I recently did a post on how to hedge a bear flattening of the yield curve. Originally I viewed it as a hedging exercise. Now I want to take a more aggressive stance and play it as a speculative trade. Fortunately for us all, this post will be easier to write up and explain.
When I talked about this before, I used Eurodollar futures and options on Eurodollar futures to develop my hedging strategy. The cost was nominal, and the tail risk I was defining was hedged in a straightforward manner. To play the flattener another way, you can take a view on the spread between the 3mth Overnight Index Swap (OIS) rate and the Eurodollar rate pair. All the OIS does is track the 3mth forward expectation of the effective Fed funds rate. So it’s a pairs trade with the Fed funds vs. a LIBOR-based rate.
As a pairs trade with options, you have four strategies you can execute. There’s a good graphic of this I borrowed from a strategy paper the CME Group put out:
Constructing the Scenario, Constructing the Trade
I circled the two strategies on the left because they’re the ones I’d consider executing in an environment where I expect rates to increase. But since this is not a directional trade, I need to think about how to play the spread and consequently, the pair. The most recent pieces of data I have include the most recent Fed statement and stories like this and this. First, let’s look at the Fed statement. The most important part of the statement is here:
With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.
The other two stories deal with mortgage loan buybacks and non-performance of private-label residential mortgage-backed securities. All of those purchases/unwinds are going to cost money. I’m inclined to believe that cash will have to be raised to do this. Most likely through an asset sale of some sort. And what have banks been going long on?
And then this guidance came out. That guidance, along with speeches like this warning banks and other credit investors to manage duration and convexity risks in their portfolios, tell me someone is concerned about the carry traders and how crowded the trade has gotten, and banks may be involved in size. Wholesale funding/brokered deposit rates may rise so if you’re funding your lending book with ultra-cheap, ultra-short funding sources, narrowing of yield spreads will require you to use more leverage to earn the same cash spread/interest income. The analogy of stepping in front of a bus to pick up pennies comes to mind…
But the Fed also said it is going to keep its overnight lending rates low, leaving in that “extended period” language we’ve all keyed in on. Sounds like a spread widening if you ask me. Much like the one we saw in this chart (courtesy of the St. Louis Fed):
Another chart that corroborated the spread widening is this one I made that looks at difference between the effective Fed funds and the target Fed funds rates that are announced at FOMC meetings. Typically this spread is small. But when we saw the LIBOR-OIS spread blow out, there was also a widening of this spread as well:
So looking at my handy strategy matrix, the way to play this scenario would be to sell OIS puts and buy Eurodollar (ED) puts at a 1:1 ratio (buy 1 ED put (GE on CME’s Globex), sell 1 OIS put (OSS on the Globex)), since both futures contracts are priced in IMM points and based on $1MM notionals. After you spend some time learning the conventions of the contracts trade, the mechanics of the trade aren’t hard to understand. But there are risks, just like in any trade.
Risks with the Trade
In looking at the ways this spread can play out, volatility between the two rates is a key issue that has to be managed. If you look at the chart from the St.Louis Fed again, you’ll see the spread reduce rather sharply and episodically after it reached its peak. The 1mth LIBOR-OIS spread almost went back to the levels last seen in mid-’07. Here’s a chart that looks at effective Fed funds, 1mth LIBOR, and 3mth LIBOR of the past year:
So you can see spreads narrowed as the various unorthodox central bank programs got underway (lending facilities, MBS purchases, etc.) which would have killed a flattening trade as the yield curve steepened. In short, you need to stay on top of the information that drives rate expectations. That means minding the economic calendar and watching rate direction. But more importantly, watching rate volatility.
Wrapping it All Up
So in short, the Eurodollar-OIS trade offers you a lot of flexibility in how to make plays on the shape of the yield curve. There are some challenges with the trade, because it’s not simply a curve shape trade, it’s a spread trade.
But if you’re looking to either add or reduce macro-level exposure to your portfolio, this is a pretty good way to do it since rates and the short-term funding markets help shape the market views of other asset classes like currencies, commodities, real estate, private equity, and stocks.