9/7/2023
I wanted to present to you with my favorite trade. It has incredible risk/reward on a stand-alone basis and also works as a portfolio hedge.
First, let me set the stage of where we are and where I think we are going.
The Fed kept rates too low for too long and expanded the balance sheet to $9 trillion resulting in the current inflation dynamic that no one thought was possible. In short, the Fed overreacted to the downside in rates and created today’s inflation instability.
Now, the Fed is quickly making up for lost time and aggressively hiking rates while also starting to rapidly shrink the balance sheet by $95 billion per month. The Fed has just raised the overnight rate by 2.25% in the last 6 months and they are expected to raise it another 1% by year-end.
The speed and magnitude of this rate hiking cycle is unprecedented since the Paul Volker days of the early 1980s. Monetary policy acts with a 6-12 month lag and the Fed is likely overdoing their move towards higher rates based on backward looking analysis.
As result of the Fed aggressively hiking rates into a slowdown, there are increased odds that the US economy is about to get hit by a 1980’s Mike Tyson right uppercut.
The best trade to play for an economic hard landing is to get long Eurodollar rate futures. These rate futures are liquid, specified to an exact date and scalable to one’s desired risk/reward tolerance.
While these futures are called “Eurodollars” they have nothing to do with the Euro, they are simply rate futures that predict where the Libor rate is going to be at a given future date.
My favorite trade is to buy the EDZ3 (Dec 2023 rate future), which is based on the expected Libor rate at the end of 2023, at a price of 96.18. This price implies the market expects Libor to be 3.82% at the end of 2023 (implied rate = 100 – Price).
The Libor rate is currently 3.08%. Thus, the market thinks the Fed is going to be able to hike an additional +110 bps to 4.18%, have the Libor rate peak in March of 2023 and then only slowly lower rates into 2024:
My bet is that Libor is going to end up being 2% or below by the end of 2023, which will put the price of EDZ3 at 98.00 or above for a potential gain of at least +182 bps.
Chair Powell has stated that the Fed does not intend to cut rates quickly into a mild recession. This trade is calling Powell’s bluff.
The time to play for inflation was at the end of 2020 when rates were at zero and no one thought it could happen. The time to play for deflation is now when inflation is high but peaking and no one thinks deflation is possible again.
The Fed does not the backbone to keep rates high into any unemployment spike and they will quickly pivot towards aggressive rate cuts into any major recession, especially if deflationary forces take over and inflation goes negative.
Given that all global central banks are simultaneously hiking rates and tightening monetary policy, we could be in for one of the biggest deflationary shocks to the economy that we have seen in our lifetimes.
I personally place greater than 50% odds that the economy falls into a severe recession by early next year.
The more stubborn the Fed is about reversing course with rates, the faster economic data will deteriorate and force the Fed into lowering rates.
The recent strengthening of the US Dollar furthers my belief that bad things are on the horizon for our economy. Dollar strength has preceded most major economic downturns.
Commodity prices are also indicating that inflation fears might now be in the rearview window.
I am not alone in the view that dark deflationary clouds are on the horizon.
Jeffery Gundlach recently gave an interview agreeing with my view that the Fed might be overdoing it in its tightening and could risk having to reverse course in a significant way before the end of next year:
https://themarket.ch/interview/the-period-of-abundance-is-over-ld.7369?mktcid=smsh&mktcval=Twitter
Raoul Pal also agrees with my view that “the Fed is going to leave the rest of the world in ashes otherwise and that will create a massive deflationary wave in 2023”:
https://twitter.com/RaoulGMI/status/1567255224951128067
Getting long EDZ3 and betting that rates will be much lower than 3.8% by the end of 2023 is the best way to play for a transition from inflation back to deflation.
Here are my answers to some of the more common questions I have received from investors:
Why Not Just Buy Bonds?
While an investor could just buy bonds or the TLT exchange trade fund to prepare for a deflationary spiral, they won’t be as effective as getting long Eurodollar futures. Eurodollar futures give you precise exposure to the part of the rate curve that is likely to reprice lower the most, specifically 2023 Fed rate expectations. By concentrating all of your duration exposure to this part of the curve, it allows for outsized returns if 2023 Fed rate expectations get repriced aggressively lower.
Getting long Eurodollar rate futures just before a Fed rate cutting cycle is the dream of macro traders because the trade is positive carry, massively convex and it tends to trend heavily. It is a more levered and precise version of 2-year Treasuries, which traditionally fall rapidly into economic recessions.
Stanley Druckenmiller famously said that the best trade of his career was buying 2-year Treasury notes and Eurodollar futures in late 2000, when the dot-com bubble burst but before the central bank cut rates:
The reason that catching this turn towards Fed rate cutting is so powerful is that once the turn starts the move rapidly lower tends to occur quickly. Front end rates don’t hang out at the top of the roller coaster very long, they quickly plunge back to earth as the economy screams in terror.
While the above shows the 2-year Treasury yield over the last 20 years, the below graph shows the current forward rate curve. The blue dotted line below shows what the market currently expects for forward rates. This trade is a bet that the more likely realized forward rates will either be the orange line (in a weak economy) or the yellow line (in a bad recession).
How to size the trade?
The trade is sized based on DV01 (dollar value of a basis point). Each EDZ3 contract has a duration of 25, meaning if rates go +1 bps it loses -$25 and if rates go -1 bps it gains +$25.
Perspective sizing based on 2.5k, 5k & 10k DV01 amounts and the hypothetical profit/loss outcomes above would be as follows:
Yet, the trade can be sized based on any desired risk profile. Options can also be used to limit potential downside in the Roaring Economy outcome.
Like most futures trades, the best way to size is to allocate a maximum $ amount you are willing to risk based on the worst downside outcome that one projects. In the scenario analysis above that would be Max Loss = DV01 x -130.
What are the risks to this trade?
This trade would lose if the economy remains stronger than expected and inflation stays higher than expected into the end of 2023. The nice thing about having the expiry go out to the end of 2023 (Dec 2023) is that it is not a bet that the economy and inflation will roll over imminently.
I am not a fan of getting long the Dec 2022 Eurodollar contract because I think the Fed can potentially stay stubborn about keeping rates high through the end of this year.
But I am much more confident that the Fed will not be able to keep rates high through the end of 2023, because over the next 15 months the economy and inflation will likely roll over as the restrictive monetary policy poison takes effect in the US economy.
The other risk to the trade is stagflation or inflation staying high into a weakening economy. High inflation would tie the Fed’s hands and stop them from responding to economic weakness and a weakening labor market with rate cuts. Recent fiscal stimulus measures such as student loan forgiveness are inflationary in nature, so there is risk that is more of this occurs it can keep inflation high into an economic slowdown.
My view is that any stagflationary environment is unlikely to persist, because ultimately prices track wages and if job losses result in slower wage growth then slower inflation should result. There is only so much credit card debt that people can accrue until consumer demand falls off a cliff.
What makes this trade so attractive?
In my opinion, this trade is the best portfolio hedge there is against a broader basket of assets that are tied to the US economy because the worse the economy gets the more this trade benefits.
The trade is locking in a +3.8% yield and benefiting from the realization of any yield at the end of 2023 that is below that level.
It also is positively exposed to bad tail events occurring. For instance, if an unforeseen geopolitical event or shock to the US economy occurs, it will likely result in the Fed rethinking their rate hiking campaign.
Fed pivots tend to be unforeseen and their rate cutting cycles are urgent and drastic. If unemployment spikes > 10% and inflation drops below 0% by the end of next year, the Fed isn’t going to be gradually cutting rates, they are going to be rapidly cutting rates back to 0%.
This trade is positively exposed to bad things happening and makes the most money in the event that the Fed cuts rates back towards zero before the end of 2023.
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