It’s becoming clear that the markets want to price in some kind of libor widening ahead of the high-probability tapering coming in September.  This makes sense – as the Fed stops buying assets, you would expect that spreads should widen.  However, there are a few inconsistencies currently priced into the markets:

  • Longer rates don’t seem to want to go higher. What happens if the Fed tapers and rates don’t rise?  Should we expect ED spreads to widen to FFs?  Right now, EDU7-H8 vs FF are the steepest they have been in a while.  Part of this is a high settle.  I could see an argument for spreads widening as rates go higher.  But rates are NOT higher (the term premiums are still very low).  Then should spreads be wider?  Part of the reason for low term premiums further out could be that the markets expect the Fed tapering to be less material[1]
  • The tapering will be extremely gradual. All other things being equal, the larger the tapering, the higher the rate move, and the higher the yield spread we could expect.  The Fed has implied that they will phase in tapering in FIVE quarterly increments.  The first taper (presumably in September 2017) will be just $10 billion a month and this will be the pace for most of the rest of 2017.  But by NEXT September 2018 (assuming things go according to plan), we should expect the full amount of $50 billion in tapering every month.  So when would you expect the maximum amount of spread widening on the forward curve?
  • If I know that the maximum tapering will occur in September 2018 (all other things being equal) that’s when I want to own spread wideners. I may want to own steepeners after Sept 2018 if I think the markets will be slow to react or in denial.[2]  I may also want to own ED-FF wideners anywhere before if there was a cheap amount of spread widening priced in.  This was the case a few weeks back when I mentioned EDQ7-FF was pricing in no spread widening, and when I mentioned later that EDQ7-V7 vs FF was not pricing in any spread widening.  Currently, EDU7-H8 vs FF seems to be pricing in an excessive amount of spread widening relative to the rest of the ED-FF spread curve.  EDH8 is only halfway through the tapering process.  I’m not sure this should be the relative point of greatest widening.
  • If you are going to make he argument that the markets are forward-looking and price in the bulk of spread widening earlier than Sept 2018, then the widest point should be EDU7-V7 vs FF. This is because EDV7 is the first ED future after the taper.  I’m not sure the markets will make some kind of grand realization 1-5 months after the taper, but not earlier or later.  As a result, if the ED-FF curve is starting to steepen, taking a position on the flatter parts of the ED-FF curve could have value.  See the Flip Trades section for more discussion.
  • The very long end of the curve has been increasing disproportionately to the spreads around the belly. For example, EDM1-M2 spread settled at 19.5, while year spreads 1-2 years earlier are lower.  This could make some sense on a taper on a “flat” curve, since there is more convexity in the farther-end EDs.  But relative to the rest of the yield curve, this does look a little strange on a “reflation” move for the yield curve to be concave.  The consensus seems to be that tens could recapture about 35-40 bps of term premium from the taper.  That should cause a convex curve, all other things being equal (i.e. no recession).  I think if this persists, we may be able to find some good roll opportunities further behind the high year spreads.  Stay tuned.

[1] Again, should ED-FF spreads widen noticeably if this is the case?

[2] There may be some in the markets who think the tapering will have a negligible impact on term premiums.  I think these participants may need to see the longer term effects of Fed non-participation in buying to break the reliance on previous trading patterns.  I suppose this especially applies to algos.  I’ll discuss this further in a later post.