I sent out an email earlier in the week discussing the noticeable ED-FF spread widening since the start of the year.  On the right is a chart of EDH7 vs a 50-50 weighting of FFJ7 and FFK7.  This FF mix matches up the Fed meetings in EDH7 exactly, and is a good reference point for the libor spread widening.  The spread settled Friday at 36.75, but this looked to be a high settle in the spread (EDH7 settled a little low).  The previous post-Treasury money rule high (from mid-October) was 36.5.  So we are in the ballpark of that previous high.  But as you can see from the August high, there is no reason to think this couldn’t go higher.  I’m not saying this is likely, but the possibility exists.

The question becomes, why is this here?  The most obvious answer is Brexit.  This is a London bank rate, after all.  While the possibility of a hard Brexit been known-about for months, I suppose you could argue that there could be a “shock” to the system when Article 50 is announced.  I do think the UK banks will take a notable hit (call me the anti-Carney), but it will take at least two years before the official exit takes place.  And the banks are more capitalized than in the past.  So I’m not sure Article 50 will be much of a shock to the system.  But this doesn’t mean people couldn’t panic-buy the spread.

As we’ve seen from the various libor rigging scandals over the years, trying to predict where this spread is going to be is not going to be a competitive advantage for us in the zero-sum game that is futures trading.  I mean we don’t set the rates or see any flow so this equals disadvantage.  However, libor blow-out protection is fairly cheap.  I’ll discuss this further in the next section.  I’m a little unsure of the timing (with respect to the shape of the curve).

The other possibility for ED-FF spread widening is that the FFER could start drifting a little lower, possibly based on funding supply/demand and repo rates drifting lower.  Maybe.   But this shouldn’t account for that large a move, and would only explain 1-2bps of the ED-FF spread widening.

Here are some things we should consider with respect to the ED-FF spread.  We should look at some of these areas for corroboration, but more importantly, to see if there are areas where we can find some cheap protection or positive expected value:

  • Sell EDs vs Buy FFs. As I discussed last year with the “China/DB” scare, the FFs outperform EDs on a crisis rally.  With any type of libor scare, ED-FF could widen more.  Call me Captain Obvious.  But this is also true for FF flatteners…
  • This makes fading un-attractive meetings more attractive. Any kind of financial headwind is going to put the Fed on hold.  Perhaps this is why fading the non-quarterly meetings performed well the past two weeks (in addition to the fact that they were high).  It was nice to profit on some of the move, but it’s possible we could get a larger move…
  • What’s going to happen to our FFX7 buddy? I think he was primarily responsible for driving the non-quarterly meetings higher.  Someone sitting on 2/3 of the open interest on a previously unpopular FF contract is going to have a hard time exiting if they happen to get a tap on the shoulder (to unwind).  The Nov meeting could start becoming an ease candidate on a libor crisis and they are short FFX.
  • It is tricky trying to predict ED slope, since the more likely scenario will be a non-crisis one. So I’m going to be a little more cautious about ED spreads in the whites and reds, until levels get more extreme or I have a stronger view.
  • The very long end of the curve should start steepening. It is fairly flat – especially if the first market reaction to a crisis is going to be to take back the hikes currently priced in, and an ease wouldn’t be out of the question.

I’m not putting a potential libor crisis out there as a high probability scenario, but it is a tail to consider.  Let’s look for some protection next week.