August 10. CB’s backstop the USD funding crunch?
–The main feature of Tuesday’s trade was huge put spread buying on EDU6 and EDZ6 contracts. (Details below). EDU6 at 99.10 and EDZ6 at 99.055, are the only interest rate contracts that closed lower on the day. Several research pieces came out yesterday suggesting that the 50 bp penalty on foreign currency swap lines ought to cap libor around 90-95 bps; essentially right where the first two ED contracts are trading. Yesterday’s setting was 0.816. From BBG, “…FRA-OIS should have an ‘upper bound’ of ~50bp, which is the penalty rate on the Fed’s dollar swap lines with central banks” according to Credit Suisse. The money market reform deadline is October 14. As Pimco noted, 3 month libor is now above the two year treasury note yield, and indeed is almost identical with the new three year note that was auctioned yesterday at 85 bps.
–Once again, central banks have to become the backstop for the system. However, several news outlets note that yesterday, the bank of England ran into problems because UK insurance and pension firms are loathe to sell long gilts for QE, as they then have to try to replace those assets. Though the issues of money market reform (which is the primary driver of the USD funding crunch) and the UK QE program are in different currencies, the theme becomes one of reduced carry due to higher funding costs, and lower long end yields, i.e. a flatter curve.
–This is highly obvious when looking at the eurodollar curve. The red pack (2nd yr) to deferred packs made new lows. Red/green (2nd/3rd) settled at just 12.75 bps. Red/gold (2nd/5th) is pictured below, having closed below 44 bps, the lowest in nine years. Ordinarily the flattening occurs as a result of central bank tightening; note that the FF target was 5.25% in 2006-2007. The search for long dated ‘assets’ extends into the stock market, which breezily pushes to higher levels, despite the 3rd quarter in a row of lower productivity (yesterday released at -0.5%). Supposedly higher unit labor costs should be squeezing profits, and indeed that does seem to be the case, but in a world of zero the old rules crumble.
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Large trades: EDU6 9912/9900ps bought in size of around 70k, paid 4.0.
EDZ6 9900/9887ps 3.75 paid for 50k.
EDZ6 9912/9887p 1×2 with 9900/9875p 1×2 12.75 to 13 paid for over 50k (appears to be cover of top strikes)
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Chart below goes back to 2006. Red line is red/gold pack spread and white line is 2/10 treasury spread. The recent divergence is about as wide as it gets….
