The various peaks in the 3/5 spread as denoted by the alphabets A-E can be explained as follows:

Analysis of the peaks in the 3/5 spread
Point	Date	3/5 Spread (bps)	The Peak Happened…
A	26-Feb-09	62	On the new 3-year MGS 8/12 tender date
B	12-Mar-09	128	On the reopening 5-year MGS 4/14 tender date
C	01-Apr-09	65	2 days after the reopening 3-year MGS 8/12 tender date
D	11-May-09	110	3 days before the reopening 5-year MGS 4/14 tender date
E	11-Jun-09	89	3 days before the reopening 3-year MGS 8/12 tender date

Observations:

• The 3-year MGS is less volatile compared to the 5-year MGS
  
• The 3/5 spread peaked prominently during the 5-year MGS auctions (points B and D)
  
• The 3/5 spread increased during the 2 weeks period before a 5-year
  auction and then decreased for about 2 weeks after the auction
  
• The 3/5 spread also peaked (albeit smaller amplitude and shorter duration)
  during 3-year MGS auctions (points A, C, E)

The upcoming govvies auctions are as follows:

Upcoming MGS Auctions
Month	Auction
Jul	5yr GII New 7/14
Aug	2.5yr MGS New 2/12
Aug	5.5yr MGS New 2/15
Aug	5.5yr MGS New 2/15 (PP)
Sep	3.5yr GII New 3/13
Oct	5yr MGS Reopening 2/15
Oct	10yr GII New 4/20
Nov	5yr MGS Reopening 2/15
Nov	3.5yr MGS New 5/13
Dec	2yr MGS Reopening 2/12

Focusing only on the open market MGS auctions, we note that there will be three 5-year (or 5.5-year) auctions after the 2.5-year in August. This point to a very volatile 5-year benchmark from the period of mid-August to mid- November.

As the next auction is the 2.5-year, we expect the 3/5 spread to narrow further in the near-term until early August. After that, we expect market to focus on the three 5-year MGS auctions coming on board. We expect three big peaks to coincide with these three auctions, one of which may exceed the 128 bps high last seen in March. Lastly, in the last 1.5 months of the year, we expect the 3/5 spread to narrow again as market will then focus on the 3.5-year and 2-year auctions.

Short-term traders can benefit from this trend by executing the following trades:

• Long 3-year and short 5-year MGS two weeks before a 5-year auction, then short 3-year and long 5-year MGS sometime at the auction date, and finally squaring the position two weeks later. The trader should adjust the timing or length of the trade accordingly depending on the market movement.
• Should the trader experience difficulties shorting securities, an outright purchase of the 5-year during the auction and then holding it for 1-2 weeks should also provide alpha returns.

A point of caution: an important assumption for our view on the 3/5 spread as mentioned above is that market will continue to believe that OPR will remain unchanged until end of 2009 and beyond.