After Morgan Stanley's call for the 10 Year hitting 4.5% in 2010 ended up being one of the worst calls of the year (together with each FX call by the Goldman team), the firm's head rates strategist Jim Caron is back on the scene with his latest set of Top Trades for 2011, as well as some views on where the fixed income market is headed next year. In summary: just fast forward the firm's bearish 2009 view on yields one year forward. After all if the firm was so wrong one year, it can't possibly be wrong two years in a row...
Below is a summary of the Top Trades for 2011:
- 10y yields to rise, front-end yields to stay low: receive 1y1y OIS at 64.5bp, 1y rolldown of 41.5bp
- Forward curve steepeners: 2y forward 2s10s steepener
- Front-end receivers are attractive: Buy 3y1y receivers
- UST 2s10s to steepen toward 260-280bp in 1Q11
- Long 10y swap spreads. Tighter Agency and mortgage spreads
- Longer-dated vega will drift lower as callable supply picks up in the new year. We recommend: Long USD 1y5y straddles, delta-hedged over a 6m trade horizon
- Inflation trades - Long 2y breakevens, 5-10y TIPS breakeven flattener
- Focus on carry trades amid sovereign risks
- Peripheral stresses to keep euro 2s-10s curve steep
- Front-end receivers: Buy EUR 3y1y, GBP 3y1y receiver
- We like extending out of 5y into 10y gilts and receiving in GBP 5y5y swaps in the 4.75% - 5% range
- Buy the belly in UKT 5s-10s-20s butterfly
- In UK we favor short-end asset swap spreads
- Vega in Europe looks rich, with shorter tails looking more vulnerable. We recommend: Long EUR 6m10y straddles, delta-hedged, Short EUR 5y5y receivers vs. a long position in GBP 5y5y receivers.
- Inflation trades - Long 5y UK and 5y euro breakevens. 5-30y euro breakeven flattener
Asia – ex-Japan
- Short duration to position for rising inflation and policy tightening in 1H11
- Switch to the 3y-5y sector for better carry and roll down, particularly as FX will continue to dominate USD returns. Exceptions – Receive fixed in Australia and New Zealand, receive SGD 5y5y forward outright or versus TWD 5y5y.
- Position for bear steepening of the 2s5s curve in AXJ with the exception of AUD and NZD. Enter into AUD 3s10s bull steepener.
- Pay HKD 2s7s10s PCA butterfly.
- Enter into Spread wideners: Pay 5y INR OIS, long 10y GOI (entry: 100bp, target 50bp)
- Front-end receivers in AUD and NZD: Buy 2y1y AUD receiver, Buy 6m1y NZD receiver.
- We expect vega to remain well bid in 2011 given Fed QE2 extension uncertainties We recommend: Sell SGD 5y5y vega, delta-hedged versus Buy TWD 5y5y vega, delta-hedged
- Buy £100mm 5y5y GBP receivers struck 50bp OTM and sell €116.5mm 5y5y EUR receivers struck 65bp OTM
- Pay 2y HKD IRS, receive 2y USD IRS (entry: -10bp, target: +10bp, stop-loss: -15bp);
- Receive AUD5y5y, pay TWD 5y5y (1.5:1 Beta ratio): Using TWD 5y5y as a substitute for a pay 5y5y USD, receive 5y5y AUD forward position, which is near post-crisis historical wides, this position offers flat rolldown
- Receive SGD 5y5y, pay TWD 5y5y (0.82:1 Beta ratio; entry: 180bp, target: 100bp, stop-loss: 200bp)
- Go long duration after recent sell-off – particularly in the 10y sector
- Enter into curve flatteners: we like 5s-10s, 7s-10s curve flatteners
- We recommend buying relatively short expiries JGB puts or payor swaptions on the belly of the curve as a cheap hedge for long positions in JGBs.
- Protracted deflation throughout 2011 but BEIs are too low.
Notably, unlike before where meeting supply and demand was a key concern for Caron, he no longer has any doubts that the trillions (and following last night's tax deal, the bond issuance over the next year will likely be a record one) in supply will have a problem meeting demand. Instead, the five key themes of 2011 per Morgan Stanley are the following:
Inflation: This will be the main driver of asset allocation decisions in fixed income markets. The initial conditions of low yields and low inflation expectations in DM bond markets have yields running near secular lows. This has been helped by investor demands to harbor the safety of fixed returns and deleveraging forces driven by the US financial crisis in 2008. But if the investor mindset shifts toward rising inflation risks, then reducing fixed income exposure will be a more thematic trade in 2011 (see Exhibit 2).
Positioning: Inflows into bond funds have been running at a record pace in 2009 and 2010 (see Exhibit 3). It may reverse direction in 2011. This indicates vulnerability for higher yields, sparked even by modest expectations of rising inflation, as an unwind of two years’ worth of long bond positions can exacerbate the sell-off. Essentially, bond flows may shift from being buyers on weakness to sellers on strength. This will likely inflate the level of yields.
Quantitative easing (QE): This will be a source of volatility in 2011. It stems from conflicting views on whether or not the Fed will fulfill intended purchases of $600 billion USTs by the end of 2Q11 or if it will succumb to political pressures and fall short. QE2 adds a bimodal risk to bond markets in that the market will likely price its conclusion well before it ends. If economic conditions are improving in the US, then the end of QE represents the loss of one of the biggest buyers of USTs in the market; a risk for higher yields that will be priced perhaps in late 1Q11. Conversely, if economic data disappoint, then the end date of QE2 represents the loss of a substantial market support facility; a risk for yields to decline that may also be discounted in 1Q11.
Political risks: Politics and policy will play a larger role in the markets in 2011, in our view. This may not just be an extension from 2010 but intensification. There are many variables to consider – among them are monetary policy, capital controls, currency policy, financial regulation, tax policy, fiscal austerity versus fiscal autonomy and a resurgence of nationalism and protectionism. They are likely to add to risk premiums and reduce market efficiencies. Nevertheless, navigating these risks will be a key part of investment decisions in 2011, in our view.
European sovereign crisis: Our central case is that core Europe will continue to provide support to peripherals, but at a price of fiscal tightening and reform. In this context: i) peripheral markets will be buffeted by bouts of uncertainty, while ii) core curves will remain under steepening pressure due to both the cost to core countries of supporting peripherals and to increasing perception of inflation risks.
This can be summarized simply as follows: hope for the best, expect that the Fed will take care of everything else, reversion to the mean will eventually happen, and an increasingly older US population will suddenly decide to throw all caution to the wind, take their money out of bond funds, put it all in stocks (despite 31 weeks of equity outflows), and live happily ever after. Good luck.