Hit it
November 15, 2020 -Weekly comment
This week I was honored to be on the Market Huddle podcast with Kevin Muir and Patrick Ceresna.
https://www.youtube.com/watch?v=UbiiDoYcAWw&feature=youtu.be
My basic premise is this: the Fed has told us the funding rate is locked near zero for the next couple of years. The first eight quarters of the Eurodollar strip have warmly embraced this outcome. All contracts from EDZ’20 to EDZ’22 are only in a 15.5 bp range from 99.785 (EDM’21, the peak) to 9963 (EDZ’22). Implied vol in these contracts has been crushed.
When one considers something like the five year treasury yield, the first half of the term is dead. It’s the forward two and a half years that could get some play. If there is to be action after two and a half years, it can only affect today’s five year yield by half the expected amount (ignoring coupons). If only we had forward starting contracts to take a view! We do, of course, and those are the forward contracts on the Eurodollar curve. These deferred quarterlies have already given a nod to either higher inflation numbers, or higher growth. For example, the two-year calendar spread between EDZ0 and EDZ2 is only 12 bps (9975, 9963). But the two-year spread between EDZ2 and EDZ4 is more than three times that level at 39.5 (9963, 9923.5). That’s why these forward three-month term contracts mimic longer dated treasury yields. If higher yields are the expectation, whether due to an upcoming Fed normalization campaign, or better than expected growth as a result of increased global trade, or any other reason, then forward contracts provide a good vehicle for the trip. As mentioned, pricing is beginning to reflect this. For example, EDZ’23 was comfortable at 9963 into the end of September, but traded down to 9941 on news of Pfizer’s vaccine results. In other words, in a month and a half, this contract adjusted by 22 bps. Keep that number in mind for later.
Not everyone considers an outright sale of forward futures as fitting into their risk/reward framework. The curve roll can work as a headwind, and if things really get moving in favor of shorts (higher forward yields), the Fed could announce yield curve control to further stifle market signals. One might consider using calendar spreads, buying nearer contracts and selling deferred. However, the near contracts appear capped by the Fed’s repeated dismissals of negative rates. That leaves the idea of buying put structures on longer dated futures. There are liquid options on the first four years of the euro$ curve that expire with underlying contracts. I would say the first two and a half years are quite liquid, less so after that. There are also midcurve options. These are options on forward contracts that expire within the next year. For example, I have recently highlighted large trades going through 3EH puts. These options are priced on EDH’24 (blue March), but expire on March 12, 2021, next year. Expirations of Dec 11, 2020, (on EDZ21, EDZ22, EDZ23 and EDZ24) are quite liquid. The March 12, 2021 expiration (on EDH22, EDH23, EDH24 and EDH25) are also liquid. June 11, 2021 is less active and Sept 10, 2021 has not yet seen much interest. This was my basic point on the Market Huddle. If one thinks the curve can steepen, perhaps aggressively, then buying puts on forward Eurodollars makes sense.
Now we get to a few things that happened this week that make this type of idea more reasonably priced than it had been previously. Implied vol in near contracts has been absolutely crushed. For example, due to huge selling of EDU1 9975 puts, the 9975 straddle could have been bought for just 7 bps on Thursday. This, with the EDU1 contract trading 9978 and 302 days until expiration. I have never seen the 4th contract straddle this cheap. This is sort of like the auto insurance companies cutting premium rates during covid because no one was driving. Of course, when there WERE accidents they were worse because drivers were speeding! These straddles are pricing NO chance of accidents. Of course, by Friday EDU1 9975 straddle settled 8.5, a more reasonable level, but still very low.
For Market Huddle I prepared the following table (next page), which shows atm straddle level snapshots at three month intervals, so that days to expiration are equal or similar. Then vs now. Just nine short months ago, in February, is the first snapshot, pre-Fed ease, before Covid was really treated seriously in the US.
There was a trade on Thursday that really hammered home the insane levels of premium sales: a seller of 70k EDZ22 9962.5 calls at 10.5 bps while the underlying EDZ22 was 9963.0. Synthetically sold the straddle at 20.5 with 766 days until expiration (dte). That is why I wanted to note the 22 bp sell off in EDZ23 from 9963 to 9941 in 40 days while a 25 month straddle is 20.5. Yes, EDZ22 is a nearer contract, but odds are, straddles at these levels will provide several great scalping opportunities. Put levels provide cheap hedges for those that need them.
This table simply shows nominal straddle levels. If a given euro$ contract is trading at 9900 or 1% yield, a straddle might trade 20 bps. But if a contract is trading 9950, or half the yield level at 50 bps, then a straddle with the same amount of time might be 10 bps, equating the relative premium vs strike level. In any case, that is a bias in pricing.
In this table I have only used select contracts; the third quarterlies and midcurves, and the next forward treasuries. Notice that all treasuries have the same dte, the same expiration date. Same with midcurves. I am a day off on my current Nov 12 prices, just because I wanted to wait for Thursday’s settles.
The top Feb 12 prices were pretty much pre-COVID and pre-Fed emergency rate cuts. The atm ED straddle with 215 days to go was 27 bps. That was the 9850, or 1.5% strike. Currently, on Nov 12, the quarterly straddle with 214 days to go is EDM1 at a price of 9979, with a 9975 strike, or 0.25%. “Why! (you might exclaim) that makes the current straddle relatively EXPENSIVE! Seven bps on a 25 bp strike is 28% of underlying while 27 bps on a 150 bp strike is only 18%.” Maybe that’s what sellers are thinking. Maybe some math wizard kid has it figured out.
I have highlighted (boxed) just a couple of prices in May and November, 6 months apart, same relative expirations, both after the Fed easing. In May, the third green, which is the 11th quarterly, 9975 straddle was 55.5 bps vs 9971. Currently, the third green long-dated straddle is the 9962.5 strike, against a future level of 9958, and it’s 33.5. Sure, these contracts have been flatlining. But there are 950 days to go. Look back again at Feb, 270 or so days ago. The third green future was 96 bps lower in price.
Now check out the third blue midcurve with 212 days to go. In Feb the 9850 strike was 41.0. In May the 9950 strike was 37.5. By August, the 9950 strike, with the same futures level as May, was 32.0. Now in November, the atm 3rd blue midcurve is just 28.5 bps. But you know what? The strike is now the 9925 line. The same relative future is actually 25.5 bps lower, 9956 in May and August, and 9930.5 in November.
| 2/12/2020 | fut pr | atm ^ | dte |
| EDU0 | 9851.00 | 27.00 | 215 |
| EDU1 | 9868.50 | 56.00 | 579 |
| EDU2 | 9862.50 | 80.00 | 950 |
| 0EU0 | 9868.50 | 38.50 | 212 |
| 2EU0 | 9862.50 | 41.00 | 212 |
| 3EU0 | 9854.00 | 41.00 | 212 |
| FVM0 | 120-027 | 1’185 | 100 |
| TYM0 | 130-18 | 2’12 | 100 |
| USM0 | 160-23 | 5’06 | 100 |
| 5/13/2020 | |||
| EDZ0 | 9969.00 | 18.00 | 215 |
| EDZ1 | 9979.00 | 23.00 | 579 |
| EDZ2 | 9971.00 | 55.50 | 950 |
| 0EZ0 | 9979.00 | 23.00 | 212 |
| 2EZ0 | 9971.00 | 30.50 | 212 |
| 3EZ0 | 9956.00 | 37.50 | 212 |
| FVU0 | 125-175 | 1’09 | 100 |
| TYU0 | 138-315 | 2’29 | 100 |
| USU0 | 179-04 | 7’40 | 100 |
| 8/12/2020 | |||
| EDH1 | 9978.50 | 10.50 | 215 |
| EDH2 | 9978.00 | 26.50 | 579 |
| EDH3 | 9970.50 | 51.50 | 943 |
| 0EH1 | 9978.00 | 16.00 | 212 |
| 2EH1 | 9970.50 | 21.50 | 212 |
| 3EH1 | 9956.00 | 32.00 | 212 |
| FVZ0 | 125-27 | 0’60 | 100 |
| TYZ0 | 139-02 | 2’10 | 100 |
| USZ0 | 177-04 | 7’26 | 100 |
| 11/12/2020 | |||
| EDM1 | 9979.00 | 7.00 | 214 |
| EDM2 | 9967.50 | 14.00 | 578 |
| EDM3 | 9958.00 | 33.00 | 949 |
| 0EM1 | 9967.50 | 9.50 | 211 |
| 2EM1 | 9958.00 | 16.00 | 211 |
| 3EM1 | 9930.50 | 28.50 | 211 |
| FVH1 | 125.257 | 0’445 | 99 |
| TYH1 | 137-245 | 1’55 | 99 |
| USH1 | 173-18 | 6’02 | 99 |
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In conclusion: We have a Fed begging for more fiscal stimulus while promising to overshoot inflation. Powell is stuffing the balance sheet with bonds. We’ve got 18% yoy M2 growth. And a vaccine on the way. Hit it.
As Elwood would say: “It’s 106 miles to Chicago. We got a full tank of gas. Half a pack of cigarettes. It’s dark. And we’re wearing sunglasses.” Jake: “Hit it.”
| 11/6/2020 | 11/13/2020 | chg | ||
| UST 2Y | 15.3 | 17.7 | 2.4 | |
| UST 5Y | 36.1 | 40.1 | 4.0 | |
| UST 10Y | 83.7 | 89.1 | 5.4 | |
| UST 30Y | 159.7 | 164.6 | 4.9 | |
| GERM 2Y | -78.0 | -72.7 | 5.3 | |
| GERM 10Y | -62.1 | -54.7 | 7.4 | |
| JPN 30Y | 62.6 | 64.9 | 2.3 | |
| EURO$ Z0/Z1 | 0.0 | 0.5 | 0.5 | |
| EURO$ Z1/Z2 | 10.0 | 11.5 | 1.5 | |
| EURO$ Z2/Z3 | 15.0 | 15.0 | 0.0 | |
| EUR | 118.77 | 118.38 | -0.39 | |
| CRUDE (active) | 37.49 | 40.40 | 2.91 | |
| SPX | 3509.44 | 3585.15 | 75.71 | 2.2% |
| VIX | 24.86 | 23.10 | -1.76 | |
