In anticipation of Brexit, most traders are closer to flat positioning. This is evident from the low volumes and the flat open interest in Eurodollar futures the past week. This also makes sense from a logic perspective - in a negative sum game like futures trading, it is less favorable to commit to a position when you will not be one of the first to know the results.
Assuming efficient markets, there should be something on the order of 21% of Brexit priced into the curve. There are two things that could happen to the U.S. curve if there are problems after Brexit:
- The London InterBank Offered Rate to Fed Funds ("LIBOR-FF") spread may blow out again. Just like 2007. But everyone is aware of a potential LIBOR problem now. The Brexit vote has been on the calendar for a long time. Banks have had a long time to prepare. And even if they didn't, the central banks have said they would provide liquidity. This is one of the reasons why we haven't seen the 3 month LIBOR fixings blow out yet. At Wednesday's close, the spread of 3mo cash LIBOR to matched Fed Funds was 25.5 basis points. The EDU6 (the 3 month Eurodollar future settling in September 2016) spread vs the matched Fed Funds settled yesterday 28 basis points. You could see these spreads come down a few basis points on a "no Brexit."
- Brexit may cause global weakness. You would expect the FOMC hikes in 2016, 2017 and part of 2018 to be priced lower. In Eurodollar ("ED") space, this would mean a rally led between EDZ7 (the 3 month Eurodollar future settling in December 2017) and EDZ8. Part of the problem is that no one knows what will happen, so people may think the worst. It's a 2 year negotiation process, so people may think there will be a lot of confusion for a while. Things may get so bad the Fed may have to ease. Back in 2007-8 the front of the yield curve inverted from the eases priced in. But rates were 5.25% then. So there was plenty of room to ease down the line, which was part of the inversion. Rates are 0.37% now. The Fed basically has only 1 bullet in the chamber. If they need to use it because of Brexit, it will probably be in the next few months. Possibly next month. That's it. Then they will be on hold for while, until they think of something else, like more QE. You could see a selloff on the curve led by EDZ7 thru EDZ8 on a "no Brexit."
My general sense is that there was a lot of risk taken off the table, but I think there is probably some bullish positioning out there now (in particular, yield curve steepeners) heading into the voting results. In keeping with my "be prepared" philosophy, I want to look at both scenarios:
- Libor-FF spreads should narrow about 2.5 basis points. Express bullish rate views (rates lower) with Eurodollar futures and short rate views with Fed Fund futures, all other things being equal.
- Volatility should get crushed. As with equities, there has been a lot of activity going into this vote.
- Look for a sell-off led by the belly of the curve (around EDZ8). The long end of the yield curve may flatten, as people may have put on steepeners going into Brexit, and traditional long-term buyers may have lightened up on positioning ahead of Brexit.
The two risks I've identified are: (1) LIBOR-FF spread widening, and (2) some sort of global weakness. If things haven't moved much, take a look at ways to express one of those views.
- Look for cheap ways to express an ED-FF spread widener.
- If you are going to look for an ease, look at FFs, and not EDs, because if there is a LIBOR problem, ED may not move as much, even on an ease. Look at buying some front FFs. Most the near-term hikes will get priced out, but there is some ease potential if things get terrible. Anything up to FFQ6 could be good because Brexit will most certainly cause the Fed to pause in July.
Overall, my opinion is that the Brexit damage stories may be overstated. Part of it is the recession rhetoric by the anti-Brexit side. The International Monetary Fund and the Bank of England have both implied Brexit may cause a recession. The other part of it is from "anchoring" expectations to conditions similar to the last Great Recession. But knowing what is priced into the curve and what traders have been doing will be valuable in terms of developing your interest rate trading view going into this potentially volatile week.
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