Fixed Income Trade Recommendation

Submitted by Nic Lenoir of ICAP

Following our focus yesterday on key supports in Fixed income, we feel that the risk is that on a rally here the curve could flatten. Indeed 2Y yields even though they rose recently, remain very low, and we feel that if the next leg is up in fixed income then the long end should outperform. We have attached a chart of 2/10 for US treasuries, as can be seen we just retested the 50-dma.

We look at conditional bull flatteners in more details here. The best way to express this given the lack of liquidity in 2Y treasury future options is to use a short May call on EDM1 against a June TYM0 10Y future call:

Buy 100 TYM0 117.5 calls / Sell 290 0EK0 98.625 calls, use 100 TYM0 calls for 290 0EK0 calls, making it neutral in terms of underlying exposure. Using market mids of 28/64th and 6bps, we find that the trade is basically premium neutral. Therefore we can express a bull flattening trategy with virtually no negative carry. For comparison putting on a 2/10s flattener in swaps has a negative carry of approximately 15.6bps per quarter.

The trade should perform well if the market breaks to the downside as further selling off from here would most certainly come along with a flattening of the curve (and since it is premium neutral worst case scenario both options expire worthless). The risk is if we experience a bull steepener of course, which at these levels in 2Y yields seems relatively limited in our opinion.

Good luck trading,