The two big stories this year are: (1) Libor increasing and (2) Kong buying EDZ8-Z9. These two factors have had a negative impact on the back of the whites. Kong has also had a negative impact on the steepness of the curve past EDZ9. Kong has had an indirect effect on the curve past EDZ0, since there appears to also be some chunky EDZ9-Z0 buying from time to time, in response to Kong’s EDZ8-Z9 buying. The question is, when do these two factors turn?
There’s some probability the correction could happen at any day. We have had some false normalization signals in the past. But I do think we have a few interesting potential turning points coming up:
- 4 week Treasury Bill auctions. Next week’s 4 week Bill auction is the last Bill whose term ends before April 16 (tax deadline, where the Treasury should get a lot of money). I’m no security expert, but as the Bill maturities start going past the April 16 tax deadline, I would think both supply and demand for bills would normalize.
- March 21 (Fed Meeting). I think March 21 (or a few days afterwards) could be the earliest time where Kong may start exiting. It’s widely expected that the Fed’s dots will go higher. People are focusing on where the median FOMC member rate could end up, but I think Kong may be more focused on the longer term rate being higher, and the 2019 median dot being potentially higher. We can get to about 2.4% by the end of 2018 if the Fed hikes 4 hikes this year. A noticeably higher longer term rate would require more hikes in 2019. My contention has never been that buying EDZ8-Z9 made no sense on an absolute basis (1.5 hikes in 2019 is not “high”) – just on a relative basis, to the rest of the curve. The chart above shows ED4-ED7 spread being over 10 bps high to the curve. Kong may want to take some of his trade off, after we get the “news” of higher long term rates in the SEP (and more hikes in 2019). Of course this could be a longer term play, where he holds until the June meeting (since a June hike is “highly probable”), or even a later meeting. But I do think there is a good chance they significantly lighten up by the end of the year. If Kong is the Z-algo, then we have seen a year-end reduction of positions in past years. But they may also want to lighten up some ahead of the elections, which could/should end up with the Republicans losing the House, and more legislative stalemates.
- Before or on April 16. As we move towards April 16, we could see less Bill issuance but more importantly, more demand coming in from people who had been holding off. This could alleviate pressures on the Libor curve.
- Post-April 16. I would be shocked if the Libor curve didn’t normalize after April 15. This is for two reasons: (1) if most of the rise in Libor was indeed a Treasury bill effect, this would be the seasonal time where the Treasury should have much lower issuance going forward. So the libor fixings should normalize, relieving pressure on the rest of the ED-FF curve. (2) if the Treasury bill story was not the key driver of Libor being higher, then there would be no reason to think that Libor would narrow later this year, and the ED-FF spreads further out the curve should widen (normalizing the inversion of ED-FF). If there are no takers for the front end now when Libor-FF is about 45bps, why would you expect there to be takers later in the year, when rates will be higher and the Treasury will owe more money?
I have some trade thoughts for later in the week, that I discuss in the Trade Thoughts section.
[Note: One potential turning point I did not mention in the article is quarter-end]