FED Meeting Cuts & Probabilities and Trading Strategies

Fixed Income Monthly: RiskVal July '19 Commentary


Fed Chairman Powell’s testimony and the June FOMC meeting have indicated that the FOMC is on track to cut rates. However, many different factors may affect the FOMC’s policy, such as uncertainties around trade tensions, concerns about the strength of the global economy, unemployment rate, inflation rates, etc. As a result, the markets are expecting cuts and fighting strongly over how many cuts there will be and when the cuts will be implemented. Looking forward, RiskVal’s Fed Fund Simulation projects rate cut values and probabilities implied by Fed Fund Futures (Figure 1). In Figure 1, at least 25bps ease is expected at the July FOMC meeting and another 25bp ease at the September FOMC meeting.

Figure 1: RiskVal’s Fed Fund Simulation

Assuming that the markets have already priced in the rate ease then, in the short term, the markets may remain neutral on duration. However, looking backward, RiskVal recorded similar behavior in the market around the beginning of 2007 (Figure 2). Given this, RiskVal estimates continued maintenance of short term/long term curve steepening.

Figure 2: US Treasury curve spreads with RiskVal’s 15-year historical data

Figure 3 shows the 5/30 spread is quite cheap now, compared to its 3-month history. Usually it would be expected to be richer, but because of the 100% probability of a Fed rate-cut, circumstances are different.

Figure 3: UST 5s30s spread over a 3-month period

Figure 4 shows how the 5/30 spread, cheapened after the Fed cut rates in September 2007, which made the curve steeper. The blue line, 3-months before the rate-cut, is quite similar to the 5/30 spread history we see today.

Figure 4: UST 5s30s spread in the last cycle of rate cutting, starting in September 2007, up until 2008

USD TRADE IDEA #1: US Treasury 5/30 steepener (LONG CT5, SHORT CT30)


Figure 1: Most recent 5 year historical for EUR 2/10 Swap

Looking at Figure 1, the EUR 2/10 swap curve has been flattening since the latter part of 2018. There is an expectation that the flattening pressure will continue further. However, the spread of the 2/10 swap curve has nearly reached the lowest point in the last 5 years. In comparison, the EUR 2/30 swap curve (see Figure 2) also shows the curve is at one of its strongest tightening points since 2008. Moreover, another important factor that the chart demonstrates is that the EUR curve has only inverted once in almost 15 years, which marks the last global financial crisis.

Figure 2: EUR 2/30 swap curve historical time series from 2004 up until now

There is a small chance that the curve is going to invert, especially in the near future. On the contrary, as the spread approaches its historically tightest level, there is a good chance that the curve is going to steepen. Therefore, holding a Bull Steepener conditional trade would be an ideal strategy if this proves to be correct.

Figure 3: EUR 2/10 Conditional Bull Steepener in RiskVal’s Pre-Trade Analytics (RVFI)

RiskVal’s Conditional Trade supports multiple hedging methods that are implemented by adjusting strike or notional values with a forward-looking scenario analysis. In the first step, the scenario is created for a given set of yield curve shift shock values and volatility surface percentage shifts. Then, the forward curve model is built based on these scenarios and future dates. Finally, the P&L matrix and $Greeks are calculated with respect to each scenario and future date. As expected, the 2/10 Bull Steepener performs well when the 2/10 spread increases with limited risk exposure.

The horizon analysis equips portfolio managers with a complete life-cycle scenario pre-trade analytics tool. PMs can capture the amount of exposure for each of the financial Greeks and confidently estimate how each strategy’s characteristics and risk structure will change with time before making trading decisions. With this, managers can re-balance their portfolios to hedge against specific future risk exposures.


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