Wednesday, January 28, 2015

Trade Idea: Long End ASW Widener vs. Long Vol

The  ECB QE in Europe can play out through either expectation channel (inflation expectation leading to long-end sell off) or portfolio re-balancing channel (leading to a general rally). Based on the numbers from my last blog on this, at least for Germany I expect the portfolio re-balancing to be stronger. So we can expect a rally or status quo in near future.

Given  the short end Germany already near zero there is little room left to push it down further compared to swap. In pricing in any uncertainties, there is bigger room on the long end. The negative carry rolling to the 2 year point (which is even more negative on yields) clearly indicates that. This is the same reason that we will have less of a steepening pressure on euro curves from QE (as opposed to what happened in the US). 

Add to this, the interesting relationship of the long end ASW to vols, in rates and across asset classes.Since turn of the last year, the Euro ASW spreads (spread to Germany vs. interest rates swaps) has shown remarkable correlation to volatility in levels. If the correlation is maintained this implies a possible way of trading convexity through this spread going forward. On the long end, 10y shows similar characteristics, but less pronounced.

30 year ASW already widened quite a bit, but given the uncertainties around Greece, there is good chance for further move. This is a fantastic opportunity to proxy a long vol trade, with positive carry!!

The 30 year ASW actually narrowed in 2008 blow-out, but that was presumably driven mostly by receiving pressure from exotics and ALM desks. This time that pressure should be absent, at least given the level of rates.

[UPDATE] The updated numbers and charts on ECB QE

Till Sep 16 (19 months from Mar 15)
Total purchase @60 B/ month) : EUR 1140 B
Total ABS (@~12 B/ month): EUR 230 B
Total EU Inst. (@12% of Addl Purchase): EUR 110 B
Implied Sov Purchase (remaining): EUR 800 B

Total Risk Sharing @12% (EU Inst, purchase by NCBs) + 8% (Sovs, purchase by ECB) = 20%. Rest sov to be purchased by NCBs
Sov Risk Sharing EUR 72 B out of 800 B

Tenor: Min 2 year, Max 30 year

Updated chart above(based on approximate current O/S and assumption of no net new issuance). In the US, QEs had generally had selling off pressure for yields. However, MBS yield generally lowered, and according to Fed research, the Fed QE resulted in holding substantial market share in MBS that explains the impact beyond expectation channel (through portfolio re-balancing effect). Given the high share of core for proposed ECB purchase, this might generate net rallying pressure for rates.

1. QE2 size of 600 B, calculated on current O/S debt
2. QE3 size of 45 B/per month assuming 19 months of purchase on current O/S debt

Friday, January 23, 2015

ECB QE: Finally The Credit Impulse Is Here?

European business is typically more dependent on bank credit than other developed economies. And in this regard, 2014 has been a study in contrast. While the loan demands from both businesses and consumers turned a corner start of the year, the banking system was stubbornly tight with supply. One can assume, among other things, one reason of that was the Asset Quality Review (AQR), that incentivized the banks to keep balance sheets in checks, perhaps at the cost of new business.

Now that the AQR is over. With the newly announced QE, and improving credit demand, Euro area is finally seems poised to realized the much expected creditimpulse economists have been talking about for years.  The January survey already shows signs of that. The QE could not have come with a better timing.

This present a big upside to Euro area economy as whole and particularly for European equities.

Wednesday, January 21, 2015

ECB: The Trillion Euro "Leak"

The last ECB "leak" we had was back in October I think, about a large corporate bond QE program that never happened. Actually could not, as there was not enough to buy!

The latest 1.2 trillion-ish "leak" also sounds a bit like that. The total market size I think around eight and a half trillion for euro area sovereigns. That is roughly 14% of outstanding amount, more if we exclude outstanding interests. On top the distribution is fairly skewed towards lower maturity. That can mean a much higher percentage for eligible securities. All depends on the details. On GDP basis at 10% is similar to US QE though. 

But the sell-off in rates and the moves in EUR/USD today, both cannot be right simultaneously. One of them has to correct. The late rally in European equities also interesting. Reports say energy stocks rallied most. Sounds more like short covering than optimistic rally.

We will know tomorrow.

Tuesday, January 20, 2015

ECB Meeting Primer: The Wise Men At The Table

The big ECB meeting on Thursday. It seems Draghi has almost managed to pull it off with QE with most of the stake holders. But I do no think it is signed sealed and delivered yet. The voting on the particular day can still have some fireworks left.

Personally Mr Draghi has all the incentives to go all in, irrespective of whether he ever runs for  the President of Italy. The question is about the rest. Below is the table showing the voting rights on 22nd Jan (the voting rights are changed since 2015 after Lithuania's accession to EU).

On the numbers, 1 signifies strong yes, -1 a strong no, and 0 is the nutral. This is based on recent news bytes.

On paper, it seems QE should go through. At least in some form. The real question is how it will look like? Full metal jacket or a run-down version. In rates, the best way to position for this event is pretty much tilted to longs. If QE happens there is a chance of selling off, but should be limited. In fact it may rally as well. But if no QE, rates are definitely going to rally out of deflation fear.

On EUR/USD it is a bit tricky. It is anybody's guess to what extent the recent euro weakness has been driven by QE expectation. If you look at the sharp drop in recent time from the 1.25 levels, it seems most of it is QE driven. So if no QE, at least the knee-jerk reaction to rally will be large. If we do have a QE, for a strong sell-off in EUR/USD we would really need a pleasant surprise from ECB, not the run-down version already priced in. So best path is to go long with sizes where you can take the pain. If it does rally, reverse the position on Greece election coming Sunday.

Wednesday, January 14, 2015

Macro: Europe Leaking, A Rate Hike to Fight Deflation

Things you must not miss reading this week

1) From the ever-impressive Flow team from JPM (via FTAlphaville) on how Europe is Leaking...
2) A brilliant observation from Michael Pettis on why PBoC should hike rates to fight deflation...

Friday, January 9, 2015

ECB QE: What to Expect When You Are Expecting!

Some quick charts on the expected QE from ECB

The first chart shows the maturity distribution of sovereign debts across euro are countries as well the US and the UK. Except Greece, most of the other countries in Euro area are front-loaded. However, Germany, with the highest capital contribution to the ECB has the least amount in the near maturity bucket.

Source: Bloomberg

The second chart shows the holding patterns across different sovereigns, split in to MFIs (monetary financial institutions including banks and central banks), Other FIs (insurance, pension funds etc), Other residents (individuals, non-fin corporates and governments social securities holdings etc) and finally non-residents. Note for Euro area countries, non-residents may include residents from other euro zone countries. Except for Spain, domestic banks holdings are comparatively low, given they are the primary player for QE auctions. Which is potentially significant especially if the other holders are sticky (held till maturity)

Source: Bruegel data base

The third chart shows a scenario of possible pressure from ECB QE. This assumes a EUR 500b size and focus on less than or equal to 3 year maturities (as indicated in previous similar policies, including OMTs), and ECB buys according to capital contribution. Also assumes incremental net new issuance will be small. The chart shows target purchase for each country as a percentage of total outstanding of the within target maturity bucket, as well as percentage of bonds held by MFIs (assuming, conservatively, 50% of the non-resident is held by other euro area MFIs). Note the significant pressure on Germany as well as France, Netherlands and Portugal. (Greece may not be in chart as ECB already holds significant amount).

We opened the year with continued sell off in EUR and flows in to bonds. The broader question on the long end rates is now NOT about Europe anymore, but about US. How much of the flows we have seen in to long end US in 2014 will continue. Will we see carry flows from Europe in US rates. And more fundamentally, what drove the US long end down? An expectation of subdued inflation in spite of improving economy (i.e. risk neutral rates remaining down) or is it purely flow driven compressing the term premium?

I hope to have a model to look in to this sometime. The answer will guide what kind of rates transmission on the long end we will see when the eventual lift-off happens. Will we see a sharp sell-off in the long end from reversing flows? Or will we continue to have a subdued transmission to the long end from Fed hikes, as we have seen in past hiking cycles progressively since mid 80s?