161030 6mo spreadsOf the numerous things I could have written about this week, I thought I would go back to an old friend – a chart of the 6mo ED spreads.  In Q2 I went to this a number of times because I couldn’t believe the spread curve was so flat.  Then we had Brexit and all the front spreads got smooshed.  Now we are back to having a strangely flat curve.  I mentioned that we had a “straight line” selloff this past week.  You can see that on the chart from the roughly parallel shift between last week’s curve and this week’s curve.  We have a little bit of weakness priced into ED3-ED7 spread thru ED6-ED8 spreads (possibly Brexit), and a very slow and gradual recovery.[1]

As previously mentioned, when the curve is this flat, it gives you a blank slate to express a strong view.  I still think the market (overly) pricing in Brexit headwinds next year plus the continued long-end QE by the ECB and BOJ will keep the flies in the belly lower.  So on the chart, I would expect the slope to maintain its shape, where it is upward sloping from the reds to the golds.  I also think the Fed could hike ~2 times next year, so avoiding EDZ6-H7 and buying flies behind on dips make sense (all other things being equal).  However, it seems like we could get an action-packed nine days that potentially could drastically alter the current core views:

  • Election news swings. We should note that the markets think a Trump victory could steepen the curve.  This probably makes sense, since he plans on giving tax breaks and spending a lot of money.  You would also expect the reverse to be true if Clinton wins (since some Trump is priced in).  Obviously the people who said they were going to move to Canada on a Trump victory are dumping their bond holdings before they go.
  • Fed meeting. I would think everyone expects no hike next week, an upbeat assessment and some reference to a hike at the Dec meeting (as they did last year).  Anything else would be fairly shocking.  It was interesting to note that FFF7 rallied 2.5bps on the Clinton news on Friday, before settling 1bp lower from the highs.  I’m not so sure the election is enough to derail a Dec hike.  The next Fed meeting is over a month away from the election results.  If anything, the majority/plurality will have spoken and people will be on net happier with the election uncertainty gone.  And if Clinton gets elected and then indicted (not likely), are people really going to be shedding a tear that Kaine will be in charge?  Many Clinton votes are just anti-Trump votes.
  • Other central bank meetings. To QE or no to QE?  That is the question.  We hear from the BOJ and the BOE next week.  Neither of them are expected to do anything meaningful, but the markets could (over)react to the tone.  In particular, the BOE meeting could be interesting in that additional stimulus does not appear to be needed (for now).  And if anything, they may need to take some stimulus back.  However, this is hard to see until after Article 50 is declared.
  • Economic data. We haven’t had a real shocking number in a while.  The conspiracy theorists will tell you that there will be no downside to the data a week before the elections.  That would not be me.  If the data do show an uptick, I would expect the front flies to do better from current levels.
  • People across the globe really hate long bonds.  The long end was probably rich for most of the year, we had some taper talk, we had Gundlach calling for the end of the 35 year downtrend, the UK has performed better after Brexit, and the US data in general has looked better recently so a chunk of it was to be expected.  It’s also possible a lot of people got long at the beginning of the year, and are locking in at the end of the year.  So do we liquidate to the Jan 2016 levels?

 

It should be an interesting week.  Stay tuned for updates.

[1] The magnitude is less than is shown because of the convexity adjustment in Eurodollars.