June 24. Pin the tail on the Donkey

Starting with a micro theme this week, sparked by a couple of Eurodollar option trades.  Last Wednesday there was a buyer of 50k EDM9 9687.5/9675/9662.5 put butterflies for approximately 1.7 bps (using a futures hedge).  On Friday, the top put spread of this fly was bought in size of 100k at net premium 3.75 to slightly lower.  Settles were: EDM19 9711.0, puts 7.25/3.75/1.75.  The 9687.5/9675 put spread settled 3.50 and the put fly 1.50.  These options expire June 17. 2019 so there are 357 days to go.  Trades like this can be thought of as trying to ‘pin’ the final settlement based on Fed policy (though these might be a part of a larger strategy).  With EDM18 having expired at 97.675 and the Fed in a quarterly tightening mode, one could just tack on 100 bps of Fed hikes over a year and forecast final settlement of EDM19 at 96.675.  Therefore, the top put spread will fill out to 12.5 and the put butterfly will be worth 7.5.  The only problem is that recent euro$ settlements have not moved in discrete 25 bp increments, as the table below shows.

FOMC	UPPER	DAY AFT	LIBOR	PRICE	CONTRACT
DATE	BAND	HIKE	SETTING	EQUIV	SETTLE	CHANGE
12/14/2016	to 0.75	12/15/2016	0.99317	99.0068	99.0057
3/15/2017	to 1.00	3/16/2017	1.15178	98.8482	98.8688	13.69
6/14/2017	to 1.25	6/15/2017	1.26744	98.7326	98.7198	14.90
12/13/2017	to 1.50	12/14/2017	1.60042	98.3996	98.3745	34.53
3/21/2018	to 1.75	3/22/2018	2.28557	97.7144	97.7775	59.70
6/13/2018	to 2.00	6/14/2018	2.33469	97.6653	97.6753	10.22

Over the five hikes shown above, the average move is 26.6 bps, but the variation per hike is pretty wide, from 10.2 to 59.7.  This is, of course, due to volatility in the libor/ois spread, as the chart above shows.  Nothing too special here, the trend is captured.  We just can’t be too sure about relationships that used to be more stable.  Going forward libor may not even be the benchmark rate.

In observing a few markets since Q4 of last year, this idea of somewhat elevated volatility jumps out.  As a small example, consider the nearly 5% surge in the front crude oil contract just on Friday!  Or look at the July Copper contract, which was under 3.00 in December, soared over 10% to 3.31 in January, broke down below 3.00 again in April, started June around 3.00, went to 3.30 in six sessions and is now back at 3.02.  This is Dr Copper, supposedly the metal with a PhD in economics.  A bit more like Jekyll and Hyde.

Where we do have strong trends over the past several years is in the realm of consistently appreciating financial claims on income streams supposedly derived from the real economy.  For example, the increase in the value of stocks relative to commodities is represented in the chart of SPX divided by BCOM, the Bloomberg Commodity Index, up 6x from the low in 2008.

I also include a variant of one of Buffet’s favorite indicators, the value of stocks relative to GDP.  This shows a new high using the Wilshire 5000 as the numerator. However, when using the Corporate Equities value from the Fed’s Z.1 report, the value of stocks is 133% of GDP, below the peak of 151% in the Nasdaq mania of 2000.  CHART FROM DSHORT ADVISOR PERSPECTIVES.

https://www.advisorperspectives.com/dshort/updates/2018/06/22/market-cap-to-gdp-an-updated-look-at-the-buffett-valuation-indicator

In any case, the economy itself seems to be driven more by financial asset values than by productive investment.  On the other hand, estimates for Q2 GDP are quite strong, with the Atlanta Fed GDP Now at 4.7% and the NY Fed at 2.87%.  The case for continued near term hikes remains intact, even though the back end of the euro$ curve from EDZ19 forward is pinned flat.  On the treasury side, 5/10 closed 12.7 bps and 10/30 at 14.2.

Not much in the way of news to finish out the last week of the first half.  Durable Goods Wednesday and 3^rd estimate of Q1 GDP on Thursday.

 

OTHER MARKET THOUGHTS/ TRADES

 

July option expiry on Friday saw the TY contract fall short of the 120 strike (TYU8 contract 119-26.5s and USU8 143-31).  The 120 call strike in both August and Sept are peak open interest levels.  Actually, the 120/122 call spreads are the position stand-outs.  TYQ 120/122cs settled 25/64’s (29 and 4) with OI of 125k in each strike.  TYU8 120/122cs settled 33 (43 and 10) with OI of 127.7k and 121.7k.  The flattening curve, Trump’s tariff rhetoric and European issues driven by both Italy and Merkel’s future have tempered enthusiasm for the downside.

There was notable buying Friday in TUQ calls, for example a late buy of 25k TUQ 106.25/106.375c spd for 1/64.  Max value is 8/64’s.  There was also buying of the 106.125/106.375cs, which settled 2.0 (3.5 and 1.5).  With a settlement of TUU8 at 105-275, the 106.125c (106-04) is about 12.5 bps out of the money and the 106.125/106.375c spd is about 12 bps wide; 2/64’s is ~ 1.5 bps.  TUU8 DV01 is $41.60.  August options expire July 27.  Compare these call spreads with 0EN 9712/9725 call spread vs EDU19 9704.5.  Settled 1.75 bps, 8 out of the money, expiring sooner on July 13.  Perhaps TU has a slight edge due to flight into short treasuries and 2 extra weeks of time?

 

There was buying of EDU8 9762c (2.25s ref 9754.0) vs 0EU 9750c (2.0s ref 9704.5).  There have been many trades that have piled into this sort of theme.  Buy front calls near the money and sell deferred calls that are out of the money for close to even premium due to elevated call skew in mids.  I wouldn’t exactly call the trade ‘crowded’ but I would say that if the front calls appear to be in play because of an iced Fed, the back end could have a monster rally as well. If the Fed has to stop it’s probably due to a big exogenous change.

 

 

	6/15/2018	6/22/2018	chg
UST 2Y	255.0	254.5	-0.5
UST 5Y	279.7	277.2	-2.5
UST 10Y	292.2	289.9	-2.3
UST 30Y	304.6	304.1	-0.5
GERM 2Y	-61.8	-66.5	-4.7
GERM 10Y	40.3	33.7	-6.6
JPN 30Y	70.6	70.7	0.1
EURO$ Z8/Z9	37.5	35.0	-2.5
EURO$ Z9/Z0	2.5	1.5	-1.0
EUR	116.09	116.56	0.47
CRUDE (1st cont)	64.85	68.58	3.73
SPX	2779.66	2754.88	-24.78
VIX	11.98	13.77	1.79

• ABOUT:
  Former member of the CME specializing in interest rate options and yield curve strategies.

  The risk of loss in trading futures and/or options is substantial and each investor and/or trader must consider whether this is a suitable investment. Past performance, whether actual or indicated by simulated historical tests of strategies, is not indicative of future results.