It has been many years since I’ve seen flows this aggressive and wacky on the US rates curve. It appears King Kong (the EDZ8-Z9 buyer) likes to try and pound square pegs into round holes. The curve has wanted to flatten, but he insists on keeping EDZ8Z9 steep. I thought he was done after the stock market correction, as the OI in EDZ9 declined noticeably. But he came back even stronger. This was very unexpected, since seeing how the greens led a crisis rally (thanks to him keeping the curve steep) should have made him realize that EDZ8Z9 was going to underperform on a rally. The curve flattening this week should have made him realize that the EDZ8Z9 steepener would also: (1) underperform on an inflation-led bear flattening, and (2) could underperform on any sort of major near-term libor-FF curve flattening pressure. So basically, in the current environment, it is a three-way loser… unless you keep it supported with insane amounts of buying.
In any event, he seems to have taken out a bunch of locals and algos, as there seems to be less depth in the market now than before the equity correction (factoring the partial normalization of volatility). What is a trader to do when there is a large player disrupting the curve? The overall level of the swap curve is less likely to be affected. This means that extreme EDZ8-Z9 spread buying will: (1) depress the curve in front of EDZ8, and (2) depress the part of the curve behind EDZ9. There are a few suggestions:
- Consider using options. Since the disruption to the curve was large, you can play for an equally large correction using a low-cost options structure. For example, one trade I suggested earlier in the year was to buy 1.5x 2EH8 green midcurve calls vs selling gold midcurve calls. When equities corrected, that structure performed well – especially when Kong exited some of his position. I think there is a medium probability (~50%) that we retest the recent equity lows around either month-end or quarter-end. Some low cost options structure would be further OTM if Kong persists, and should result in minimal losses.
- Make use of the fact that the curve in front of EDZ8 is flat. This is a strange time for the ED-FF spread. The correct structure for your view depends on your libor view. However, the buying of EDZ8 will cause year-end turn plays to be cheap. EDZ8 richness will also cause H2 2018 hikes to be lower than usual. If you are bearish, look for cheap meetings in the second half of 2018 that fit your view.
- Make use of the fact that EDZ8-EDZ9 is too steep. The combination of EDZ8-Z9 being too steep and libor being wide to FF makes owning calls immediately behind EDZ9 attractive. The curvature around EDZ9 is also too high (for example, EDM9-Z9-M0 fly), given the relative flatness of the curve. The main issue with taking a direct short fly position is that it is unclear how much EDZ8-Z9 buying is left. But this 6mo fly could drop precipitously eventually.
- Make use of the fact that the curve behind EDZ9 is too flat. If you like curve steepening further out (reflation), this is a great opportunity to scale into attractive slope positions. The selling in EDZ9 will also reduce curvature further out the curve. You can look for attractive curvature plays here as well.
- The eye of a tornado can be calmer. If you like looking at micro curvature trades, the area between EDZ8 and EDZ9 may be calmer. EDZ8-Z9 will be steep, but the (over)steepness will move together. So you can consider 3mo fly or double fly trades within EDZ8-Z9. It may be safer to stay inside, than venture on the border.
I am certain the EDZ8-Z9 relative oversteepness (aka the jagged fly curve) will resolve at some point. I’m not sure what the Kong trade is targeting, so we need to make sure we are comfortable with the move. The main concern with a normalization of the fly curve would be some sort of economic disruption – potentially from an equity collapse. However, as I mentioned last week, I do not see a 15-20% equity correction as an impediment to continued growth. As we saw with the consumer confidence data last week, most Americans don’t associate equities gains with wealth. When I saw the consumer confidence results, I thought about my friend in high school who felt richer when the stock market went down because he didn’t own any stock. Therefore became richer relatively. He’s probably singing a different tune now, since he is very senior at a major bank, but the point is that middle America doesn’t care as much as most Wall Street traders about the stock market.
After surveying the landscape, I have some thoughts on new trades and improvements on existing trades in the Trade Thoughts section.