But just in case I am wrong about DB [Deutsche Bank], I thought it would be instructive to take a look at this past February’s bank scare (where DB was rumored to be in trouble). It can’t hurt to be prepared. I found the review useful – hopefully you will too. From the previous graph, you can see we had a massive fixed income rally at the beginning of the year. The point I am interested in is February 11, 2016. That was the day we had that panic spike in ED and FFs. After all, what we are “afraid” of as light bears is that type of panic spike. I compared the close on Feb 9th to the close on Feb 11th and the intraday spike high on Feb 11th. Why Feb 9th? Well as per the previous chart, the five year Treasury yield was almost exactly the same as it was this past Friday (1.16%). So I thought the environment would be more comparable.
It turns out the days aren’t as comparable as I would have liked. The notable differences between Feb 9th and this past Friday are:
- Libor is much higher now. Libor back on Feb 9 was 23.3bps LOWER than it is now, despite the fact the Fed effective is roughly the same (mostly 38bps in Feb, compared to 40bps now). This is why in the analysis of the Sept FOMC meeting, I said the rise in libor is almost like we got a full hike already – 23+bps is basically a hike.
- The curve was much steeper in February. On Feb 9th, ED1-ED20 spread was 123bps. Currently it is only 70 bps. The curve was over 75% steeper than it is now! That’s pretty shocking considering five year Treasuries are yielding the same rate. A steeper curve allows for flies to have a much wider range. This makes comparison of curve between the periods difficult.
- There were not as many bps of hikes priced into the near-term. On Feb 9th, there were only 3.2bps of hikes priced into the FF1-FF7 spread. That’s basically nothing. Currently there are 17.8bps (and 15bps by year-end). This is especially notable, since the curve is much flatter now. What this means though, is that those 17.8bps are going to be the low-hanging fruit on a crisis rally (on a flat curve).
For these reasons, the year spreads and flies aren’t really comparable. However, I do think there are some things we can take away from looking at the history:
- 3 month libor did not move much. Normally, we think of libor blowing out in a banking crisis (as in 2008). 3mo libor did almost nothing in February. On Feb 9, it was 0.6205. On Feb 11, it was 0.6172, and the following five days was 0.6184 average. If you just looked at the 3 mo libor fixings, you would have no idea anything happened. So how cash libor moves could be completely different the next time around. We saw some large flows in EDZ puts last week. However, I’m not so sure spending a ton of premium on EDZ puts really makes sense – especially considering EDZ-FF is already pretty high because of the new money fund rules. So you basically have to hope that libor goes higher from the banking crisis, AND doesn’t go lower from the money rules going into effect, AND doesn’t go lower from eases being taken out of the curve on a banking crisis. That’s a lot of things you need to have go right to make any money on a crisis.
- Fed Funds futures on the other hand, rallied. FF7 was up 3bps between Feb 9 and 11, and another 4bps to the intraday highs. At the intraday highs, 4bps of ease were priced in. The comparable Eurodollar contract to FF6 (or FF7) is ED2. This was up 3.5bps close to close and another 4bps intraday. So EDs kept up with FFs. Again, the “sticky libor” story didn’t hold – this time, for ED futures.
- The long-end EDs out-performed because that’s where the “meat” was. On a closing basis, we got a full bull flattening – the purples and oranges+ led the rally. On an intraday basis, ED14 thru ED22 led the rally. Part of this is a function of where the “meat” was on the curve. The high year spreads further out on the curve made those more of a target for bulls. This time around, all the “meat” on the curve is in EDZ6 or EDH7 (where so many hikes are priced), and possibly the high year spreads on the curve, like EDU0-U1.
- Even though FFs were pricing in eases intraday, the ED slope remained positive. ED1-5 year spread was +1 at the intraday spread lows, and settled at +7. …. You really would have to think the Fed goes to negative rates for the year spreads to invert. I’m not saying this is not possible, but considering negative rates may be causing banking/financial stress, it’s not particularly attractive (unless you are desperate). With only one ease in the barrel (that would presumably be used “soon” in a crisis), why would the year spreads go negative? People are just going to go look at “meatier” parts of the curve, which after EDZ6 gets taken out, would be the very long end of the curve.
- Considering how flat the curve currently is, it’s unlikely a flattening will be as dramatic as on February 11th. Yes – ED1-5 spread traded sown to 1 (before settling 7) intraday on Feb 11th. But at the intraday spread lows on February 11th, ED5-9 spread was 1bp HIGHER (and at the close was 8.5bps higher) than where ED5-9 spread is now. Even during the Brexit intraday ED highs, ED5-9 year spread was 2bps HIGHER than where ED5-9 year spread is now. Weakness is already priced into the curve.
- The curvature rally was led by the greens. ED7 and ED8 1yr flies were down 3.5 bps from the Feb 9 close to Feb 11 close. Those flies were down 7 and 7.5 bps on the intraday ED highs. With the current flat curve shape, it’s difficult for the flies to move that much. However, I do think the flies centered in the greens could take a hit. The flies centered around the greens seem like toxic waste to me (especially relative to flies centered in the reds and blues). It’s like being short strangles – you get killed on a massive rally, and on very strong data, the few hikes the Fed has left will get priced into the front of the curve. It doesn’t even roll particularly well. See the Flip section.
To me, the “banking scare” is like the boy who cried wolf. From the first scare (in February), the markets should have a better preparedness on what to do. After a while, the markets get used to it. The key though is to know when “wolf” is being cried and when it is the real deal. We may get some more shenanigans, so it pays to have comfortable sizing, to counterpunch after a squeeze.
This exercise in looking at February made me realize three things:
- Double flies are a good way to take both a bearish and bullish view on the curve. Let’s add that to the Flip Trade section.
- We should look for another protection trade that uses some of what we learned from the intraday highs on Feb 11.
- We should look for a more aggressive front-end steepening trade. Steepeners right now have a double-whammy of higher libor fixings (which may be lower later in the year) and fears of DB/Brexit/EU/China/global trade/equity meltdown/boogey-men/etc. At some point, if the danger(s) is over, the front end of the curve could steepen out. We had the same yield in five year Treasuries in February and the year spreads were north of 25.