Thursday, August 14, 2014

Trade Ideas: The Curious Case of Down Under

See the left hand side chart below for all large developed economies in interest rates swaps space, 2 year rates differential to US vs the 5s30s slope. Returns of FX carry trades have strong correlation to curve slope. Researches (see this and this, open PDFs) show buying currencies with flatter curve slope against steeper slope pair produces returns which are often better than the traditional carry trades based on short end rates differentials.

My general conjecture is that in this connected global economies, the long end of the yield curve is driven by the state of the global economy (flow of goods, services, money and inflation drives nominal rates). Where as the short end is up to the central bankers. Now to the extent that US drives the global, or at least the developed, economies, the relationship between this differential to slope is a straight line. Higher the differential, lower the slope, driven by the shorter end. And all points should lie on the trend line.

And to the extent they are off from it, that signifies the presence of other possible drivers. In this case, the Aussie and the Loonie are the obvious picks, possibly China driven. But AUD is simply way off. Assuming China does not influence, the AUD curve needs to flatten a lot. Assuming China does influence, and is forcing Australia to a possible recession, then there is a good chance it will keep rallying pressure on the long end further, which will lead to flattening if US rates hikes drive the carry trades out. 

The only case against it is a sharp central bank response. Australia has not seen much recessions in recent years and it is not clear how the response will be. On the flow side, we have seen recent international outflows (dominated by equities, but also in bonds), while stepped up bonds allocation from domestic investors. The assumption is internal flows will be concentrated more in the shorter end of the curve than domestic

Wait out for the possible rate cut next meeting and then go for a significant AUD flattening in the medium to long term. A good cross market version is against EUR, the spread is near historical lows

Wednesday, August 13, 2014

O Captain, My Captain!

What’s wrong with death sir? What are we so mortally afraid of? Why can’t we treat death with a certain amount of humanity and dignity, and decency, and God forbid, maybe even humor. Death is not the enemy gentlemen. If we’re going to fight a disease, let’s fight one of the most terrible diseases of all, indifference.

- Patch Adams(1998)

Friday, August 8, 2014

This is NOT Nuts, Where is the Crash?

The secret of making money in the market is to bet against it and then be right as well. As a far-fetched corollary, we can also say when everyone is worried about a market crash, that is perhaps not the best time to actually position for a crash. Even if they are central bankers warning of over-valuation of certain stocks or warning of outright market crash. Central bankers have not shown particular excellence and consistency in timing the markets. Keywords charts for "asset bubbles" and especially "market crash" bursting through the roofs here!

So here we take a look at the global market valuation. We have all range of valuations, from downright moribund Russian stocks to upbeat Mexico. And these excludes much of emerging and frontier markets. As good as a time to stay invested for long term, as any other time. And look for value.

And the markets seem to understand. We have hardly seen any great shift in momentum in equity flow. We have seen recent outflows in emerging market debt, high yield and developed markets equities. And also some increased flows in to US and core Europe bond funds. But before you listen to financial analysts and talking heads, there are very little evidence of flight to safety here. On longer term, what we are seeing is NOT rotation, rather a reflation, i.e. money continues to flow in to both bonds and equities. This is corroborated by central banks flows of funds accounts, as well as other higher frequency flow data. The amount of recent outflows from US equities is dwarfed by the amount pumped in since the financial crisis.

There are reason to believe these latest rounds flows in to bonds has little to do with safe heaven demand. The unforeseen consequences of changes in regulatory landscape (BASEL 3, SOLVENCY 2, all leading to higher bonds demands) and austerity and stress on balanced budget (leading to lower supply) may be the major driver. Clearly yield chasing has been significant as well, but there is some amount of caution out there - see the recent outflows of high yields. The real dangers are the developed economies getting in to the next recession following a natural business cycles from a much lower peak than past recoveries, and a China problem. But none of these present an extreme tail scenario to me. And if your expectation is a total Chinese melt-down, then heaven save us! So unless we see a central bank induced shock therapy gone wrong, a crash may never come anytime soon. At least not when everyone is looking for it! 

And even if it does arrive, probably it will be safer to stay in equities than in fixed income

And, oh, if someone tells you the evidence of irrational exuberance in the equity market is the insane levels of margin debt on NYSE and/or the cheapening of put skew, just sigh and shake your heads.