One of the things that were baffling me a few days ago was how the long end could be so rich when the flies centered in the reds were so high. We did a trade and cashed in. Now that the flies in the reds have come off some, I’m still wondering how the long end could be so rich, relative to the curve. Then I took a step back to look at “valuations,” which for interest rates involves analyzing the path of Fed rates.
Here is the CHRONOLOGICAL order of how the Fed would respond to continued economic weakness:
- The Fed has to stop hiking this year. No more babbling about 4 hikes this year. At some point, we will get to 3, then 2, then 1 and eventually to zero (and all this could happen in a very short amount of time). In other words, the year spreads in the front of the curve will approach zero. The three year low on whites-reds spread is 11.5bps (currently 46.3bps). Unless we are talking about some sort of five-year-long Armageddon, as the year spreads (and flies) in the front of the curve go lower, year spreads (and flies) in the back of the curve (slope and flies) will start getting higher (but typically not as much as the year spreads in the front declined). We started steepening further out the curve towards the end of the week, but flies are at low levels on basically the entire curve.
- The Fed will take back the last 25bp hike from Dec 2015. That’s another rally of 25bps in the whites somewhere… and something between 0 and 25bps that should go back into the long end, causing flies to go higher. You may see a theme here…
- The Fed may consider negative rates and/or QE4. Negative rates could cause a further rally in the reds and the steepening of the curve in the long end. However, additional QE would have the opposite effect of flattening the curve more.
The long end has just been bid relatively for a while. Part of it is a lower neutral rate, part of it is lower inflation expectations, part of it is lower oil, part of it is cross-rates trades (EU and Japan QE), part of it is hedging demand and part of it is retirement demand. I’m not saying those things aren’t valid.
However, there will be some point at which Fed rates will normalize, at whatever the long term terminal rate is. Before we go pricing in the “Armageddon scenario,” maybe we should price in the “Hiccup scenario”? That is, before we start pricing out the Fed for the next 5 years, how about we start at Step 1 and take a closer look at what is reasonable for 2016? My over/under for number of hikes this year started at 2.5. The events of the past week maybe nudged it down to 2.25 (basically unchanged). Most members of the Fed are not stupid. They are going to be accommodative and not hike rates if things don’t look well. They will revise their estimates over time. I’m not sure the events of Week 1 were not that dire, but panic has a funny way of spreading.
That is just my view. Your view may differ. However, the three-step order of Fed action won’t change:
- If you are in the Armageddon camp, look at buying ease calls (FFJ6 99.50 calls settled at 0.5, and you may be able to sell EDH6 99.50 calls against it for flat). Because before we get to Step 3, we need to get through Step 2. The risk/reward of buying the long end seems questionable to me from the current levels.
- If you are like me, and see this as a Hiccup, I think this could be a good time to start accumulating puts. This will be my primary focus next week.
My secondary focus will be to look for Fed November skip plays, as it should be lower-priced before the major election. So stay tuned.