150928 1 year flyAs mentioned last week, the fly curve is absurd.  I can see arguments for various parts of the fly curve being the way it is – but not for these various features to exist simultaneously.  So this is NOT an equilibrium curve.  I was going to discuss the second hump on the curve this week,[1] but the Boehner resignation and what feels like curve nervousness is making me want to discuss the dip further (red arrow).  I previously mentioned that the long end is going to be bid because bears are going to like flatteners and bulls are going to like buying the long end with a potentially active Fed.  The second needs more elaboration.  In addition to just “bullish punting,” there are a few other reasons to want to buy the long end:

  • There could be long-end buying from a potential government shutdown. I don’t think this is likely, but Goldman thought it was 50-50 before the Boehner resignation.  A week of shutdown is 0.1 lower in GDP.  The 16 day 2013 shutdown supposedly shaved 0.3 off of GDP.  I don’t see a shutdown as high probability short term, but longer term one can never underestimate government stupidity.
  • Flight to quality. In addition to China, EM, equities, commodities, etc, we also have people rotating out of riskier assets into safer assets.  The last time I checked, you can also buy purples (instead of blues and golds) – especially when it offers more value via curvature rolldown.  As mentioned earlier, it will be interesting to see if we get an orderly risk repricing or a violent one.
  • Ray Dalio (Bridgewater) is not a believer of a sustained recovery.  Last month, he said, “We are not saying that we don’t believe that there will be a tightening before there is an easing. We are saying that we believe that there will be a big easing before a big tightening.”  I didn’t think much of it at the time, because I thought it was an investment guy just trying to keep all asset prices high – especially since he got torched for a -4.2% return in August.  But maybe he got some people to buy into that theory, because we are pricing what I would consider a disproportionate amount of a recession/QE4 scenario in the curve.  What’s funny is that at least one of the economists that were calling for a September rate hike is now talking about QE4.  Are you insane?!?  Here’s my problem with trying to play for QE4 – there are a few things that have to happen before QE4 is even on the table: (1) the economic data have to fall noticeably, AND (2) the inflation data would have to fall noticeably.  In terms of the curve, all near-term hikes have to get priced out, and the flies in the reds have to go severely negative.  These things could happen simultaneously if something were to happen, like the S&P selling off 500 points.  But I’m still waiting for #1 to occur.  I have been talking about headwinds for a while and I believed in the fat tail as much as the next guy.  I just haven’t seen enough evidence in the data to think the market hasn’t overplayed this.  The UR is 5.1%!  When the Fed ENDED tapering, the UR print was 5.9%.  I think most reasonable people would expect some sort of lognormal distribution of the UR around the current 5.1% level (maybe lower) in 3-6months’ time.  I don’t know if it makes sense to have a UR of 6+% be a “base” scenario to get QE4.
  • Swap spreads being negative doesn’t help. It’ll be interesting to see if this is an aberration, or a permanent and worsening situation.


There are some reasonable arguments for some of the bullish scenarios above.  I had previously said I thought the risk of a recession by the end of 2016 was 20%.  The markets seem like they are pricing in something closer to 50%.  I’m not saying this isn’t possible, but we are three months into the Chinese equity crash, and we haven’t seen a huge impact in the data thus far.  It’s possible it could take a few more months for this to feed through, but it’s also possible it may never feed through.


My main reservation is this… Yoy headline inflation will get higher in early Q1.  This is a fact, barring another leg down in prices.  Higher yoy headline inflation is going to make the case for owning tens and QE less compelling.  Higher headline inflation also means lower real rates of return – for tens at 2% to be attractive when the yoy PCE is 1.7%, there has to be a severe downturn in the economy.  Is this really the central tendency?  I’m not saying we couldn’t rally more in the short term.  But there is a reason to think we could get a pop in ten year yields at some point within the next 4-5 months.

[1] I will discuss the second hump in a future issue.