HOUSE_OVERSIGHT_014758.jpg

Best Vol Trades Ralf Preusser, CFA Herve Belmas MLI (UK) MLPF&S ralf preusser@baml.com herve.belmas@baml.com Sphia Salim Christopher Xiao MLI (UK) MLPF&S sphia.salim@baml.com christopher.xiao@baml.com Tension in Trump’s policies are bullish for vol ¢ Weighing up the impact of fiscal easing vs protectionism and shifting from deflation to inflation risks should be bullish for vol. e Inrates, we see room for the belly of the curve to reprice to the dots. 2yly should cheapen 75bp, vol is cheap vs rates and the skew the least expensive in that sector. e In FX, we think vol and skew have room to reprice higher compared to the repricing seen in rates. We like cheapening a EURUSD put with a 3m30y strangle. e In EM, USDCNH calls are attractive in our view. A stronger USD adds pressure to depreciate, while the risks of trade tariffs, labelling China a currency manipulator, etc could lead to a sharp re-pricing or risk premia higher. Highest conviction in FX, belly of the US curve and CNH We view Donald Trump’s election as bullish for USD, bearish for real rates and challenging for EM. The inherent tensions in President-elect Trump’s policy proposals, as well as the question marks over the Fed’s reaction function should also support a repricing of vol higher, especially since neither FX, nor front-end rates volatility look stretched by historical standards. However, expressing a view on long-end nominal rates is harder, and implications for rates vol are less clear. USD 5y5y breakevens are consistent with the Fed’s definition of price stability for the first time in more than a year. In Europe, the sell-off in rates (both Bunds and BTPS) is tightening monetary conditions at a time when the ECB should do more, not less. Finally, the Bo)’s yield curve control should provide an anchor for JGBs. Consequently we focus on the following three trades: 11. Buying USS100mn 2y1y payer, struck at 2.50% (ATM+69bp) 12. Buying a EURUSD 3m 1.05 put, partly financed with a 150bp-wide 3m30y strangle 13. We recommend buying a 6m USDCNH 7.60 call US rates to converge to the dots: attractive in vol The view on long-end rates is complicated by the significant repricing of breakevens, the likelihood of the ECB doing more, and the Bo) defending its )GB yield target. We do, however, see room for a further increase in risk premia in the belly of the US curve. We believe that the market will ultimately view the Fed dots as a floor, rather than a cap. Supply pressures will weigh on the belly of the curve, rather than the long-end. This makes the cheapness of the upper left corner of the vol surface attractive. As we look for a repricing of Fed expectations, to levels more consistent with the dot plot, we recommend buying US$100mn 2y1y payer, struck at 2.50% (25-delta), i.e., ATM +69bp. The cost is US$165K, equivalent to 17bp of yield. We target a PNL of USS300K. Bankof America 28 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 Merrill Lynch HOUSE_OVERSIGHT_014758