J.P. Morgan is recommending to customers a trading strategy designed to profit from the relative wideness of four-and-a-half-year swap spreads over Treasuries versus one-and-a-half-year swap spreads over Treasuries. The gap between one-and-a-half-year swap spreads and four-and-a-half-year swap spreads is about 32 basis points, said Terry Belton, head of North American derivatives strategy in Chicago.
The Treasury yield curve has steepened over the last several weeks, as the economy has shown signs of slowing down, which would point to trends such as a smaller budget surplus and fewer Treasury buybacks, and more government issuance in the long end. As the yield curve steepens, the swap spread curve should flatten--other things being equal, Treasury yields should rise relative to swap rates, as these trends affect Treasuries more directly than swaps.
The one-and-a-half year/four-and-a-half year spread is a good part of the curve to take advantage of this trend. An upcoming five-year Treasury auction will cheapen the five-year sector of the Treasury curve. On a historical basis, the four-and-a-half year swap spread is wide relative to the one-and-a-half year. Finally, the bank forecasts aggressive Federal Reserve easing in the near term, which should cause the yield curve to steepen.
The trade the bank recommends entails paying fixed in a swap and buying a Treasury maturing in June 2002, and receiving fixed in a swap and selling a Treasury maturing in May 2005.