wmeubank@ocp.kcmo.com
ONE CAUTIOUS, YET BULLISH
WAY TO BE POSITIONED
Prepared by Jack McIntyre
Strategy
Buy 10 June 1998 Eurodollar contracts and sell 14 June 1998 BAX contracts. The spread is currently at 103 bps. Target 150 bps. Stop 83 bps. The 1.0 to 1.39 ratio adjusts for contract size differentials as well as for foreign currency exposure.
First of all, for those of you who are not familiar with the BAX contracts, think of them as Canada's version of the Eurodollar contract.
The primary reason why we like this trade is that you are selling the short interest contract for the country whose Central Bank is implementing a more restrictive monetary policy. Meanwhile, the long portion of the spread trade is in a short interest contract whose country has a more “mixed” monetary policy. Or at least that is the view which is in the marketplace. For instance, who was the last North American Central Bank to raise official interest rates? Right, the Bank of Canada, who did it yesterday. However, the way the BAX strip is currently being priced by the market it tells us that sentiment expects the BOC to continue to hike rates through most of 1998 and beyond. For instance, the December 1997/December 1998 spread is currently 114 bps, which is well off the wides of the year at 152. We expect that the spread is going to widen back out into this vicinity as the market becomes even more aggressive in pricing in potential rate hikes by the BOC for next year.
After yesterday's rate hike the BOC made the statement, “in recent months there has been growing evidence that the Canadian economy is expanding rapidly and absorbing unused capacity.” The unused capacity part tells us that the BOC is growing more concerned about the potential increase in inflation which could result from this development. Moreover, a 25 bps is not going to have a tremendous impact on the Canadian economy and that they will be forced to continue to raise rates which is not fully reflected in the BAX strip.
Meanwhile, in the U.S. sentiment is becoming more clouded on Fed policy. In fact, it is no longer biased toward when the Fed is going to raise rates again, but to whether they will have to raise rates again. There is a huge difference. We've seen this type of sentiment gain momentum which in turn has resulted in the Eurodollar strip becoming much flatter. For instance, the December 1997/December 1998 spread has traded from 46 bps to 31 bps over the last several weeks. This would not be the case if the market thought the Fed was going to aggressively raise rates going into 1998.
The technical studies on this spread support the outperformance of the June 1998 Eurodollar contract relative to the June 1998 BAX contract.
October 2, 1997 MCM, Inc.
294 Washington St, Ste. 734, Boston, Massachusetts
Copyright 1997, by Consensus Inc. All American and Pan American rights Reserved. editor@consensus-inc.com
Hosted by:
One Crossroads Place
610 West Maple Ave, Suite WWW
Independence, MO 64050
(816) 252-4080
sysop@kcmo.com