There are a bunch of strange things going on in the front of the curve (next 12 months). It’s been a really long time since I’ve seen so many unusual cross-currents go through at the same time:
- The libor fixing is going nuts. EDH8 vs FF has widened about 21bps since January 23. Part of that is just us breaking the multi-decade tens downtrend line – you would expect some widening of ED-FF spreads on a selloff. And part of this is EDH8-FF going from being about 5bps narrower than libor-FF to 6bps wider than libor-FF. The popular narrative is that this is related to the large supply of Treasury bills. But there is also positioning switching in options (calls vs puts). All I see is 3mo libor being 1.96 and ten year Treasuries yielding 2.87. 3mo libor is also over 40bps above weighted Fed Funds, where the March meeting is basically fully priced. I’m still trying to wrap my head around how these three numbers could co-exist in a global economy where many countries are still grabbing for yield.
- The non-quarterly meetings have been showing signs of life. Apparently, there’s a “think tank” report suggesting we could get press conferences at every meeting, starting midyear. This could explain the interest in the intermeeting hike. I haven’t seen the report, btw. But most think tanks have access to some “insider.” After the Lacker fiasco (where he gave info to Medley), I’m thinking the “insider” is probably some Fed economist plebe. I suppose with a new Fed Chair, we could have a change of policy. If the Fed Chair was someone who liked to hear himself talk, I could see this. I don’t know Powell, but I’m not sure Powell is that guy – he seems fairly soft-spoken. This isn’t Fed Chair Trump. Going to non-quarterly meetings could also freak out the markets, and make them think the Fed is not going to be “gradual.” I’m not sure why they would want to rock the boat when their current accommodation removal seems to be going even better than they could have ever hoped. I do think that we could go to press conferences at every meeting if we look like we could need 4 or more hikes a year. This seems a long way away, considering the 12 months from July 2018 through June 2019 is only pricing in 48bps of hikes. Why would you change to press conferences at every meeting, when you are gradual and there are less than 2 hikes per year priced in after June? Makes no sense. Speaking of less than 2 hikes a year…
- How can the H2 2018 hikes be this low? I’m not saying the economy couldn’t take a tailspin. But 43bps for EDM8-M9 seems very low, if the narrative is that we get great growth – great enough to buy EDZ8-Z9 bought so aggressively. I did mention that the markets could discount September because of the elections. The November meeting is after the elections, so perhaps that is why we have seen FFX8 open interest increase 120K this year (the largest increase of any contract after FFJ8). A Q4 hike looks like pretty good value, relative to the current curve. Part of H2 2018 hikes being lower could be:
- Are people are looking for equity protection? The recent equity correction adds an interesting twist. So far the Fed has basically said they don’t care about the equity correction. However, the fixed income markets seem to (over) react to noticeable drops in equities. Typically, you would buy options around the red midcurves calls for crisis protection, but given the current curve, green midcurves calls are probably a better buy…
- King Kong is a beast. The EDZ9 open interest is now the largest of any contract (1.986 million). This is highly unusual, as the whites are generally the largest Open Interest contracts (by a lot). This is the result of a Kong-driven +958K in OI since the start of the year. It’s possible he may have 50% of the Open Interest in EDZ9. We’ve seen Bill Gross with large positions, but it wasn’t on two specific contracts (EDZ8 and EDZ9). So this move is extremely rare. I estimate that Kong is distorting EDZ9 (relative to its surroundings) by about 5bps. That is an insane amount on one of the most liquid curves in the world. Trying to corner the market on one contract could be an interesting concept – like the Hunts and silver. But silver can be anywhere. ED contracts eventually settle to libor. 8 years is not that far away. EDZ9 open interest increased 257K last week, but the EDM9-Z9-M0 fly was unchanged (low settle). The point is that, if Kong doesn’t keep buying, it’s going to be difficult to keep some of these types of structures elevated. Last week was probably unusual (as I would have expected 257K contracts to move the EDM9 fly a bp or two). But in any event, Kong is basically swimming upstream. Kong has also been known to buy EDZ8-Z9, so there is a similar depressive effect on curve structures around EDZ8.
Unusual moves like these, while they can be annoying if you are caught off-sides, can be the source of great risk-reward trades. That is the topic of this week’s Trade Thoughts section: