Lehman Brothers and Goldman Sachs are both recommending clients purchase volatility on swaptions to enter into five year swaps in five years. Continued demand for short-dated hedges by mortgage investors and servicers is bidding up short- to medium-dated swaption vol relative to the back end. Similar trades have made sense for at least a month (DW, 1/28), but the value is now in buying options to enter five-year swaps, said George Oomman, chief interest-rate derivatives strategist at Lehman in New York.
Mortgage servicers and investors were hedging interest-rate exposure in earnest early last month, as the market was uncertain about the number of easings the Federal Reserve was likely to implement. This boosted swaption vol across the board, including options to enter five-year swaps. Following the Fed's easing at the end of last month, mortgage players are more comfortable about the direction of interest rates. Although they are still hedging, they are hedging mainly with options to enter 10-year swaps, as 10-year swap rates tend to be more highly correlated with mortgage rates. Volatility on options to enter five-year swaps has hence fallen. In the case of options to enter five-year swaps in five years, vol was late last week at 102 basis point (normalized), versus 117 basis points at the beginning of January, said Oomman.
Lehman is recommending investors buy straddles on swaptions on five-year swaps, for example, five-into-five year swaptions and to a lesser extent, six-month-into-five-year swaptions, and selling two-into-10 year swaption straddles.
The U.S. economy is unlikely to recover quickly, according to Goldman economic research. That would imply that interest rates would fall gradually and rise gradually, rather than dropping through the floor and then surging, which is what the Eurodollar futures market expects now, said Marcus Huie, v.p., fixed income derivatives strategist at Goldman in New York. A slower-than-expected recovery would translate into higher longer-dated interest-rate volatility as the market comes to grips with a slow recovery. Higher-than-expected consumer price index data last week influenced shorter-dated swaption vol, but had little impact on this trade.
