Brexit potentially changes the regime we are in, as we now have to consider an increased chance of an ease.  Any time we may have a regime change, some additional caution is warranted.  To use the homeland security advisory system colors, I would say we are probably a yellow-orange (elevated-high)[1] for the next few days, and decreasing thereafter (assuming nothing happens).  I wanted to go over some thoughts and minutae about potential impacts on the STIR futures markets:

  • While I did say the over / under on number of days before we get over Brexit is 2.5, the tail is really big. FFV6 settled 99.66 (about 2.5 net bps of an ease[2]).  This traded up to 99.71.  5 net bps of ease is no joke, considering the low was 19bps lower less than 24 hours ago.  You don’t see FF4 change that much nowadays.
  • This makes a July Fed hike impossible. No kidding.  I agree that some probability of an ease should be priced into July.  FFV6 is leading the ease rally, so people think it is more likely that the Fed eases in September than hikes.  I’m not sure this is true, unless the data turns really slowly or the Fed acts really slowly.  Keep in mind the Fed only has 1 bullet left.  So a Sept ease means they do nothing in July and eases in Sept.  It’s possible.  It just seems if they have to ease, the more likely candidate is July.  Negative rates could also make it possible for a Sept ease (not sure if this could happen).  But they only have one or two bullets for that (if at all).
  • If you are an old timer, you may think. “OMG! the front of the curve is going to invert!” But the Fed can only ease ONE time.  So if you know any Fed ease is in 2016 and the curve may not invert past Z6 from an ease (it can invert for other reasons like credit, or the Fed going negative, which they did not seem to like), then buying any 3mo ED spread further out at like 2bps is a free put (something for term structure / risk premium and something for non-zero probability of hike).  You just need to pick a part of the curve that won’t invert.  And I think that’s why things like H-U came back.  The main issue with H-U is the extent to which negative rates will be priced.  I think this unlikely as this is not one of the preferred alternatives.  I suppose if you think the Fed could go negative, then maybe we could get an inversion in late 2016 or early 2017.  But I don’t think negative rates are particularly effective.  There is no real place for the curve to go after the ease… except for the long end, because QE will follow the ease.
  • ED vs FF spreads. I discussed the benefit of having this spread in times of crisis, if you think LIBOR-FF spreads increase.  There has been no real sign of this though.  And it’s not clear if an overabundance of liquidity will be provided, causing that spread to decrease (it’s possible).  The other benefit of owning FFs is that the Fed may provide temporary additional liquidity in times of crisis by lowering the Fed effective rate.  But the current high FF effective fixings make holding a bunch of FFs less attractive.  For Thursday the fixing was 39bps, and the previous 5 days it was 38bps.  This is after being 37bps (other than month-ends) for three months.  If this doesn’t go back to 37 bps early in the week, FFN starts looking less attractive as an intermeeting ease or additional liquidity play (unless you strongly believe this).
  • If ED-FF spreads are stable, this makes available EDN thru EDU options to play for an ease. So let’s look for cheap ease plays next week.  In particular, I think if nothing major happens in the next week or two, we may be in the clear.
  • An ease is not likely. However, it’s not clear how the global equity markets will react.  In particular, there was apparently a ton of equity puts purchased leading up to and after Brexit.  It is not clear to me if this was against longs, or if these were outright positions.  Keep an eye on equities – because any significant downside move could start multiplying because of options. 
  • Where the S&P is will matter a lot in determining the Fed’s actions. I’m looking at equities as a sign of corporate and consumer confidence.  I think equities could move very quickly.  If it is <1800, then “yes” – an ease is possible in the next two meetings, and a hike is not.  If we break 1800, we could be much lower.  If it is > 2100, then “no” – an ease is not possible in September and a hike is “possible.”  I’m actually am not sure where we will be.  To be honest, I’m shocked it is still above 2000, with all the fearmongering banter.  Logic would have dictated we should be < 1800 for the past year!  Yet we were at 2100 just last week.  So did Brexit do anything to kill the elephant?  We’ll see.
  • There may be higher volatility on any equity or headline risk, and a higher potential for the bears to get squeezed. This uncertain environment may dampen investment and slow growth in the UK, the EU, and possibly the US.  This remains to be seen.  You could argue that now we have some certainty and can move on.
  • Towards the end of Friday, you started seeing some of the long end bulls who squared up pre-Brexit, come back into the market (curve flattened). If the Fed is going to be on hold, the Fed only has 1 bullet (and limited scope for curve steepening) and QE may be on the horizon, why not?  A flatter curve means less of a possibility of the curve (year flies) to get extreme.  This is because there will be a yield grab around the center of any fly that sticks up too much.

 

Logically, I don’t think Brexit matters that much to the US.  And I think the most likely scenario is that we move on.  Can we still trade with the EU?  Yes.  Can we still trade with the UK?  Yes.  Can the UK and EU trade with each other?  Yes.  But some of the rules will change.  I can see how short sterling futures (LZ7) were up 40bps at the high.  You can expect some economic weakness in the UK.  Goldman reduced their 2017GDP estimate from 2.0% to 0.2%.  But why was EDZ7 up 34bps at the high?  We’re not *that* related.  Brexit may cause the Fed may be on hold for a period of time, but the Fed is not responsible for the UK.  The BOE may have to ease if their economy looks shaky.  It’s not the US on credit watch or whose GDP got downgraded.  It’s also possible longer term global growth will need to be downgraded for Europe if any EU synergies are lost.  More reasons to like the long end.

 

The UK accounts for 2.7% of US trade.  If JPM relocates from London to Paris, that’s bad for the UK, good for France and mostly neutral (but annoying) for the US.  Half of the industrialized countries are not part of the EU, and they do fine.  It’s just divorce can be messy.  They just want to renegotiate trade terms.  I realize there are second order issues at stake, like others following suit, headline risk, and some unaccounted-for risk.  We will have more uncertainty in the short term, and the tail can not be ignored.  My only real concern with Brexit is that somehow this causes the spark for some kind of equity market meltdown.  If Brexit is the catalyst for that equity meltdown people have been expecting for the past 1-2 years, then it matters.

[1] The colors are: (1) Severe (Red), (2) High (Orange), (3) Elevated (Yellow), (4) Guarded (Blue), and (5) Low (Green).

[2] “net bps of ease” = bps of ease – bps of hike.