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A Key Reflation Trade Support Level Just Broke

Thursday, April 6, 2017 10:42
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(Before It's News)

While most eyes are focused on the longer-end of the curve and the butterfly-rotations in the Treasury complex…

RBC's Mark Orsley points out that there is a substantial repricing going on in the front-end that could bleed into the broader reflation theme.

Arguably the most popular way in rates to play reflation and the thought of a more aggressive Fed has been the EDZ7/EDZ8 steepener (buying Dec ’17 Eurodollars/selling Dec ’18 Eurodollars).  Conventional wisdom was the curve had 2 hikes priced in, the Fed has been saying 3 hikes for 2018 so its 1 hike light and thus a buy (steepener).  Fair enough and I was a believer of this theory as well.   However, Dudley really threw the Eurodollar market for a loop when he:

  • talked down the Fed’s urgency to hike
  • revealed that the taper of reinvestments represents a hike or two
  • showed us that the markets current pricing for terminal rates is pretty fair when he said there is 100-150bps more of hikes (was priced)

As I have been saying in the past couple notes, this caused a recalculation of Fed hike expectations by the Eurodollar market and that caused the bleed lower in the EDZ7/EDZ8 spread.  It may not look like much in the charts but we are talking about a significant move.  From the pre-March FOMC high to now, that curve has fallen from 57bps to 38bps (19bps).  That is an 11 standard deviation move.  For those equity minded, it would be equivalent to S&P’s dropping 150 points (~7%).

Yesterday’s FOMC minutes from the March meeting only exasperated the move in Eurodollars.  The statement that most Fed officials saw reinvestments shift warranted this year was slightly more aggressive in terms of the timing that many in the market expected. Thus when coupled with Dudley comments, the Fed is confirming that tapering is on the way which means there will be 1 or 2 less hikes than we all originally expected.  That flattens the Eurodollar curve and pushes the Eurodollar unwind further. 

So now what?  I think the take away is when you look at the chart of EDZ7/EDZ8; it is the same formation as 10yrs.  While 10yrs are holding its range, Eurodollar spreads are potentially foreshadowing a pending break down in yields.    Essentially, Eurodollar curves are breaking the equivalent level as the all-important 2.31% level in 10yrs which is being watched by everyone in the world.

EDZ7/EDZ8 spread…

Looks familiar doesn’t it? We noted the critical levels on US 10yr rates

The bottom line is, although getting a slight reprieve this morning, the breakdown in Eurodollar spreads increases the probability of a support break in 10yr yields which is watched by the entire market and has repercussions beyond rates (into financial equity names and credit products to name a few).  If it does break, it will likely lead to a significant round of capitulation in reflation trades.  From there, the story will turn to knock on effects and potential liquidations in other products (ie: book gains in S&P longs against losses in Eurodollars).

The trend line break this week in US 10yr yields to me indicates the froth being taken off the Trump side of the reflation theme.  If the support level at 2.31% gives way, this will mean rates will retrace to the longer term trend line first put in place post-Brexit.  This post-Brexit trend line represents the stronger economic data momentum (non-Trump induced) and central banks pivoting away from easing themes.  Those two themes still persist.   It would not be unreasonable to see 2.15% by May which fills the gap from November and meets up with the longer-term uptrend that I think will end up holding. 


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