I have a whole discussion of the U7 3mo double fly that traded about 100K times last week (including an 80K block trade) in the Appendix emails. The tl;dr (too long; didn’t read) takeaways and additional implications are:
- The March 2018 meeting is going to be the first meeting with a potentially new Fed Chair. This meeting has more risk of a “break” in the typical pattern of Fed meetings, and that part of the curve is more susceptible to a severe kink.
- A large market participant (the “800lb” gorilla) is selling EDH8 (buying the March 2018 meeting). Open interest in EDH8 has shot up 283K contracts since last week. This is a very specific play – the next largest weekly change in OI (outside of EDZ6, that is about to roll off) is EDM8 at only +41K.
- Don’t try to smooth the 3mo fly curves in the front of the curve. A bunch of algos/traders probably got smoked last week doing this (the OI is lower in 4 out the first 5 contracts). The Fed moves in discrete jumps and as I mentioned the day after the election, we are in a new trading regime and the old ranges won’t hold. If you want to smooth some flies, look at the back of the curve – that is more stable.
The nice thing about the jagged Fed meeting curve is that we may be able to find some value looking at each meeting. On the right are Fed meeting pricings derived from the FF futures curve. The main pattern that stands out is what we’ve seen all year – that the quarterly meetings (in bold) are going to be noticeably more priced than the non-quarterly meetings. In addition though, the following stand out:
- The semi-annual meetings (June and Dec) are higher priced than March and Sept. Now that we are in a “Fed hikes twice a year” mode, and the next hike is in Dec, it seems natural to gravitate towards June and Dec in subsequent years – especially when…
- Dec is the highest probability meeting. This makes some sense when the Fed’s only two hikes in this hiking cycle will have been in December (assuming a hike in a few weeks). There may also be a very minor “we have to hike to maintain our credibility” factor, should we get to year-end and there is some disconnect with the dots. An interesting ramification of the elevated Dec meeting pricing is that it is more difficult to calculate what should be priced into the year-end turn in the EDZs. Typically, people back out the year-end turn from “smoothing” the ED curve, but if the Dec meetings are considered more likely candidates for a hike, it will be difficult to separate out what is year-end turn and what is Dec hike. I discuss this further in the Trade Thoughts II section.
- The most interesting meeting is the March 2018 meeting, for reasons previously discussed. Let’s keep any eye on it. Being on the same side as the gorilla can be good, since they may keep accumulating and supporting their position… unless they have to stop out. So puts may be better. I’m also not sure if this is an “800lb” gorilla, or just a “100lb” chimp. But I am starting to lean a little bearish once we get past Article 50, so let’s see if next week’s European volatility will bring us a good entry point on a deferred bearish trade.
- The first meetings of the year (Feb 2017 and Jan 2018) are the two lowest-priced meetings. There is a good reason for this, as Dec is the highest priced meeting, and the Fed is unlikely to hike in consecutive meetings in the current environment. In 2017, Yellen will be “gradual,” all other things being equal. Jan 2018 could be Yellen’s last day as Chair, and it is unlikely she will hike – especially from a game theory perspective, if she thinks the next Chair will be too hawkish. These meetings seem like they would be so unpopular, that they may get closer to “zero” as people take more aggressive positions on the surrounding meetings. Let’s watch for it.
There are a number of trade themes we should be looking at. This is the topic of my Trade Thoughts I, Flip Trades and Trades sections this week.
 The date of the Jan/Feb meeting in 2018 is likely to be Wednesday, January 31, 2018. The new Fed Chair won’t take office until February 1, 2018
 I’m not saying this is anything but a minor consideration. But if I were Fed Chair, this would cross my mind.