An exercise in connecting the dots: the Libor-OIS spread


The Libor-OIS spread is such a technical topic that I will leave the details to professionals with a much more profound understanding of it (plus Shawn already wrote a very good post about it). I am just trying to investigate the subject from a different angle.

I have been thinking about a few things some very smart investors shared with me and I am finding connections between the following:
·     A tactical long view on USD and the fact that investors will, during the next downturn, sell the most liquid asset they own first (although I personally believe a proper USD bounce should happen only after a credit event of some sort).
·     The recent Libor-OIS spread widening, which got a lot of attention. I am not convinced by either bearish and bullish views.

·     The bullish case concentrates on the fact that most of the widening is coming from T-bill increase in issuance, that should decrease in the near term. There is no clear correlation between the recent increase in T-bill issuance and an increase in CP yields (I understand the RV argument, but that cannot explain the full move alone).
·     The bearish case concentrates on the fact that the wider spread would signify a tightening of funding conditions and, potentially, a Dollar shortage. If this was the case, I guess the xccy basis for Eur and Jpy should widen too (this has happened in the last few days, but almost as a reaction to the Libor-OIS move).

I think the pressure is mostly coming from tension in the commercial paper/short duration credit space (as T-bills widened earlier in 2017 and they recently outperformed vs Eurodollars and Libor, not showing much of a sign of overwhelming issuance). This is potentially confirmed by the fact that low beta, short dated paper, have been under-performing the credit market in beta-adjusted terms. What is interesting is that the same part of the credit curve is under pressure also in the European market.


CP yields rising relative to Fed Funds (%). Source: Citigroup



1-5y US HG corporate bond spreads vs CP rates. Source: JP Morgan

A recent JP Morgan research piece pointed out that the tension might not be coming out of repatriation flows only, as that would have called for a flattening of the credit curve, which, during the last leg of the move in the Libor-OIS spread, did not happen.



Change in spreads on the JPM JULI Domestic index of US high grade corporate bonds by maturity bucket in bps. Source: JP Morgan

I think these developments should be followed very closely. In fact, at least for the moment, I see banks` excess reserves remaining ample, which should support the FX swap market. This could change if an increase in T-bills issuance starts weighing indirectly on banks` excess reserves.

I wonder if we might be closer to a downturn than the market expects, with market participants starting to sell liquid assets, but in a slightly different fashion, as we are still in a very low yield environment. They might have started liquidating some very expensive government bonds between end of 2017 and beginning of 2018, but, after a certain level of yields was reached, moved into selling short-dated corporate paper. If this trend in low beta corporate paper selling should continue (which is a big if), together with a continuation of the increase in T-bills yields (driven also by an increase in issuance and higher Fed rates), it could create pressure at funding level. This would potentially translate (at a certain point) to a shortage in Dollar funding, which could theoretically be supportive for USD itself (like in 2008, with the USD bouncing only after Bear Stearns at the beginning of the year), which would be in line with the view of a potential tactical bounce.
I think one of the scenarios the market is not pricing is that the Fed might have already tightened (or it is very close to) financial conditions too much, but other elements may have hidden this, especially in 2017 (i.e. Chinese liquidity injections). Something like what I tried to explain above might be one of the canaries in the coal mine. I understand it is a bit of a far-fetched hypothesis, but I would appreciate any thoughts or feedback, especially those that go contrary to my view.

(Disclaimer: I took some liberty in using some of the analysis done by Citigroup (Matt King). You can find most of its piece on Zerohedge in case you have no access to Citigroup research (https://www.zerohedge.com/news/2018-03-20/why-citi-suddenly-freaking-out-about-exploding-libor-ois))


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Cbus20122
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March 27, 2018 at 7:59 PM ×

Thanks for the good article and alternative take. It'll be interesting to see how this plays out in the end.

With that said, wanted to mention that 10 year yield just dropped below 2.8 - look for a potential squeeze here now.

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Leftback
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March 27, 2018 at 9:03 PM ×

Ugly afternoon after Mr Whippy all morning. Not tempted to catch this knife. Let's see how this closes and how the rest of the week goes. A simple interpretation of days like today is that there are a lot of people out there who can't wait to sell stocks.

2s10s 51 bps. 5s30s 46 bps. The flattener is back. Stocks sell off, long bond goes bid. This is good old-fashioned risk off.

Not sure what to make of the close. Unfinished move? It was a good day to be long a big pile of Treasuries.

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Nico G
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March 27, 2018 at 10:11 PM ×

Warned people ad nauseam those last years and was a total wrongannoying bitch. The time has come now. This is the tape of a bear market. I'm convinced noone can be short this market since the POMO/QE/eternal can kicking/JBTD/passive indexing mantra served as a general anesthetic the last nine years. I never wanted this market to crash, now with the FANG generals going downtown am afraid a cascade of sell stops will hit this week.

Algos won't help. Every hedge fund in the world is long FANGs up to their eyeballs. How does this quarter end? Congrats to IPA LB swinging face ripping bounces for a day of 36 hours but know your timeframe for the longer timeframe trend is down and not a popular friend.

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johno
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March 27, 2018 at 10:51 PM ×

FB is amusing. People who were never on it (predisposed to hate it) or think they're so important that deleting their account sends a message the world needs to hear (journalist-types for example) are all saying this is the end for the stock. Meanwhile, I check my feed and it's life as usual .. people posting baby and travel pics, articles, etc.. Call me a fool, but I've taken a position here. Not my wheelhouse, but what is. Oh, and Exhibit A: Equifax. Remember those guys? Buying six days after the scandal broke (you know, when everyone said it was finished and even the bonds were a short) you made 20% in a month. And BBG shows it on a 26x/20x (LTM/'18F) PE today versus 25x/21x for FB.

I love how Buy Stocks never posts on down days.

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Polemic
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March 27, 2018 at 10:55 PM ×

Meanwhile in Europe Macron's economic guru calls for Italian debt restructuring. Still long BTPs anyone?

https://www.project-syndicate.org/commentary/debt-restructuring-for-eurozone-members-by-jean-pisani-ferry-2018-03

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Bye Stocks
admin
March 27, 2018 at 11:04 PM ×

Another day of easy money. Anybody else short ES from 2870 like me?

(In all seriousness, very impressive calls around here lately, especially LB)

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IPA
admin
March 27, 2018 at 11:51 PM ×

@Nico G, agree, FAANG (generals) are being shot now and survivors may be shot again. But...Feb lows are not broken yet, except for FB (I was lucky to catch some of that), while GOOG is threatening it now, and there is a symmetrical distance from the top equal to the Feb sell-off distance on the charts at a higher level still, traders love the symmetry (everyone is entitled to an orgasm here and there). I am not advocating going out and ferociously buying every dip (I was slapped on the wrist this afternoon on my 2638 long ES entry), but if Feb lows hold and stickier bounce comes (for more than one day) I would not stand in the way if I were you. Earnings bring positive momentum and I expect the same to be the case this season. Also, I am not sure one can say the long term trend is lower yet. Weekly and monthly looks bullish still, with some players probably lining up to buy weekly 50 sma @ 2560 with lower weekly BB @ 2544 and Feb low @ 2532 on SPX. That's roughly 30 points of a buy zone for bulls and I think they will use it to get long or longer. Now, bids being pulled has been the problem, so these air pockets are being hit during the day. I would watch the King more than FAANG. King being SOX and NVDA in particular. NVDA got the driverless car wreck started today.

My notion has been that we now have a 300-point SPX trading range to trade with no new highs in foreseeable future. I am not a bull nor a bear here, just want to be on the correct side of these wide moves inside the band. Today was not my day.

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D
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March 28, 2018 at 2:15 AM ×

Bitcoin and now Facebook are definitely the generals who got shot. Facebook might be due for a tactical bounce but has plenty of downside over the medium term, given how broadly owned it was. Equifax breach was a one-time deal and their revenue model is less cyclical than Facebook thus deserving a higher multiple than FB which now has an overhang that won't get resolved for a long time. A good comparison is MSFT which went through similar government scrutiny, and traded in a range for a decade. Beyond that, there are other fears that were ignored until now - ad load is maxed out, user growth / usage stalling, so basically all revenue gains have to come from ad pricing. Instagram has saved them for the last 4-6 quarters but ad load there also seems close to maxed out. They are also very dependent on using SBC and will have to increase cash comp.

Equity L/S (my background) index barely up for the year and once they get to flat will start derisking more aggressively. Started seeing some of that in the action today with heavily shorted TMT names in the green. As these crowded names blow up we will see more L/S funds getting unwound. Feels like a lot of hedge funds are close to throwing in the towel honestly.

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Shawn
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March 28, 2018 at 5:13 AM ×

I think the parallel shift in the credit curve illustrates that a non-zero portion of the libor-ois move is simply credit--while the rest is some other technical factor in the market--the CS piece I alluded to (and had sent to me by a number of readers...thank you) makes a persuasive argument that Deutsche is a big dog in this USD funding market and they, along with a few others, have been incentivized by a change in the tax code to issue directly in CP mkts rather than issuing in EUR (or JPY, or CAD) and swapping into USD to fund their US businesses. regulatory whack-a-mole.

@johno...I tend to agree on FB. Maybe a better example is Microsoft, who back in the day couldn't do anything without running afoul of regulators. Did it destroy the company? No, but the weasels at FB should read up on that case study before drinking more of their own kool aid.

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johno
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March 28, 2018 at 11:37 AM ×

Thank you for the great feedback, D. Much appreciated.

Added to short EURSEK here. Of course, I thought it was worth fading 1% ago, so that call not working out so far.

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Leftback
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March 28, 2018 at 2:37 PM ×

Another choppy session ahead, I think. Sometimes you have to let Mr Market come to you, instead of chasing. In the words of Mr Leon Haywood, don't force it:

https://www.youtube.com/watch?v=6UdhqV3VURo

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IPA
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March 28, 2018 at 3:24 PM ×

I think DXY is not kidding this time, and not because I went long yesterday. Look at the descending wedge to be broken to the upside. That usually produces a violent move higher. There is a two handle box distance to travel above 90.50
If you want to be conservative and wait for breakout then you may get lucky if it comes back to backtest the broken trendline.

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Cbus20122
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March 28, 2018 at 3:46 PM ×

Well, now all the FANGS have issues...

Amazon seems to be picking fights with Trump as Bezos takes out a full page ad against Trump. Not that it wasn't obvious that there was opposition here, but this isn't exactly ideal. And then we get more recent news that Trump is looking into anti-trust measures or taxing AMZN heavier now.

Meanwhile, I-Phone demand is down yet again.

Not a good time to be in FANGS, won't be surprised to see the FANG index break below trendline now if for no other reason than uncertainty. Momentum is dead, time for value.

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IPA
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March 28, 2018 at 5:30 PM ×

Important to point out that a part of my DXY long call yesterday was that oil is possibly in a double top scenario and gold is in triple top. Both are selling off hard today. Something to keep an eye on here, imho.

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Leftback
admin
March 28, 2018 at 5:30 PM ×

@Cbus: "Momentum is dead, time for value" +1

Agreed. MORT has come back to life since the February downdraft, for example. Exactly the same story for XLU. This is what you have to do if you find yourself running a LONG-ONLY fund in a declining market. Rotate to value/income and out of mono/growth.

Of course if you are a 12y-o DBer running a MOMO-only portfolio, things are a bit different. Perhaps they will be in later to give us tips on portfolio management techniques. :-D

We may yet get an absolute screamer here, but punters should be wary - once the market narrative changes, the last 2 hours are often dominated by dumps, not ramps, as trapped longs will take advantage of any strength to sell. Be very suspicious of low volume midday rallies henceforth. SPX 2635 is overhead resistance - that's where Monday morning's initial rally stalled.

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Cbus20122
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March 28, 2018 at 6:51 PM ×

Well, I took the plunge and bought a small September call for a dollar rally. Not confident enough to put a huge stake in here, but I feel like this is an instance to trust the charts as opposed to trying to find the specific catalyst in advance.

I also bought back in some pretty close to today's earlier bottom (haven't sold my longer term puts however). QQQ is getting towards oversold on a daily basis, and unlike before, market breadth is showing bullishness in the more recent selloff.

Still more bearish long run, but I'm definitely in the camp that thinks this will more or less trade sideways (possibility for slight up or down) until negative economic factors start to trickle into earnings and economics. I think in most other economic cycles, Oil would be a great trade at this point, but Shale has changed the game here.

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Nico G
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March 28, 2018 at 7:39 PM ×

Tesla is another example of 'market priced to perfection that cannot tolerate one iota of imperfection. In present case discounting the best possible growth through mass production which might not happen at all. Big car companies are simply waiting to Tesla to disappear. Which makes its rapidly shrinking market cap still pretty hefty at $43bn.

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Cbus20122
admin
March 28, 2018 at 7:45 PM ×

@Nico

During or at the start of every recession, there are hallmark companies that go bust. During the dotcom era, there was a litany of non-profitable dotcom businesses, and of course the more egregious enron and other types of scandals.

During the great financial crisis, we of course had the bank and financial company busts like Bear Stearns, Lehman, and others.


This time around? Who knows for sure who it will be, but I wouldn't be surprised if Tesla is one of those companies. We already have had a lot of retail companies silently go belly up over the past year or so. I know there are supposedly tons of zombie companies out there as well.

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Leftback
admin
March 28, 2018 at 8:05 PM ×

3pm... the bear cometh....

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Leftback
admin
March 28, 2018 at 8:09 PM ×

During most days now (face-rippers excepted) there is a big red candle at around 3pm as volume picks up into the close.

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Leftback
admin
March 28, 2018 at 8:09 PM ×

"You can observe a lot by just watching." - Yogi Berra

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Gus
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March 28, 2018 at 11:09 PM ×

Is tomorrow the day the S&P finally busts thru the 200DMA decisively, signalling a regime shift has occurred? Or will it just kiss it due to end-of-quarter trimmings?

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Unknown
admin
March 29, 2018 at 12:24 AM ×

Tesla would be the prime candidate for “hallmark bankruptcy”. Their rate of cash burn and likely working capital moves indicate a decent chance they are out of cash by May-June without a sizeable raise. It’s valuation has always been bitcoin-esc ie 250 is no different than 125 or 60, given intrinsic, and now the whole market seems to want them to fail. It could happen very fast and bring some sanity to tech. The market reaction to next weeks delivery report will be key to how it plays out ie whether they can place 3-5bn equity.

A case of hubris in so many ways

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March 29, 2018 at 4:32 AM ×

I'm going to be fair. 100 years from now AI programs will be able to detect flows and behavioral sentiment on a global scale when analyzing particular country index's . The globalization of monetary and production factors and superannuation are the main culprits. Global markets are in a new paradigm. The old saying nothing changes except price levels is wrong in one variable.....why do sellers outweigh buyers....reflexive point. The way these dickheads have managed the market will make AI programs a thing of the future. Its just a matter of catching up....to what exactly.....a couple smiley's on the dance floor for me!

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IPA
admin
March 29, 2018 at 5:41 AM ×

Guys, Tesla is not going out of business. Pick another company to bet against if that's your thesis. Like SHLD was a good one all last year. Been yapping about it here with a target of $0. Now, nothing wrong with playing the driverless car wreck for a week or two, but know your exits and be quick, Tesla goes from 0 to 60 in 2 seconds. Trendline and horizontal laminate support comes in at around $235-242 with a double top box extension target at $228. I say that $14-wide zone invites new buyers. Momentum is scraping the floor, this would not be the best time to sell a stock that can go up $40-60 points to backtest the double top neckline at $294, imho.

Speaking of backtests, DXY is doing just that, I think. Specifically, USD/JPY may tag 106 (broken descending wedge upper trendline touch) and take off again. Targets: 107.30, 108.15, 108.82, 109.21, 110.17
Also, EUR/USD has a sell zone in 1.2340 - 1.2380 and could do a serious damage all the way down to 1.19

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March 29, 2018 at 7:45 AM ×

Piss off, IPA. telsa on two wheels ain't no car. He's a dog of stock!

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March 29, 2018 at 7:45 AM ×

Hear that telsa... your a dog of a stock.

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March 29, 2018 at 7:50 AM ×

IPA.....you see that photo......i hope those shares f##kin plummet on you , you dirty dog.

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March 29, 2018 at 7:55 AM ×

Oh...there's IPA on stony creek road ringing his pals to hit the market. While his mate is on the floor of some pyscho ward. Good on ya f##kwit.

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Unknown
admin
March 29, 2018 at 8:26 AM ×

IPA these things don’t necessarily trade or work out like you suggest.

The ones that survive for ages have liquidity/assets. Tesla has cash burn and debt and survives on the kindness of others which has historically been fuelled by hope. They need money soon and whether they can get is completely dependent on where their shares are within five weeks. I think there is a non zero chance of imminent bankruptcy.

I also don’t believe the technical levels matter so much here, as we have broken through nearly all technical levels.

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March 29, 2018 at 8:38 AM ×

Uknown. No. Let's get the market straight now. I had a pop that used to trade this market and you know what set him off to retirement. The welfare of greyhounds that he punted on. That's what tipped him over the edge. This bastard is a natural evil f##ckwit.

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Cbus20122
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March 29, 2018 at 2:47 PM ×

Hooray, was able to sell off my short-term positions I opened yesterday on the modest bounce this morning for modest gains. The market loves being up in the AM, only to drag into the closing bell. Probably retail BTFD in the AM followed by institutional selling in the PM. Once the corporate bid comes back in when we're not in blackout period, I would imagine the PM selling will stabilize more (unless fundamentals have deteriorated such that retail buyers have capitulated moreso).

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johno
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March 29, 2018 at 5:46 PM ×

Quarter-end plus Easter holidays makes for Scandinavian fun and games ...

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IPA
admin
March 29, 2018 at 8:20 PM ×

FAANGs are flashing reversal signals. Daily engulfing, double bottom, inverted head and shoulders, trendline and horizontal supports - pick the one you like and you will see it today. I don't care about volume or end of the month or any other rebuttal, price is right most of the time. The farther we bounce from YL the more of a chance we have bottomed. FAANGs don't necessarily have to go back to their highs, they just need to stabilize and other sectors will take over on the rotation theme within SPX. I am a firm believer this is a trading range and one to stay here for a while. Don't care whether you are in agreement with me or not, as the matter of fact, this is what makes the markets. But, respect and restraint need to be a part of the dabate. So for that matter, @amps, need to watch your mouth, buddy. Just imagine the punch you'd receive at the pub for your potty remarks.

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Leftback
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March 29, 2018 at 8:59 PM ×

Quarter end window dressing meets weekly expiration vol selling meets front running of the Q2 fund flows…

I think IPA Is right, the bounce will probably have legs into next week. This sets up as a range between the moving averages. Bears may have to wait until the 50DMA comes into view as overhead resistance to cap the trading range. It won't be too long after that before the range ends - when the 50DMA meets the 200DMA we will see another round of high velocity selling.

For the mean time, LB intends to study the charts for crude and the dollar.

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Gus
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March 30, 2018 at 2:28 AM ×

The past 5 Aprils all have had positive returns:

2017 = 1.11%
2016 = 0.42%
2015 = 0.86%
2014 = 0.53%
2013 = 1.81%

Makes one wonder whether next month will be different this time.

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Cbus20122
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March 30, 2018 at 8:30 AM ×

Kind of an irrelevant statistic in a long-running bull market.

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IPA
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March 31, 2018 at 5:37 PM ×

@LB, on dollar, I loaded up on DX futures and UUP calls. Looking for 23.70 - 24.10 area to be broken. Stops above 24.10 will probably carry it to high 24s corresponding to a roughly four handle DXY move. Completely irrational considering the seasonals, right? Exactly...

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