Rates Vol Watch: JP vol – Selling frontend 1x2 payers

Research evidence excerpt

Rates Vol Watch: JP vol – Selling frontend 1x2 payers

On a contrarian view, the magnitude of the bear steepening momentum is at levels

generally seen only in an early-cycle dynamic as fundamentals improve but policy rates

remain anchored. In the current context (not early cycle), this is generally the hallmark of

an environment where the central bank is behind the curve. On the yield curve, the

contrarian view therefore maps to either (1) a bear flattening dynamic as the market

fades the BoJ lag, or (2) bull flattening dynamic where the market fades the recent

backend bearish pressure (which we find less likely).

While bear flattening trades look attractive (6m fwd 2s10s bear flatteners pick c.20bp

to the fwds – Exhibit 39), we favor selling 6m1y payers 1x2 atm/atm+15bp to position

for a more explicit scenario of hawkish BoJ repricing (costless indicative, target = 30bp,

stop = -15bp, risk would involve -15bp max downside).

To trade with the recent momentum, we favor backend payer spreads as bear steepeners

give up to fwds (Exhibit 39): long 6m10y payers spreads atm/atm+30bp, cost 11bp

(indicative), target 19bp, stop -11bp, risk would involve the premium paid. Alternatively,

for investors with a higher degree of conviction on the limits to the bearish dynamic we

favor long 6m10 payers 1x2 atm/atm+30bp (costless indicative), target= 30bp, stop = -

15bp, risk is a selloff beyond downside BE with potentially unlimited downside.

Exhibit 1: Moves in JP fwds since start of ME Exhibit 2: 10y JGBs underperformance vs Exhibit 3: Measure of fragility at the backend

conflict global yields of the JGB curve

Bear steepening bias in JP rates, driving pressure Residuals of 10y JGBs, USTs, Gilts & EGBs in our Recent dynamic reflecting higher levels of