151026 9-17 spdOne of the reasons this has been such a tough fixed income trading environment is because there has been very little curve movement, relative to the movement of rates.  The scatter plots on the right are of the ED9-17 two year spread vs the level of ED9.  The blue triangles represent the trading levels from the past 6 months, and the grey diamonds represent the trading levels from the prior 18 months (previous to the last 6 months).  We have had a reasonable trading range in ED9 in the last 6 months.  However, the shape of the curve (using ED9-17 spread as a partial proxy) has had very little movement.  This is evident from looking at the flat “straight line” distribution of the ED9-17 spread the past 6 months, when compared to the scatter from the past two years.  There was a lot more movement, and hence opportunity, last year.

 

151026 5-9-13 fly

Even in butterfly-space, the curve move has been very muted.  On the right are the 6 and 24 month scatter plots of ED5-9-13 1 year fly.  This too has traded in a fairly tight range, as compared to previous historicals.  The big curve move the past 6 months has been the flies centered in the (back reds and) front greens getting pummeled on the rally.  We did well to stay away from those – not buying those any more on dips a few months back.  But the flies never got to levels where we would want to aggressively buy or sell, based on the environment at that time.

 

Granted, we are comparing apples to oranges in that the regimes then (6-24 months ago) and now (last 6 months) are different.  The Fed finished tapering and are now about to hike (allegedly).  Another reason is the collapse in ten year yields earlier in the year.  QE in Europe, combined with global weakness, downside inflation risks and a crisis bid at various times in the year have all contributed.  But all things considered, I still would have expected more curve volatility than we have had.

 

While I was writing that blurb about Taleb, it reinforced my idea from the past few weeks that perhaps while the curve is unusually flat, we should think more about the tail scenarios, and what the curve should look like in those scenarios.  While the current curve is not offering much in terms of opportunity, we can be like Nassim and think about any tail possibilities that are not being correctly priced into the markets.

 

Among all the midcurve options, vol/premium on the options in the golds are the highest.  This does make some sense in the context of short term moves.  After all, most weeks, the move has been led by the golds (or the blues).  However, I am not sure this will always be the case, and in particular on a very large move.  So looking at the extreme curve scenarios and putting on some “zero-cost” structures makes sense.

 

On a massive upside move, it’s a little unclear what the shape of the curve will look like – typically you would expect a bull steepening, but with QE4 likely to be priced in, the shape is less clear.  I would prefer to continue to wait for better levels.  I think waiting until H8-H0 2 year spread (currently 78.5) gets in the 60s before putting on a conditional call steepener makes sense.  This corresponds to the lows from a few months ago, and even in the EU (where they have an active and potentially increasing QE) this similar spread is over 60.  I think we could bull steepen on a large rally, even from the current levels, but it’s not as compelling a trade.  So I continue to wait.

 

On a massive selloff, I think the first year spread is very underpriced relative to the rest of the curve.  Friday’s move was not helpful to this pricing, so I want to see if we can get to better levels.  I like owning overweight 0EH puts vs puts further out the curve.  I’m hoping we get a pop, either after the Fed meeting or a low GDP print next week, so that we can put some on.

 

Until then it pays to be patient.  The curve hasn’t moved much in the past 6 months, so we can probably be selective about entry points.