I was looking at a chart of EDZ7, and we have traded in a 28bp range the past SEVEN weeks. And it doesn’t even feel that wide! We have CPI next week, but then two more weeks of nothing before the June ECB meeting and payrolls. So I thought this would be a good time to talk some strategy on a new trade thought… on nothing. That is, nothing happening. People tend to think about trading the markets in terms of rallies and selloffs, and not enough focus is given to “nothing.”
I have been saying for some time I thought EDU6 would start getting pinned near the 99.25 strike. It’s not much of a call to say the Fed would be capped between 0 and 1 hike through the September meeting, and the November meeting was always going to be negligible. The libor-FF spread has been very close to 25bps for a while, and the NY Fed’s new FF effective calculation (using the median instead of the mean) has caused the FF effectives to be exactly 37 bps every day for the past two months except for month-ends. People are going to be pricing something in for the June, July and Sept meetings. So this confluence of factors has crushed the potential movement of EDU6 and caused us to be around 99.25.
However, I do think after the June meeting, EDU6 will start gravitating midway towards either the 91 or 93 strike – we should have a little more clarity then. EDU6 also settles before the Sept FOMC meeting, so you know a full hike or a full skip won’t be fully priced in, but as we get closer to settle, you would expect the markets to start forming a stronger opinion – especially if there is no hike. We could sit around here for a while, but the problem with the 25 strike on EDU is that it’s not a great settlement strike. We should hopefully pick up a little more on the decay before then.
For many of the same reasons mentioned above, I like taking a terminal position on EDZ6 some time in the next month or two. Hopefully we get a meaningless spike in vol to sell. As mentioned a few months ago, EDZ6 settles AFTER the Dec FOMC meeting. At that time, the Fed will be at 0, 1 or 2 hikes, and EDZ6 has a good chance of getting pinned very close to the 93, 91 or 88 strike at settlement (respectively). This does not happen very often that the settle of an ED contract is after the FOMC meeting day. I think we should try and take advantage of this development.
The big wild-card is what happens to the libor-FF spread as the year goes on. There are some in the markets who think it could widen – either from Brexit (June) or from the SEC’s new money fund rules (October). I’m not so sure. Brexit odds seem to be getting lower every time I look at the oddsmakers, and the BOE and IMF did warn about consequences last week. But I think in an environment where rates are so low around the globe, that there is a limit to how much the ED-FF spreads can widen from just non-crisis supply/demand. Ten year bunds are at 12bps, the ECB is about to start buying corporate debt, and people are afraid that there will be no demand for commercial paper and libor may go through the roof?!? I’m not a believer. I think supply and demand for short term and longer term fixed income will re-adjust (issuers will shift to the longer end and buyers will migrate to the shorter end). This might be what is going with the large corporate debt issuance lately. If there is value, people will buy it. Even if there isn’t value, because of the elephant, people will still buy it. As a result, I like even more owning (overweighted) calls in the ED whites vs other things, as a cheap play for ED-FF spread narrowing later this year. But back to the topic at hand… EDZ6 options trades.
I think it makes sense to protect the side you think libor may drift to via EDU structures. If you think libor-FFs stays around 25bps, it makes your decision easier, as you would have nothing you need to do but to take the appropriate view on EDZ6. If you think libor-FF goes lower, you can do something like F19. If you think libor blows out, you probably want to wait until the dust settles. While I’m mulling this over, you should too… I feel like we would be letting a good trading opportunity go to waste if we don’t take advantage of the EDZ6 options expiring after the FOMC meeting, and the nice opportunity to pin a strike (depending on your rate hike view).
[This was originally published in the May 16, 2016 issue of the Curve Advisor.]
 I don’t consider Brexit a “crisis” – everyone knows it’s a possibility and have ample lead time.