I laid out a framework for thinking about the US curve last week in the new regime. Here are some additional thoughts I had this week.
- Article 50. I was not sure what to think about Article 50 timing, so I went to old reliable – the bookmakers. [sarcasm intended] I realize they have been wrong quite a few times this year, but just because it’s not likely for you to roll 6s on a die twice in a row doesn’t mean it can’t happen. I still think the betting odds are a useful guide – especially if you don’t follow the UK news developments on a regular basis. On the right is a list of probabilities of when Article 50 would be declared, based on a combination of SkyBet and Ladbrokes odds. The “2021+never” camp is a somewhat-healthy 16% considering May’s “Brexit means Brexit” comments. I’m not sure if these are wishful thinking-Londoners skewing the markets again. Note that 2017 is a 72% probability. The last FOMC minutes stated that a few participants thought “significant downside risks remained,” and one of the risks was Brexit. Last week, we discussed the gradual FOMC and fiscal stimulus timing reasons for 2017 to be underpriced relative to 2018. When we overlay these Brexit odds on this thesis, this view is starting to look more attractive. However…
- The US economic data has been very good. As a result, the very front of the curve showed more strength (earlier hikes) last week. We get both PCE inflation and the Employment Report next week, so this could be more definitive than some of the secondary data we got so far. Any time the data looks better, the nearer term hikes will be more aggressively priced than the later hikes. I still like the 2018 vs 2017 theme. However, we need to adjust our scale levels appropriately on the trade, based on how we see the data come in. In addition to the US data, we have a few important dates coming up in early December…
- The Italian Referendum is on Sunday December 4th. This occurs less than one business day after payroll Friday. According to Ol’ Reliable (the bookies), the odds of “No” is 74%. I am less interested in the politics of this, and more interested in what happens to fixed income positioning going into the referendum. As we saw with the Brexit vote and the US elections, the best strategy was to be light on positioning and fade any extreme move. I don’t think this referendum is anywhere near as important as the previous two votes – this is just a constitutional referendum. But we supposedly have a very large number of people short US fixed income. Is this Italian referendum important enough for people to want to lighten up? As my former manager used to say, “no one ever got fired for locking in a profit.” We are getting close to year-end. I would assume the fixed income bears are going to want to have shorts on for payrolls (since the data recently has surprised to the upside). It will be interesting to see what happens afterwards on an in-line or even a strong number. Do we just get a small amount of profit-taking or a larger short squeeze?
- The ECB meeting is a few days later on December 8th. It seems most people are expecting additional stimulus to be announced at that meeting. We may get some more information Monday when Draghi speaks to the European Parliament. All other things being equal, I would think most bears would want to wait until after the ECB meeting to re-establish shorts (unless they think the ECB does nothing). We would have had a ton of data, referendum results and color from the ECB, so the landscape could look quite different by then.
- The pace of the very long end sell off has slowed (for now). The highest year spread on the curve is 45.5bps (less than 2 hikes). I could easily see an argument for 2-3 hikes per year in the current environment. However, if the very long end does not want to sell off, it’s not clear where the room on the curve for such a steepening is going to come from on the current curve in the current environment (gradual Fed, central bank stimulus, and uncertain and delayed fiscal stimulus). I still have no visibility on this. I would assume the ECB and BOJ would continue their stimulative policies, despite the favorable FX (especially considering the defection prospects form the EU and the lower inflation in Japan). But there are other factors to consider, like the Trump fiscal stimulus. Some potential wildcards include an impactful oil deal (affecting inflation), a radical change in the Fed’s dot plot, the FOMC’s position on reinvestment of its portfolio, and even conspiratorial things like an enraged China potentially dumping its Treasuries.
We could get a lot of volatility in the next 12 days. It is not clear to me right now what the dominant narrative is going to be. However, I am just listing the possibilities in case you have a strong view. Depending on your views of payrolls, the Italian referendum and the ECB meeting, you may get some excellent entry and exit levels for your directional views. We do seem to be consolidating for a big move. In a vacuum, I would think the bears would (continue to) be in charge up until payrolls. The bulls would have more leverage going into the Italian referendum, and possibly the ECB meeting. And when the smoke clears, we may have a resumption of selling. That’s what the current positioning seems to imply. But directional trading can be very unpredictable. Hopefully, this will be like the 12 Days of Christmas and we can get some good opportunities to do some bigger things. For now, I list some trade ideas and themes I currently like in the Flip Update and Trade Update sections.
 I normalized the odds to add to 100%. The methodology used may slightly underweight the more probable odds and overweight the unlikely selections, but the error will be less than 15% (not percentage points). Skybet odds were used for 2016 and 2017, while Ladbrokes odds were used to 2018 and beyond. This is because Skybet only provided one line for “2018+ never” and Ladbrokes provided a year-by year breakdown.