March 31. End of quarter; weekly wrap in US interest rates

The week can be easily summed up: continued reaction to the last FOMC meeting, which solidified expectations that the taper is on course to end in October and initial rate hikes will begin about six months later.  From Friday to Friday red euro$ pack was -1.375, green -1.875, blue +0.625 and gold +2.125.  On the day prior to the Fed, green/gold pack spread was 163.875, now it’s 142.625, a plunge of over 20 bps.  The 30yr bond yield fell 7 bps over the week from 361 to 354.  So the greens, or really 2016 contracts, are the weakest part of the curve, but thereafter the curve has flattened, which makes sense if one believes that the terminal rate will be much lower than it was in the past.


Implied vol again had an end of week resurgence, with ten year moving from around 4.7 to 5.0 from Wed to Friday.  Euro$ vol also went bid Friday, for example 2EM 9825^ from 36.5 to 37.5.  There has been a consistent seller of TYM 122/125.5 strangles around 40 (yield equivalent strikes currently around 2.92 to 2.46; Friday close 2.71).  From a longer term perspective though, these are low vol levels.  When looking back at the taper/tighten swoon of last summer, ten year vol went from around 6% in late June to briefly spike at 8% in the beginning of July.  Bond went from around 10.25 to 11.7.  Fives from around 4.0 to 5.0.  I marked bond vol at 7.6 on Friday.  Now that tapering is actually under way, the market has become quite comfortable with the idea that inflation will stay under control and there’s little chance of a big economic growth spurt, in other words, yield increases at the back end will be limited. The normalization trade has embraced the idea of a lower real FF rate than in the past.   Though I am notoriously bad at anything having to do with the stock market, I would say that even here, the air is coming out like a tire with a small leak….when the Fed is pumping hard, the tire stays full, but when the pace slows there is a bit of deflation, and confidence in organic growth just isn’t strong enough to keep it rolling.


There has simply been an explosive increase in Green June put open interest as the market has targeted the initial hike for late next spring.  Open interest in EDM6, the underlying contract, finished Friday with 761k open which is about 7% of total euro$ open interest.  Green June puts, not including April or May expiries, have 2.402 million open.  Here is a sample:


STRIKE          PREM                         DELTA           OPEN INT

9850p              35.25               73                    180k

9837p              27.00               63                    159k

9825p              20.25               52                    243k

9812p              14.75               42                    273k

9800p              10.25               32                    431k

9787p              7.00                24                    256k

9775p              4.75                17                    462k


There has been tremendous size buying in, for example, 9812/9800/9787/9775p condor for 2.5 [Makes 10 on settle between 9800 and 9787.5] and trades like 9825/9800/9775 p fly.  Now it’s all about perceived timing of Fed hikes and market control.  The August 2015 FF contract is 99.47.  In looking at the calendar, I believe there will be an FOMC meeting on July 29, 2015.  Let’s say that FF are correctly predicting a 50 bp FF target at that meeting.  (So perhaps the first official move to 25 is at previous meeting on June 17, 2015).  If there were hikes of 25 at every subsequent meeting, then by the late April meeting in 2016 the rate would be 2%.  So a price for EDM6 or somewhere around 9775 makes sense.  But we won’t know the actual outcome, because Green June options expire June 13, 2014, in just 11 weeks.  And, with this type of open interest (in puts relative to underlying), there would appear to be more than enough firepower to peg and defend this area.  More on FOMC meetings and pegged trades below.


Implications for futures calendar spreads are pretty clear if one buys into this argument of Fed timing.  Contracts like EDZ4 at 9954.5 and EDH5 at 9933.0 should be immune from perceived hikes and therefore have a steady roll up the curve.  However, contracts from EDU15 thru EDU16 will be pegged with vigorous defense, and likely will NOT be allowed to participate in the normal roll.  It’s not exactly an earth shattering revelation; this phenomenon has already been reflected in futures flies like EDH5/H6/H7 which has rallied from -20 to -4 since the FOMC.


Last year when the Fed was talking about the initiation of the taper, financial dislocations across the US curve and in EM caused the Fed to backpedal and non-taper in September. (Payroll data on Sept 6, 2013 was also soft).  It seems very unlikely the Fed will backtrack on the taper schedule this time even if data were to be a tad weak, and the fact that the back end of the curve is controlled at low vol also suggests a Fed goal of financial stability has passed the smell test, even if there are still lingering vulnerabilities in EM.  So what could possibly throw a monkey wrench into the greens from here?  I hardly think it will be that data is so strong that the Fed will have to be even MORE aggressive than currently priced.  No…it’s more likely to come from geopolitical problems, something that shakes the belief in the Fed’s tightening schedule.  My guess would be something in China or Japan.



FED MEETINGS (2015 and beyond approximate) w/ FF target IF first hike is June 2015


2014                            2015    FF Target??     2016                FF Target??


1/29                             1/28                             1/27                 1.50

3/19                             3/18                             3/16                 1.75

4/30                             4/29                             4/27                 2.00

6/18                             6/17     0.25                 6/15 or 22        2.25  (EDM16 exp 6/13/16)

7/30                             7/29     0.50***           8/3

9/17                             9/16     0.75                 9/14

10/29                           10/28   1.00                 10/26

12/17                           12/16   1.25


***FFQ5 9947.0 currently, so that fits with 50 bp target at 7/29 meeting


Other trades that are targeting this schedule: 0EU 9900/9862/9825 put fly for 5.5.  EDU5 currently 9908.  With expected hikes of 25 on Sept 16 and Oct 28, contract should price a bit under 9900.  Breakeven is 9894.5.  0EZ 9875/9837/9800 put fly for 5.5.  With expected FF target 1.25 on Dec 16 and another hike in late Jan, contract should price just under 9850.  Currently 9880.5.


Call for trade ideas.


Alex Manzara  312 281 4411

Posted on March 31, 2014 at 3:56 am by alexmanzara · Permalink
In: Eurodollar Options

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