Short, and not so sweet, for the shorts

April 28. 2019 – Weekly comment

Last week I cited a WSJ headline, ‘Fed Officials Contemplate Thresholds for Rate Cuts’ which had been planted posted on the WSJ site on Saturday 4/20. (Sure, I’ll have a hit of that).  The Fed’s continued shift to dovishness, crystallized by the above article, sparked a flurry of buying in eurodollar calls in the early part of the week.  The yield on the 2 year note plunged 9.6 bps on the week to 2.286%.

This week’s note isn’t about technicalities in money markets and central bank policies.  It’s more about what we can see with our own eyes with respect to interest rate futures and options flows.  I’ve read a million times that the “investing public” doesn’t believe in this year’s stock market rally and is still stuck on the sidelines (being constantly chastised by tv investment professionals).  In the rates markets, I sort of have the feeling that it’s the other way around.  The tv investment professionals just don’t want to believe that rate cuts are on the way, even though market flows are unmistakably sending that signal – with a bit more urgency last week. 

In short term interest rates, near one-year eurodollar calendar spreads trended more negative through the week.  In the middle of the previous week, on April 16, spreads had hit their highs, with EDM19/M20 at negative 18.5, EDU19/U20 -20.5 and EDZ19/Z20 (the lowest one-yr on the curve), at -23.0.  Seven sessions later on Friday, April 26, the levels are M19/M20 -29.5, U19/U20 -28.0 and Z19/Z20 -27.5.  The lowest one-year spread is now the front M9/M0 which fell 11 bps in 7 sessions.  This collapse indicates a couple of things: first, that the market is moving the idea of rate cuts slightly forward in time, and second, that there is some additional funding pressure on the very near part of the curve.  In more deferred contracts, the curve has actually steepened, which is another reflection of eases on the horizon (and perhaps recognition that the Fed is serious about letting inflation run a little warm, if indeed that’s in the Fed’s power).  For example, reds/golds (2nd year to 5th year forward on the euro$ curve) settled at 23.5, +4.25 on the week, at a new recent high. and close to the ytd high set in late March just above 25 bps.  The green/gold pack spread did close at a new ytd high of 25.125.  In treasuries, 2/10 spread closed at 21.6, the highest since late last November, and 2/5 was finally able to close above 0.

With respect to flows in the aftermath of the WSJ headline, there was a surge of eurodollar call and call spread buying over the week.  Open interest in both regular ED quarterly calls and in one-year midcurves (0E) were up 6% on the week.  In quarterly long-dated EDZ20 calls, open interest swelled by over 20% as there was a big buyer of call spreads vs puts.  (Bought 9775/9812cs and sold 9737 puts and bought 9800/9850cs and sold 9737 puts).  The total EDZ20 call open interest increase was acounted for by these trades, from a total of 668k to 814k.  One-year midcurve total call open interest went from 3.929 million to 4.174m.  Again, the point is that these flows are helping to further invert near one-year calendars, in order to capture coming eases.    Consider that the EDZ20 put being sold in above cited structures, the 9737.5 strike, which is 45 bps out of the money, settled 11.25, while the EDZ20 9837.5 call, which is 55 out of the money, settled 14.25.  Skew is leaning to calls for a reason.

Once again, it’s clear from the Fed funds curve that the market is raising odds of a cut specifically at the September FOMC.  Actually, both the August/October calendar spread, and the Nov/Jan settled -6.5, projecting 1 in 4 odds of an ease at either the Sept or Dec FOMC meetings.  January 2020 FF settled 9782.0 or 2.18%, 26 bps under the *new* Fed Effective of 2.44%, fully pricing at least ONE 25 bp cut by year end.  In touching upon the topic of the Fed Effective rate at 2.44, the natural progression is to discuss this week’s upcoming FOMC meeting and a possible tweak to IOER.  At 2.44, the EFFR is 4 bps above IEOR, leading some to speculate that a reduction in IOER is in the cards as early as Wednesday.  A ZH article over the weekend cites JPM as saying “liquidity conditions in the US banking system are perhaps close to their tightest in a decade.”  This claim is made on the basis of the ratio of bank reserves at the Fed divided by total assets of US banks, having fallen below 9%. (Link to article at bottom). Again, it’s hard to comprehend that reserves are ‘tight’ but that’s what the market is saying.  I recall a previous speech by Simon Potter, head of the NY Fed’s Market desk, noting the importance of the Fed being able to keep EFFR within target.  Of course, as recently as last September, he, like others on the Fed was advocating “further gradual increases in interest rates.”  The point is, that the Fed will respond to EFFR above IOER, and the market on Friday timed that tweak for the July 31 FOMC, as the July/Aug FF spread closed at negative 3.5, down 1.5 on the day.  I would also note that EDM19/EDU19 settled at -8.5 on Friday.  Last week I recommended selling at -4.0 with a target of -9 to -10.  With USD strength and near term funding demand, EDM9 should be held down relative to deferred contracts. 

Another theme that has been cropping up is deteriorating credit quality at the margin.  On the consumer side, several credit card issuers have noted increasing deliquency rates and have tightened terms.  For example, Capital One said its Q1 US card charge-off rate rose to 5.04% from 4.64% in Q4 2018.  Financial conditions are becoming mixed.  Yields have fallen, stocks have continued to rise, corporate spreads remain tight.  But the dollar is strengthening and weakness across several EM currencies is obvious, for example in Argentinian peso and Turkish lira.  The South Korean won and Swedish krona are also breaking to new lows, not to mention the euro.  The Fed appears to be more focused on USD with respect to downside risks for the US economy.  “Normalization” is over.  


The market’s reaction to Friday’s Q1 GDP print of 3.2% says it all.  An initial kneejerk sell off was instantly reversed with rates contracts making new highs as shorts scrambled to cover.  “He who sells what isn’t his’n, must buy it back or go to pris’n.”  The treasury market isn’t yours anymore.  It’s the Fed’s.  Weak price data and (unintentional) inventory building in Q1 were the focus, and of course Trump’s tweeting about wanting to see energy prices lower emboldened the DE-flationistas.  CLM9 had an outside week and closed lower on a large weekly range.  After having posted ytd new highs on Tuesday at 66.60, it settled 63.30. 

Last week I said TYM was likely to settle between 123 and 124 due to positioning in expiring May TY options.  TYM settled 123-215 Friday, and open interest in June TY calls is clustered around the 124 strike.  Tens will probably probe under 2.5% this week (2.502 on Friday’s close). 

Last week I suggested buying TUM9 106.375/106.625cs for 3.5 ref 106-09.25.  Settled 6.5 ref 106-15.  Likely more upside though there could be a pause early in the week. 

In general I favor the theme of bull steepening. 

4/18/2019  4/26/2019  
UST 2Y 238.2 228.6 -9.6
UST 5Y 236.8 229.3 -7.5
UST 10Y 255.6 250.2 -5.4
UST 30Y 295.9 292.5 -3.4
GERM 2Y -57.4 -59.5 -2.1
GERM 10Y 2.5 -2.2 -4.7
JPN 30Y 55.5 55.8 0.3
EURO$ Z9/Z0 -26.0 -27.5 -1.5
EURO$ Z0/Z1 -0.5 1.0 1.5
EUR 112.34 111.49 -0.85
CRUDE (1st cont) 64.07 63.30 -0.77
SPX 2905.03 2939.88 34.85
VIX 12.09 12.73 0.64

Posted on April 28, 2019 at 1:25 pm by alexmanzara · Permalink
In: Eurodollar Options

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