argues. “This is visible not only in terms of rates vol rise on its own, but also relative to other measures of risk premia” the bank adds. Thus, “irrespective of the metric one uses, rates vol appears excessive.”
To be sure, Deutsche points out that “in previous tightening cycles, the ratio of rates/equity vol was always declining, or was at least stationary – as the path of rates became predictable while brakes on growth put more constraints (lower limit) on risk, rates vol declined faster than its equity counterpart” while in contrast, in the current cycle, “the continued bid for rates vol against a steady or mildly upward trend in equities vol pushed their ratios higher.”
“Under normal circumstances, the rates/equity vol ratio tends to reside in the 4-5 range” while currently, the ratio is around 5.5,” it notes. “Assuming that uncertainties around the rates path get resolved and that doesn’t significantly impact equity vol (the scenario which corresponds to our base case forecast)” then Deutsche sees that the 3m10y “should decline to the 90-100bp range.”
Further, the bank believes that “normal functioning of the rates market is predicated on short tenors not falling significantly below long tenors, because monetary policy shocks arrive from the front end of the curve with bull steepening and bear flattening as dominant modes.” With vol ratios generally residing “around 1,” Deutsche argues that “once there is a consensus regarding the turnaround in monetary policy, the upper left corner could lose 10-15bp of its premium relative to long tenors.”
As far as positioning for this outcome, Deutsche finds that “the current inversion of the curve and distribution of vol inhibit forward steepeners or other alternative expressions of policy turnaround” and “in the absence of precise timing, these trades promise only to bleed carry.”
Thus, Deutsche believes that short vol “remains the most straightforward articulation.” In that vein, it declines to short the highest sector on the surface - the ULC - as it believes “it is risky to short it.” Instead, it favors selling 3m5y or 1y10y straddles.
New structured notes
For a complete review of USD MTN activity over the week, please see USD MTNs.
- Bank of Nova Scotia sold a $40m 15y NC6 zero coupon callable (non-Formosa). The SMTN matures Jan 2038, is callable annually from Jan 2029 and has an estimated IRR of 5.50%. Self-led and announced Jan 10.
- Bank of America is working on a self-led step-up callable maturing Jan 2030 NC1 that pays 5.25% to Jan 2025, 5.65% to Jan 2027, 6.25% to Jan 2029 and 7% thereafter. Domestic MTN.
- UBS is working on a floating callable maturing Jan 2024 NC6m that pays O/N SOFR flat. EMTN.
- Bank of Montreal is working on a self-led USD extendible with initial maturity Jan 2024 and then extendible to Jan 2028 that pays 5.75% to Jan 2024, then pays 5.85%, 6%, 6.15% and 6.35%, stepping up annually. Domestic MTN.
- Bank of Montreal is working on a self-led CAD extendible with initial maturity Jan 2024 and then extendible to Jan 2028 that pays 5.4% to Jan 2024, then pays 5.5%, 5.6%, 5.85% and 6%, stepping up annually. Canadian.
- Societe Generale is working on a self-led fixed callable maturing Jan 2026 NC1 that pays 4.88%. EMTN.