It appears that something is amiss in the rates markets.  It’s interesting the equity markets bounced back and there is no (net) ease priced into the 2016 Fed Funds futures markets, but the fixed income markets continue to price in the weakness scenario.  I still think there’s a chance we could snap back, but I wanted to share some strategy adjustments if we have to start pricing in this new regime.


  • Front Spreads

It’s a little baffling, but considering we have 2 bps of a Sept hike priced in (and no net ease), I feel pretty good with my thesis that U6-U7 should start becoming better supported.  I mean if the Fed can hike 2bps in September(!) then pretty much every quarter should be good for 2 bps of hikes (and I’m not even counting the non-quarterly meetings!), and you get about 2.5-3bps in term premium in U6-U7 over FFs.  That basically gets you to the 11bp close in U6-U7.  I don’t see Sept being more likely for a hike than Dec or any other meeting in 2017 – especially since the next UK PM may not be elected until September 9.  It’s only 12 days until the Sept FOMC meeting!  Is that enough time for the fog to lift?  I’m not saying U6-U7 couldn’t go lower, but for that U6-U7 spread to go noticeably lower, some other factor needs to present itself.  There is a reason to think it should be supported around here.  However, as previously mentioned, it may be more attractive to add plays earlier in the whites (next 6-9 months), as people may be wary of going further out and the shorter end takes less time to converge to actual Fed policy.  Apparently, 9-15 months, like H7-U7, is too far out (for now).


  • Back Spreads

While I am bearish the short end, I think it is very possible the long end rallies more (assuming Brexit article 50 is eventually invoked).  Having some long end flattening protection for our front bearish trades makes sense.  I look at the 30 year in the US being 2.10%, and 30yr Bunds yielding only 0.35% (and 30yr JGBs yielding 0.09%) and see the elephant.  I could see more demand with the baby boomers nearing retirement.  It’s possible the long end sells off, but I think the long end will flatten on a sell-off.


  • Year Flies

This sets up an interesting dynamic, that I wrote about in the Forum last week:   The jist is:

(U6-U7 spread) – (U0-U1 spread) = (U6-7-8 fly) + (U7-8-9 fly) + (U8-9-0 fly) + (U9-0-1 fly)

The difference between two year spreads is the sum of the flies in between.  In this case:

(11) – (20.5) = (-0.5) + (-3) + (-3.5) + (-2.5)


If it is my belief that U6-U7 stays supported (or goes higher), and the long end goes flatter (in both a rally and sell-off), then what I am basically saying is that buying year flies between -4 and -3.5 is a great buy.  Because if the left hand side is now -9.5 and going to compress towards 0 (or positive), and the FOUR flies on the right are generally all going to be negative (belly buying), you would be hard pressed to come up with a reasonable distribution of the four year flies that gets you to where a single year fly is noticeably less than -4 on such a flat curve.  Flies can easily get lower than -4, but only if you think the front spread goes much flatter or the back spread goes much steeper.  I don’t see this when the Fed has one ease bullet (presumably used sooner than later), does not seem to want to go negative, and their next major line of defense is QE.


  • Double Flies

160710 Fly CurveI loved buying negative year double flies as a way to get carry when the flies on the fly curve were positive.  This was because we made money on favorable roll on both the front fly and the back fly.  Buying the year double flies around the steepest points of the fly curve still makes sense, but are less attractive on a negative fly curve.  When the year fly curve looks like this (where the year flies fall on a straight line), there is a better approach.  We should be looking to sell the peak vs something further out (or some kind of slope hedge further out if we don’t want to go out too far out).  I mentioned this in a Portfolio email last week, but it has moved away.  Admittedly, it’s a bit of a roach motel (you can get in, but can’t get out) back there.  The market is going to look to hammer the peaks in a yield grab environment, so we should keep looking.


  • Volatility

If there is no ease and no hike (i.e. rates are low), shouldn’t volatility get absolutely hammered?  And in particular, calls.  In a bullish scenario, you need some ease protection.  You can get ease protection for nothing in FFs.  In a bearish scenario, if you believe the thesis that some of the front spreads are cheap, you have bearish protection.  If Dimon is right and Brexit somehow gets cancelled, we could get a big selloff, so I think having a put tail makes sense.  I like an overweighted F28 for protection on both sides for a favorable decay trade.


So in the next week or two look for some new official trades, that try to capture some of the new concepts mentioned above.