I wanted to discuss the 6mo spreads. On the right is a chart of the 6mo spreads from Friday. The curve is turn-adjusted, and the x-axis lists each of the 6mo spreads, starting with ED1-ED3. On May 9, I discussed how strange it was that the middle of the spread curve was so flat (green shaded area). Back then, the levels of the spreads were about 2bps higher, but the recent flattening of the curve (even after Friday) caused the green box to be shifted lower. So this “pattern” of having the meat of the spread curve be flat seems to be here to stay.
This time, I want to discuss an interesting feature of the current curve. It’s highly unusual for the 6mo spread curve to have multiple peaks. Typically, the curve only has one peak – at the beginning, middle or end. We now have this strange situation where there are THREE distinct peaks in the curve: (1) around ED1 6mo spread, (2) around ED5 & ED6 6mo spreads, and (3) around ED18 & 19 spreads. This is not an equilibrium shape for the curve.
The first peak is basically what you expect when the Fed is expected to hike “in the coming months” (or at some point shortly thereafter). And I think there will be enough hawks unphased by payrolls to keep this the high spread on the curve. The third peak is the reason why the 1yr single flies further out and the 1yr double flies are negative. I discussed in the past why I did not think this belonged here.
What I wanted to discuss today was the second peak. This does not belong here either. There’s a very small chance that we have some strange timing issue on the curve – like if you knew the Fed was likely to hike in Q4 2017 and Q1 2018. Again – bless you if your crystal ball is that good. I don’t see it, so I feel like this is some sort of excess large positioning that needs to be faded. For all I know, the Fed could be easing by then! And there are plenty of people in the market who are scratching their heads on this also. Since I am aware that there may be a timing issue (as unlikely as it is), I think if there is a problem, we could be one of the first ones out. As we saw when Bill Gross used to take his massive positions, it gets a little uncomfortable trying to figure out when they stop. But when they get out, it can be amazingly profitable.
Now that some of the shorts in the greens got stopped out, it’s also looking possible that EDU7 may be too rich. So now, this situation is looking like the markets are being doubly “too fine.” One or both of those kinks will resolve over the summer. There’s a small chance the contract roll in a week will help, so I like having some size on.
[This was originally published June 6, 2016]