The next few weeks should be very interesting in fixed income.  On one side, we have the seemingly unstoppable force of the flattening yield curve.  On the other side, we have what looks like a Fed that wants to taper (despite the softer data).  The markets are pricing in almost a 50% chance of hiking later this year, which probably will have a hard time moving noticeably higher barring a turn in the data (so harder for a EDZ7 selloff to lead a flattening).  So we have a “supported” EDZ7, a EDZ7-Z9 that wants to flatten, and a EDZ9-Z2 that wants to steepen.  On Friday, we had EDZ7 that rallied 1bp on the weak housing data, a 2bp flattening in EDZ7-Z9 spread and a 1.5bp steepening in EDZ9-Z2 spread.  On Thursday, EDZ7 sold off 2bps, EDZ7-Z8 steepened only 0.5bps and Z9-Z2 steepened 2bps.  I suppose we could get a similar move for a few days, but one would expect something to give in the medium term.  In particular, I feel like we could get a very large move in the next few weeks, where either the EDZ7-Z9 or the EDZ9-Z2 will break.

I saw the following chart that I thought was interesting:[1]

 

I’m not expecting a 100bp move – I’m not sure it’s even possible in the current environment.  However, I think we could easily get a 25+ bp move – possibly on “nothing.”  Since vol is low right now, with the markets expecting the Fed not to do much, options may be a good way to express a view.  We may not get a large move until later this year (if at all).  But let’s consider where the value could be on a hypothetical large selloff or rally in the next “two” weeks (where we get no major piece of data like the Employment Report).

On a large selloff, I think the major catalyst would be a reflation of the curve from the markets heeding the Fed’s tapering plans.  I can not see a large amount of hikes being priced back in in the near-term, without some data or news (like payrolls and PCE inflation).  We chose for this exercise a “two” week period, since there was no news.  I suppose we could get some European or Asian data.  Or we may get some a positive fiscal stimulus news surprise (LOL).  But barring news, we probably get a bear steepener, with stops from people in 2s-10s flatteners contributing.  A large amount of stops could cause relative (curvature) outperformance in the greens.  I think the best way to play for reflation is via longer-end flies and steepeners (as in the Trade List), and ED spread vs FF spread trades (like the highlighted Flip Trade).  But fading the popular 2s-10s flattener via OTM puts could make sense.

On a large rally, it’s a little unclear if we get a bull flattener throughout the curve, or if the rally is led by the greens.  The greens will lead if the Fed tapering story remains intact.  Any extraneous hikes in the next two years would be taken out (and eases may be priced in).  I had previously speculated that the greens-golds spread were near “skin and bones” levels, but this depends on the tapering story staying.  If the tapering story cracks (the markets do not believe we get the taper), we could just get a curve-wide bull flattener through the very long end.  On a large rally, it’s hard to see the curve rally 25+bps without at least one of the following: (1) eases being priced in, or (2) the Fed tapering being ignored and the longer end leading a rally.  These two things have different effects on the curve shape, so this could be trickier to play for (other than a direct bullish play).

Let’s watch for signs of a large move.  In particular, watch for unusual EDH8-EDH0 steepening (as a sign of 2s-10s stops) or EDZ9-Z2 flattening (the Fed taper story weakening).  I’m still not sure about the best structure to play for the tail scenarios.  But I do have some preliminary thoughts in the next section.  And I have a strong view on the higher-probability status quo scenario (continued weakish but constructive data)…

[1] Francesco Filia via Fasanara Capital, http://www.zerohedge.com/news/2017-06-16/are-new-lows-bond-volatility-calm-storm