I wanted to review some trading themes going into next year, and the trades I think make sense.  The black bullets have themes and the white bullets have trades.

  • How many hikes next year? We have liftoff.  The question is how many more?  The Fed thinks we get another 80-100bps in 2016.[1]  The markets think about 60bps.  My over/under is 2.5, so basically what the markets have priced in.  The more interesting question is, which meetings?  I like the idea of the March meeting, for reasons previously mentioned.  After that, I don’t have a crystal ball.  However, I do like the idea of using the fact that the Fed in the early stages may be reluctant to hike at consecutive meetings.
    • Own the March meeting. I don’t want to prattle on about March.  But at around 52% priced, this meeting still seems low to me, despite the low PCE inflation reading.  The Fed does see about 3.5 hikes next year, so they will need to get started at meeting #2 out of 8 for the year.  Data seasonals may be favorable considering the past two winters were so harsh.  We bought FFG-J (Trade E24b) at 7.5 and scaled in as low as 6.5.  It settled 13.5.  Since we had a nice move, I like taking 50% off between 13.5 and 15 (on an uptick towards our original target of 15) and keeping the rest.
    • Sell the April meeting and Buy the June meeting. Look for Trade E32 Monday.  It’s similar to Trade E27, which has worked great for us, and the nice thing is, it has limited downside (and could make money) if hikes get priced out.  It looks about 0.5bps away from my target level, but like I said, the trading could be thin and choppy next week.  So you never know.
  • Do we get a double dip recession? The tail should be there.  Whether you look at high yield, oil/commodities, EM turmoil, global unrest/terrorism, and/or the specter of Trump or Clinton running the country next year.  If your capital and cost structures permit, I like putting on various “zero cost” ways to play for an ease.
    • Those May 99.50 calls look attractive. I like working a 0.5 bid (in these or the EDJ6 99.50 calls), and as I accumulate them, selling (some of) the EDH6 99.50 calls at 0.5 or higher.[2]  Yeah – this probably won’t amount to much, but if it does, you may be able to take the rest of the year off. [3]  Look for Trade E33 on Monday.
    • I’m still a fan of conditional call steepeners in case of a blow-up. The ones we did haven’t been great, but we knew the curve could flatten on a selloff.  But now that we’ve flattened, you can probably find strikes that suit a little better.
  • There could be a downside tail. Just because I think the upside tail in EDs is larger than the downside tail does not mean the downside tail is not worth looking into.  The scenario that no one is talking about is what if we get some kind of massive upside surprise on growth and/or inflation next year.  It’s not implausible for the Fed to need to hike more than 4x next year.  I’m not saying it’s likely – just that very few people are looking at it and so it will not be priced.  This is still a work-in-progress for me, mostly because I am looking for something with low risk if it does not materialize.  This past PCE inflation print was a little disappointing, but perhaps there will be an interesting opportunity in January.
  • What is the deal with swap spreads? After that massive move in 30 year swap spreads in 2008, I suppose no one does convexity trades any more.  I can buy the fact that swap rates are lower than Treasuries – it’s just supply and demand.  And with too-big-to-fail, I suppose you could argue some banks’ credit is at least as good as the US government credit.  What I can’t buy is the lack of consistency in the curve in the short end vs the long end.  How can one year swap spreads be +18bps and the 30 year be -34bps?  Decide please… because a bunch of short terms become one long term, and the current structure does not compute.  So it seems to me that one or both of these things need to change.
    • The short end still seems nervous. I like the idea of buying EDs vs FF, but I can’t get that excited about it when cash libor is still fixing relatively high to FFs.  In fact, EDH and EDM spreads to meeting-matched FFs are lower than cash libor spreads to FF right now.  Looking in the reds may provide better value.  I’m going to be on hold for now.
    • The long end of the yield curve is a little harder to trade. My favorite play right now is just indirect – owning flies on the long end of the curve.  As the swap curve reflates, we should see more shape.  I like buying the low year flies at 2 (look for Trade E34 on Monday).  A better but harder-to-get-filled way to play would be to buy the H0-U0-H1 fly @ 0.[4]  It settled unfavorably at -0.5 last week.

[1] 100bps based on the median of all 17 dots, or 80bps based on the mean with the high 6 and low 2 dots removed.

[2] Assuming it makes sense based on your capital and cost structure.

[3] Just joking.  If your trading is positive expected value, you should rarely take time off – it’s like a casino turning off a slot machine.

[4] You need a low capital and cost structure.