I’ll get you on the back end

January 24, 2021 -Weekly comment

This note is Eurodollar specific (which ought to whittle down the audience).  I was having a conversation with former pit trader/spreader, who is shorting a red/green/blue one-year butterfly, reasoning that the nearer one-year spread is constrained by the Fed holding rates near zero for some time, while the back spread will react to the prospect of post-covid growth and a rise in inflation by widening.  I started to think a lot more this week about one-year Eurodollar calendars and where I have seen them trade.

I created the chart below using just two constant-maturity one-year calendars.  The white line is the 2^nd quarterly contract versus the 6^th, (white/red).  The green line is the 9^th to 13^th. (green/blue).  I noted this week that green/blue is currently the peak area of steepness on the curve; on Friday EDH1/EDH2 settled 0 (white/red), EDH2/EDH3 settled 10.5 (red/green), EDH3/EDH4 at 40.0 (green/blue) and EDH4/EDH5 (blue/gold) at 35.5.  I ran a lot of charts from 1991 until present, but roughly distilled my findings into this single graph, otherwise it’s just a jumble of lines.

The peak one-year level I have ever seen was at the end of 2001, 262.5 bps.  This was the Nasdaq bubble fallout, when the Fed slashed rates from 6.5% in Dec 2000 to 1.75% by Dec 2001.  At the end of 2007, the all-time low 1-yr calendar level was negative 158 bps.  That was the 1^st contract to the 5^th; the chart I created shows a minimum of negative 95 (at the same time) for the 2^nd to 6^th.  This nadir followed the Fed’s “hike-every-single-meeting” campaign from summer of 2004, starting from 1%, to June 2006, ending at 5.25%.  The Fed left FF’s there until September of 2007; near spreads cried uncle by seriously inverting. 

What I find interesting about the chart concerns the level of green/blue, represented by the 9^th to 13^th contract spread.  Over the past thirty years, it has been roughly bounded by around -5 to +120 bps.  The high in 2003 was 119.  In 2009 it briefly spiked to 126.  There are a series of other highs from 2009 and 2012 between 100 and 110. Even though it is not the actual max value, I circled the Q3 2013 level of 122.5, as that was the outcome of the taper tantrum, which has taken a bit of added significance this week due to Dudley’s ramblings, of which I have included the following snippet:

However, later this year, as vaccination helps get the virus under control and the economy rebounds, Fed officials will become more confident that they will need to start tapering in early 2022.  As this comes into clearer focus, the Fed’s communication about tapering will necessarily change to foreshadow this shift, and that will generate the inevitable tantrum.

These spreads sort of beg the question, “Were the calendars correctly forecasting the future?”  Or were positions all just leaning one way only to be capsized as everyone ran to the other side of the boat like the 1915 SS Eastland disaster on the Chicago River?*  Obviously, the surge in the curve in 2013 was incorrect.  The 9^th to 13^th spread would have been EDU’15/EDU’16, and the first hike was in Dec 2015 followed by the next 25 bp increase in 2016.  In hindsight, a spread of 122 was too high. 

Dudley’s argument is that the Fed has lured complacency into fixed income markets.  Powell himself made what I thought was sort of a reckless remark about servicing debt, saying that while debt levels are high, servicing costs remain more than manageable because rates are so low.  Yellen explicitly said the same thing, “The world has changed. In a very low interest-rate environment like we’re in, what we’re seeing is that even though the amount of debt relative to the economy has gone up, the interest burden hasn’t.” The implication is that rates will stay low forever. (FF chart below)

Clearly, when considering one-year calendars, there is asymmetric behavior.  When the Fed is slashing rates from relatively high levels, calendars can explode as front contracts plummet much faster than deferred.  However, in a tightening regime, the market perceives a limited pace.  The 2004 to 2006 cycle featured a 25 bp hike at every meeting, a total of 200 per year given eight meetings.  At the beginning of the effort, the 2^nd/6^th had it about right, as the spread in Q204 peaked at 193. From there, spreads actually compressed, underpricing the Fed’s resolve.  The last time there was a hike of 50 bps was May 2000 with a move to 6.5%, the final straw for Nasdaq.

My question is whether the market might have a ‘tantrum’ prior to any Fed signals, specifically with respect to back spreads.  The max one-yr spread on the curve is currently EDM’23/EDM’24 at 42.  Seems high, but remember, green/blue maxes at around 120. 

At Powell’s recent Princeton interview, he notably mentioned the reserve status of the US dollar several times (is he secretly harboring some concerns?).  Reserve status is clearly a factor which allows rates to stay low.  However, the quest for inflation coupled with increasing deficits has led some to voice concerns about interest payments on the debt overwhelming all other spending categories.  In this case, would belated rate increases by the Fed underpin the dollar?  Or would it have the opposite effect due to the exacerbation of budget deterioration, thus causing reinforcing steepening on the back end of the curve?  Does this line of thought filter into crypto-ccy demand?

My conclusion is that back spreads are likely still too low, even though they’re currently at the top of the recent range.  That idea squares with recent buying of blue midcurve puts, for example the purchase last week of 50k 3EU1 9862.5p for 5.0.  Giving free rein to imagination, I can envision scenarios where even 120 bps fails to cap back spreads.  I am not saying the odds are high, in fact they are likely quite low.  But consider an utter breakdown of fiscal discipline coupled with Fed accommodation.  The dollar would continue to decline, and if even remotely plausible, a spillover into equity market selling would further aggravate budget problems.  In such a low probability event, back spreads could surprise to the upside.

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*The SS Eastland disaster
On July 24,1915 employees of Western Electric Company were heading to an annual picnic. About 7,300 people arrived at 6 a.m. at the dock between LaSalle and Clark streets to be carried out to the site by five steamers. While bands played, much of the crowd—perhaps even more than the 2,500 people allowed—boarded the Eastland. Some reports indicate that the crowd may also have all gathered on one side of the boat to pose for a photographer, thus creating an imbalance on the boat. In any case, engineer Joseph Erikson opened one of the ballast tanks, which holds water within the boat and stabilizes the ship, and the Eastland began tipping precariously.

More than 800 people perished in this accident. 

OTHER MARKET THOUGHTS/ TRADES

The EDU3 9950c settled 19.75 on Friday, up 1.25 on the day and 1.75 on the week, with futures up from 9947.5 to 9948.0.  As selling has abated (one player short ~115k), vol floats up.

As noted last week there’s a possibility of a SOFR/libor spread announcement this week regarding the fix.

TYH1 pinned the 137 strike going into the Feb option expiration on Friday.  I had mentioned buying USH put spreads last week, but the contract never made it above the 170 strike, which is where I would have liked to set shorts.  Currently consolidating between 169-08 and 169-08.

FOMC on Wednesday.  Treasury auctions of 2, 5 and 7 year notes this week in size of $60, $61 and $62 billion!   PCE Core yoy prices on Friday expected 1.2%.

With respect to prices, note that Philly Fed’s price index last week surged to 45.4, highest since 2018 (when the peak had been 60.8).  Markit flash Mfg PMI was released Friday at 59.1, highest since May 2007.  From Reuters: “…the pandemic is gumming up the supply chain, resulting in manufacturers paying more for materials, and they are passing on the higher production costs to consumers.  The survey’s gauge of prices received by factories vaulted to its highest level since July 2008.”

	1/15/2021	1/22/2021	chg
UST 2Y	13.5	12.3	-1.2
UST 5Y	45.3	43.3	-2.0
UST 10Y	109.5	108.7	-0.8
UST 30Y	185.2	185.6	0.4
GERM 2Y	-72.0	-70.7	1.3
GERM 10Y	-54.3	-51.2	3.1
JPN 30Y	64.3	64.9	0.6
CHINA 10Y	314.8	312.6	-2.2
EURO$ H1/H2	1.0	0.0	-1.0
EURO$ H2/H3	10.5	10.5	0.0
EURO$ H3/H4	39.0	40.0	1.0
EUR	120.80	121.75	0.95
CRUDE (active)	52.42	52.27	-0.15
SPX	3768.25	3841.47	73.22	1.9%
VIX	24.34	21.91	-2.43

• 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.