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  • Milan
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    #1239 |

    Hi Jo,

    I’m looking at some historical data and I’m curious as to your interpretation. Attached are graphs for 6 and 12 mo flys from two dates – 12/13/2005 and 5/10/2006 (data is non turn adjusted and non interpolated). There was a rate hike on both days. The market seems to be pricing the next hike, but then immediate cuts and a relatively flat curve for over two years. Am I reading this correctly? It would seem reasonable for the May graph, but why would that be the case for the Dec 2005 graph? There were 4 more hikes afterwards. Also, later in 2006 (in oct, for example) flys in whites and reds are very negative and flat after GE-10. Was the market pricing aggressive cuts at that point? And my main questions is, how high could the flys go in the whites and reds now if the fed is going to be very gradual (as per Yellen today)? Could we expect flys in greens and beyond to be closer to zero rather than higher than 4-8 range as of late?

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  • Curve Advisor
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    First an ancillary note: the 6 mo fly charts basically show the importance of turn-adjusting. Every alternating 6 mo fly (ZMZ and MZM) is going to be long or short TWO year-end turns. According to my sheets back then, the turn was worth about 1bp. So that is why the chart of 6mo flies oscillates 4bps every 6 months. When you look at a static chart like this, you don’t have to adjust for constant maturity (no interpolation), but it’s fairly easy to set up a cell in your spreadsheet to manually adjust all the Z contracts by a fixed amount (in this case 1bp), to give you a better view of the curve.

    As I always say, you have to consider the historical context of the charts. Here are the major differences between the two periods:

    * In Dec 2005, the Fed statement read “some further measured policy firming is likely to be needed” – so more hikes should have been priced in. In May 2006, the Fed statement said “some further policy firming may yet be needed.” They were signalling a more data-dependent environment. So it makes sense that year flies around ED5 were much higher in Dec 2005 than May 2006.

    * In Dec 2005, the FOMC raised rates to 4.25%. By May 2006, the rate was raised to 5%. As rates get higher, you get closer to (or surpass) the long run neutral funds rate. If you get above “neutral,” you would expect the Fed to have to ease at some point. I used to sit next to a rocket scientist (literally) and one time, he was saying how Fed policy actions are a feedback system, and like most systems with a lag (between policy and effect on data), there tends to be a real chance of overshoot. In fact, in most econometric models, you will see an overshoot in rates (and so rates are seen as coming back down slightly).

    * The data in the first half of 2006 was even stronger than in 2005. Payrolls were close to 300 for Q1 and the unemployment rate dipped to 4.7% (from being 5% for the 3 months prior to the Dec 2005 meeting). So while rates may have been more above the “neutral” rate in 2006, it seems like the data supported the higher level of FF, so there was not more ease priced in in 2006 than 2005.

    [to be continued]

  • Curve Advisor
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    Q: And my main questions is, how high could the flys go in the whites and reds now if the fed is going to be very gradual (as per Yellen today)? Could we expect flys in greens and beyond to be closer to zero rather than higher than 4-8 range as of late?

    There are generally four ways a fly will be positive (from most to least common, going forward in the current environment):

    1) the curvature around the contract of the END of the hiking cycle will generally be high. You can see this from thinking about a very measured hiking cycle. Say a central bank hikes 25bps a quarter until they reach 4%. In theory, you would expect the most curvature around the meeting where they do the final hike. The first leg of the spread will be very steep, while the back end of the spread will be close to zero (or even negative). In practice, the highest curvature occurs earlier, since there is a very real chance that the the central bank could stop hiking if the economy/inflation slows. They may even have to ease if the economy/inflation backtracks. And even if the economy heats up, there is the chance that the central bank starts going every meeting, or hikes in 50+bp increments, or even hikes inter-meeting. So the only way the “measured” scenario works out is if the economy/inflation situation is not too hot or not too cold for multiple years. Typically, the increase in curvature is seen because market participants will generally sell the contracts on the part of the curve where they see the greatest chance of continued steepening, which has the effect of increasing the curvature.

  • Curve Advisor
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    2) The market thinks a hike is imminent, and prices in the near-term hike more than a hike further out the curve. This type of positive fly occurs in the front of the curve (usually in the whites), and is easier to see when a possibility of a 50 exists because the bank is seen as being behind the curve. It also helps if a “measured” pace is not priced in. You can see that if the hike(s) is priced into the front of the spread, with relatively nothing in the back of the spread, the fly could get noticeably positive. This is not the environment we are in now, as the Fed has indicated the first move will be a 25bp move, and we have a ways to go before we get to the long run FF rate. But a different country may be in a different environment.

    3) The markets price in an ease a little further out the curve. If nothing is priced into the next 6 months but there is the chance of an ease further out, the front flies could get positive. This is not the environment we are in now, as the US economy has been growing somewhat and we are at the zero “bound” (note that some central banks have gone to negative rates). But a different country may be in a different environment.

    4) The markets price in a credit event. This type of positive fly *could* occur in the very front of the curve (but it depends on the environment). When libor blows out relative to the FF target rate, the libor cash fixings could be perceived to get higher and higher as the months go on. This having been said, there will be a lot of volatility in the markets so the shape of the fly curve will also depend on what kind of ease (if any) is priced in.

  • Curve Advisor
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    Q: And my main questions is, how high could the flys go in the whites and reds now if the fed is going to be very gradual (as per Yellen today)?

    Back in the 2004 hiking cycle, the ED1-5-9 fly was over 100bps. Part of this was that there was some chance of a 50bp move, and 50bp moves are generally priced into the very front end of the curve. It is rare for a 50 to be priced in, say, a year from now. Also, the Fed was perceived to be hiking at most meetings back then. This is not the environment we are in now. The Fed has said the first move will be 25, and Yellen has indicated it would take “several years” for the Fed to reach their long term target rate. If “several” is taken to mean 3-4 years, this would mean between 100-125bps per year (a 25bp more every quarter). So as a baseline, the year spreads probably won’t get higher than that (and it could possibly be even less). The slope of the curve is one of the main drivers of curvature – the steeper the curve, the higher the flies can get. I think I discuss this somewhere, but I’ll expand on this some more in the Single Contract, Spread, Single Fly or Double Fly? Thread at some point. Because of these two factors, it is highly unlikely for the year flies to get that high, or anywhere even close to that. I believe last year, some of the year flies in the greens were over 50bps intraday, and that was absurd in the current environment. So of course we sold.

    Getting back to your question about the whites and reds, it’s hard to say because it all depends on why the Fed has decided to hike. Currently we are probably 3-6 months away from a hike, and it’s not clear to me what the trigger will be, and what the environment will be.

    [next: curve considerations]

  • Curve Advisor
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    Given the current environment, it’s hard to say what the curve should look like in a vacuum. Currently, we do not need a rate increase. So some thing(s) will have to change for a hike (or a series of hikes) to be necessary.

    There are two main reasons to cause the Fed to hike: 1) excessive inflation, and/or 2) excessive growth. Other central banks may only focus on inflation. I suppose there could be other ancillary reasons, but let’s keep the discussion “basic.” The shape of the curve during a hiking cycle depends on a number of things related to the hiking path. While rates are always subject to supply and demand forces, eventually, the ED contracts will settle to a tight function of the target Fed Funds rate. So when you think about the hiking path, you need to think about:

    1) When will liftoff occur? The part of the curve covering the period before that meeting will generally be the point of lowest curvature. How negative we get depends on how much tightening you expect. Depending on how sure the markets are of the timing of the first hike, you may get some positive curvature shortly after that meeting.

    2) How much do you expect the Fed to hike at that meeting? Currently, the Fed has stated the first move will be 25bps. However, this does not have to be the case. The more the Fed can hike, the larger the magnitude of curvature can get.

    3) When do you expect the next hike(s)? How many bps? Are intermeeting hikes possible? There may be a positive hump around the last of the “most likely meetings.” The magnitude will depend on what the markets think the Fed does next.

    4) What does the rest of the hiking path look like?

    5) What will be the terminal rate? Theoretically, you should expect the largest positive curvature around the last of the hikes. In practice, the end could be so far away, and the terminal hike timing distribution so wide that the peak of the fly curve occurs much earlier.

    6) At what point could the Fed pause? This is one of the reasons the further out the curve you go, the lower the curvature. Because even if you feel strong like the Fed will finish hiking in 3 years, it’s like you are short a straddle – any aggressive increase in growth/inflation will cause the Fed to hike faster (and end earlier), and any aggressive decrease in growth/inflation will cause the Fed to slow/delay hiking (and end later). So even if you eventually end up being right, we will veer off the course many times, and sometimes in large amounts.

    7) At what point could the Fed have to reverse course? This is always a possibility. Even from zero rates, we have seen central banks go negative.

    To say anything meaningful about the shape of the curve, you will need to answer most of the above questions.

    [next: hypothetical scenario]

  • Curve Advisor
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    I’m not avoiding answering the question. I just wanted to highlight some of the thinking that needs to go on in looking at curvature. In particular, that AS THE CONDITIONS CHANGE, THE PROSPECTS FOR EACH PART OF THE CURVE CHANGES. You can think of the yield curve embedding the probability-weighted hiking paths of all possible scenarios, as seen by the market participants.

    So let’s take a “reasonable” current “mode” scenario to try and take a stab at answering your question. If we assume:

    1) The Fed hikes “some time this year”, as per Yellen’s last speech. Say the data continues to be constructive, and the economy follows the Fed projections (caveat to follow). Say the first move is at a “quarterly meeeting” (Jun, Sep, Dec, Mar).

    2) They hike 25bps at the first meeting, as indicated in previous Fed communications.

    3) They hike roughly once a quarter, in 25bp increments, with no chance of an intermeeting or a 50bp move. Assume there is no move in the non-quarterly meetings (Jan, Apr, July, Oct).

    4, 5 & 6) The rest of the hiking path is hard to say… The terminal rate is the major assumption we need to deal with. The Fed projections have something on the order of 3.75% being the long term rate. The markets are only pricing in 2.25% FF at the end of 2018. There is a disconnect. You can think of this simply as a 40% chance the Fed hikes to 3.75, a 40% chance the Fed has to pause at 1.75% and a 20% chance they stay at 0.25%. Obviously there are a ton more scenarios (as well as paths for those scenarios).

    7) About 6(?) months ago, a primary dealer survey showed they believed there was a 20% chance the Fed would have to ease after hiking. This is going to weight down the flies in the reds and greens. Let’s for now ignore the chance of a double dip.

    Does the above look “reasonable”? Well, on the one hand it looks too simplistic, but on the other, it’s hard to have a basic discussion about curve shape without making simplifying assumptions.

    [to be continued]

  • Curve Advisor
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    Part of the reason the flies are currently subdued is because currently there is a small, but real chance the Fed does absolutely nothing for the next year (or more). So when you ask how high flies in the whites and reds can get, I will assume that the labor market has continued to progress to where the Fed feels good about hiking (say the unemployment rate gets close to 5%), and the market is mostly convinced the first hike at the Dec 2105 meeting. I will assume there is no strong inflation scare (as that would probably imply a different rate path, and seems to be an unlikely catalyst right now). Note that if we set the odds of the Fed on hold scenario to zero, we get a terminal Funds rate of 2.75%.

    We are assuming that the Fed goes in 25s, mostly on a quarterly basis. In practice, what ends up happening is NOT each of the 3 month spreads going to 25. Once the market decides the first move is in Dec 2015, that meeting will be priced at something very close to 25bps. The subsequent (quarterly) meetings will generally be priced progressively lower than 25bps (assuming the Fed can’t go in 50bp increments), because there is a non-zero chance the Fed will have to pause, the further out in time you go (assuming the odds of a pace acceleration is smaller). So the flies in the whites become positive, as the front spreads that start with the Dec 2015 meeting is more fully priced than the ones behind. How high?

    [next: numerical example]

  • Curve Advisor
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    How high can the flies in the whites get in the current environment? Again the answer is going to be that “it depends.” If you are looking at a 6 mo fly, say the U5-H6-U6 fly, you will have the Fed meeting exposure in the table below. If you have no idea what the graphic represents, see the “What is Priced into Each Fed Meeting?” thread (http://www.curveadvisor.com/forums/topic/basics-what-is-priced-into-each-fed-meeting-coming-eventually/).

    Since we are assuming the non-quarterly meetings have a negligible chance of a hike, being long the U5 6mo fly would get you short rates for the Dec 2015 and Mar 2016 meetings, and long rates for the Jun 2016 and Sep 2016 meetings. I would think the highest something like this could go would be about 10bps (probably closer to 8bps). It is less clear what happens if we get rid of the “one quarterly hike” constraint. We could now have 25bp moves at the non-quarterly meetings, or a chance of a 50bp move. What happens to the risk on the fly is, it’s another “it depends” situation. I see the risk for U5-H6 spread and H6-U6 spread to be roughly equal, in terms of which spread would benefit more from more aggressive hikes. Typically the front spread would benefit more (as you would expect the first hike to have some “50” in it). However, in the current hiking cycle, the first move will most likely be capped at 25, so this environment is a little unusual.

    If the first meeting is noticeably less than 100% priced in, the first fly with the first hike could be zero (or even negative). But the question was, how high could it get? And barring the aggressive hike scenarios, I would be happy selling the fly between 8 and 10 in small size. This is not the type of trade I would “back up the truck on.” Keep in mind there could be a lot of volatility, and things like people getting stopped out of habitual short vol or long rates trades (that they have been living off of for 5+ years) could push this fly higher. And there is always the risk of some Fed watcher who calls for a 50bp move to make a name for themselves, and that view catches on. Even if there is little risk of a 50bp move, we could get noticeably more than 25bps priced in, because if the 25bp move is a “sure thing,” people are going to want to spend the extra few bps to play for the 50bp scenario. If you are getting 10 to 1 and you know they are hiking, why not?

    [next: curvature further out the curve]

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  • Curve Advisor
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    Think about a generic hiking cycle… say something like the 2004+ cycle where the Fed hiked 25bps every meeting. In theory, as a very basic example, if you knew rates were at 1% and they needed to hike to 4%, and they were going to hike every meeting, you would expect the peak of the fly curve to be in 18 months. This is because all the calendar spreads between now and 18 months would be fully priced, and all the calendar spreads after 18 months would be “zero.” 18 months is where the peak of the fly curve will be.

    While positive flies in the whites can get slightly high (assuming many hikes are expected), the really high flies will occur further out the curve, near where the markets think the terminal funds rate will be. You can see that if the Fed were to hike every quarter and the moves were telegraphed way in advance, the highest year fly could approach 100bps. Of course, no one knows the exact path, so the markets reflect a collection of many rate paths (probability weighted).

    One of the basic facts you should know is that the further out the curve you go, the less certainty there is. So when you are putting the terminal rate hike 18 months from now, that can reflect a stronger view than putting the terminal rate hike 36 months from now. A lot more things can happen between now and 3 years from now. So this will be reflected in how high the flies can get – in other words, a terminal hike expected to occur in the reds will result in a higher fly than a terminal hike expected to occur in the blues. I’ve never seen research on terminal rate distributions, but here is the distribution of liftoff probabilities from one of the Fed models, published 1.5 years ago. The exact details aren’t too relevant, but just note that if rate hikes are sooner, there is more possibility of higher probabilities (and thus higher curvature). Something similar would hold for terminal rate probabilities.

    [next: numerical example]

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  • Curve Advisor
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    When I am done answering questions, I will start writing in the “Single Contract, Spread, Single Fly or Double Fly” thread. But one of the main points is: The maximum height of a butterfly is a function of the slope of the curve. A good example is, on an upward-sloping curve, ED5-6 spread is greater than or equal to the sum of all the three month flies after (and including) it (ED5-6-7 fly + ED6-7-8 fly + ED7-8-9 fly + …). And as you all know from reading the “Decomposing Butterflies” thread, all flies can be decomposed into 3mo fly building blocks. So once you can say something about the 3 mo flies, you can use that to say something about 6 mo, 9 mo and 12 month flies.

    So trying to determine the maximum height of a fly further out the curve is going to depend on the maximum slope of the curve. Slope is probably going to be more intuitive to most beginners than trying to guess curvature. The main component of slope is going to be some function of (perceived) interest rate moves by the central bank. Well, everyone who trades any kind of interest rate should have some view on where they think rates should/could go. There are other things that go into slope (like term premium, convexity, supply/demand forces, etc). But fortunately, when you start constructing an equally-weighted butterfly, there is a lot of cancellation of these factors between the spread you are long and the spread you are short. I am just speaking in general terms, and there could be exceptions.

    [to be continued]

  • Curve Advisor
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    I realize this has been somewhat of a long-winded answer, but the truth is, there really is no ONE answer that is going to hold for all environments. Because I could see lower-probability liftoff paths that could lead to all kinds of “crazy” curves. So what I am attempting to do is to give you a framework for how to think about maximum curvature. Like I could say… “the flies in the whites won’t go much higher than 8, when the Fed hikes.” I threw that out there in the “high probability” scenario of slow recovery and slow Fed. But if for some reason we had some hyperinflation scenario develop, those could easily be north of 25. So what you really need is some way to think about how the risk on the curve shifts, as you get more information – whether it be economic data, news, crisis risk, etc.

    My best guess right now is that in the “slow recovery” hiking cycle, the 6mo flies in the reds and greens could get to around 15 (possibly higher if a shorter hiking cycle is priced in). Right now, the highest 6mo flies are currently around 8-9 around ED8 and ED9 respectively. There is currently a reasonable probability priced into the curve that the Fed NEVER does anything, or does something much later. The combination of three factors leading up to liftoff: (1) spreads in the whites and reds increasing by 25-50%, (2) spreads in the blues and golds to declining 25-50%, and (3) a “piling in” effect as people get stopped out or just flock into hiking trades, is going to be the difference between the peak flies now, and the estimate I gave you as we get to liftoff. Note that the peak curvature can move up the curve slightly, as we approach liftoff.

    [next: flies in the back greens and beyond]

  • Curve Advisor
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    Q: Could we expect flys in greens and beyond to be closer to zero rather than higher than 4-8 range as of late?

    I can’t emphasize enough the following point: when you look at the markets, don’t think of the curve as a single point, but rather a probability weighted distribution of many/all possible rate paths and conditions. So there are going to be rate paths (and conditions) that could cause the fly to go to zero. In fact, there are plenty of scenarios that could cause the flies to go negative – double dip recession, crisis, terror event, etc. So while these kinds of questions are very natural to ask, it’s really hard to answer with just a number. I suppose if you need an answer with a number, the best way to answer would be with some sort of probability (or confidence interval) associated it. I could say something like… if the Fed started hiking, I would expect the odds of the 6mo flies going below 2 centered in the greens to be about 20%. But it all really depends on the environment we are in that is causing the Fed to hike, and your view of the Fed hike. While looking at central tendency can be useful, I prefer considering the various possibilities (bullish, bearish and neutral).

    What I really enjoy about looking at curvature is that while the level of rates adjusts rather quickly to a piece of news, sometimes curvature is slow to catch up. So if something were to happen that would change the probabilities of various rate paths, if you look at direction, slope AND curvature, you have more ways to find value on the curve.

    [next: what could cause flies further out the curve to go negative in a hiking cycle?]

  • Curve Advisor
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    Apologies for the delay in finishing this – Fed meeting weeks tend to be busy.

    When you ask about flies further out the curve going to zero in an environment where the next move is a hike, there is usually some probability of the flies going negative. This is because there should be a non-zero chance of the hiking path ending in the middle of the fly (resulting in that fly being positive). So to get to zero, there have to be some probability/risk of the fly going negative, so that the probability weighted paths are zero. Below are some ways a fly could be negative:

    * IN THE BEGINNING: If hikes are not imminent, you will generally have more hike priced into the back spread of the fly, than the front spread. You saw this through most of the past few years (except for the past 9 months or so, depending on the part of the curve). Another way to think about this – since hikes haven’t started, there is a zero chance the hiking cycle will end in the middle of the fly (which is the main way fly becomes positive, other than term structure and convexity).

    * IN THE END: The primary way a fly can be negative after (presumed) liftoff is if there is an overshoot priced in. So when growth and or inflation get out of control, the Fed may have to hike more than the long run target. Recently Dudley and Yellen both said the Fed should have hiked more in 2006. Well, had that happened, that means they would eventually have to ease to get back to the long run target. Any time there are eases priced in further out the curve, you can have negative flies. In the current environment however, there is no sign of inflation, and growth and productivity are low. The risk of a Fed overshoot is negligible, so you would not expect there to be any negative flies. And the typical shape of the curve is for the ED curve to be upward sloping (term structure and convexity), which means the longer end flies should be slightly positive. So there would have to be a material overshoot to be priced in for flies to get negative. The main risk would be if there was a catastrophic tail to be priced in, which would get us back to the previous “IN THE BEGINNING” bullet.

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