Whenever I have a hard time with macro views because of news uncertainty, I like thinking about scenarios. Most people think only about the current yield curve, but you can also look at the conditional yield curve – the yield curve implied by the options market. You can use this conditional yield curve to structure trades such as: if ED6 is at price x by time a, then ED10 should be at y by time b. Typically, a = b, but this is not necessary. This may be the topic of a future CA. For now, I just want to discuss some of the major scenarios I think are out there. The current yield curve should be the probability weighted result for the various possible scenarios. If it is not, some positive expected value could be gleaned.
I see the following as being representative of the views currently expressed in the markets, from bearish to bullish:
- The inflation scenario. We finally get the rise in inflation and wages hawkish economists have been predicting for years. The Fed has stated that they would not overreact to a pop in inflation. But if the inflation looks persistent, then they would have to act. While some on the FOMC also said they would not invert the curve, I think a material inflation risk could cause an excessive Fed tightening in the very short term. The markets have been reluctant to price in more than 3-4 hikes per year. However, it’s not completely out of the question that we could get a trade war, an overheating economy, surging commodity prices or a collapsing dollar causing more inflation than we had been used to. The GE0U8 96.75 puts (29.5bps OTM) is 1.5bps. This is less than 4 hikes in the next 10.5 meetings, expiring in almost three months. If inflation was high enough, there’s no reason why the Fed couldn’t hike 50+bps at a meeting, or in consecutive meetings. I suppose there could be some merit in puts, but I lean a little too dovish on inflation to get excited about this lottery ticket. I prefer low flies like buying the FFV8 3mo fly (as the earlier hikes will be more priced relative to later hikes).
- The term/risk premium coming back to the curve. <crickets> I realize this has been non-existent the past decade. But we do have crazy fiscal deficits, other central banks normalizing, and we have people like Gundlach babbling about 6% rates in three years. It’s possible. But considering the recession risks, I think the best way to play for this is in the very long end (that could also steepen on a recession). So spread and fly structures starting in the golds make sense.
- The continued growth scenario. The markets are currently pricing in about 3 more hikes through the end of 2019, and >50% chance of a hike in each quarter through Q1 2019. As a result, we see some high flies centered around the back whites and the front reds. But should the current recovery extend further, we could see the flies centered around the mid to back reds go higher. And if we are to believe the Fed’s dot plot, where we get enough growth to cause an overshoot in rates (with tame inflation), we could see the flies around the back reds to front greens go higher. I don’t think directional options plays make sense for this scenario, as the growth story will probably materialize slowly over a long period of time. The only exception would be if you thought trade resolutions could cause a large selloff, and eventually leads to the markets pricing in sustained growth. Some sort of put flies (or spreads) may make more sense, if you wanted to spend a little premium.
- The slowdown scenario. The markets are currently pricing in a little over one hike less than the FOMC through 2019. Part of this difference could be some tail risk currently priced in by the markets. I believe that the Fed’s estimate is a median or mode point estimate, while the markets will use the mean. Some of the economic data in other major countries are starting to show signs of fatigue. It’s possible some of the strong activity earlier in the year was due to trade tariff preparations, and we are due for a correction later in the year. In any event, we would expect the high flies to be centered more in the front to mid whites if the growth path is slower. We currently see the high flies at the very front of the curve, but this is partly a function of the Fed being expected to reach the current level of neutral later this year or early next. We need to see some additional growth for the neutral rate to keep rising.
- The EM/credit blow-up scenario. The shape of the curve is going to depend on the magnitude of the crisis. We got a small taste during the Italian mini-crisis. Any potential Fed ease would also depend on magnitude and contagion potential. As a first step, the Fed is more likely to pause. I would think Libor-FF would widen from current levels. With all the front end vol selling, optionality is cheap.
- The recession scenario. This is the scenario I’ve been thinking more about. I do think a recession is a real possibility before the end of 2019. I’m not saying it’s “likely.” But there are a number of possible causes, including trade relations gone bad, an equity correction, a housing correction, and some pension funds and municipalities blowing up which causes a panic among retirees. I’m reluctant to say that trade tariffs could cause a recession, because equities seem not to care much. But then again, equities do seem to have this way of overshooting right before the fall, just as the unemployment rate looks spectacular right before it goes screaming the other way (graph credit to Steph Pomboy). I’m still trying to find “zero cost” options structures (conditional calls), until I have reason to think a recession is imminent.
The trade rhetoric should get worse before it gets better (if at all). And some of the data last week looked a touch soft. Let’s see if anything looks interesting next week with respect to the pricing of some of the above scenarios.