For the rest of this month, I’ll reprint the Trade Thoughts section of the CA Newsletter.  There are seven parts to the Newsletter: (1) My take on the events of the previous week, (2) A summary of where I see value on the curve, (3) The Weekly Essay, which you can access on the web site or receive in the CA Digest, (4) Trade Thoughts, where I discuss a particular area related to trading (Fed pricing, ED-FF spread curve, interesting technicals, trade basics, or where I see some value in a trade), (5) The Flip Trade Update, where I discuss trades for jobbers, (6) The Official Trade Update, where I discuss larger macro and relative value trades, (7) An Appendix of Daily Thoughts emails and other emails sent to clients during the week.  This excerpt is from September 24, 1017.

In this algo world, the year spread that broke out to the upside (EDZ7-Z8 spread) keeps going higher, and the spread that broke out to the downside (EDZ9-Z0 spread) keeps going lower.  The former is understandable, since it has been low and is still low – especially considering a hawkish Fed.  For now, I’m just going to attribute the latter to a North Korea crisis bid going into the weekend, and the “QE causes rates to go higher” folks buying on the taper news.

As mentioned during the past week, I think we could get a breakout in longer run rates soon.  It’s just not clear to me in which direction.  It was pretty insane that rates had gotten as low as they had.  Maybe the ETFs and other central bank QEs are stronger than anticipated.  I suppose if “value” is being ignored in the equity markets, we have similar forces ignoring “value” in the fixed income markets and just buying regardless of the price/yield.  If people can buy Exxon at a P/E of 30, why couldn’t the same people buy tens at 2.25?  I mean people are lending to Italy at 2.11%!  And buying the JGBs of a country that could potentially get nuked @ 0%!!!

This complete disregard of value on the curve has been really surprising this year, and the curve has been trading in strange ways.  Going forward, I think we need to be a little more tactical.

  • At some point, this “bond bubble” will break. I heard Warren Buffet mention in an interview that if US Treasuries were a stock, it would be trading at like a 45 P/E.  This sounds generous.  He didn’t go into specifics, but I’m not sure how a severely negative cash flow entity like the US government can even get financing if it were a business.  If you were going to ask me what I thought of a security where the debt was going to increase 50% to $30 trillion within a decade (probably much sooner), I would not want to touch that getting 2.25%.  But this is like trying to short equities, or long vol, or any other “common sense” value trade that has gotten killed the past few years.  I think one thing we can do is to look at the timing… in particular, I think if we break last week’s lows, we can keep selling off.  That may be a good time to unwind any flattening hedges, or just go short with an easily-identifiable stop back to the post-FOMC range.  Because as we have seen, the markets like buying on dips, except for the short windows there they step away and fixed income pukes.
  • Focus not on value, or even regular relative value – look at relative value with a bias towards a longer-end yield-grabbing flattening. For example, if you like the idea of early hikes, rather than buying EDZ7-Z8 to get to 50, buy EDZ7-Z8-Z9 fly (that has a EDZ8-Z9 flattening).  I think if we make new post-FOMC highs in tens, we just have to assume the “buy on dips” mentality will have taken hold, and we should be more defensive.  In particular, I think the bulls are going to be looking at 2019 as the most likely time for a recession.  The growth momentum is still a little too robust to look at a 2018 recession.  The exception to this bullet would be if we sense that fixed income will puke.
  • Look for cheap hikes in FFs, not EDs. The Fed seems like they want to hike.  Fed Funds seem more reluctant to price in Fed meetings – this may have something to do with the relative Treasury bid.  There seems to be a strong ED-FF widening priced in the front end, when there is no such spread-widening is visible in the long end.  Take for example the Fed meetings through March 2018.  In FFs, the markets are pricing in 24 bps for the Nov, Dec, Jan and March meetings.  In EDs, EDH8 is pricing about 26.5bps above the libor fixing.  However, you have to factor in that cash libor is already pricing in 59% of the Nov meeting and 13% of the Dec meeting.  So after you make that adjustment, EDs are pricing in 28bps through the March meeting (after subtracting 0.8bps for the May and June meetings in EDH8).  Those 4bps are a 17% premium of the amount of hikes priced in.  The ED-FF spread can be volatile, but this is on the high side for 6 months of roll.
  • Look for smart rolldown behind EDZ0. If the curve can’t reflate and all the buying in tens is going to permanently cause slightly negative curvature around EDZ0 and EDH1, and there is positive curvature behind it, there are structures that could work on a large reflation AND roll positively.  We just need to look for good opportunities (like Trade G21) to take advantage of this.

I always like to plan ahead.  Let’s see how the markets trade next week.  I suppose we could get a false break-out (especially in thin overnight markets), but I like the risk/reward of riding the momentum.