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(an interoffice email)

On Thu, May 29, 2008 at 11:58 PM, Deep wrote:
>    The attached charts shows the change in 3M Forwards for the USD curve from its
>    lowest yield point this year (17Mar08) to today.
>   
>    In Chart 1, the changes are compared to two other periods where we had strong
>    selloffs Jun03->Sep03 and Apr07->Jun07.
>   
>    As the chart shows, in the current selloff, the front end has moved approx 180bp
>    (similar in magnitude to the 2003 selloff). However, in contrast to both 2003 and 2007,
>    the forwards beyond 8y have barely moved. In 2003 and 2007, the 10Y3M rate sold off
>    approx 55% as much as the front end. Both of these periods were characterized by
>    mortgage convexity paying.
>   
>    The lack of movement of the back end in the current selloff is leading to an extreme
>    flattening of the yieldcurve compared to prior selloffs.
>   
Hi Deep,

I’m thinking the forwards are anticipating future Fed moves. They see a relatively quick ‘take back’ of the cuts as market functioning returns and we are left with a ‘normal ‘ slowdown.

With cpi looking to move past 5% over the next few months, passthroughs to core increasing, gdp muddling through with strong exports, the Fed will have to decide what the appropriate ‘real rate’ is for what they feel is an appropriate output gap.

The markets will likely believe/discount the Fed will be successful, which means a eurodollar curve that rises sharply with the inflation attack and then tails off after it’s success.

Warren

>   
>    A possible reason for the unusual nature of the current selloff maybe that
>    two offsetting flows characterize it –
>   
>    a) unwind of yieldcurve steepeners by Fixed income, Credit and Equity Funds
>    as part of their delevering out of steepeners – this leads dealers to hedge by
>    paying the front end (less than 5Y) and receive the back end (beyond 10Y).
>   
>    b) paying of 10Y by mortgage convexity hedgers
>   
>    The offsetting flows in the 10Y sector may result in the lack of movement in the
>    forwards beyond 8Y.
>
>     A low-risk way to position against the extreme flattening selloff is through
>    the Midcurve steepener. The trade is to
>    
>     Buy 3160mm Z8expiryZ9 97.00 Call
>    Sell 100mm 12Dec08->10Y 4.25% receiver
>     execute at zero cost
>
>   

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