May 24. Eurodollar calendar spreads under pressure

All eurodollar calendar spreads are being crushed. The first four contracts (whites) to reds as avg spread is only 60 bps. Red/green spread is only 88 bps. One month ago the front one-yr spreads were around 140 and red/grn was 120, so this has been quite na inversion. There are huge strains and funding concerns in the market, also evident in VIX which closed at 40 and has nearly tripled from last month’s low. I think the central banks would like to alleviate pressure in the front end of the curve, but the Fed may defer to the ECB on policy response.

–There was heavy buying of near calls, for example July 9950c traded 130k, bought for 0.75 to 1.0.  Open interest in the strike gained 65k. Ten year yield closed at 3.20% and 5 yr fell just through 2%. Two years are hovering near crisis lows at 73 bps. (2’s, 5’s and 7’s auctioned this week).

–32 states have borrowed from the federal govt to pay unemployment benefits as their funds have depleted.  Next year fed’l debt will likely cross the threshold of 100% of GDP.

–The question now is whether renewed financial strains will spill over into the real economy.  While lower oil and other commodities will be a benefit, as will lower long term rates (if available to other than the govt), lower stock valuations will hurt.  Also, exports are likely to suffer with renewed dollar strength.

–Currently the big banks have access to cheap funding while smaller banks remain fragile or are going out of business.  It has only been a couple of years since Lehman and probably not enough time has elapsed for the subsidy of the steep curve to allow for full write downs of bad assets.  Further, financial regulation may break up banks and invite true rating agency scrutiny and downgrades which would exacerbate funding pressures.

Posted on May 30, 2010 at 3:38 pm by alexmanzara · Permalink
In: Eurodollar Options

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