Thursday, October 8, 2015

EDZ6-EDZ7; In Scheme of Things Jobless Claims Matter




Weekly jobless claims came out with a 260K handle again.  The 263K posting today is lower than all but 2 readings since 2000 (chart).  Both of those readings were somewhat recent, in April (262K) and July (255K).  So, instead of 273K expected, initial jobless claims are running at even lower levels.  In the context of recent data stream, this is an outlier.  But is it a one-off?   

Hard to imagine this claims number being ‘THE’ overwhelming surprise that changes the backdrop from continued weaker than expected economic reports, most notably the employment report last Friday with its negative revisions, to a greater appreciation for likely moderate growth.  However, change happens in small degrees. 

Expectation for diminished growth, inflation and Fed response has been the fuel to generate trade over the last week or more.  Volume during such trade has been sparse, neither attracting new longs nor prompting revolt by shorts.  Instead, lazy trade has drifted since the extended high reached on Friday.  We are never comfortable with trade that does not generate volume.

With curve sellers abounding and a lesser Fed’s policy response priced even further out the curve, there seems room for a non-spectacular economic report or two to have more than a marginal impact on market psychology.  Of course any substantial rate snapback would require continued employment growth, the shrinkage of the output gap and of course further inflation pressure.  Without getting ahead of ourselves, here I am only talking about a modest correction because of unsupported and likely unsustainable prices.  The risk for the next 10 bps in 10yr equivalents, especially ‘up the curve’, appear now to be towards higher rates. 

Right now, I like using the EDZ6-EDZ7 calendar spread to benefit from a re-pricing.  That spread prices only 2 Fed policy moves (25 bp each) over the period December ’16 to December ’17 (really late-December 2016 through early March 2018).  It may be the Fed never moves policy rates again (not my base case).  If it does move to normalize policy however, I don’t think the market initially prices a return to zero bound as soon as March 2018.  If the Fed doesn’t pull the trigger by year-end, then the guessing of 'when' (the Fed starts) will keep the spread from shrinking further. 

EDZ6-EDZ7 is tighter by 20 bps since June.  It trades to 52.5 today, having settled 52 on Wednesday.  I think this spread moves out to trade with a 60 handle without settling below 50.  If there are any stronger economic reports, the move to 60 could come quite quickly.