[Editor’s note: The following is an excerpt from a recent, longer piece by Kevin Muir, formerly head of equity derivatives at RBC Dominion and better known for his exploits as “The Macro Tourist.” His daily letter is now subscriber-only. The following is reprinted here with permission and is available exclusively to his subscribers and mine. Those interested in trading ideas from Kevin related to the piece below can check out the new MacroTourist here.]
I’m a big fan of Jefferies’ market strategist David Zervos, who, for years, has been consistent on his “long spooz and blues” idea.
For my non-bond crowd, I know you hoped I would stop writing about yield curves and other fixed-income trades, but rest assured, this is important for everyone.
David Zervos pioneered (or at least popularized) the strategy of being long stocks (by buying the spooz contract – the S&P 500 futures) while also being long “blues.”
At this point, some of you will ask, “what the heck does it mean to buy blues?” For the longest time, I was in that camp. These macro guys (don’t give me too much guff for using that noun – let’s face it, they are almost exclusively guys) would talk about buying or selling “golds” or “greens,” and I would be completely lost. I sometimes felt like Sesame Street had taken over the trading desk.
Although this strange color world seems like a secret language developed by institutional STIR (short-term-interest-rate) traders, it’s really not that difficult. It behooves us all to understand what they are talking about – not only to evaluate David Zervos’ strategy, but because there is a cornucopia of opportunities in this area of the market that most non-institutional fixed-income investors miss.
The colors refer to various maturities in the Eurodollar futures market. As a reminder, Eurodollar futures have nothing to do with the euro currency and are short-term fixed-income instruments. They represent the 3-month LIBOR rate at various points in the future.
Each color denotes a full year in the future (usually four contracts – March, June, September and December). For example, the “white” contracts represent the first year of ED contracts, while the reds are the second year.
The white “pack” is currently represented by December 2020, March 2021, June 2021, and September 2021. The red “pack” contracts are December 2021, March 2022, June 2022 and September 2023.
For those with Bloomberg terminals, if you pull up the contract table (function CT) for the EDA Cmdty future, you will notice that the contracts are color coded.
Back to David Zervos’ “long spooz and blues” strategy. When David says long “blues” he is referring to buying the 4th-year pack of Eurodollar futures.
What exactly is David accomplishing when he does that? He is purchasing the 4-year forward one-year strip of 3-month LIBOR. Sounds complicated, but it’s not.
In essence, it’s what the market expects 3-month LIBOR will be trading at 4 years from today. And then, it’s a rolling return of that 4-year forward.
The reason David chose the “blue pack”? That pack earns the carry from a steep yield curve. Think about it as similar to why a bond investor who expects rates to trend lower is better off venturing out the yield curve with a longer duration instrument.
What Zervos is doing with his long “spooz and blues” strategy is combining a position in the S&P 500 with what has been a negatively correlated long fixed-income position. Not only does the “long blues” offer negative correlation to a risk asset (stocks), but over the past decade it has been a steady winner as interest rates have trended lower.
That 15th ED contract has earned the carry while at the same time protecting the portfolio in times of financial stress as the Federal Reserve slashed interest rates.
For the next part of my piece, I owe a big thanks to the original “Macro Man,” Bloomberg’s Cameron Crise, who has kept an ongoing tally of Zervos’ strategy throughout the years. Here is the performance chart since 1997:
What I find interesting is how, since the Great Financial Crisis, the “spooz and blues” strategy has been in a steady march higher.
However, this chart is somewhat misleading because it is not demonstrating the same percentage performance change throughout its long history (as the strategy chart rises, the recent changes appear bigger than the earlier rises). To make it more appropriate, we need to change the scale from linear to log. By doing so, the chart now looks like this:
What immediately sticks out is the high volatility pre-GFC, and how since then, it has settled down.
The decade following the Great Financial Crisis was the golden era for the “spooz and blues” strategy, exhibiting unbelievable low-volatility combined with outstanding returns.
I contend it represented the final hurrah of Wall-Street-over-Main-Street. After four decades of relying on monetary stimulus to fix every economic slowdown, in the years after 2008, central bankers took policy to extremes, and in doing so, created the ideal environment for financial assets to shine. The “spooz and blues” strategy was a manifestation of this financialization of the global economy.
Although this trade now seems obvious, back when it was first introduced by Zervos, there was plenty of pushback. Hedge funds were convinced that QE would create inflation and/or stocks would continue to suffer from the aftershocks of the GFC. Advocating that investors get levered long stocks and 4-year forward Eurodollar futures was a bold call. David Zervos deserves a ton of credit for his forecast.
The start of a new era?
If long the “spooz and blues” represented the ultimate Wall Street trade, then what will happen in the coming years, if Main Street garners a bigger slice of the pie?
Perhaps “spooz and blues” should be retired.
To that point, what’s interesting is that although the stock market has hit new highs, this strategy is not confirming:
Why do I feel like “spooz and blues” should be shelved?
Well, to start with, the blue pack of ED is trading around 99.45. Spot 3-month LIBOR is trading at 0.22%, so that means there is a whopping 33 basis points of carry in the blue pack. That’s a terrible risk-reward. I know that technically, US rates could go negative, but that’s a poor bet. Federal Reserve officials have consistently thrown cold water on the possibility of negative rates and market participants who are anticipating this outcome simply aren’t paying attention. Even if you don’t believe the Fed’s communications, Europe and Japan’s foray into NIRP has not worked, so why would the United States follow them down this path? It’s like watching two of your buddies jump off a bridge and then proceed to drown, but sure, according to your other buddies on the sidelines, it still makes sense to jump.
Another reason why “spooz and blues” has reached its expiration date is that the negative correlation between stocks and bonds is something that has worked over the past forty years, but that’s largely occurred in a disinflationary environment. If we have moved to a period of inflation, then the ballast of a fixed-income position in a portfolio of risky assets might turn out to be more of an anchor.
As I have highlighted in previous posts, if labor gains a larger share of the economy, then capital will suffer (at least on a relative basis). This is not a recipe for stronger stocks. If the polls are correct and there’s a Democratic sweep in November, it will represent a dramatic change in the public’s attitude. Over the long-run, it’s hard to see how this is beneficial for equities.
“Spooz and blues” was a terrific trade, but its time is up. Watching its performance in the coming months/years/decades will be important to understand where we are in this process of Main Street winning over Wall Street.
My bet is that whereas once “spooz and blues” produced nice, steady non-volatile positive returns, it will increasingly result in violent uneven poor performance.