I mentioned in client emails that I prefer taking Fed hiking views in FFs, and I wanted to explain a little more fully.  One of the things I have been doing more work on this year is looking at opportunities on the ED-FF curve.  We had a nice trade when we bought EDH8-U8 spread vs FFJ8-V8 spread at 1 and 0.5 and recently got out at 3bps.

The ED1-ED5 vs FF spread curve has been wide relative to the past few months.  It’s possible it can widen more, with the recent Fed tapering which may cause spreads to widen as the Fed starts unwinding the balance sheet.  Consider that libor-FF is currently about 20bps lower than where it was earlier in the year.  So while that was a different environment, I just wanted to show that it is possible for the markets to price in a tremendous amount of ED-FF widening on particular events.  The Fed tapering could be such an event.  What has been curious however is that while the ED-FF curve has been reflating in the front end and showing a widening of ED to FF spreads, the back end has not had a commensurate move.  The demand for longer end US continues.  It’s not clear when that breaks.

The ED-FF curve past the first couple of contracts is about as steep as I’ve seen this year.  This is why I have a preference to use Fed Funds futures to express my 2018 Fed hike plays.  EDX7-U8 vs FF spread (10 months) is 9.3bps wide!  Considering FFZ7-V9 spread (the closest proxy to EDX7-U8) is “only” pricing in 31bps of hikes, 9.3bps seems really high.  So unless you have a continued ED-FF steepening bias, I think sticking to FFs for your hike views is better risk-reward.  EDX7 has not been trading very long.  However, since about 10 days ago (roughly the Fed meeting), the EDX7-U8 vs FFZ7-V9 has really taken off.  But when I can’t get confirmation from the very long end, I can’t get that excited about playing for this to continue.

I also wanted to highlight the strange shape in the front of the curve.  The table on the right shows the current level of the various ED to matched FF spreads.  Note that the contracts with “*” could have a year-end turn priced in (which has not been factored in), so the prices and rolldown could be affected.  For now, let’s ignore the turn.  I think there could be three factors at play for the strange ED-FF curve:

  • Part of this could be the Fed tapering, which should cause swap spreads to widen. Tapering starts this month, and will gradually escalate until Q4 2018.  So assuming this is a primary driver, you would expect more steepening over time.  It is curious that libor-FF spreads are expected to narrow in the next 1.5 months (highlighted in yellow), and then take off afterwards.  I suppose the markets could be taking a literal interpretation of the tapering in the front end, but I’m just not sure why the ED-FF spreads would narrow in November, relative to now.  You would also expect the long end spreads to widen (out in the blues and beyond) from reduced longer end Fed buying, but the effect has been muted.
  • Another factor could be a play on a debt/budget impasse. This could occur at the Dec 15 deadline, and the Treasury could run out of money some time afterwards.  However, if they planned prudently and could make it to April 15, they will have a lot of cash coming in then.  So I’m not sure this is that large a factor.
  • The final interpretation is that it could be a sign of futures and options positioning in EDs. We have has a large selloff recently.  This analysis is a work-in-progress.  I follow my own advice that I give to new (and old) traders – always find new things to look at.  When traders have strong directional views on specific parts of the curve, they naturally gravitate towards EDs.  Instruments like Treasuries and swaps are very blunt instruments, and FFs are not very liquid past 1 year or so.  So it’s very possible that EDU8 is just getting pushed out more relative to the rest of the curves from all the selling demand.

I think looking at the ED-FF curve could be promising in terms of future P&L opportunity.  Stay tuned.