Inversion accentuated
November 27, 2022- weekly comment
Last week I highlighted two market themes. First, was buying of otm call spreads in SFRU3, namely the 9700/9800 call spread for 4.25 to 4.5. This week that ripple turned into a small wave with significant buying of Z3 and H4 call spreads in SOFR.
The other feature I noted was a new high in SFRZ2/Z3/Z4 butterfly which had settled at a new recent high level of +108. Last week (11/18) SFRZ2 settled 9545 which was -4.0. SFRZ3 9544.5 -22.5 and SFRZ4 9652.0 -4.5. Dec’22 and Dec’24 were down a bit, but Z’23 was hammered on a relative basis.
On Friday 11/25, the SFRZ2/Z3/Z4 fly settled at a new high of 124.25. However, net changes on the week reflect a different story. SFRZ2 settled 9543.25 down just 1.75 on the week. SFRZ3 9544.0, down 0.5. SFRZ4 was the driver at 9558.5, UP 16.5.
First, I will briefly cover the call spreads.
SFRU3 9700/9800cs traded a bit more, settled 4.25 ref 9514.5. OI in both strikes >65k
SFRZ3 9625/9725cs settled 17.75 ref 9544, OI in both strikes +20k on the week
SFRZ3 9700/9800cs settled 8.25 ref 9544, OI in both strikes +40k
SFRH4 9700/9800cs settled 16.0 ref 9584.5, buying on the week >50k 14.5 to 15.5.
The theme is for a much lower FF target in 1 to 1.5 years.
Of greater significance is the message from the one-year butterfly.
On the week ending Nov 18, SFRZ’23 was hit (-22.5) because the Fed is clearly saying a pause is NOT in the cards. The minutes released this week indicate a slowing in the pace of hikes, but perhaps a higher peak. The lowest contract on the SOFR curve is June’23 at 9500, exactly at 5%. The low in that contract is 9475.5, made in the beginning of November (11/4). The market is comfortable with a peak rate projection of 5% or perhaps slightly more. Downside in front contracts seems limited from here.
What changed this week to push the fly higher? The change is in the back end of the curve. SFRZ’24 was UP 16.5 on the week, while Z’22 and Z’23 were essentially unch’d. The market is projecting 5% as an approximate terminal rate, but the concern is that funding at that level will become stifling. SFRZ3/Z4 was -20.5 at the start of June. On Friday it settled -124.5, over 100 bps further inversion in less than six months.
Indeed many curve trades are at historic inversions. For example, 2/10 closed Friday -77.5. According to my (2:00 pm CST) marks, that is the twelfth day in row at a lower level. Have to go back to 1981 to see a more negative print. The red/green pack spread in ED settled just below -80 (same in SOFR). That too, is a historic low.
Does it make sense for SFRZ’24 to be at a rate of 3.315%? The five-yr treasury ended at 3.884, down 11.2 bps on the week, while tens ended 3.698, down 11.8. The market continues to price longer term inflation at lower levels and is signaling a large deceleration in growth. It doesn’t pay to fight the trend. The question is whether the inversion accelerates going into the Dec 14 FOMC. CPI will be released the day before, on December 13.
This week the major economic data are released Thursday and Friday. However, NY Fed’s Williams speaks at the Economic Club of NY on Monday, and Powell discusses the economic outlook midday Wednesday. On Thursday, the Fed’s preferred measure of inflation, CORE PCE prices are expected 5.0 from 5.1%, with headline yoy expected 6.0 from 6.2. ISM Mfg is also on Thursday, expected 49.8 from 50.2. It hasn’t printed sub-50 since May 2020 during COVID. Friday features the employment report with NFP expected 200k from 261k.
My guess is that peak pressure on the curve will occur prior to Powell’s speech on Wednesday. I would look to cover shorts or take a shot at buying red/green spreads before the data at end of week, which I suspect will show cracks.
OTHER MARKET THOUGHTS/ TRADES
There is some talk of loosening financial conditions which the Fed might want to lean against. Dudley, the previous NY Fed chief, had five inputs: short and long term interest rates, the value of the dollar, equities and credit spreads. Goldman’s index GSUSFI has eased since early October. The Chicago Fed puts out a weekly chart on financial conditions, also easing, here’s a link:
https://www.chicagofed.org/publications/nfci/index
Clearly equities have firmed, long rates have declined slightly, the dollar index has fallen and is at an interesting level. I don’t know if VIX is incorporated into the Chgo Fed index, but at 20.5 it’s near the low of the year (16.60 in January) having recently peaked at 33.6 on Oct 12. VIX is not my focus, but I am highly tempted to buy UXZ2 vs sell UXF3 spread which is at a recent extreme of 2.52, having been 1.00 a month ago. SPX is testing the 200 DMA at 4057, and has failed that MA in April and August. SPX has not been above the 200 DMA since early April. Likewise DXY is testing the 200 DMA at 105.33 (close Friday 105.96). DXY has not been below the 200 DMA since June 2021. The 38.2 retrace from June’21 low to Sept’22 high is 105.15. The 50% retrace from this year’s low in Jan to the high is Sept is 104.70. I believe the value of USD is a big determinant of financial conditions, and though it has recently weakened, it’s near major support.
| 11/18/2022 | 11/25/2022 | chg | ||
| UST 2Y | 451.0 | 447.3 | -3.7 | |
| UST 5Y | 399.6 | 388.4 | -11.2 | |
| UST 10Y | 381.6 | 369.8 | -11.8 | |
| UST 30Y | 392.7 | 375.0 | -17.7 | |
| GERM 2Y | 210.5 | 220.5 | 10.0 | |
| GERM 10Y | 201.4 | 197.9 | -3.5 | |
| JPN 30Y | 140.2 | 147.8 | 7.6 | |
| CHINA 10Y | 283.0 | 284.0 | 1.0 | |
| SOFR Z2/Z3 | 0.5 | -0.8 | -1.3 | |
| SOFR Z3/Z4 | -107.5 | -124.5 | -17.0 | |
| SOFR Z4/Z5 | -28.5 | -23.5 | 5.0 | |
| EUR | 103.26 | 104.00 | 0.74 | |
| CRUDE (CLf3) | 80.11 | 76.28 | -3.83 | |
| SPX | 3965.34 | 4026.12 | 60.78 | 1.5% |
| VIX | 23.12 | 20.50 | -2.62 | |
