That’s a lot of derivatives
January 19, 2024
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–Yesterday’s price action featured little change in the front end, but higher yields along the back with pronounced weakness in the long bond. Two-yr yield up 0.5 bp to 4.357, 10s +4.0 to 4.142 and 30s +5.9 to 4.369. Similar changes on SOFR curve, SFRM4 +1 to 9610, M5 -1.5 to 9654.5, M6 -4.0 to 9658 and M7 -5 to 9646. My bias is that this steepening will develop into a strong trend in the back end of the SOFR curve, but more about that later.
–A friend called yesterday in an exercise to try to peg June’24 SOFR. His base assumption is that once the Fed begins easing, it will do so in 25 bp increments at every meeting. The main question became whether the first ease comes March or May. My personal bias is that the first ease will be in March, but of course there are strong arguments against that scenario, some being made by Fed officials. Recall the first ease in 2007 was a 50 bp cut, and we all know that the recent hikes weren’t in clean increments of 25, so the base assumption could well be faulty.
–When Dec’23 options expired, the market pegged the 9462.5 strike exactly. A lot of calls above that level went out worthless. Currently, SFRH4 is 9489.5. The 9487.5 straddle settled 16, so b/e 9471.5 and 9503.5. Open interest in the future contract is 1.16 million, the most of any contract on the strip. What’s somewhat interesting is that open interest in H4 calls (not including Fed serials) is 6.8 million, 4.25x as much as the future. The call strike with the largest OI is 9500c at 774k, settled 3.75. (Call your Congressman and warn her about $7 trillion of derivatives on March SOFR. Her reply, “What’s that? I only trade NVDA”). Anyway, everyone knows that there have been massive buys of call condors and butterflies to peg the March 15 option settle of SFRH4. The FOMC meeting is March 20. It’s almost all about the ease, not much about the ‘hold’. According to settles one could almost sell the straddle and buy the 9500c for 12.5. Complete protection on the upside. But open risk below 9475…
–Blue midcurves don’t really trade much, but IF steepening starts to take hold, then nominal levels of blue straddles should start to converge toward reds. From yesterday’s settles, 0QM4 9650^ settled 70.0 ref SFRM5 9654.5. 2QM4 9662.5^ settled 62.0 ref SFRM6 9658, and 3QM4 9650^ settled 60.5 ref SFRM7 9646.0. Not recommending anything here, but I think blues are a bit low on a relative basis.
–One trade of interest, SFRZ4 9625/9700/9775c fly bought vs selling 9487.5p, paid 5.0 for 20k. Settled 4.0. Max profit at 3% (9700) by the end of the year. SFRZ4 is 9610; the Fed’s FF projection for end-of-2024 is 4.6%.
