Rates

Desk Strategy Buy 15y gilts on ASW

European Macro Strategy
Trade opportunities
28 January 2020
 Gilts to continue their strong performance vs swaps, stay long spreads

 Buy UKT 1T 37 on ASW or on ASW butterflies vs surrounding gilts

 With spread volatility being low, the roll-down factor becomes

significant

UK spreads: the show must go on

We flagged the ongoing strength of gilts in ASW last year. First we focused on the 10-
year area (17 May 2019) then we discussed the steamrollering of the ASW term
structure (17 July 2019) and at a later stage we presented long spreads as one of our
main themes for 2020 (21 November 2019). So let’s provide an update:

We believe that there is a strong, underlying investor base that is willing to buy
spreads given any decent cheapening. On 7 January 2020, the DMO announced
additional gilt issuance in shorts and mediums due to increased financing needs. It is
remarkable that any cheapening due to that announcement reversed within a matter of
days with 5y spreads trading almost unchanged since the begin of the year and 10y
spreads being now richer, despite the UKT 4T 30 auction (scheduled for 10 March).

Chart 1 shows how spreads have performed across different maturities. The strength
has largely been led by the 10y sector which has barely seen any cheapening since
the beginning of 2018. The 20y sector has to some extent followed suit, but there is
more to go therefore we like buying UKT 1T 37 on spreads.

Chart 1. A structural bull market for spreads

Source: NWM, Bloomberg

70
60
MMS OIS discounted (bp)

50
40
30
20
10
0
-10
-20
Jul 17 Jan 18 Jul 18 Jan 19 Jul 19 Jan 20

UKT 1 1/2 07/22/26 UKT 4 3/4 12/07/30 UKT 1 3/4 09/07/37

Strategists
Theo Chapsalis, CFA
Head of UK Rates Strategy
This is Non-Independent Research, as defined by the Financial Conduct Authority. Not intended
+44 20 7085 9884
for Retail Client distribution. This material should be regarded as a marketing communication and may
[email protected]
have been produced in conjunction with the NatWest Markets Plc trading desks that trade as
principal in the instruments mentioned herein. All data is accurate as of the report date, unless
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otherwise specified.
Bloomberg: NWMR<GO>
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 Rates

Chart 2 shows 3 month changes across ASWs along with the ASW term structure.
The term structure has clearly flattened both because of richer long-end spreads and
cheaper short end spreads while 10y spreads have slightly richened. Even following
this move the 10-20 area continues to stand out as steep.

Chart 2. Steep 10-20 area of the ASW term structure

Source: NWM, Bloomberg

50 20

3m change
40 (RHS)
15
ASW OIS
(LHS)
30

MMS vs SONIA (bp)

10

20

3m change(bp)
5
10

0
0

-5
-10

-20 -10
07/09/2020

07/09/2021

07/09/2022

22/04/2024

07/06/2025

22/07/2027

07/12/2028

07/06/2032

07/09/2037

07/12/2040

22/01/2044

22/07/2047

22/07/2052

22/07/2057

22/07/2068
07/03/2020
22/07/2020

22/01/2021
07/06/2021

07/03/2022
22/07/2022

22/07/2023
07/09/2023

07/09/2024
07/03/2025

07/09/2025
22/07/2026

07/12/2027
22/10/2028

22/10/2029
07/12/2030

07/09/2034
07/03/2036

07/12/2038
07/09/2039

22/10/2041
07/12/2042

22/01/2045
07/12/2046

22/01/2049
07/12/2049

22/10/2054
07/12/2055

22/01/2060
22/07/2065

22/10/2071
Roll-down and little spread volatility
Chart 3 shows the pick-up that investors are offered per annum for taking 1 additional
year of duration risk. In the last 3 years, annual spread volatility for UKT 1T 37 has
been at around 2.2bp/pa. This compares to 3.7bp/pa from roll-down alone which has
acted additive to the spread appreciation.

Roll-down becomes bigger for UKT 4Q 32 and UKT 4H 34, but those bonds are much
less available. For example the BoE holds 70% and 58% of the free float for those
bonds respectively which compares to only 3.5% for UKT 1T 37. So in the event of
APF operations, there is a different buying potential for those bonds.

Chart 3. Significant roll-down in the 10-20y area given low ASW volatility
Source: NWM, Bloomberg

50 8

ASW pick-up / duration

40 (RHS) 6

4
Annual pick-up in MMS (bp)

30
MMS vs SONIA (bp)

ASW OIS (LHS)

2
20
0
10
-2

0
-4

-10 -6

-20 -8
07/03/2020
22/07/2020
07/09/2020

07/03/2022
22/07/2022

22/04/2024
07/09/2024

22/07/2026
22/07/2027
07/12/2027

07/12/2030
07/06/2032

07/12/2038
07/09/2039

22/01/2044
22/01/2045
07/12/2046

22/07/2052
22/10/2054

22/07/2065
22/07/2068
22/01/2021
07/06/2021
07/09/2021

07/09/2022
22/07/2023
07/09/2023

07/03/2025
07/06/2025
07/09/2025

22/10/2028
07/12/2028
22/10/2029

07/09/2034
07/03/2036
07/09/2037

07/12/2040
22/10/2041
07/12/2042

22/07/2047
22/01/2049
07/12/2049

07/12/2055
22/07/2057
22/01/2060

22/10/2071

Trade idea: Buy UKT 1T 37 on ASW: entry 32bp, target 12bp, stop 42bp

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Consider butterflies as an alternative

UKT 1T 37 is at the slightly cheap relative to surrounding bonds. Chart 4 shows the
directional link between the level of yields and the UKT 34-37-40 butterfly. Since the
beginning of the year the butterfly has failed to perform in line with yields, making UKT
1T 37 cheap vs peers. We think that this is a temporary deviation, hence we suggest
fading it.

Chart 4. Deviation from the directional move

Source: NWM, Bloomberg

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All data is accurate as of the report date, unless otherwise specified.

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