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Thanks Mr Weber! --> Eurozone Bear flattener.

|Includes: GRE, iShares 20+ Year Treasury Bond ETF (TLT)
Let's face it: this is an incredible title for today's Thaler's Corner, given my oft-stated views on Mr Pignon's contribution to eurozone monetary policy in recent years.
But what a coincidence and helping hand from the Bundesbank president on the very day that I advised an upward bet on Schatz rates (‘QE2 = Hike in 2-year rates on eurozone?’), after spending the last two years apologising for the Bund, Schatz and Bobl.
 
 
The most extraordinary part of this story is that we could have sworn that Weber and Hoenig, whom I call the Fed's masked Austrian, have been sharing scripts. Let's read and weep:
 
Poor risk/reward of QE
Weber: “the risks associated with the Securities Markets Program outweigh its benefits, these securities purchases should now be phased out permanently.”
Hoenig: "the benefits (of QE2) are likely to be smaller than the costs."
 
As a consequence, end the QE
Weber: “ECB Bond Purchases Should Be Phased Out Permanently.
Hoenig: “the Fed should consider discontinuing the policy of reinvesting principal payments from agency debt and mortgage-backed securities into Treasury securities...Slowly but systematically." “Better to let balance sheet shrink.
 
And increase interest rates
Weber: ‘ECB could lift rates before emergency measures all ended. ECB hike possible in principle before exit finished.
Hoenig: “We should take the first early steps to normalize interest rate policy," he went on. "This is not a call for high rates but a call for non-zero rates.” ‘End 0% FFR extended period, move to 1%, and then pause.”
 
The central bank must not help governments
Weber: “Bond buys risk blurring fiscal, monetary policy responsibilities
Hoenig: “More QE is quasi-fiscal policy, it could undermine Fed independence”.
 
At least we can say one thing: these two have really found each other. Let us hope that they enjoy a long vacation together in some far off resort in the High Alps... a very long vacation!
 
 
On a more serious note, while no one seems to be paying much attention to Mr Hoenig, Mr Weber has much more influence.
 
Let's not forget that this gentlemen was the architect of the ECB's infamous hike of key interest rates in July 2008, and that it was only when he realised that bank balance sheets from his own country had become some of the main depositories of the most hazardous toxic assets that his monetarist ardor began to cool.
The fact that the chief of the Buba has proven himself unable to observe the damage left behind him is all the more troublesome in that all he needed to do from mid-2007 was to read a newspaper to size up the magnitude of the danger (‘Subprime exposes chronic German bank profit woes’). It is frightening to think that he is being groomed to become the new president of the ECB.
 
 
All this tallies with my feeling that the Schatz is at a delicate equilibrium, and, as announced yesterday, for all those remain bond bulls and do not want to sell the Schatz alone, we are advising today a bear flattening curve trade: sell Schatz, buy Bund via options to benefit from the undervaluation of Schatz options vis-à-vis the Bund.
 
I have been talking a bit less about stock markets as of late, but our positive asset allocation biases and targets remain the same (2800à2900 on the Eurostoxx 50) and should benefit from the set-up of the QE2, while fixed interest rates should see higher volatility.
 
 
Why do 2/10?
 
The interest rate spread between these two maturities is still at an historic average of 135 bps.
 
In case of an overall bearish bond market, like in 2005-2007, check out the graph, below, which shows the Schatz suffered the most from the ECB's interest rate hikes, as the yield curve flattened. At the time, the spread averaged 30 bps.
This would tally perfectly with our option strategy via the purchase of Schatz puts and sale of Bund puts.
 
In case of a overall bullish  bond market (QE2 US + European deflation), nothing to worry about either, since the premium received at the initiation of this strategy is kept.
 
In case of a steepening of a bear market curve, which is the only worrisome scenario in our advised option strategy (+ Schatz put/ -Bund put), the Bund would have to decline all by itself, which does not appear to be the most likely scenario, given capital flight from the American QE2 and the ECB's well-earned reputation for Austrian rigour (mortis?).
 
 
2-year and 9-year German bonds and their spread
At these rates and yield curve, is the risk/reward ratio positive on 10-year debt?
 
 
 
Option strategy: + 5 Dec. 109.00 puts  – 1 Dec. 130.50 put
 
 
First, let's start with a small point on implied volatility, December options expiring 30 November in 48 days.
 
Bund 131.50 December straddle: 2.44, vol 6.40%.
Schatz 109.20  December: 0.39, vol 1.23%.
 
The sensitivity of the Bund Schatz ratio is 4.84. A simple rule of three shows that either the Schatz strategy should be worth 0.50 (2.44/4.84) or that the Bund straddle should be worth 1.89 (0.39x4.84).
 
Consequently, either the Bund is 22.5% too expensive or Schatz volatility is 28.2% too cheap.
And all this based on a homothetic curve. It will even better if the 2-year debt, which changes in a non-linear manner, abruptly changes to new levels.
 
Today's undervaluation of Schatz options stems from the fact that investors continue to anticipate more vibration on the long part of the yield curve. And they consider that the 2-year segment is frozen.
We are betting on precisely the opposite. Our strategy will thus benefit from a double boost if it materialises, since we have already seen implied volatility on 2-year debt higher than that of 10-year debt when the short end of the curve shifts!
 
 
This difference in volatility will naturally be seen in the premium received during the establishment of the put for put strategy. I am taking this opportunity to bolster this structure a bit more.
Not only do I use a 1 to 5 ratio, which enables us to have a higher number of Schatz puts in portfolio, but it also separates us a bit from the Bund strike price.
Schatz strike: 109.00, i.e. 20 cts with the future (109.20) à Bund strike price at 92 cts of the future (131.56), i.e. 130.64. We will sell the 130.50 put, which save 14 cts from the Bund exercise price.
 
Premium of Schatz put 109 December: 12 cts. à x 5000 = €600,000 in premiums received.
 
Premium of Bund put 130.50 December: 75 cts. à x 1000 = €750,000 in premiums received!
 
Net premiums received: €150,000, with a number of Schatz puts higher than the theoretical price and a strike price closer.
 
 
Given these results, we can adjust this structure to your priorities.
For example, if you prefer safety over premiums, we can shift the strike price of the Bund put sold by an extra 50 cts to 130.00, since it is worth about 60 cts and thus is still worth it!
 
 
Feel free to contact me at any time for information about strike prices, maturities and the establishment of a strategy adapted to your velocity scenarios.
 
Have a good day.
 
 
Asset allocation biases and advised option strategies 
 
·        Bund, Bobl, Shatz see belowBear Schatz
 
 
·        2800/2900 on the Eurostoxx 50
The Eurostoxx call ladders are working perfectly, given the hike in the spot price and the passage of time.
We have even suggested and set up for certain clients call spreads and outright call purchases on the Eurostoxx on October and December, hoping for a little velocity, while benefiting from affordable implied volatility.
As valid as ever!
 
 
 
 


Disclosure: Long 20 years OAT and 30 years BTP Zero Coupons, EDF Corp 5 Years 4.5%, Grece 2 Y and 10 Y bonds, Long Eurostoxx50 ETF