Long time readers will know this story, but when I went through the (JPM) Chase two-week trading simulation, I just crushed it.  I had been playing strategy games and video games all my life.  So making markets and buying and selling many trades in fast markets was relatively simple.  One trading unit was in foreign exchange.  I had no experience with FX whatsoever.  But I had no reason to think I couldn’t do as well in this simulation, as I had in the past simulations.  When I sat down, the default trade size was set to “1”, which seemed very small, so I increased it to “5,” which was only half of the size of the other simulations.  The simulation started, and I assume most people left the setting on “1”.  We would get news like “BOE raises rates unexpectedly,” and I would sell GBP.  Stronger payrolls and I sold USD.  Because I had larger size and there was enough indecision among the other traders, I basically moved the markets… even though it may not have made any sense “theoretically.”  After a few minutes of this, the resident FX expert yells out, “what is going on?!?”  I crushed that simulation too… being a doofus.  Sometimes it’s okay to be a doofus, when you have size working for you.  The ability to move the markets adds an interesting dimension to any trading dynamic.[1]  The instructor used the simulation as a teaching point that sometimes, when you have a large enough player in the market, really strange things could happen and that you need to adjust accordingly.

Well, here we are.  I’m not saying King Kong is a doofus for buying EDZ8-Z9.  The Open Interest in EDZ9 has increased 684K since the start of the year, and this probably increased even more on Friday with the 143K volume.  We have also seen buying of EDH9-H0 (91K in volume) and EDZ9-Z0 (57K in volume).  It’s curious that EDH9-H0 saw the most aggressive buying Friday (relative to the curve).  There are three main reasons he may like buying year spreads:

  • He may just be looking at a larger picture view. I mentioned Dalio’s possible “2019 growth” scenario.  With all the optimism surrounding the economic prospects, this is possible.  The move could also fit in with Gundlach’s “equity correction later this year” story if he thought the growth story would still be intact.  This latter story sounds a little too “fine” (too fancy).  It’s not too difficult to make up plausible stories for curve steepening from such flat levels when the Fed thinks they could hike 2.5 times in 2019.
  • He may be trying to trigger technical levels. Breaking the 30+ year downtrend line is a big deal.  Even if you were bullish, if you can move markets, why not break the downtrend line to get the bulls to stop out, get the bears to pile in, get the algos coming along, and THEN buy?  It’s not a coincidence that the many moves occur with a blow-off top or bottom.
  • He may be trying to stop out the consensus trades. I had mentioned for a while that the markets had been piled into flatteners.  There may also be options positions involved.  I remember a lot of buying of puts in the whites vs selling puts in the red midcurves.  I don’t remember the sizes though.  It feels like a lot of stops have been hit the past two days… in flatteners, some curve trades and options trades.

King Kong may have been trying to do all of the above.  This has been a wacky week in curvature trading.  It’s not every day you see a 35 year downtrend line broken.  And it’s not every day you see a 6 month fly curve that looks like this.  That is definitely not an equilibrium shape for the curve!  The large buying of EDH9-H0 (which typically has lower volume than the Z contracts), has caused a noticeable depression in the 6mo fly around EDH5, and caused the 6mo fly around EDH9 to surge.  It’s also curious how the 6mo fly around ED11 has stayed depressed.  Whoever has been keeping the ED9-11-13 fly depressed apparently missed the memo on how there has been increased selling around the greens.

The equilibrium shape of the curve depends on what you think of the following:

  • Growth path of the US economy. We did get a strong Employment Report which finally showed an increase in average hourly earnings.  All other things being equal, you would think the Fed is going to be hiking 3-4+ times this year with continued growth and signs of wage pressures.  It is curious that on this move that the Dec meeting (FFX9-F9) is 9bps, while EDZ8-Z9 is 36bps.  You would think a Dec hike should be much more likely than a 2019 hike.
  • Weak equities. A wrench that has been thrown into the curve has been the recent drop in equities.  I’m not saying a 4.1% decline in the S&P after a 7.4% increase in equities to start the year is particularly meaningful.  However, many people think higher rates will cause equities to decline.  It’s just math… the discounted cash flow valuations of equities will be lower if you use a higher rate.  Granted, the markets have been ignoring valuation with all the central bank liquidity.  Higher rates will make asset allocations to fixed income more attractive relatively.  What may be more important though are all the direct and indirect vol sellers out there that could cause an exacerbated move.  A good discussion is in the following podcast: https://www.macrovoices.com/podcasts/MacroVoices-2018-01-25-Chris-Cole.mp3  A fear of a stock crash may have caused increased buying of EDZ9-Z0 (as you would expect the longer end to steepen).  But this would not explain the EDZ8-Z9 or EDH9-H0 buying.   A small equity correction could be healthy for the stock market.  But a larger move could be devastating in the longer term, as many Baby Boomers may have their retirement nest-egg at risk.  If the Fed has to stop hiking because of equities, we could be on the brink of a recession.
  • Foreign Central Bank activity. There had been speculation earlier in the year that the ECB and BOJ are decreasing stimulus.  So far, we have seen very little indication of it.  The ECB was dovish at their last meeting and the BOJ sounded last week as if they will aggressively defend their ten year target rate.

I discuss the implication of a potential regime change in the Trade Thoughts section.  Any time you get a stop-inducing move, the key is to bend but not break, and focus on the better risk-reward parts of the curve.

[1] This is one of the reasons I am not a big believer of technicals – the ability of larger players to manipulate technicals makes them less useful.