One week after we observed the biggest monthly short squeeze in 10Y TSYs in history, it was a relatively calm week in the longer-end of the Treasury curve.
According to the latest CFTC data, spec net shorts in aggregate Treasury futures was little changed from the previous week at 612K contracts in TY equivalents. While, they continued to pare net shorts in TU and TY by 18K and 14K contracts, respectively, they increased their net shorts in FV and TN by 35K contracts and 6K contracts, respectively. Spec net shorts as share of open interest was unchanged at -5.8% over the week and was at about -2.0 standard deviations away from neutral.
While net Treasury futures shorts are now back to the lowest levels since early December 2016, traders continued to pile into the short-end betting massively on further rate hikes as Eurodollar shorts push on beyond $3 trillion: in the last week specs sold another 73K contracts in Eurodollar futures, taking their net shorts to the seventh successive week of record high of -3,129K contracts.
What is surprising is that there was no short covering after Bill Dudley's March 31 comments which were taken as dovish by the market, sparking EDs to flatten and reds to outperform on potential for a less hawkish Fed in 2018, which as we observed last week prompted a collapse in the Eurodollar 2018 spread (EDZ7/EDZ8) to briefly slide below a key support level on what was seen as the last sign of "reflation trade" capitulation on the front end.
While the mid-week CFTC report captured the market reaction to the initial round of Dudley comments, it failed to take into account Dudley's Friday "little pause" discussion, which as we quoted RBC on Friday afternoon, prompted "Devastating Eurodollar Unwinds."
The confusion following the contradictory Dudley statements prompted Morgan Stanley to announce on Friday that it was taking off its EDZ7/Z8 flattener, but keeping a EDZ7/Z9 flattener. This is what Morgan Stanley's Matthew Hornbach said over the weekend:
Did Dudley change our mind?
No sooner had we published our thoughts on how markets price the pace of rate hikes than Dudley clarified his remarks from last week.
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'.
We said last week that we thought Dudley's original comments suggested that, upon the initiation of balance sheet reduction, if financial conditions tighten too much, the Fed may have to take a step back from raising the fed funds target rate. We never thought he meant going on hold for an extended period of time. So now that Dudley has clarified his view, we no longer suggest investors hold EDZ7/EDZ8 flatteners.
However, we still suggest investors enter EDZ7/EDZ9 flatteners based on our analysis of how markets priced the pace of rate hikes in previous cycles. We looked at 3 historical hiking cycles and here's what we found:
- The Fed delivered more rate hikes than the market expected early on in these cycles, but delivered fewer than the market expected toward the end.
- The Fed delivered fewer hikes than expected toward the end of these cycles because it cut rates during the period in which the market had previously expected hikes to occur.
- The market never fully priced the pace at which the Fed ended up delivering hikes from each cycle's start to its end.
- At their most hawkish, markets priced 2/3rds of the annualized pace of the previous 3 hiking cycles, on average.
At present, the market only prices 2 of the 3 hikes the Fed projects over the next 12 months. Our analysis of previous cycles suggests this pricing is fair, even if the Fed delivers 3 hikes as projected.
Hence, we don't see the need for EDZ7/EDZ8 to flatten from current levels.
However, the potential for the prospect of balance sheet reduction in 2018 to tighten financial conditions enough to warrant a pause in rate hikes, even if not strategic, and possibly rate cuts eventually, means that the market is not likely to price more than 3 rate hikes on net through 2019, in our view. Hence, we still suggest investors embrace EDZ7/EDZ9 flatteners
With Eurodollar shorts failing to be squeezed into last week's violent move, we anticipate that Dudley's clarification will only add to the net shorting on the short end. Of course, just like with the record 10Y short squeeze, it is a matter of when not if, the trade will unwind. As such we continue to look for the dovish catalyst that may lead to epic carnage among the Eurodollar trader community once this trade begins to move in reverse first gradually, and then quite rapidly.