Morgan Stanley's Top Rates Trades For
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
Front-end receivers in AUD and NZD: Buy 2y1y AUD receiver, Buy 6m1y NZD
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-
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,
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.