“Know Your Enemy”
– Sun Tzu & Green Day

On Friday, we got a 2bp flattening in EDH8-H0.  As mentioned in a previous CA, there is a tendency for the curve to flatten a few days going into the Fed meeting.  Note that I didn’t mention EDZ8-Z0, which was unchanged on Friday.  The price action felt differently on the Zs last week, and may last going into this Fed meeting.  Unlike prior weeks, the Z algo seems to be offering the Z contracts more often than not.  Whether this is just a lightening-up before the FOMC (before further buying) remains to be seen – I don’t see anything notable in the open interest however.

An extension of last week’s “top-down” analysis of the curve is to think a little more about the various people who are bulls.  Even though I still think the markets are severely discounting the bearish tail, I’m going to discuss a number of very-valid reasons of why people may be bullish, and my thoughts on those reasons.

  • US rates are very attractive to EU and Japanese rates. This could be a reasonable way to pick up some yield.  Bill Gross seems to love this trade, as do some European and Japanese firms.  I suppose when Bunds are yielding 26bps and JGBs are yielding 6bps, getting a multiple of that via a spread to FX-hedged Treasuries could be extremely attractive.  I’m not even going to pretend to be any kind of expert on doing an FX swap to lock in the gain.  But all other things being equal, if UST-Bunds or UST-JGBs widen, didn’t you just lose money on some kind of mark-to-market, capital-utilization and/or opportunity cost basis?  I’m not saying there aren’t good versions of the trade out there.  Just that among the three major regions (US, EU, Japan), there are two that look like they will never get growth and inflation and one that might.
  • 2s-10s flatteners are attractive – especially going into Fed meetings. I posted a chart earlier in the year that showed the flattening pattern a few days before FOMC meetings.  Since we have the hawkish tail to the FOMC members (the hawkish Bank Presidents that I too ignore), you expect the dots to be way too high, and it’s not unreasonable to think it’s possible the Fed makes a major policy error and flattens the curve.  Except this is a Fed led by Yellen, Dudley, Brainard and company – the same people that took forever to hike in the first place, and only hiked once last year despite suggesting they could hike four times.  They are not going to be shy about switching gears if the data turns.  That having been said, the composition of the FOMC could look much different next February (when we probably get a new Fed chair).  I discuss a related trade thought that I like (see next section).  The names mentioned as additions to the FOMC have been more hawkish (Quarles, Goodfriend, Warsh), but at the end of the day, Trump is going to prefer lower rates.  So it’s not clear that he is going to pick a new Chair that is going to go nuts.  But maybe.  The bear flattening story could make more sense then.  I just don’t think it makes much sense now.
    Another consideration is the current level of calendar spreads.  When reds-blues pack spread was almost 80, there was some decent meat a bull could gnaw on.  At the current level of 42, we are starting to get to the advanced carrion state (aka “skin and bones”).  I mean greens-golds is 35.5 and blues-purples is 32.8.  There are things called term structure and term premium, so there’s going to be a limit to how much this can go.  And you can see from how similar the calendar spreads further out are that there is going to be more resistance.  If you are going to put on a flattener, why wouldn’t you just buy bonds?  You’re going to need the whole spread complex to go lower anyway.  I’m wondering if this is why Z8-Z0 was unchanged Friday, even though H8-H0 (closer to 2s-10s in Treasuries) was down 2bps.  Maybe 40 in Z8-Z0 is too close to the “skin and bones” level.  But H8-H0 is still 50bps, and is in the part of the curve that could also benefit on a recession, so that may be more attractive to bulls.
    The main concern I would have if I put on a flattener is that we seem to be steepening on selloffs and flattening on rallies.  Although I suppose the past few weeks, we have been steepening less on selloffs and flattening more on rallies.  You could argue that this position is going to help you in case the Fed is hawkish.  But c’mon!  How is the Fed going to be hawkish on rate hikes next week?  Inflation has been dropping like a stone.
    We’ll probably get another “dovish hike” next week.  The 2018 median dot will probably stay the same.  You would need all six of the dots at 2.125 to go lower for the median to be lower.  And you would need one (or more) of the 2.125 dots to go higher in conjunction with none of the current 2.375 dots coming lower.  Neither of these scenarios seem likely.  The more interesting set of dots could be the 2019.  The median was 3.0 last time, determined by two dots at that level.  It just takes one dot to move lower or both dots to move higher to get a change from 3.0.  I would think most people should expect 2018 to change to 2.875, but I suppose we could get a larger decline.  But it’s not like the markets care much about the dots.
    The main dovish risk is that they put in some sentence that shows less confidence in inflation rebounding.  That means if inflation doesn’t rebound, they may not hike in the near-term, although depending on what they say, either the reds or the golds can lead the rally.  The main bearish risk is something related to the tapering plan, which may affect the longer end of the curve.  So it’s not clear to me that the flattener is the best trade for this particular Fed meeting.  I’m not saying we couldn’t flatten… it’s just if you wanted that result, you may as well just be long the long end of the curve…
  • US rates are attractive because you don’t think the Fed is going to hike much (if at all) past June. I suppose depending on your rationale, this could be a perfectly reasonable trade.  I mentioned the tail risks last week, but if you think the low inflation is here to stay and/or there are major economic downturn risks, then being long is reasonable.  Low inflation or growth prospects could mean the longer end of the curve is more attractive, and a recession could make the belly more attractive.  Taper could be off the table on further weakness and QE could be back on the table on even more weakness.  FWIW, someone bought the EDM8 99.00 calls last week for 2bps – that’s basically a recession (and ease) trade.  They probably lit a little money on fire by not waiting until after the Fed hiked, but maybe this was some sort of Fed play.
    Carry is good… as long as we done get an upside surprise to growth, inflation or news.  It seems like the data has been leaning all one-way recently, as evidenced by the grind lower in GDPNow from 4.1% to 3.0% in the past month.  It’s not clear if this is a trend or just some data noise.  I think Trump stupidity is mostly priced in… although the stupid always manage to surprise.  There are always random bits of news bulls can benefit from.  Last week, we had the UK elections.  I’m not exactly sure why a Conservative loss should lead UST to rally.  I was not aware that a softer Brexit and a stronger EU was bad for the US.  [Sarcasm alert]  People monkey-reflex-buy Treasuries all the time.  But I suppose we could get that equity meltdown or some other crisis event that people are always calling for.

Of the three reasons for bullish positioning about, the only one I hate is the flattener, unless you see some sort of libor crisis flattening in EDs.  I can see the argument for being long (either outright or vs other countries’ notes) – I just am not crazy about it going into a Fed meeting where the main focus will be on the progress of their tapering plan.  We could see a double-whammy of less buying from the Fed and more debt issuance from the US in coming years – especially if rates increase.  After the Fed meeting, the next US news focus will be on a debt ceiling increase.  That’s going to cause the longer end to sell off (eventually).