We are now in an environment where we have growth, but no inflation.  This is great for businesses and consumers.  This is not so great if you are a trader, as we could just sit around here, barring some catalyst.  But we get the big monthly data week next week and we are data-dependent.  While my central tendency is to think that we just sit here the rest of the summer, I am feeling better about finally taking some outlier tail views.

We had two notable developments on the curve last week – interestingly at the very extremes of the curve.

1. The very long end continues to steepen. There are two major things at play:

  • The Fed REALLY wants to taper. The addition of a “relatively soon” taper to the FOMC statement should cause a longer-end selloff.  I’ve liked the “longer end puking into tapering” story for some time.  I just didn’t think the Fed was this eager to taper.  This story was (and is) complicated by the lack of inflation.  But if the Fed wants to go ahead anyway, that is going to be a headwind (not an impediment) to further rallies in the longer end of the curve.
  • LIBOR will be no more. At first, I wasn’t sure what to make of this.  On the one hand, we saw some flattening overnight on Thursday, presumably because if LIBOR is discontinued, ISDA would have to come up with another reference rate for the hundreds of trillions in existing  The rate that is talked about for the US is some sort of Treasury repo rate, and Treasury repo rates are generally lower than bank-credit rates.  But it would be strange to use a lower rate for existing swaps so I’m guessing they could use some repo rate plus a spread that is equivalent to libor.  For new swaps, once the new reference rate is determined, the market-makers could roll the old libor-based swaps for the new benchmark swaps.
    HOWEVER, it occurs to me that the reason longer end swap spreads (to Treasuries) are so negative is because so many people wanted to receive fixed – probably to convert their fixed debt to floating, or just as a punt.  I do not think negative swap spread rates are a natural equilibrium.  I could be wrong – I’m a swaps caveman.  But if I am not wrong, and negative swap spreads can only exist when there is continual demand to receive fixed, how exactly is this going to happen on a potentially discontinued product?  It may not.
    MOREOVER, it seems like the people you have to depend on to take you out of the trade (the swaps market-makers) may not be so accommodating when you are the tenth client calling them up to do the same trade.  The timing of any mass exodus may not occur until the new reference rate is determined.  But again, the uncertainty of the fate of libor may cause some people to unwind or step aside.  That’s really all you need for a non-equilibrium condition (like negative swap rates) to revert.  I’m not saying this is a central scenario (especially in the short term where things are in limbo and people have no idea what to do).  But in this low-volatility environment, it makes sense to make a cheap play for the tail.  Higher volatility in this environment means higher rates (all other things being equal), because the tail has been so beaten-down.

I’m no legal or swaps expert, but this is what my unfrozen caveman simpleton logic tells me.  Let’s see what happens.

2. Someone bought 50K FFV7-X7 spread @ 1 on Friday. This is peculiar with a very “gradual” Fed. The markets are basically pricing in one hike a YEAR, and you think it’s going to be in November?!?  I suppose the November meeting is over three months away and so there is some time to set up an inflation trend.  But really?!?  Inflation is going to look so bad that the Fed is going to want to hike at a non-quarterly meeting?  The next Fed meeting after Nov (the Dec meeting) is only 6 weeks away.  Since people who trade 50K lot clips generally aren’t complete idiots (usually), the two most likely explanations are:

  • They needed some tail protection. Maybe they are long further out the curve, or have some options position where they needed some tail protection.  They may have been short FFV7 and wanted to roll into FFX7.  We’ll see when the Open Interest comes out on Monday.
  • A confluence of factors make them think we could get an early hike. I mentioned the new iphone sales a couple of weeks back, oil prices are near $50, the dollar looks very weak, and the US should have its debt/budget in order by then.  But you would need a massive lottery-ticket move for the Fed to hike intermeeting.

All things considered I’m not a fan of the Nov hike. I suppose paying 1 isn’t so terrible – since you get 0.3bps from FFV7 having one extra month-end day than FFX7, you can only lose 0.7bps.  Now once you start getting to 1.5bps for FFV7-X7 (some traded Friday and you could have legged into a bunch), I start seeing a tiny bit of value.

That GDP deflator data and ECI initially put a halt to any bearish plans I may have had.  These two developments on the curve above lit a fire under me.  We very well could have no additional hikes because of the lack of inflation.  But the fact of the matter is, inflation data usually can turn much more quickly than growth data, in the current environment.[1]  For example, the dollar can easily weaken another 5% on NOTHING, oil can rise $10 on NOTHING, and who knows how $1,000 iphones are counted for CPI?  Part of the reason for the recent low CPI and PCE is that some of the higher m.o.m. prints from last spring have rolled off.  This is all done now.  Of course, this doesn’t mean inflation will rise, but at least some of the reasons for the y.o.y. declines have abated.

I’m not ready to put on bearish positions just yet, but there are some tail plays I like…

[1] The notable exception would be an “event,” like an equity collapse (where the growth data can change faster than inflation data).