161023 FF tableFor an economy that is close to achieving full employment and 2% inflation, there sure aren’t many hikes priced in the front end of the curve.  In fact, after the December meeting, the hiking odds start falling off again.  As you can see, the March meeting falls off noticeably.  Any time we start seeing a nearer-term quarterly meeting (March) noticeably lower than a subsequent meeting (June), we have to give some pause.  I had implied previously that this could happen – namely that we should look to fade the Q1 FOMC meetings.  The combination of: (1) a Feb hike being unlikely after a Dec hike, (2) the Fed being “gradual” (only two dot hikes in 2017, which “aesthetically” could be Jun and Dec) and (3) the Article 50 deadline in March, makes the March hike more unlikely than the other 2017 quarterly hikes.  This does not mean a March hike is impossible, with firmer growth or inflation.  It’s just unlikely.

One thing that is becoming apparent is that the underpricing of the Q1 2017 hikes (and thereby EDZ6-H7 spread) could be depressing the front of the fly curve.  I think there are enough algos and traders out there who are used to “smoothing” the curve – either directly (for example, visually smoothing the graph) or indirectly by using historicals (for example looking at the relationship between Z6-H7 and the rest of the curve).  All other things being equal, a depressed Z6-H7 could depress the rest of the curve behind it.

The biggest of the three causes of Z6-H7 depression is the Article 50 deadline.  What does the market expect from Article 50?  The last time we had the Brexit vote, we had that absurd price move (short squeeze).  It was supposedly a low-probability event.  And the results came out during non-US hours.  And everyone seemed to have put in a stop.  And the algos went wild.  And a few hedge funds probably felt like they could exacerbate a short squeeze.  That was a confluence of one-sided factors.  So we had a move where EDZ6 traded up to 99.38.  Whaa?!?  Man, if that wasn’t the trade of the year to fate that!  Here we now are, with EDZ6 at 99.05 (thirty three bps lower!), and the FOMC about to hike, despite all the Brexit worries.

I definitely do not expect a repeat of this past June.  For one thing, it is now a well-publicized event, and everyone should be expecting it.  The positioning is probably more balanced now (and we could be leaning towards a bullish market positioning as we get closer to the announcement).  It’s the “boy who cried wolf” analogy – the second time around, people will have adjusted.  This gets us back to the current positioning.

The question is, how low could that March meeting pricing get?  It is currently 4.2bps.  I would easily buy it for 2.5 bps.  I’m indifferent about it between 2.5 and 4 bps.  A lot of things can happen between then and now, and not all of them are bad.  I do think that the Feb and March meetings should be lower, for the reasons previously mentioned.  But this should also mean that June “should” be higher, as the Q1 odds get pushed back.  I have no strong feeling about May.  It’s possible we get enough Brexit visibility that the Fed could hike on strong data.  But we may not – they are not in a rush (all other things being equal).  Assuming the data in Q1 and Q2 are something close to the “2% and 2%” (growth and inflation) pace, June seems like a reasonable candidate for a hike.

If the above is the case, then we should expect all year spreads and flies containing Z6-H7 spread to be depressed and the spreads and flies starting with H7 on out to resume the “normal” shape for a hiking cycle.  Do we really expect the Brexit uncertainty to affect the US more than a month or two (assuming growth and inflation are on track)?  The Brexit vote in June had almost no impact on US data.  Is there some reason to think Article 50 will?  I lean “no” for now, but prudence suggests lighter positioning as we get closer to the deadline.