I mentioned this in the email last week, but it seems to me that the markets are overly focusing on the “meaty” part of the curve.  That’s fine – when you expect a big move, it’s perfectly understandable to do that.  But one of the great things about curvature trading is that you get to pick up the value that the markets leave behind.  The markets seem overly fixated on some kind of EDZ7-Z9 calendar spread steepener.  It seems strangely bid all the time.  That’s a perfectly fine trade if you are super-bearish, but it’s high relative to the rest of the curve.  I’m not saying it couldn’t go higher, but this means there are other cheaper ways to be bearish.  So people who were left out of the selloff can still get in on the action.  And the nice thing is, if we get a reversal of last week’s move, Z7-Z9 spread could be the first thing to take a hit, and we may benefit as well.  Let’s start at the very beginning… a very good place to start…



I emailed Friday that I thought EDZ6 1 yr double fly was a reasonable buy around -18.  This was based on recent developments in the markets and the hiking environment I think we are still in (where every meeting is “live”).  One of the things I like about writing on the weekends is that I get a chance to take some time off from the markets and reflect.  It also gives me more time to do some additional research.  I’ve said in the past one needs to be wary of historicals in a regime change.  But looking at a much bigger picture can also give some clarity.  On a 1 year basis, this structure is near the low (1 year low of -16.8).  However, the two year low is -69!  So I had to see what was going on.

161113 Z64DHere is a 5 year constant maturity scatter plot of EDZ6 1yr double fly.  As you can see, around the current Z7-Z9 spread levels, the Z6 1yr double fly is noticeably north of Friday’s close of -15.5.  However, we do get some much lower lows as EDZ7-Z9 approaches 100 (Z7-Z9 closed at 70.5 on Friday).  Part of the reason for the historically low double fly values is that post the Great Recession, we generally didn’t think the Fed was hiking “any time soon.”  But in the current environment, every meeting is going to be live.  In any event, this trade in the current form does not seem attractive in the current environment.

161113 Z64D w hedgeHowever, if you look at that chart again, it is something a historical relative value trader would get excited about.  Because if you just bought 50% Z7-Z9 calendar spread against the Z6 1yr double fly, you get the chart on the right.  I think we were near the lows on Thursday afternoon, when Z6 1 yr double fly was 2.5bps lower and Z7-Z9 was 2.5 bps lower.  Then that, combined with the fact that unlike the past (time period over 1 year ago), every Fed meeting is currently “live” makes this an attractive look.  That’s a sexy chart.

This is going to take a little more research, because that is a lot of contracts, some of which cancel out.  So ignore my previous “buy @ -18” email comment, and instead let’s wait for a better structure/opportunity.  Also, we have to think a little more about how we feel about a Q1 2017 hike – I had previously suggested this was less likely, and that is/was one of the things keeping the Z6 1 yr fly lower.  However, this is currently priced, and we have to ask, is this another assumption that should have changed in the new regime?



EDZ9 seems like it is being aggressively offered regularly.  This corresponds roughly to tens being offered.  At this point, it’s getting overextended on a relative basis.  One of the ways you can see this is that Z8 1y double fly is near the highs (settled 4.5, near the local high).  While the Z9 1yr double fly (settled -2, which is the local low).  However, this is not near any levels where would want to fade this move.  I have a related flipping suggestion in the next section (Z9 1 yr double fly).

People generally don’t look at the very long end during volatile markets – they are too busy looking at the “meatier” parts of the curve.  So many times, you can find a hidden gem there.  What I would ideally like to do is buy some kind of Z1-Z2-Z3 fly, which is 1bp from the 5 year low (that low could have just been a bad settle so we would start accumulating around here).  But this would be going too far out the curve, and I’m not sure we need to go that far out to get a similar exposure:

161113 Z1Z2Consider the following chart of Z1-Z2 calendar spread (settled @ -16).  That’s seems more reasonable, since the Z contracts roll in a month and so this would be a golds-purples spread then.  That’s another sexy chart.  The small cluster of dots at the far left was when rates were absurdly low (won’t happen now).  And the small cluster of dots on the lower right are from a time where Z6-Z7 was in the 80s and the highest year spreads were in whites-reds.  Currently the highest spreads are in the reds-greens.  The markets are pricing in deferred hikes in the current regime.  We are unlikely to see 3+ hikes out of the Fed in 2017 with a new President, Article 50 coming up, all of our trade partners’ economies being driven down (and possibly more QE), and even the FOMC dot plots showing only 2 hikes for 2107.  What we are looking at currently would be a deferred hiking scenario, and that deferral could last an indefinite amount of time.

Based on historicals, you could lose maybe a few bps in the Z1-Z2 spread, or make 10-40 bps (depending on whether you think the 2 year or 5 year highs are more relevant).  Umm… Yes please?!?  That’s very good risk-reward – especially if we can explain away some of the lower dots.  These trades could also do well if the Z7-Z9 buyers decide to take profit.  I actually have a preference for one of the year spreads further out (like H2-H3, M2-M3 and U2-U3) – those are a little less liquid, but may have lower downside.  If you don’t like the liquidity in EDs, you can do something similar in longer maturity swaps or treasuries.  And if you need some insurance against the 35 year down-trend line on 30 year rates breaking, this is pretty good [Edit: if the 30 year breaks out, we should get reflation of the curve].  Breaking that multi-decade downtrend line could be the next big shoe to drop on a continued fixed income selloff.

The curve has noticeable changes almost on a daily basis.  Wild markets like these are where curvature trades could identify some great opportunities.  Stay tuned.  I discuss some additional trade opportunities in the Flip Update and Trade Update sections.  [Edit: Look for these in coming days]