Before you say, “Man! Not this chart again! Don’t you do anything else?!?” But it ties in what I think about the short end of the markets, and what I think should be going on in the rest of the curve. We still have three peaks – it looks like 5 peaks in this week’s curve, but I think further out the curve were just some bad closes. This is not an equilibrium shape for the curve – I know I said this last week. But it’s true again this week.
The curve just got “stupider” this week. I fail to see how one of the PRIME areas for hiking (H7-U7, labeled as “4” on the x-axis) is now the lowest 6mo spread on the entire curve! If you notice, the green box dropped about a basis point overall. What is more interesting is how the spreads at the front of the green box fell and the spreads further out are near the top of the box. This makes no sense, considering the high year spreads are still in the front of the curve. Somehow the Fed is going to hike soon (despite the fact that most people think the Fed will be dovish next week), as evidenced by how high the first few spreads are (relatively). And the distribution of spreads in the green box is this? Before I believe the weakness story being told by the distribution of spreads in the green box, I need to see the front spreads get much lower. Unfortunately, I can’t sell those front spreads at the current levels because I think the Fed could hike in December – otherwise you can do something like sell the U6 6mo double fly (I’m NOT saying this is a good trade).
I want to discuss the bigger picture of what is going on, and what I think the curve should look like in various scenarios. I decided to try and figure out what the bulls are looking at, and what the bears are looking at. I’m focusing on what is priced up to EDZ7. I think 18 months is a reasonable timeframe. The crystal ball is hazy enough as it is. The solid Red line (“6m spd”) on the chart on the right is the market close on Friday.
The dotted Blue line (“CA”) is where I think the curve should be. Note that this is about 10bps lower in EDZ7 than the market. I think we should be even lower, but I wanted to factor in a most-likely bullish FOMC, and some possibility of a fixed income rally (and/or short squeeze) going into Brexit. In a nutshell, I think a hike in Q2 and Q3 are unlikely. However, a Q4 hike, assuming continued 2% GDP growth pace, seems reasonable. I think there may be about 2 more hikes possible for 2017. This to me is very reasonable…
The “Bull” scenario (dotted green line) is how I see the curve if EDZ7 were to rally 20bps to a bull. This is different from what the curve will actually look like on a 20bp rally, because we will have both bulls and bears (and everyone in between) making up the curve. This is just my interpretation of what the curve should look like in the minds of the bulls. If you are a bull, you basically think the data will continue to disappoint, and the Fed won’t hike for a while. Note that this is just if EDZ7 rallied 20bps. If you were super-bullish, you may think EDZ7 rallies 75bps because the world is blowing up and the Fed is going to ease. But there is almost no ease priced in right now.
Similarly, if you were a “Bear” (dotted purple line), you probably think the Fed hikes a few times…. possibly as early as September. You like the earlier hikes, rather than the later hikes, since you don’t know how often they will have to move.
What is the point of this? I just wanted to see what a 72/25 curve would look like in the Bull world and the Bear world. You are never going to get rid of either group. The thick teal line is the 75/25 Bull view (“Bull75”) and the thick orange line is the 75/25 Bear world (“Bear75”). Note that the first two 6mo spreads look like they are from Bear75 and the ED4 6mo spread on out look like they are from Bull75.
I’m not a big believer of schizophrenic curves. Someone is wrong. You could make the argument that the markets think the Fed could hike once and then be done. Maybe. But this presumes a high degree of stupidity and myopia on the Fed’s part. Despite my making fun of them all the time and the inane hawkish tantrums of the non-core members, I think the core members have a little more common sense than to hike when they think they only need to go once. This is being a little too fine.
Comparing the red and teal lines shows that the thing that is most at risk of dropping should eventually be the first few 6mo spreads. This may not happen right away, but eventually, you should expect all the hikes in 2016 to be priced out on a bullish scenario. The 16bps in 2016 are quite fragile. Say we got a negative payroll next month. Or even an extremely dovish Fed next week. Those are some of the easier bps to get on a rally. However, when we look at the meetings, other than the 4.7bps in July, the rest of the rally would be swimming upstream. Even if I were bullish, I’m not sure I want to fade the Sept meeting at 5bps, the Nov meeting at 0.5bps or the Dec at 5.8bps. So I’m not a big believer in the rally.
But on a selloff, the easier bps to get are probably in 2017. We are coming off some terrible payrolls, a potentially dovish Fed, the upcoming Brexit vote and lackluster data. The near-term hikes should be a little slower to get priced back in.
 In a future issue, I will discuss another reason why having high spreads further out don’t make sense. I had an epiphany.
 Right now there is almost nothing. A reasonable proxy could be the EDZ6 99.50 call. This was as high as 10.25 in February. This was as low as 0.75 earlier this month, and it’s 1.75bps now. At the highs from early May, this got up to 2.5, and at the highs from early April, this was 3.5. Part of this is just that this is only a 6mo option, while in April it was an 8 month option. But basically, no one is thinking ease now. If an ease is not going to happen, I think the markets are severely discounting the possibility of a hike in 2017, and to a lesser extent Q4 2016.
[This was originally published on June 13, 2016]