2018: QE distortions will fade, we buy 1y10y USD 2.9% swaption

We said:

Distortions caused by central bank policies are suppressing global bond markets. Term premiums are pushed lower, muffling domestic drivers. In the US, for example, the decline in the term premium has obscured an increase in real short-term rate expectations and stability in inflation expectations in the last few years.

The nature of the first factor in fixed income means volatility has also been suppressed. All government bond markets are dancing to the same tune and are limited in the degree to which they can sell off before a central bank-induced bid emerges. But as the pace of QE slows and first factor loading declines, realised volatility will rise.

Fixed income implied volatility is currently at a record low. Compared with FX and global equities, fixed income also stands out as being driven by a single factor, which we expect will diminish in importance next year. Fixed income volatility should therefore rise in 2018. We buy a 1y10y USD 2.9% payer swaption for 86bp (2.36% yield spot ref).  The trade should make money on rising volatility and on the diminution of QE distortions, allowing the term premium (and therefore yields) to rise. We choose the US as the forward curve is flatter than in Europe, minimising the roll-down cost.

Outcome:

US 10y yields rise from 2.36% at trade inception and hit our target of 2.9% on 14 February 2018. 10y then range trades between 2.8-3% until breaking through 3% on the upside in September and 3.2% in October. 

As yields rose sharply on 7 February 2018 we sold a 3m10y USD 3.1% payer swaption to protect some of the gain. We repeated this hedge on 3 May 2018 be selling a 3m10y USD 3.18% payer swaption. 

We closed the trade for a total return of 155bps, including hedging costs, a 3x return on capital.

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