“In the weakness / recession scenario, it is almost impossible for the 6mo spreads NOT to be monotonically increasing through the reds.” – CA last week

 

160704 6mo spreadsThis could be a little smoother, but we are here!  The giant “almost recession” rally we had last week caused us to break out of the green box.  But I expect that by next week, we should be back in the box for two reasons:

 

(1) Whites – reds spreads are absurdly flat.  If any potential ease is going t o happen in 2016, then low 2017 spreads just become cheap puts.  So I expect some of the low spreads that fell out of the green box to go back in.  While even I would admit that recession risks have increased, weaker US data isn’t a foregone conclusion.

 

(2) When I see the ED15-17 spread, I see a nail that needs to be pounded down (relatively) by the yield grabbers following a renewed round of global QE.  The 1 month low on this spread is 8.5 (albeit when hikes looked more likely).  It’s not clear we couldn’t get there again, in the yield-starved environment we are in now.  If the Fed hikes, how many are they going to do?  Three or four tops?  Then what?  If the Fed doesn’t hike in the next 12 months, why would you think the Fed would need to hike in 2020?  They won’t.

 

160704 1yr flyIn case you don’t think the 6mo spread curve is a big deal, take a look at the 1 year fly curve.  The small distortions in the 6mo spread curve start magnifying into the 1 year fly curve.  This is not an equilibrium fly curve.  In a recession, I would expect a more uniform dip in the year flies centered in the reds.  In a continued expansion (as opposed to a one and done hike), I would expect positive flies in the year flies centered in the greens.

 

The CA positions basically are various versions of owning the low points and selling the local high points.  This makes sense to me if: (1) you think the yield grab in the very long end continues, or (2) the economy stands firm.   That covers a lot of scenarios.