Boring Equity Action Masks "Devastating Eurodollar Unwinds" After Dudley Speech

On the surface, and in equities, it was a painfully boring day.

Stocks tumbled overnight after yesterday's Syrian airstrikes, then as it emerged that the conflict will likely be contained, futures ground higher and not even the worst jobs report in nearly a year managed to put a damper on today's rebound, as the narrative shifted to the drop in the unemployment rate, which dropped to 4.5% on the back of a 400K+ increase in employment according to the BLS' Household Survey.

A sharp bounce in the dollar/USDJPY/treasury yield complex during Bill Dudley's speech around noon tried - and failed - to inspire a levitation in the S&P ...

... which ended up closing the day small in the red, despite so much earlier drama.

And yet, while on the surface things appeared calm, below the surface, and especially in the Eurodollar complex there was a surge in activity, courtesy of the abovementioned Bill Dudley remarks.

What happened?

Recall the previously discussed Eurodollar 2018 (EDZ7/EDZ8) spread, which as we showed yesterday, had finally broken below a key support level...


... and was threatening to pull the technical support for the 10Y.

In fact, with the 10Y dropping as low as 3.28% in early trading during the overnight, risk-aversion phase, the reflation trade appeared all but dead.

That's when Bill Dudley took the podium. This is what he said:

“Some people misconstrued what I said last week. I said a little pause. A pause is pretty short already, and I think a little pause is even shorter than that.  Presumably at the time that you make the decision on the balance sheet you might want to forgo the decision on short-term rates just to make sure that the balance-sheet decision doesn’t turn out to be a bigger decision than you thought you were making.  So, I would emphasize the words ’little pause.’

While those words were largely ignored by equity traders, momo chasers and various algos, they meant all the difference to Eurodollar traders, and anyone who had assumed that following Bill Dudley's comments last week, that the Fed would "pause" its rate hikes during the balance sheet runoff phase.

We'll start with the result, and show just how big the move in the EDZ7/EDZ8 trade was: what the chart below shows is that as a result of Dudley's hawkish comments, the Eurodollar spread spiked to the highest level since the FOMC Minutes, where as a reminder the Fed's balance sheet unwind was a primary topic.

So what happened? As RBC's Charlie McElligott expains, Dudley delivered the “clarification heard ‘round the (global macro trading) world,” as Dudley, in a mid-Friday afternoon interview, sought to alter the market’s initial interpretation of his massively impactful comments made last week, in turn disrupting thematic trades across the macro landscape. 

Those comments about the likelihood of a “little pause” in the Fed’s hiking trajectory as-and-when the FOMC begins the process of balance-sheet normalization sent shockwaves through the front-end of the US rates complex, forcing devastating stop-outs / unwinds in MEGA popular macro “reflation” trades like Eurodollar redpack shorts / EDZ7EDZ8 steepeners and the EDZ7-8-9 butterfly and a LOT pain at various and unconstrained funds over the course of the past week.

As McElligott adds, the pain seemingly-culminated in this morning’s Syria strike / NFP headline clunker / Stockholm terror attack trifecta, which sent markets into their initial ‘risk off’ spiral, driving a major UST bid.  Even as stocks recovered over the course of the morning (as per my note this morning), rates remained pinning near the high-profile psychological 2.30 level nearly all day.  Seemingly, the mix of new longs (after the momentum in the ‘short rates’ trade reversed 3 weeks ago) and capitulation from legacy shorts was behind the strength.  And then, Dudley “dropped the bomb” in his above-quoted “clarification.”

Essentially, Dudley said that the Fed will NOT be substituting B/S policy tweaks for Fed hikes, which as noted had quickly become the new market narrative in short-order.  He was clearly taken aback by the market reaction to his comments and viewing them as a statement on the Fed looking to reduce the scale of the overall 2018 hiking landscape.  In turn, the price-action via the stop-outs and unwinds in the front-end trades over the past week were violently reversed this afternoon. 

Indeed, as the chart below shows, the vollume in the Eurodollar spread was the highest since election night!

Some other aftereffects: nominal yields turned sharply higher.  Breakevens turned off their worst levels too.  UST curves flattened.  The US Dollar screamed higher against everything from G10 to EM (everybody’s recent ‘fave’ high-yielding longs as it seemed the Dollar was ‘stuck’). 

In equities, the higher rates dynamic reinvigorate “cyclicals” and “value” factor, while “defensives” / “low volatility” / “anti-beta” factor market-neutral rolled over.  And as I’ve been pointing-out, “growth” logically settled-back too, as it had become a hyper-crowded “hiding-place” over the course of the year as investors sought stocks which could perform without fiscal policy and interest rate exposure.  Thus, FAANG and PANE (FB, AAPL, AMZN, NFLX, GOOGL and PCLN, AMZN, NFLX, EXPE story stocks in tech / consumer discretionary) lagged broad index on the day.  Thus ‘momentum’ market-neutral reversing lower on the day too.

McElligott's conclusion:

As such, I’m getting sudden jolts of confidence from the last of the ‘reflation hold-out’ clients, now feeling really emboldened.  And for the folks who didn’t cover their rates shorts or unwind their ED$ curve trades, there are now STATUES being built for Dudley in various fund offices around midtown.


The one RISK that I see right now for ‘risk’ is this: that we are seeing the largest move TIGHTER in ‘real rates’ since the day post-March Fed hike.  This idea of “tightening faster than we are growing” / “inflating faster than we’re growing” continues to be a concern to monitor.

Bloomberg opined also, noting that Dudley comments benefited a fresh wave of hawkish Eurodollar Bets. Re-established downside options positioning across eurodollars unexpectedly benefited from Dudley comments Friday as focus shifts to clarity from Yellen on Monday.  Signs are emerging that traders are looking to re-establish eurodollar put positions across 2018 maturities, potentially a sign that the rally in reds -- triggered by Dudley’s comments a week ago -- may have been overdone. Friday’s CME open interest changes rose in June 2018 eurodollar puts by 106k contracts; largest gains across 9762 (+25k), 9800 (+30k) and 9812 (+48k) strikes consistent with downside trades initiated Thursday.

While open interest is starting to build again across June-18 eurodollar puts, there has been a sharp drop in Jun-17 open interest, reflecting position liquidation. Latest CFTC positioning data, covering week ending April 4, shows speculators adding $1.8M/DV01, to record eurodollar shorts. Earlier this week, a purge of eurodollar positions saw heavy losses, one of which included a trade liquidated Wednesday for a $15m hit, across Jun/Sept./Dec mid-curve eurodollar spreads from March 1. The purge came as a result of a collapse in eurodollar spreads, along with the Fed probability term structure which inverted as the rate-hike probability edged higher for June 2017 but then fell further out after Dudley’s comments last week.

If all of this sounds overly technical for regular equity traders, don't worry it is, however the implications for the yield curve, and thus the reflation trade, or what's left of it, are substantial.

It also means that as we pointed out yesterday, suddenly focus has intensified on Janet Yellen, who’s scheduled to speak at 4pm Monday at University of Michigan, taking questions from the audience and Twitter. What she says may roil if not the equity market, then certainly lead to a new set of big headaches for eurodollar traders.