Last week, I said that we could see the ED-FF spread come in by at least 10bps by year-end.  Assuming the libor widening is “just” the Treasury money market rule changes[1], below are some thoughts I have on the ED-FF spread:

  1. EDU-Z spread could be negative while the FFs are still pricing in a year-end hike.

As mentioned last week, we could see EDU6-Z6 spreads approach zero while the Dec meeting is in the mid-single-digits (in FFs) – and it could even get negative if enough people think libor-FF collapses by the end of the year.  If you look at EDU-Z @ 4.5 (which would make it 3.6 removing the year-end turn), that’s fairly low.  In fact, the lowest this has closed in the past 6 months outside of the Feb crisis rally and the recent Brexit crisis rally was 5.5 (this past Thursday).  Before that EDU-Z was between 6 and as 12.  So the million dollar question is, is there another crisis looming?  I don’t see it, unless someone knows something about the data next week.

EDU-Z spread is basically the Dec meeting (plus 50% of the Nov and Jan meetings – so a total of two meetings).  FFX-F spread is basically the Dec meeting.  FFX-F settled at 5bps.  It’s unusual for more meetings in a hiking environment to be worth less than fewer meetings.  This 1.5bp difference is all the ED-FF spread priced to narrow by Dec.  And we would get more of this.

  1. People/algos who aren’t looking at ED-FF may think the ED curve is signaling more weakness than it is.

Even though EDZ6 rallied 5.5 bps last week, the EDZ-FF spread only came in 1.5bps.  This is because the Fed Funds also rallied on the week (about 4bps).  While Q2 GDP was disappointing, Nowcast’s forecast for Q3 only dropped 0.1 to 2.5%.  In addition, we had a marginally less dovish FOMC and BOJ.  It made sense for the Sept meeting odds to decline, but Dec should stay firm.

I do think that there are people and machines that look at EDU-Z and say… Whoa… what is going on there?  While it doesn’t seem like a 1.5-2bp move from the ED-FF spread is that much, keep in mind this is only on a 3month spread.  You should think about how this affects rolldown and what the entire curve looks like.  A lot of spreads (and flies) start looking like there is flat roll, but this is not the case.  If you are looking at 6mo spreads for example, they all roll not to the 7bps in EDU-H, but the 8bps in FFQ-G.  Again, this is going to seem like minutiae now, but if EDU-Z goes to zero, this could be more important.

I have to catch myself at times and remind myself that the roll is better than it currently looks because EDU-Z could go lower, and this may be (temporarily) dragging some of the nearby structures with it.  For example, EDU 1 year spread looks worse, as does the 1 year fly.  However, as the data starts looking a little better, I like looking at this as an opportunity to get on some cheap bearish fly structures.

  1. What will be the timing of the ED-FF spread narrowing?

This is obviously the million dollar question.  ED-FF could even widen back out (multiple times) before the Oct 14 deadline.  While I think ED-FF spreads eventually narrow 10bps or so, the timing is not clear.  Will it occur before EDU expires?  I’m guessing it will be sometime after October 14, but we could have “part” of the move happen before and “part” after.  The importance of this will affect how EDU-Z trades.  If all of the libor-FF widening is taken back by September, then there will be no effect on EDU-Z.  If it takes longer than the end of the year, then the other spreads could be affected.  My central case is that the new rules go into effect and people adjust sooner rather than later in this yield grab environment.

  1. Will there be any effect on the long end?

On the margin, this should cause some ED calendar spreads near the belly of the curve to widen.  I’m not sure to what extent companies hedged their commercial paper risk by paying floating (via various methods).  But when I look at the world of negative yields and the gigantic elephant, it’s hard to see a noticeably steepening.  I still think any nail that sticks up on the yield curve will get beaten down.  And I’m starting to think that with so many retirees on the horizon, that we could see noticeably negative term premiums in the very long end.  I may discuss this further in a future post.

 

[1] …and not something like European banks collapsing (FYI, the European banks did reasonably well on their stress tests).  But there is no corroboration of any bank/economy collapse in other markets.  I’m actually a little surprised libor-FF widened this much, so unless this is all speculators getting in the same boat, there could be other reasons.