I thought I'd ask our resident experts what their preferred method of playing a flight to quality is? I.e. when everyone gets risk averse due to some liquidity crunch, such as post 9/11/2001, 1998 LTCM debacle, or this August just gone. In the past I've just Texas-hedged by going long T-bonds and Eurodollars, but I'm sure there must be a more efficient way of doing things. Anyone have tips for the best way to play this? Any useful past market experiences or anecdotes?
(1) You'd tend to make the most money by being spread "long" shorter-term instruments against "short" longer-term instruments.......i.e. buy the front-month Eurodollars & short-sell the 30-year bond. (2) The flight-to-quality and/or Fed Intervention would be obvious in the front-end of the yield curve while the long-end of the curve would perceive the action as being inflationary, less beneficial for bonds.
in addition you can also run a carry-trade-unwind position being long jyp or chf versus short aud, nzd or gbp.
Agree - both of our selloffs this year (2/27 & 8/16) were accompanied by vicious JPY rallies to around high 111s and 114s, respectively, vs. dollar. 2/27 was the strongest carry trade unwind so far. I may not be recalling those levels in JPY correctly.
Short of trading basis swaps, swap spreads, or other derivatives through a dealer the term TED spread that you described is probably the best way to take a position on liquidity/flight-to-quality. I was looking at buying a 2-year term TED spread during the summer but didn't place any trades because my exposure would be much more than I would have been comfortable with. I don't think spreading front month eurodollars vs. long bond contracts is the best way to go about trading flight-to-quality because you're making bets on the shape of the yield curve more so than liquidity and perception of risk. Same with betting on carry trade flows, as you aren't directly playing the flight-to-quality game - you're also taking on a slew of other exposures (that you may or may not want to take). Start with the spread between a USD risk-free asset and a USD risky asset with equal terms, then add curve steepners/flattners, FX positions, equity plays or whatever you want to take a view on. Whatever you do, don't go broke on something you had no intention of betting on in the first place - make sure you understand ALL the factors that can affect your trade and P&L.
In an "easing" environment, the spot contract. The deferreds should be priced at a premium. Avoid them. In a "tightening" environment, the front month and the second-year, the "reds". Those should be priced at a discount-to-spot and ought to rally the most if the yield curve can greatly steepen.
The curve seems to be inverting around u8 most of the time so if you just wanna get long, anything from z7 (front month) to u8 will do. The nearer the expiration the less volitile, but usually more liquid...so farther back is more risk if your wrong but a bigger winner if your right. However they're all pretty liquid so its not an issue unless your throwing around insane size.
99% of the time you'd be correct. I wouldn't be assumptive though. Those types of dislocations can blow you out. I'll give you a scenario. What if stocks erode 1000pts in the next month and commodity prices hold firm on a weaker dollar. Already happening, eh? SPX is a few % off it's high and oil/gold/beans/Euro haven't faded a bit. So you could see a non response from the Fed. If that were to happen the curve could flatten like a pancake. Hell it could invert! P.S. to Cutton: I keep most of my non-trading capital in Treasuries 24/7 365 day's a year anyways. I bitch about low yields incessantly but I always think of the Seinfeld bit about money. "I'm not an investor. People always tell me, you should have your money working for you. I've decided I'll do the work. I'm gonna let the money relax. You know what I mean? 'Cause you send your money out there - working for you - a lot of times, it gets fired. You go back there, "What happened? I had my money. It was here, it was working for me." "Yeah, I remember your money. Showing up late. Taking time off. We had to let him go."