Since the macro rates picture has been hard to decipher, I think this is a good time to look at the micro. There are a lot of interesting things going on in the very short end of the curve right now:
I. An ease is more likely than a hike.
As I mentioned earlier in the week, FFV7 and FFX7 are starting to price in an ease. FFX7 should settle at 98.843 on a typical non-event month. Not only did 98.845 trade, it went bid late Friday and some 98.85s traded. That’s a little crazy, considering we’ve had no new information on Friday. Consider that FFX7 traded 98.83 just ONE week ago. Part of FFX7 selling off could have been the debt ceiling, but c’mon, it would take stupidity of colossal proportions for the US to default on its debt. And if you did believe this could happen, why would ten year yields be dropping like a stone? These are strange times.
But back to the ease… A chance of an ease being priced is not that strange, since a small chance of an ease is ALWAYS priced. For example, if you look at the first strike of an ED4 call (less than a year away) that would require an ease to get to (i.e. EDM8 98.75 call), that is always going to be worth at least a few bps. The few bps is mostly the time value of an ease.
The ease that the FFX7 contract shows is just the “net” chance of an ease (over a hike). This could be a little strange when the Fed is in a hiking cycle. Most of the time, the hiking probability in a hiking cycle will be higher than the ease probability at every meeting, giving ups a net hiking probability. For now, I suspect the net ease is just because we’ve had low inflation prints and a higher chance of a disaster (particularly this current weekend). But we should be watchful. In particular, with the benign weekend (so far), I would think the ease probabilities should reduce somewhat early next week. If the ease is still there (and especially if it increases, even fractionally), we should be more vigilant towards a recessionary event.
II. Libor is being priced to fall like a stone.
EDU7 (which settles in one week) settled at 97.6975 on Friday. Friday’s libor fixing was 1.31033, which implies an ED price of 98.6897. But considering that some 98.7025s traded Friday, the markets think libor-FF could narrow about one bp in just one week (as an over/under). This is clearly possible, but seems a little aggressive for an over/under. Considering there’s a small chance libor could stay sticky, that means the market is saying there’s a chance libor can drop 2bps in a week. I’m not so sure. Part of EDU7 rallying Friday afternoon could have been a search for short-term crisis protection this weekend. Someone may have just needed ease protection for the weekend, so they paid up in thin markets. So if FFX7 goes back towards 98.843 early next week, we should see what EDU7 does… to see if this is a libor issue or an ease issue.
I get the argument that previous libor increase was (partially?) widening due to debt limit. But what I don’t understand is that all that has happened last week is that the US government just kicked the can down 2.5 months to Dec 15. There are some who argue that the negotiations could be tougher closer to the end of the year. I’m not sure anything has been solved. And we have Fed tapering that should cause some widening pressure on libor. So while you can argue that libor could fall in the short term, it’s not clear why EDZ7-FF is even lower now (by about 1.5-2bps) than EDU7-FF was when we thought there was a debt problem. I discuss this trade opportunity in the next section.
III. The Libor-FF curve has been volatile.
EDU7 3mo fly has gone from a high of 6 on Sept 5 to a 1.25bp settle. That’s a little crazy for a 3mo fly. Part of the reason was that the debt and budget discussions were moved out to Dec 15 (so a Dec hike is less likely). However, FFV7-F8-J8 fly (a better measure of the Fed meeting probabilities) only dropped 2.5bps. This drop is slightly overstated for FFs because of the FFX7 ease rally previously mentioned. So about half of the move was a change in the Fed probabilities, and the other half was in the term structure of libor-FF changing. I’m just not sure EDZ7-FF should have collapsed as much. Where there is volatility, there is opportunity.
IV. Why is someone playing for a hike in Dec now?
We’ve had above-average selling in FFF8 the end of last week. That’s pretty ballsy playing for a hike in Dec, when a net ease is being priced in for Nov and the new budget/debt deadline. I suppose we still have plenty of time for the data to surprise to the upside. Assuming we are still on the same 2-2.5% growth trajectory, the main argument for a Dec hike I can see is that we get higher-than-normal prints on inflation from all the hurricanes. Gas did spike up about 20% because of Harvey, and we could get additional spikes in things like building materials, agriculture, etc. But I think you would have to assume the Fed is really myopic (or just biased towards a hike). If they are going to discount the drop in inflation earlier this year because of one-off mobile service discounting, I would think they would discount inflation rises to some one-off hurricanes.
I suspect the seller of FFF8 (assuming it is a directional trade and not part of a relative value trade), is probably thinking they are getting 3:1 on a Dec hike, which is good risk:reward if you are bearish – especially when you consider that most economists (and models) are still calling for a hike in December. I suppose if you are bearish, those aren’t such terrible odds. But you can say the same thing about EDZ7-Z8, or any of the near-term meetings. I look at value from a relative perspective, and relative to the rest of the curve, the Dec meeting is too high.
It’s also possible it’s the FFF8 guy buying the FFX7. Because I’m not sure I would be that comfortable with a large bearish position in the peak “ease” part of the curve going into the weekend where parts of the US may get obliterated from a nuke or a hurricane.
V. How are the H1 2018 hikes that low?
I cannot believe the H1 2018 hikes are as low as they are. Warsh is the leading candidate for the Fed Chair (by a hair). He is Mr. “1-2% Inflation Objective” (higher short-term rates, but could crush the economy, leading to flattening) and Mr. “Auction Portfolio” (higher long term rates). If we took his sage pieces of advice from the past couple of years, we probably would have been in recession already. In any event, with Warsh at the helm, I’m not sure the H1 2018 quarterly meetings should only be 3-3.5 bps each. Past 2018, we could easily price in a “doofus-leading-the-Fed” recession. I suppose this is a reason to relatively fade the 2019 hikes. But his first 6-12 months at the helm could be immensely hawkish.
I think if given the choice, keeping Yellen is by FAR the best choice between Yellen and Warsh. I’m just not sure if Yellen wants the job. She does have some health issues. But even if Yellen was to remain the Chair, I’m not sure the H1 2018 hikes should be this low.
The above all point to a few trade thoughts, that I will highlight in the next section.