16th Sept - FOMC & Scotland

It seems like all of a sudden the discussion around the FOMC (this wednesday) is around the language use, notably the "considerable time" comment, which as Hatzius (GS) points out, is almost an informal 6-month marker from the end of stimulus until the first rate hike, which would point to sometime around March/April '15.

Market estimates see the first hike (taken from fed funds futures) to be between June and Sept... basically, next summer.

Talk about whether we see "considerable time" removed or not is unnecessary at this point, I think what is more important for the fed is to anchor expectations in a more quantitative way i.e. the dots... Currently, the market is behind the last fed dots, and while we could see an "RBNZ" esque move to lower forecasts to current market expectations, I expect no meaningful change (at least in the front end immediate forecasts, we may get some moves further out).

On the other hand, data has been promising, and an argument can be made for June or earlier hikes

By most accounts, the fed is already more dovish than needed (as per taylor rule in 1st chart) and when looking at recent activity indicators from GS, we can see quite an improvement over prior meetings. So we may see upside surprises to the dots.

On the market side, we've seen quite the run up in yields MTD, so in the event of a boring, unchanged fed then Yield curve flatteners may be attractive. Otherwise, I remain short EDZ6 from 98, as even though positioning may be against me, there is significant mis-pricing against the current dots, and any upward moves to rate forecasts from the FOMC would benefit that trade enormously.

US 10's stalling at the top end of this years down trend

A break higher on the back of a marginally hawkish fed would be important as the spill-over effects into G10-carry, EMFX and even credit markets would be significant in the short term.

AUD vs 7 year UST (inverted)

Won't dwell on this too much as we all know the impacts, but here we can see High yield vs 1Yx10Y normalized swaption vol, which will likely rise alongside G10, and especially going into a hiking cycle.

HY vs US 10 year swaption vol

The sell-off in commodities, particularly energy (as its direct impact into CPI) has seen US inflation swap pare their advance, and we've dropped 40bps on the 2 year inflation swap. This has boosted US real yields, which at the same time have been rising strongly. So right now, the strengthening USD has pushed the CRB index lower, which has led to higher real yields and so on etc.

CRB index (red) vs US inflation swaps (2y)

As noted last week, and reiterated today. I am positioned long EURUSD in a zero-cost structure between 1.27 and 1.30 or so. However, short USD works well as a hedge against my rates trades, especially with the extreme moves in the USD currently.

Off course, on to the Scottish independence vote, which the results will drop early Friday morning. Currently based on bookies odds, there is around a 20% chance of a yes majority.

*from Betfair's exchange

This is a relatively low percentage in my books (okay, not compared to a few months ago, but thats not the point. No is still far and away likely).

All over twitter in the past few weeks we've seen plenty of GBP implied vol charts, and we all know its spiked fantastically, with Sep-19th ATMs trading at (mid) 18 vol points on cable.

One thing not overly explored is that of the move in the short dated risk reversals, or even the impact on the curve a long way out.

Looking first at one week 25 delta risk reversals, we can see that it is the most extreme ever (on my data, which doesn't go back to 2008) - at -4.2 vol points!! (EDIT, asked around. Lowest 1 week in 2008 was -3.7, so... yeah more extreme than then)

GBP 25 delta 1 week risk reversals

I can't chart the risk reversal skew for Sep-19th, but as of writing its currently -5.5, So its safe to say that at least in the options market, there is a helluva lot of protection buying going in to Thursday Evening.

The thing is, given my expectations of the vote, I am still not brave enough to sell naked puts (for sep-19th) even if we have an all time high RR skew and a level of implied volatility that won't likely be delivered on the day.

GBP 3 month 25D risk reversal skew

However, I look further out the curve for GBP options (3month charted) and its 2sd wider than its mean, and back to 2011 levels.

So I definitely think, that further out in the curve there are extremes that should be exploited. Maybe not 3 month exactly, merely using that to illustrate how the entire term structure (not just very front end vols) has moved. As per last week, I still like EURGBP double no-touches, a 25delta 3month DNT costs just shy of 20% of notional with barriers at 0.8221 and 0.7786. Last weeks strucuture is doing ok, but spreads are going very wide (up to 3 or 4 vol points) so MTM is not doing as well as I think it will by expiration.

I have done some math & modelling, and I think 1.57 is fair value for cable in the event of a "yes" vote, where as 1.6450 is where I think we trade after "no" (however cable is very much dependent on FOMC, so EURGBP is cleaner to look at for the "GBP". 0.8265 is my EURGBP FV on yes.

Either way, should be a fun friday, but I think "no"