US Fixed Income

Deutsche Bank:

What form QE2 takes is debatable. Given the hawks’ resistance we think a buy-as-you-go strategy is more likely. Actively managing the balance sheet to bring down yields could allow for a bigger bang for the Fed’s balance sheet buck.

Implicit yield curve targeting reduces rate volatility and supports the mortgage basis. QE itself amounts to delta hedging inflation expectations so that real yields for now can take the brunt of any decline in nominals. This is important for risky assets although it works more through the weaker dollar channel.

FX volatility should rise as the Fed exercises QE2, especially relative to rate volatility.

5/30Y steepeners are attractive on a carry basis (relative to the volatility of the spread) and on a technical basis, since the curve tends to steepen after the month-end Treasury note auctions.

The Fed has ample ability to keep buying Treasuries in the secondary market for QE2, including raising the SOMA limit if needed, and buying the substantial amount of new Treasury issuance.

Capping rates by the Fed represents a transfer of volatility from rates to currency, and has not been priced in by the market: Rates gamma continues to trade high compared to other measures of risk premia. We are sellers of high strike payers as a way of financing a position in currency vol.

If the Fed does turn to either an indefinite buy program or a ceiling on rates, then it sounds right to hold Treasury debt into the announcement and then MBS after.

The latest Fannie Mae benchmark bond issuance showed higher participation by US investors and money managers. Foreign central banks are still buyers of the 2Y and 3Y, but have reduced their participation in 5Y issuance.


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