Using the 2018/2019 Playbook
November 20, 2022 – Weekly Comment
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On Friday, there was a buyer of about 50k SFRU3 9700/9800 call spreads for 4.25 to 4.5 (settled 4.0 ref SFRU3 9615.5). Current EFFR is 383 bps. SOFRRATE is 378 to 381. January 23 Fed Funds settled 9562.5 or 437.5 bps, which is 54.5 above EFFR, indicating high odds of a 50 bp hike at the December 14 FOMC.
So what’s with a call spread 10 months forward that won’t be in the money unless Fed Funds drop below 3 pct?
It reminded me of late 2019, when large, consistent buying of EDU’20 otm call spreads developed. Let’s take a look back.
In Q4 of 2018, Powell was talking tough on rate hikes. QT was proceeding at an increasing scale through 2018, and there were four 25 bp hikes in March, June, Sept and finally in December, to a peak 2.25-2.50%. Stocks slid hard in Q4 2018; the ED curve predicted ease with near calendar spreads inverted. From the end of December 2018 to the end of July 2019, FF were kept unchanged. Then there were three 25 bp eases, the last of which was October 30, taking the funds rate down to 1.50-1.75%. At that time, the Fed cited a strong labor market, inflation slightly below 2%, but weak business fixed investment and exports.
In November 2019, large buyers started pouring into 50 bp wide EDU’20 call spreads, starting with 9875/9925c spd for around 3.5 to 4.5 bps and moving up to the 9887.5/9937.5cs. It seemed odd, because EDU0 futures were stable at around 9840 to 9850. The market was expecting the Fed to remain on hold after the October ease.
From my note on December 8, 2019 (Stockholm Syndrome) I wrote:
There continues to be buying for forced easing, I will just highlight EDU0 9887.5/9937.5, 5.5 was paid this week ref 9848, then 4.5 on Friday ref 9841 with a settle of 4.75 vs 9844.0. The two strikes have 269k and 287k open, so the core long in this spread is ~150k or more. This call spread prices aggressive easing going into the election; it would take at least three 25 bp cuts to get above breakeven (9892.5) in the contract.
Note that back then, there were hundreds of thousands of call spreads bought. Currently, total open interest in ALL Sept SOFR calls is 694k which includes Friday’s 98k increase.
After Covid hit in 2020, I wrote a piece titled “They Knew” specifically referring to the buyers of the Sept’20 call spreads that were trading well over 40 by April 2020 as the Fed had slashed to zero.
Here’s an excerpt from my “They Knew” piece:
When the virus news was starting to really circulate in late January and February, a friend said, “those call [spread] buyers must have already known about the virus”. I replied that they couldn’t have, because the news wasn’t really known until January at the earliest. Now there’s a news story that supports the idea that they DID know. From ABC news:
Using techniques similar to those employed by intelligence agencies, the research team behind the study analyzed commercial satellite imagery and “observed a dramatic increase in hospital traffic outside five major Wuhan hospitals beginning late summer and early fall 2019,” according to Dr. John Brownstein, the Harvard Medical professor who led the research.
Brownstein, an ABC News contributor, said the traffic increase also “coincided with” elevated queries on a Chinese internet search for “certain symptoms that would later be determined as closely associated with the novel coronavirus.”
“Something was happening in October [2019],” said Brownstein, the chief innovation officer at Boston Children’s Hospital and director of the medical center’s Computational Epidemiology Lab. “Clearly, there was some level of social disruption taking place well before what was previously identified as the start of the novel coronavirus pandemic.”
Now, shall we read anything into present-day buying of EDU’23 9700/9800 call spreads? It’s abundantly clear that the market perceives Fed easing in late 2023 and into 2024; SFRZ3/SFRZ4 settled at -107.5 on Friday with hard inversion signaling rate cuts. Is the economy going to fall off a cliff? In 2019 the Fed held off from easing for eight months. This thing’s rhyming like a bad rap song.
Of course, our first order of business is to determine when the Fed stops HIKING. Goldman last week added a projected 25 bp hike in May in their updated forecast. Could the stop, then ease cycle be drawing much closer? On Saturday, Bostic said he’s ready to “move away” from large rate hikes, and added, “If the economy proceeds as I expect, I believe that 75 to 100 basis points of additional tightening will be warranted. I believe this level of the policy rate will be sufficient to rein in inflation over a reasonable time horizon.” He added that the Fed should guard against any temptation to cut rates, “even if the economy were to weaken appreciably.” (RTRS)
While current inversion of various spreads, both over stirs and treasuries, indicates expected future easing, the current buying of SFRU3 call spreads likely isn’t large enough to provide a strong signal. However, it’s worth keeping track of call spread positions.
OTHER MARKET THOUGHTS/ TRADES
Below is the SOFR Dec’22/Dec’23/Dec’24 butterfly. SFRZ2/Z3 settled positive 0.5 and SFRZ3/Z4 settled negative 107.5, therefore the fly settled at a new recent high of 108.0. What’s interesting is that Dec’23 was pounded relative to the other contracts, and that’s because Fed officials are saying there is more to come in terms of tightening (and there will NOT be an ease). Therefore, the inversion from Z2 to Z3 vanished, yet the inversion from Z3 to Z4 became even MORE pronounced, as upcoming hikes are expected to crush the economy, leading to (forced) easing. It’s not unprecedented; in Euribor Z2/Z3/Z4 is 112 (Z2Z3 is +78, Z3Z4 is -34) and in Sonia the fly is 125.5 (Z2Z3 is +73.5, Z3Z4 is -52.0). It’s simply that the 4 ½ month move is dramatic. By the way, I am NOT recommending that this fly be sold; a look back at ED1, ED5, ED9 fly shows some levels as high as 200. The only takeaway is that monetary policy is uncertain at best, especially when compared to the period from 2015 to 2017 for example.
Top image is current SFRZ2/Z3/Z4 fly. Below is the constant maturity one-year Eurodollar fly covering the past ten years.
Auctions are crammed into Monday and Tuesday due to Thanksgiving: Monday: $42b in 2yr, $43b in 5yr. Tuesday, $22b 2y FRN, $35b in 7yr. Fed Minutes from November 2 on Wednesday afternoon.
The December 14 FOMC is three and a half weeks away. Note: Philly Fed at -19.4 was the lowest it has been in the past 20 years, except for the GFC and the COVID spike lower in early 2020.
Below is a wide range of Fed expectations, summarized by Ira Jersey of Bloomberg:
UBS sees 175 basis points of cuts next year and Deutsche Bank predicts a percentage point of reductions late in 2023
Nomura projects hikes to 5.75% before a retreat to 5%, while Barclays sees 75 basis points of cuts in the final four months of the year
Morgan Stanley, which sees the peak at 4.75%, and Bank of America look for a quarter-point cut in December 2023
Goldman Sachs and Wells Fargo anticipate rates peaking at 5.25% and remaining there through the rest of 2023, while JPMorgan Chase reckons rates will hit 5% and stick there until 2024
Citigroup Inc. sees the peak in a range of 5.25% to 5.5% hit by mid-2023, and holding there through the rest of the year
| 11/10/2022 | 11/18/2022 | chg | ||
| UST 2Y | 432.4 | 451.0 | 18.6 | |
| UST 5Y | 394.1 | 399.6 | 5.5 | |
| UST 10Y | 382.7 | 381.6 | -1.1 | |
| UST 30Y | 404.3 | 392.7 | -11.6 | |
| GERM 2Y | 216.9 | 210.5 | -6.4 | |
| GERM 10Y | 201.0 | 201.4 | 0.4 | |
| JPN 30Y | 150.7 | 140.2 | -10.5 | |
| CHINA 10Y | 269.6 | 283.0 | 13.4 | |
| SOFR Z2/Z3 | -19.5 | 0.5 | 20.0 | |
| SOFR Z3/Z4 | -83.0 | -107.5 | -24.5 | |
| SOFR Z4/Z5 | -24.0 | -28.5 | -4.5 | |
| EUR | 102.09 | 103.26 | 1.17 | |
| CRUDE (CLZ2) | 86.47 | 80.08 | -6.39 | |
| SPX | 3956.37 | 3965.34 | 8.97 | 0.2% |
| VIX | 23.53 | 23.12 | -0.41 | |
