Talk From The Trenches: Forward Guidance & Brexit Risk Metrics

By Bill Sokolis

US

Markets continued to digest forward policy the day after the Federal Reserve

Open Market Committee raised target range for the federal funds rate by 25bp, to

2.00%-2.25%. With another hike for a total of four this year and an average of

three next year, conviction starts to wane into year end 2019.

     As such, it's interesting to note the jump in Eurodollar futures and

options trade targeting various quarterly expirys through 2019 over the last

couple weeks.

     Coinciding not only with central bank policy meetings, but with the timing

of Brexit on March 29 (two years after triggering of Article 50 divorce

procedure between the UK and the EU), Eurodollar options saw massive volume a

couple weeks ago (>350k short March 63/66/68 2x3x1 put flys, and 100k short Mar

63/65/67 put trees), followed by a spike in short Sterling options volume last

week (large March '19 90/91 put spread sales).

     This week has seen massive Red Dec'19 OTM put sales to help fund upside

calls -- fading more prevalent downside put skew implying either a pause in

tighter Fed policy into Dec 2019 -- and/or continued move OFF inversion of Red

Dec'19 vs. Green Dec'20 (from -0.020 last week to +0.050-0.045 on massive buying

yesterday). 

Heavy futures spreads have traded with similar themes this week with over

150,000 bought in each EDZ9/EDZ0 and EDZ9/EDH0 spreads.

Some desks suspect a coordinated cross currency effort to hedge for a global

slow-down and increased accommodation. Note the the dis-inversion in Eurodollar

futures corresponds with a rise in Euribor from mid-Aug lows (in jeopardy as

sovereign risk related to Italy budget resumes). Also note the 3M FRA/OIS

spreads that climbed over 30.0 earlier in week vs. 19.0 in mid-September have

compressed below 29.0.

EUROPE

Definitely Maybe

Next week, Theresa May is set to endure the 'most important moment of her

premiership' when she delivers her leadership address to the Conservative Party

Conference in Birmingham, UK. The relationship between May's cabinet, the

Brexiteer splinter faction led by Boris Johnson and the party members themselves

couldn't be on thinner ice, and it's inevitable that many will call for her

scalp in the coming weeks.

     The fracture running through the middle of the Conservatives is reflected

nicely in GBP/USD options markets at present, with the solid demand for GBP puts

persisting across the term structure despite historically expensive hedging

costs. How the current political environment feeds into the Bank of England's

ability to create policy is unclear - after all, they're creating growth,

inflation and unemployment forecasts based on an economic future that is yet to

be decided. 

It's this fogginess in forecasting that's kept the short-sterling strip

elevated, pricing in very little tightening (if any) in the coming years. These

still easy financial conditions are evidently failing to transmit into the real

economy, however: business investment unexpectedly collapsed in Q2, a sore point

for the supposedly pro-business Conservative Party.

     This leaves GBP/USD in a precarious position, wedged between the 50- and

100-dmas. Murmurs of leadership challenges, a boisterous, combative appearance

from Boris Johnson and worsening hard economic data may mean the worst is yet to

come for UK assets. 

Talk From the Trenches is a compendium of chatter from trading rooms, and is

offered as a gauge of the mood in the financial markets. It is not necessarily

hard, verified news.

--MNI Chicago Bureau; tel: +1 312-431-0089; email: bill.sokolis@marketnews.com