I sent out an email a week or two ago that showed Z8-Z0 locally peaking a few days before the FOMC meeting, and sure enough, we flattened strong on Friday afternoon.  Part of it may have been month-end.  The question then becomes, do we take out the low at 42?  There has been a strong flattening bias heading into the FOMC meetings, and soon thereafter.

However, given the current shape of the curve, I would argue that this could be like swimming upstream.  Now I’m not saying we couldn’t flatten much more.  As you can see from the above chart, Z8-Z0 had traded in the 20s just September of last year.  So if the Fed looks like they won’t have much to hike, it is clearly possible.  And if you had a reason to think there could be economic weakness, like little to no fiscal stimulus, or credit card defaults, or low retail sales, rates (and slope) could clear go lower.  My recession crystal ball in all honesty is not my forte.

But I am the Curve Advisor, and not the Punting Advisor.  Rather than looking at some static chart where I am comparing Z8-Z0 to static historical ranges, I thought I would take a look at how the Z8-Z0 spread looks, relative to the other year spreads.  Above is the updated 1 yr spread chart (that I had previously showed two weeks ago).  The Z8-Z0 spread would be the sum of the two red dots (Z8-Z9 plus Z9-Z0 spreads, which are the ED6-ED10 spread and the ED10-ED14 spread).  The remaining black dots are the other EDZ-Z one year spreads.  There are a few implications from looking at this:

  • The chart shows why I like the low year flies on the curve in the current environment. If you compare the two red dots to the yellow dot (which is the EDU0-U1 spread, that has been annoyingly bid), it’s highly unlikely for the ED10-14 dot to go lower than that yellow dot (other than maybe a bad settle) in the current environment (where the next moves are expected to be a series of hikes).  This is especially the case if the Fed and ECB may start tapering later this year.  I wouldn’t like these as much if we were in a recession, but that is not what the front of the curve is saying.
  • If you have some steepening bias in the part of the curve around Z8-Z0 spread, consider selling some protective flatteners on EDU0-U1 (up to EDZ1-Z2). The elevated ED14-18 spread also has had the effect of dragging up ED15-19 and ED19-23 spreads.  So the year spreads between ED14-18 and ED19-23 all look elevated to the rest of the curve.  If we are in a yield-grab environment, I’m not sure these should be as elevated relatively as they currently are.  If you have the view that we steepen absolutely, then there is no need to hedge.  But if you don’t have a strong view about steepening, consider converting some/all to a relative trade by selling some of the high year spreads further out.  Because at the end of the day, to make room for a significant flattening in EDZ8-Z0, EDU0-U1 (or EDZ7-Z8) will have to decline.
  • All other things being equal, the bulk of the flattening potential on a Z8-Z0 flattening is in EDZ8-Z9. There could be some room for ED6-ED10 spread to go down, relative to ED14-ED18.  Maybe – but there does not seem to be that much.  One could easily argue that the risk-reward is for Z8-Z9 spread to start drifting higher towards Z7-Z8.  But we are currently discussing where the room for Z8-Z0 to go significantly lower will come from.

We get a lot of data next week (and the Fed meeting), so direction and slope may be volatile.  However, the changes to curvature may be more muted, unless we get a real shocker.  What to do with that green dot?  I’ll discuss this further in the Flip Trade Update section.