JPMorgan Econ FI-Interest Rate Derivatives The Evitable Conflict-109198344.pdf

1SriniRamaswamyAC(1-415)315-8117srini.ramaswamy@jpmorgan.comJ.P.MorganSecuritiesLLCIpekOzil(1-212)834-2305ipek.ozil@jpmorgan.comJ.P.MorganSecuritiesLLCPhilipMichaelides(1-212)834-2096philip.michaelides@jpmchase.comJ.P.MorganSecuritiesLLCArjunParikh(1-212)834-4436arjun.parikh@jpmchase.comJ.P.MorganSecuritiesLLCNorthAmericaFixedIncomeStrategy12July2024JPMORGAN•Softerdataisincreasinglycorroboratingimmaculatedisinflation,whichislikelytobringaboutthefirstcutinSeptember,followedbyacutateveryothermeeting.ButforwardOISratesarecurrentlypricedtotoomucheasing.Similarly,yieldcurvesarelikelytodriftsteeperbutthisisfullypricedintoforwardsmakingplain-vanillasteepen-ersnotverycompelling•Onevariationonthethemethatdoesappearattractiveistosubstitutethe2Ylegina2s/10ssteepenerwitha6Mx3M/18Mx3Mflattener.SincetheFedwentonhold,Fronts/Redsflattenershavebeenwellcorrelatedtooutrightfrontendlongs.ButasyntheticsteepenerconstructedusingaFronts/Redsflattenerasastand-infor2soffersbothbetterentrylevelsandpositivecarry-initiate6Mx3M/18Mx3Mflattenerspairedwitha50%riskweightedshortin10stocreate2s/10ssteepeningexposure•WithforwardOISpricingintoomucheasing,bearishtradesareattractiveaswell-initi-ateexposuretoaconditionalflatteningofthe1s/7sswapcurveinaselloffusing6Mexpirypayerswaptions•Swapspreadsremaintoonarrow,especiallyatthefrontend,andseasonalsarepoisedtoturnpositiveoncewemovepastissuance-relatedswappinginthenearterm-maintainswapspreadwideningexposureacrossmuchofthecurve,butespeciallyatthefrontend•Themacrobackdropisbroadlyfavorableforsellinggamma,butimpliedsarelowenoughtoleaveusneutralonthebalanceofrisks…•…butwefindvalueinoverweightingvolatilityinthe6Mx5Ysectorversus6Mx30Y.Whileatheta-neutralweightingwouldbetraditionalforsuchaswitch,weprefersellingslightlymoreofthe6Mx30Ybasedona+1.0/-1.5vegaweighting.Suchaweightingisdesignedtomakethistradeaproxyforsellingthevolatilityofthesecondprincipalcom-ponent.Tradingprincipalcomponentvolatilityisathemeweexploredinarecentnote,andsellingthevolatilityofthesecondprincipalfactorislikelytobeanattractivethemegoingforward•Longexpiryvolatilityappearsrichwithrespecttofairvalue-weremainbearishandrecommendselling5Yx5Yswaptionvolatilityversusbuying1Yx5YTheEvitableConflictGreatsciencefictionwritershaveanuncannyabilitytoforetellthefuture;IsaacAsimov,beingamongthegreatestofthegreats,isperhapsthearchetypalexample.Overseventyyearsago,inhisshortstory"TheEvitableConflict",Asimovforesawaworldwhereeco-nomicevilssuchasunemployment(andpresumablyinflation)havebeenovercomethankstooptimaldecision-makingbyrobotoverlordswhohavesubjugatedhumans.AlthoughFedChairPowellhasyettocedehisauthoritytoanartificialsuperintelligence,JuneCPIdatasupportsthenotionthatmonetarypolicyisindeeddeliveringimmaculatedisinflation,andtheconflictbetweenfracturinglabormarketsandcontaininginflationappearsdecidedlyevitableratherthaninevitable.ChairPowellacknowledgedthisprogressthisweekinhiscommentstoCongress,notingthat"labormarketsappeartobefullybackinbalance",whichisnotableconsideringthestill-histori