The short-end of both the OIS and the risk free curve is completely out of line with the cyclical reality. While this discrepancy has corrected quite a bit since April 5, 2009 (when I first highlighted the tremendous return potential), the market still seems to be discounting a pretty sharp reversal of monetary policy.
1-year OIS is trading at 3.77%
1-year OIS 1-year forward is trading at 4.62%
1-year Gsecs are trading at 4.19%
1-year Gsec 1-year forward is trading at 5.16%
While it is difficult to make a case for further rate cuts from current levels, I am prepared to bet that if there is a move over the next-year, it will be lower. And I remain confident that the RBI will keep the market flushed with liquidity. The call, therefore, will hug the reverse repo rate (on average) over the next one-year.
For the year starting May 2010, the outlook is slightly murky. Yet, at this stage I doubt that short rates will climb 150bp higher from current levels in a relatively short period of time. The market is pricing that the RBI will normalize policy quickly once signs of a rebound are well entrenched. I doubt that. Policy makers globally are unlikely to risk nipping an incipient recovery in the bud.
Given the above, I would buy 2-year Gsecs with 10% equity for 1-year. I expect this trade to earn a return on equity of more than 20%.
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