from Zero Hedge:
Instead of allocating capital to expensive tail risk bets on direct asset class collapse (in equities, credit, and commodities), it appears, just as we detailed previously, the ‘smartest money in the room’ is “betting” indirectly on a stock market crash through eurodollar options.
As we previously detailed, the costs of tail risk protection in credit and equity markets are soaring (and perhaps the crash in global financial stocks and spike in systemic credit risk supports that concerning possibility).
And so traders are looking for cheaper alternatives to place large bets on significant downside in over-inflated assets.
As we noted previously, since the Fed folded in September (under the same conditions that are playing out now), basically admitting it is terrified to raise rates and willing to backtrack due to market fragility, IceFarm Capital’s Michael Green explains, it appears many market participants are piling into par Eurodollar calls:
[the chart shows the cumulative open interest in par calls on eurodollar futures contracts that expire in 2016 and 2017 – basically options on short-term interest rates with a strike price of zero, such that they pay out if the Fed takes rates negative]
When queried whether this is indeed a trade to bet on a market drop, Michael Green responded as follows:
[A reader] thought this might be an attempt by hedge funds to hedge out their exposure to rising interest rates very cheaply.
My initial idea was that it actually could be a bet on negative rates (if for some reason the Fed had to come back into the picture with QE4).
The bottom line:
“Deep OTM puts on the S&P are very expensive while par ED calls are relatively cheap.
In my view, we are that inflection point where the Fed is going to start to waffle…the bear market beckons and they will not be able to stick with their interest rate guidance. Of course, markets tend to frown on Central Bankers revealed as less than omniscient…“
As the chart makes clear, since the initial exposure of this trade, Open Interest has soared as market fragility, The BoJ’s shift to NIRP (and Peter Panic Policy), along with various Fed speakers indirectly hinting at the possibility, as we detailed previously…
The Fed may “seriously consider” negative rates after moving rates back to zero, reintroducing forward guidance and making “stronger pleas” to Congress for fiscal policy action as there are complications for money markets, according to BofAML strategist Mark Cabana.
This would not be a total surprise as Mises Institute’s Joseph Salerno warns recent Fed commentary suggests they want to test-drive negative interest rates…
In 2016, the Fed’s annual stress test on banks will include a scenario in which the interest rate on the three-month U.S. Treasury bill becomes negative in the second quarter of 2016 and then declines to -0.5%, remaining at that level until the first quarter of 2019. According to the Fed, “The severely adverse scenario is characterized by a severe global recession, accompanied by a period of heightened corporate financial stress and negative yields for short-term U.S. Treasury securities.” In other words, including this scenario in its stress test is not supposed to signal that the Fed is contemplating adopting a deliberate policy of negative interest rates. It is simply testing the resilience of big banks in the face of a severe recession that precipitates a “flight to safety” which spontaneously drives rates on short-term Treasury securities into negative territory. Or so they would have us believe.
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