Monday, October 20, 2014

Mostly Inflation? The Week That Was!

Kind of stabilized after the sudden panic in world markets last week. Pretty much everything sold off, except high quality sovereign bonds - in a classic risk off move. And surprisingly the moves were much more magnified in rates than in any other asset classes. I have never seen such a scale of intraday move in rates since Lehman. May 2012 Euro crisis comes close (just before Mr Draghi gave it whatever it took). Possibly everyone scampering out of risk assets into safe haven. Or may be just exacerbated by leveraged players getting margin calls. I do not know. But what I do guess is at least in rates space the moves were supported by volumes. Not a random move without any prints. I think it is true many came in late Friday to fade the move and sell the panic. But I do not think it is over. 

Not with the ECB Asset Quality Review around the corner. And oil! Oh oil! It is anybody's guess what is happening there. A supply glut or a demand shortfall, or as this excellent piece  claims, a "future" demand shortfall! Or commodity carry trade unwinding. Surprisingly none has yet focused on the last possibility. At least I have not read about it.

One major reason was definitely inflation. Or rather lack of it. In US and UK, basically these moves bring back the real rates back to unchanged on YTD basis. Before June, CPI was moving towards 2%, and the street was worried on inflation. Now perhaps 1% is closer than 2%, The sharp change in break-even end of July pushed real rate higher. And now it is catching up. 

I wont be worried about that, rather this is an opportunity. If oil can crash, it can rally as well. There is no great economic force putting downward pressure on underlying wage and price inflation. For Euro area, it is just downhill though.

And that is worrisome. The question is can the global markets handle two large economies like Euro zone and Japan being basically moribund for a long time (with China heading for a soft landing)? And will ECB turn up with the print press and fill up the void (expected to be) left behind by Fed. See another interesting piece here

Flows and positioning was the second culprit I would surmise. Weeks leading up to the last, we have seen out-flows in short end Euro area bonds matched by strong inflows in the US fixed income and also UK to some extent (carry trade? probably yes). Elsewhere on the US curve flows were rather range bound, with relatively stronger inflows in the 10y+ long end. In the UK, the gilt short positioning in ETF space is now flipped to small long in fact. On the exchange, Eurodollar shorts started to cover even before the last week's large painful moves, and 10y note short positioning conviction was crumbling anyways. On the equity space, we have seen a secular outflow starting late August, strongest in Europe and also in the US tech stocks and the EM. In FX, EUR and JPY shorts, with new interests in AUD shorts, less enthusiastic USD shorts and quite convinced GBP and NZD longs were seen leading up to last week. Crude shorts were way out of line. 

So all the pain trades moved violently as stop losses kicked in - the JPY shorts, the ED shorts (rates shorts in general), and leveraged long equities. And I would not assume the slate is clean. These trades are still out there.

The trades going forward? stay long flattener in US, last week is hardly reason enough for the Fed to come up with QE4. Also I expect a short real rate position to pay off handsomely.

And for those long shot trades for a hit-or-miss go at the year end targets, here are two from me

1) long 5s10s steepener in EUR: I think 10y is much more prone to a break-out than 5y (whichever way). This supports a USD based sell-off in rates in Euro 10y which will lead to a steepening of 5s10s. This will also benefits from a higher take up in Dec LTRO and any strong move towards QE by ECB. Go for options to leverage it up. Dual digital with EUR adds further to it (a steepening in 5s10s without EUR/USD weakening is a relatively unlikely scenario)

2) pay SONIA 12x24 for long break-even trade (alternatively long US 2s5s through options). The correlation has been steadily high. The Sonia 12x24 is cheaper compared to the break-even (based on regression). SONIA 12x24 spread to Libor (1m, 3m, 6m or 12m) is at or below levels seen before the rate hike cycles since 2000.

And both need some support from your digestive track to put on as well!

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