The bullish momentum of the last three weeks culminated in the lowest 10y yield since August 2012 (in the context of QE) on a more-dovish-than-expected Fed and a pick-up in momentum for the Brexit camp.
Despite a slight respite in the bullish momentum later in the week, the probability of a second hike ended the week priced fully only by the first quarter of 2018.
Volatility traded directionally with rates and the referendum polls as the market moved to price an increase in Brexit risk. ATM was a better bid from counterparties, but the real trade appears to be one of ‘buy the rumor, sell the fact’, with some unwinding on pops.
With program sellers on the sidelines, the right side of the grid led the outperformance, adding to the steepening momentum that has prevailed on the grid since the end of May.
In a ‘remain’ scenario for the UK referendum, it makes sense to fade the recent move in right side gamma and play for a re-steepening of the expiry curve. In particular, 1m10y versus 1y10y flattened from a recent high of 22bp to 9bp presently.
We recommend therefore selling 1m10y straddles versus 1y10y, volatility weighted (corresponding to a ratio of roughly 3.2:1), playing for a re-steepening of the expiry curve in 10y tails (the focus of the recent program selling) post-vote.
The position enjoys significant positive carry but requires significant active management. The main risk on the position is a Brexit vote, with potentially unlimited losses, but the repricing of a July Fed hike on a ‘remain’ vote also poses a significant risk for the position.