Pricing Escape Velocity – The Rubber Hits Abbey Road

The chart below is fascinating to us, particularly in light of the fairly modest in magnitude, but quite speedy rise in UK yields. The chart shows the difference between futures prices for sterling 3 month LIBOR expiring in September 2022 and 3 years later, in September 2025. They price at 100 minus the interest rate, so a price of 99.5 equates to a 0.5% prevailing rate at expiry. Roughly speaking, individually the contracts can be interpreted as the markets best pricing for interest rates at those points in time, the spread between them gives a look at how the path is priced to get there.

A year ago, rates were priced to be at about zero in September 2022, and not much higher – maybe 1 hike – by September 2025. At a starting point of functionally zero rates – that’s a pretty poor prognosis for 5 years time. Earlier this year, the spread between contracts increased as the nearer maturity contract dropped a little in price – implying higher yields – while the longer maturity contract fell more in price. The spread widened to a high of 78bps in early summer. That’s the market roughly saying things are a bit better economically – over the next few years we will see about a hike per year.

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You Can Eat Or You Can Sleep

“You can eat or you can sleep”. The biggest change I have witnessed over the course of the past 3+ decades is the change in investor preference, particularly hedge fund investors, away from positive skew to negative skew… from sleeping to eating. I sleep well. The quote came from a discussion my partner had with another manager who runs a fund that is often aggressively short volatility. He, like all of Wall Street and beyond, have monetized this preference for negative skew – regular returns most of the time, with the occasional blowup. They are eating well.

The preference for negative skew flies in the face of conventional finance theory and behavioral economics. After all, why would people buy lottery tickets? Smarter people than me have worked these ideas over, and it’s a bit of a mess. Let’s just think about 3 possible drivers (I am not bashful about stealing others good ideas). Some of these thoughts are motivated by a great blog post that can be found here: https://www.macroresilience.com/2010/01/13/do-investors-prefer-negative-skewness/

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