Plays on an expected rise in US interest rates ramp up

Thu Mar 28, 2013 11:20am EDT

March 28 (IFR) - Investment firms looking for the right time and way to play an expected rise in US interest rates may have found their trade.

Correlation across equities and rates are adding weight behind widely-held beliefs that recent equity highs cannot be maintained and a continued economic recovery will force a rate rise. The confluence of these factors, as well as an expectation that the Federal Reserve will slow down or exit quantitative easing at some point this year, is creating an opportunity for investment firms to purchase cross-asset options structures that play all four assumptions.

The trades involve purchasing options on the S&P 500 that only pay out if rates rise past a particular level before maturity.

After mostly-vanilla rates options plays gathered pace in the early part of the year, the contingent options structures have been purchased by a host of funds over the past few weeks, according to dealers.

"Strengthening US data is suggesting the Fed may move up its time-line for withdrawing QE, and if the rollback is disorderly it could be substantially negative for equities," said Mohamed El-Hioum, co-head of the equities structuring group for the Americas at Deutsche Bank. "The recovery has withdrawn some of the deflationary pressure that allowed the Fed to freely stimulate the economy, but has also raised the possibility of an uncontrollable move once rates do start rising.

"As a result, rate-contingent S&P 500 put options have emerged as the preferred way for hedge funds to get cheap downside equity and upside rate exposure at the same time."

The trades, ranging in value between US$50m and US$500m notional, pay off if the S&P drops below 95% of its current level, contingent upon 10-year rates rising to levels between 2.7% and 3%.

NUMBER CRUNCHING

Data such as home prices and unemployment figures are the core drivers. The home prices S&P Case-Shiller Index rose 8.1% in January from a year ago, while unemployment in February reached its lowest level since December 2008.

Those economic boosts drove the Dow Jones industrial Average to end Tuesday's trading at a record high while the S&P 500 closed two points shy of an all-time high at 1,565.15.

"The writing is on the wall for most investors," said Bulent Baygun, head of US interest rates strategy at BNP Paribas.

"Since the beginning of the year fixed income managers have changed their duration bias to bearish, with an eye towards higher rates, over the medium-term in view of improving US economic fundamentals. The time-line of the rise in rates is the big question, especially given the fact the asset purchase program doesn't appear to be nearing its end."

One-year correlation across the S&P 500 and 10-year Treasury yields is currently just above 50%, close to 2003's all-time highs slightly north of 60%. Two of the last three times the levels reached these heights, correlations subsequently tumbled sharply, first in January 2003 and again in 2005.

"The high correlation between the S&P and Euro or between the S&P and interest rates offers an opportunity to significantly cheapen trades that take the view that these asset pairs will diverge," said Michael Nadel, co-head of equities structuring group for the Americas at Deutsche Bank. "It's particularly attractive to sell correlation between these pairs now, before the current regime unwinds."

The contingency factor can provide real savings but of course adds risk. For example, a one year at-the-money put option on S&P 500 costs approximately 7% of the notional. The same put contingent to a 10-year rates rise from current 2.10% levels to 2.9% at maturity would cost 1.35% of the notional; 80% less of the initial put premium.

"The entry point for these trades is good at the moment," said Ramon Verastegui, global head of engineering and strategy at Societe Generale in the Americas. "As the Fed exits QE, we expect significant rates increases, which can lead to a US equity rally correction and a dollar strengthen over the medium-term. You can combine those views in a cheap way that is only augmented by the current dynamics of correlation that are likely to correct."

Other funds have preferred to replace the rate contingency with currency contingency, betting that the S&P will continue a slow grind upwards, thus supporting the dollar and weakening the euro. Those funds have picked up structures that pay out if the euro dips below US$1.25.

"I tend to agree," said one hedge fund trader. "We could see an environment where euro continues to grind down and the S&P up. I could see that as a theme into the summer at least."

Six-month correlation between the euro and S&P 500 sat at 40% by mid-week last week, a long way from the 80% peak of summer 2011, but above the median for the past decade.

FED THINKING SHIFT

Data points may force a rate rise with or without a QE exit, but a slight shift in Fed thinking is adding to the expectations.

The first indication that the Fed might be re-thinking its stance came at the end of January, when FOMC members mentioned QE concerns surrounding inflationary risks, the difficulty in withdrawing such a large balance sheet from the market, and the effects the asset purchasing program is having on participants' ability to price risk.

The appearance of that discussion sent equities and gold into free-fall at the time, as the comments provided momentum for beliefs that the Fed will eventually realise the negative aspects of QE and begin to unwind.

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