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It is no secret that Julian Robertson is not a huge fan of long-dated bonds. In hisrecentCNBC interviewhe had some downright nasty words about the back-end of the UST curve,especially if the "downside contingency" case of foreign purchases ceasing, were to pass.However, while many have known about his propensity for the bond steepener trade, hislatest trade position is the so called Constant Maturity Swap trade. Moving away from anoutright steepener makes sense as it can now only profit from a tail end widening, since thefront end of the curve is at zero. Unless Bernanke follows Sweden into negative ratesterritory, the steepener upside potential has just been mechanically limited by 50%. As forhis current preferred iteration of expressing Treasury bearishness, CMS, here is some recentcommentary from JR on the topic:"The insurance policy I would buy is called a CMS Rate Cap, which is theequivalent of buying puts on long-term Treasuries. If inflation happens the wayit could, long-term Treasuries are just going to explode. Less than 30 yearsago, long-term interest rates got to 20%. I can envision that seeming like avery low interest rate compared to what might occur in the future."No surprise then, that Morgan Stanley's Govvy desk has started pimping this trade(including some hedged and Knock Out variants) to anyone who wants to imitate thatoriginal Tiger. In a recent version of their Interest Rate Strategist, the key proffered trade isprecisely Shorting back-end rates, with the following summary recommendations:•Buy a 5 year Cap on 30 year CMS struck ATM (5.38%) for 105 bps•Buy a 5 year Cap on 30 year CMS struck ATM. Sell a 5 year Cap on 30year CMS struck at 8.38%, for a net cost of 65 bps.•Buy a 5 year Cap on 30 year CMS struck at 5.38% that knocks out in 1year if 30 year CMS is above 5.38% for 62 bps.Here is MS' entire modest proposal:In the past month, longer-dated volatility has declined and longer-dated rateshave rallied (Exhibit 1). Getting short back-end rates – with defined downside –is becoming increasingly attractive. We maintain our long-held belief that, in thelong run, the curve will steepen significantly, and we continue to believe thatlong-dated rate caps will benefit from the higher rates and higher volatility thatwill come from increased Treasury issuance and an end to the public stimulusprograms.Specifically, we propose a selection of the following trades:•Buy a 5y cap on 30y CMS struck ATM (5.38%) for 105bp•Buy a 5y cap on 30y CMS struck at 5.38%, Sell a 5y cap on 30y CMSstruck at 8.38%, for a net cost of 65bp•Buy a 5y cap on 30y CMS struck at 5.38% that knocks out in 1y if 30yCMS is above 5.38%, for 62bpInflation and long-end supply remain substantial concerns, particularly forlonger maturities. Our economists expect 10y UST gross issuance to more thandouble from 2008 to 2009, and for 30y UST gross issuance to more than triple.After 2009, we also project 10y UST issuance to increase by $40 billion peryear, and long bond gross issuance by approximately $50 billion per year
 
(Exhibit 2). This is while the Fed is projected to keep short-term rates on hold inorder to stimulate the economy and maintain a steep curve.We aim to target 30y rates. This is because we project 30y UST gross issuanceto keep increasing at a faster pace than 10y gross issuance (Exhibit 2).Moreover, we expect the curve to steepen in periods of high inflation.We also target longer expiries (3-5y). Two reasons behind this: first, we havebeen in a secular downward trend in longer-term rates since the mid 1980s(Exhibit 3). This is a trade for us to break out of that range – we expect such ashift to occur over a longer period of time as opposed to in the next year.Second, flows out of lower yielding money market funds into the belly of thecurve are expected to keep longer rates bid, at least for the next couple of months, in our view. This is something that we can exploit by entering into aknock-out cap.
 
In order to play for higher rates, we suggest a 5y cap on 30y rates struck ATM(5.38%) for 105bp. As opposed to a payor swaption, the payout of a cap islinear with respect to rates. For example, if 30y rates in 5y are at 8.38%, thenthe investor will make 300bp, multiplied by the notional on the cap.Investors looking to decrease the upfront cost of the option can accomplish thisin one of two ways: either by limiting their upside, or by playing the timing of the sell-off in longer-dated rates.Limiting the upside would involve selling an OTM cap against the ATM cap thatthe investor is long. For instance, if the investor sells a 300bp OTM cap againstbuying long an ATM cap, this cheapens the upfront cost of the option to 65bp,or by 38%. Note that OTM skew on longer tails has richened substantially overthe past three months. Exhibit 4 graphs the spread between 100bp OTM 5y30ypayors and 100bp OTM receivers, normalized by the level of at-the-money vol –the higher this spread, the more expensive payor skew is relative to receiverskew. Over the past three months, OTM payor skew has become increasinglyexpensive. This is why we prefer monetizing and selling it as opposed to movingthe strike of the CMS cap that we’re long further out of the money.Playing the timing of the sell-off in longer-dated rates would cheapen theupfront cost of the cap by selling a shorter-expiry option against the longer-expiry cap. Flows out of money market funds into the belly of the curve arelikely to keep the long end somewhat bid in the near term, in our view.Investors can monetize this by entering into a 5y cap on 30y CMS rates thatknocks out in 1y if 30y CMS is above a strike of their choosing. For instance, a5y cap on 30y CMS struck ATM (5.38%) that knocks out in 1y if 30y CMS isabove 5.38% has an upfront cost of 62bp; if investors move the strike of theknock-out to 6%, the cost increases to 79bp. Note that a 2y knockout cheapensthe cap even more than the 1y knockout. The principal risks to the outright CMSCap are either that rates continue to rally, or that vol falls. Note that both of these risks are mitigated with a 1x1 cap spread, or with a knock-out cap. Ineach of the three trades, however, the maximum downside for investors isequal to the initial premium invested.
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