This is a difficult environment to trade in. The political environment is uncertain – not just in the UK, but in the US as well with elections coming up. The direction of the economy seems uncertain – it’s not clear how Brexit will affect the US (if at all). And the main tool we have to express our view (Eurodollars) has been partially taken away from us, because libor is not well-behaved right now. However, there are some things we may be able to take advantage of:
1) We can use FFs to express our Fed rate views.
It’s been a while since we looked at the Fed probabilities. FF effectives have stabilized around 40. It has been there for three weeks, so I think it’s reasonably safe to dip a toe back in the water. You could make an argument for owning any of the meetings from these still-low levels. I don’t think they are hiking in September, but at 4.5bps, I’m not going to go nuts selling it here. It looks like we should have more Brexit uncertainty, and we will be getting post-Brexit US data soon, so that would be the motivation to fade a move in September.
The selloff in EDs has overstated the degree to which the Fed probabilities have increased. While FFV-EDZ has taken off like a rocket, the similar trade in FFs is still somewhat low. I’ll keep an eye out for this type of play as the Sept meeting gets more priced – perhaps around the Fed meeting. I still think the Dec meeting offers reasonable value for a hike. We did well with FFV vs EDZ, and with EDU6 1yr fly. And I will keep looking for better risk/reward ways to get that Dec meeting exposure on.
A little further out, we currently own the Jan and April meetings, which look like good value. I think the non-quarterlies should be worth at least a quarter of the surrounding meetings (probably not November, as I have been saying for a while). And these are our indirect plays on a Q4 or Q1 hike, until the timing is better for a more direct play.
2) We can take a position on libor – FF… using options.
Brexit is obviously one cause for the libor-FF spreads going out. But if this is somehow related to the new Treasury cash rules that go into effect in October and if nothing happens, we could see the spreads come back in. I am of the opinion that companies should be incredibly prepared for that. Unless you are some kind of idiot corporate treasurer, you should have done something to prepare for this, like issue longer term bonds and receiving fixed to replicate floating payments. So if this is what is going on, this may have contributed some to the (spread) curve flattening. This is one of the reasons why I suggested taking profit on F29 and some of the year flies we were long. I liked them both if whites-reds steepened. But when it flattens on the selloff, the trades do not look as attractive.
In case libor-FF widening is just market positioning ahead of the new Treasury cash rules, we should think about taking a position over the summer. Of course, I’m not going to be a crack-head and say that we should buy EDs vs sell FFs. I have no idea where this will stop (since we have already passed the point where I thought was “reasonable”). But we do have some other tools available to us – in particular in options. I’m going to look for signs of libor-FF stabilizing (or at least slowing) and look for some value. There is a good chance that the ED-FF spreads in the whites and reds could compress a lot by year-end. We should look for a good risk/reward expression of this view.