This week, I wanted to talk about some “inconsistencies” in the ED curve pricing.  There are now three:

1) Curvature vs Slope.  The flies centered in the back greens and blues are strangely high, relative to the slope of the curve.  That’s a very fine crystal ball you have there – it’s unclear what will happen later this year, yet we will have recovered in three years.  Umm… no.

2) Why is EDU6-H7 THE lowest 6mo spread on the curve, and even lower than its neighbors?  EDU6-H7 should not be the lowest.

3) March and April Fed meetings vs the rest of the year

I discussed #1 previously in the write-up to Trade F8, so we start with #2:

2) EDU6-H7:

Here’s an interesting phenomenon… ED H6-U6 spread is 11.8bps, EDU6-H7 spread is 7bps, and EDH7-U7 is 9bps.  What is interesting to me is that, in my mind, U6-H7 should be either the largest or second largest of these three spreads. So despite all the concerns near-term about market stability, we have this strange situation where U6-H7 is the smallest of the three spreads.

Now part of this is the phenomenon I described last year, when I wrote that you should be cautious about U6 and H7 because of day-count.  Typically, a 6 month spread should have 26 weeks in between the settlements of the contracts.  But H6-U6 has 27 weeks, U6-H7 has 25 weeks, and H7-U7 has 26 weeks.  Now, the difference in number of weeks could be part of the reason, but a 1-2 week difference is only going to account for 4-8%.  This should not be a major issue with the curve this flat.

The other factor that I had previously mentioned was the timing of the US election.  The bar for a November election could be higher than other meetings.  However, you could say something similar for the September meeting, which should put more downward pressure on H6-U6 (since it has a full Sep meeting and half a Nov meeting).  And if what would normally be priced in for November gets skipped and pushed out, you would expect December to have more hikes than normal (which would benefit U6-H7).  So the relative cheapness of U6-H7 is not related to the elections.

If you believe this market volatility is a short-term issue, but things are looking good in the long term, you would expect H6-U6 to be the smallest of the three spreads (as the Fed will be on hold for the short term, but are more likely to resume hiking later).  If you believe we are doomed, you would expect all the spreads to be low.  So the remaining possible explanations are:

  • Some sort of libor issue timing. EDU6 does seem a touch high to FFs, but only by a fraction of a bp.
  • Some sort of ease timing issue. People may think later this year is more likely for an ease.  Again, this is possible, but I don’t see it – I think if the Fed eases, they will do it earlier than later.

I’m just not buying this 6mo spread pricing.  Another way to look at this is… the H6-U6 6mo double fly[1] settled at +6.8.  This is the 1 year high.  This settled a little high, but even 5.75-ish seems awfully high for this environment.  I smell a new trade.  Stay tuned.

3) March (and April) meeting:

One thing to keep in mind is that THE FED IS NOT GOING TO SURPRISE HIKE in this environment.  Some of the recent volatility in the markets is the result of the Fed removing some accommodation after a long period of easy money.  Easy money led to an increase in people grabbing for yield, overlending to “junky” borrowers, “overdevelopment” of US oil, and a host of other issues.  The markets have had a negative reaction to liftoff (aided by the Gunds yelling “fire”).  The LAST thing the Fed wants to do is add more volatility in this environment by shocking the markets with a hike.  They are going to hike, but hike gradually.  I will go as far as to say that if March (and to a lesser extent April) is not at least 35% priced by the time the meeting rolls around, there is NO chance of hiking.  The Fed is going to err on the side of being gradual.

I could see how you would want to be short FFJ6 if you needed some kind of protection… sacrifice 2.75 bps if you can make more than that somewhere else if the Fed doesn’t hike.  But why else would you want it?  Let’s think about what it would take for us to get to 35% priced for March.  Every market needs to stabilize next week (so we can show 1.5+ weeks of stabilization afterwards before the meeting), and maybe some kind of +300K and 4.7% number.  I’m still not sure that is enough to get us to 35%.  Enough Fed members are going to say we should wait for further signs of stabilization.  But you know what would happen if we got 300K and 4.7%?  Reds would sell off 25-50bps (i.e. a gamma signal completion).

FFK6 is pricing in 5.5 bps of hikes in the next two meetings, when most 3mo ED spreads (which also have about two meetings) are only 3.5 to 5.  So basically, you can put all your eggs in the very short term, where you lose money on the status quo (if we come in-line), or you put your eggs into the basket where you make money on the status quo (we keep getting constructive data and give the markets time to settle down).  The longer you give the Fed, the more time they have to see the stability they are looking for.  Oh wait… I smell another new trade.  Stay tuned.

[1] H6-U6-H7 6mo fly vs U6-H7-U7 6mo fly