Friday, February 20, 2015

Trade Idea: My favorite Grexit Hedges

Things are getting quite edgy in Brussels and today we enter another round of showdown talks, backstairs deal attempts and hard-nosed negotiations. The reason the market has not given the due attention to this latest round of Greek tragedy can be mostly explained by the phrase "been there, done that". If you were bleeding profusely in carry and protection cost back in 2010 or 2011 or 2012, you may very well remember how it all ends. Usually. After a lot of words and diplomacy drama, they finally shake hands and make up. Sometimes the ECB chips in - either with no ELA threat, or "whatever it takes" pledge - and both turned out to be very effective. So far.

So there is, perhaps, no reason to believe this time it is any different. And there lies the rub. The chance of any tail event is probably even smaller than the word "tail" implies. At the same time, no one seems to be prepared for it. So here is my favorite list for hedge that will work in case risks flare up. But won't bleed you to death to carry.

1) In FX, it is the simplest. Short euro (or as Goldman points out, even Eastern European currencies as well). There is a chance euro will come back if talks go successful. But given the low rates and the large ECB QE looming, any comeback will hardly be a trendsetter. 

2) For equities (and for others who prefer RV) buy USD quantoed puts on Euro Stoxx Banks index (SX7E) vs vanilla. This is the trade above, plus a good RV in correlation of EUR/USD vs European stocks, which is at pre-crisis historical low levels with hardly much justification.

3) For rates, Buy 5y or 10y break-evens in Germany vs Italy. That is buy the Germany linker vs nominal and do the reverse in Italy. In bad times during the crisis, the inherent larger credit risks in linker vs nominal blows out, and this spread effectively tracked the Italy CDS during height of the European debt crisis.

All of them cost little to carry, and have huge upside. In brief quite close to a good asymmetric bet. You won't go broke carrying them for a while (and it may need a while. The end game, if there is any, is not happening possibly today, or this week or even end of March). And will pay off handsomely if the Europeans do indeed go for the nuclear option.

Good luck.

Friday, February 6, 2015

France, Germany (and Greece): A Long and Winding Road (of History)

A brilliant entry from Michael Pettis in his blog. A must-read for the weekend!

Wednesday, February 4, 2015

Trade Idea: 2015 Top Trade Ideas To Start (Rates only)

This is exclusively rates only piece. Others may follow soon.

Trade Idea #1: Buy EUR 10y30y 2% payer vs 10y5y 4% payer (Macro)
Rational: The Euro long end is ridiculously low. Lower than even Japan. Even the long-dated real rates are trading negative. This is a great trade to position for any correction whenever that happens. The extreme bottom right of the vol surface has developed fantastic vol carry vs. other points on the surface. The forwards are near-about the same (and historically they have been same). The spread has moved in negative correlation to 10y swap rates in post-Lehman era. Now it is near historical average. Given current level of rates, we will see a break-down of this correlation in a rally (i.e. the spread does not move much, the trade benefits from carry). In a sell-off the trade benefits from delta. The trade also benefits in a steepening scenario if Euro area moves further close to Japan. The adverse scenario is a bull flattening. Given the current levels, a large move in that direction is unlikely except a) another euro crisis b) strong yield chasing flows in to the longer part pushing 10s30s down. The trade will be net long gamma in any case. So a strong convex pay-out which costs nothing to carry.

Trade Idea #2: GBP 5s10s steepeners against  USD 5s10s (Cross market)
Rational: The convergence and the relative rally of GBP rates compared to USD last year was mostly a correction of the over-optimistic inflation pricing in GBP. However the underlying growth numbers for the UK has remain quite solid in terms of private consumption and capital formation, apart from a few misses in PMIs. This year, notwithstanding the election, this should continue or even pick up in speed. However, given the influence of the Euro area economies (largest trade partner for UK) , the pressure on inflation will remain on the lower side. Also the sensitivity of UK inflation to oil prices are comparatively low. This will keep front end rate hike pricings in check and may lead to a steepening in 5s10s on the back of solid economic growth. On the other leg, the US is more closer to a hike and the Fed may indeed go ahead with policy rate hike mid this year. This will lead a solid performance of this trade.

Trade Idea #3: 20y1y vs 4y1y steepener in swaps (Carry)
Rational: Unless we have something really surprising, Europe is potentially in the area of low-for-long for a while. That makes having a carry trade in the portfolio an absolute necessity. This combination is one of the sweetest spot, in terms of the carry generated per unit of risk taken. This spread in particular has also seen a sharp flattening from around 150+ bps to 85 bps area. This brings it back to about the same levels of the pre-crisis average. This presents an opportune timing to enter this trade.

Trade Idea #4: EUR Long-end ASW (Macro)
Rational: The long end ASW in Euro (swaps vs. Germany) has recently shown excellent correlation to vols, not only in rates, with equity and FX vols as well. Given the massive QE from ECB compared to Germany supply, and given the positioning in the market, the long end ASW should widen from here. In a rally, Germany long bonds have still room for yield compression and flows should work for the trade. In a sell-off, given the strong long positioning in rates, the hedging pressure will force ASW widening across maturities. Therefore the long-end offers a convex bet. Plus the correlation to vol, if continues, gives excellent way to position for long vol, as the trade will carry positive.

Trade Idea #5: Pay EUR in 10s30s (steepeners) vs USD (Cross-market)
Rational: The EUR 5s10s30s fly is too cheap, primarily driven by the too flat 10s30s leg. With the Japanification of Europe, the front-end of EUR and JPY swap curves have settled in to similar patterns. The anomaly lies in the long end. Any normalization from here will support this steepener on the EUR leg. On the USD leg, a possible re-pricing of rates (terminal rate) will keep the flattening pressure. Over the latter half of the past year, the major changes in the rate hikes pricing has been a front-loaded timing along with a lowered terminal rate. Any surprise in wage will impact the terminal rate upwards and will help the trade. On top, any long end carry related flows in to treasuries, buoyed by liquidity from ECB, BOJ and other central banks, will add to further flattening pressure even in a rally. The package can be done either through payer swaptions or through swaps. The swaps version carries better. A more efficient version will be expressing the views through the 5s10s30s fly (instead of 10s30s), which is almost flat to carry. However, the better carry comes at an increased risk of a 5y led sell-off in the US.

Trade Idea #6: Buy USD 2y1y 2%/ 2.5% payer spread (Macro)
Rational: The current ATMF is 50 bps cheaper than the minimum policy rate from the FOMC committee projection for 2017 as of Dec 14 (last available projection). This trade attempts to capture the good chance that the market is behind the curve from the FOMC. The structure takes advantage of the high payer skews to make a 4:1 pay-out ratio (max) if the view realizes. The carry is negative but tolerable.

Trade Idea #7: Buy 6m30y straddle in EUR vs 6m5y5y midcurve (Tactical)
Rational: The recent uptick in vols in most asset classes can extend its scope and bring back the missing vols in rates. Given the rates level, most of the action will be in the long end, in either direction. This trade presents an efficient structure to get long gamma on the long end while selling the expensive midcurve vol on 5y5y. The ratio of 10y to 5y vol is near historic high, making the midcurve attractive to sell. A premium neutral trade will be net flat vega, carries flat initially, and long gamma on the slope (and significantly long gamma on rates levels on the rally side). In recent time the 10s30s slope has been dominated by 30y (than 10y) and this presents an effective long gamma trade with little cost to carry. The downside is of course flipping correlation and 10y whipping around instead of 30y. The main scenario under which this can happen is an exogenous (led by the US perhaps) general sell-off in rates.

Trade Idea #8: Global Commodity Slump trade - Buy AUD receivers Vs USD (Macro)
Rational: The global commodity slump will stay here for a while. This is not helped by a Chinese slow-down, which may grow even lower than 7% depending on how the policy makers steer ahead with liquidity. The result is a global glut of liquidity and rally pressure on all commodity currency economies. The ones affected most will be ones with starting higher level of rates and large and relatively free economies. Australia is in the preferred choice. The sweetest spot in terms of carry should be in intermediate left. However even 10y or belly receivers should work. Outright, or against the USD rates (or GBP rates, i.e. economies in general poised to gain from lower commodity prices and higher liquidity).

Trade Idea #9: Currency Peg Trade - Buy DKK belly receivers against EUR (Macro)
Rational: The massive QE will put pressure on all currencies pegged to EUR. Unlike SNB, the Danish central bank has been maintaining peg since the Deutsche mark era. So it is indeed a tail event to remove the peg. However, the more plausible way to fight pressure from Euro is even more depressed rates. We have not yet seen the pressure on DKK in scale, evident in the FX reserve change in Nationalbank balance sheet vs SNB. When that does build up we will see further rate cuts, possibly into deep negative territory.

Trade Idea #10: Sell forward Euro HICP floor spread, strike 0% and -1% (Tactical)

Rational: The recent deflation fear made the Euro HICP 0% floor to blow out with a large spike in inflation vol. Given the ECB action and the still positive core inflation (and the downward price + wage rigidity), this is an opportunity to cash in on the panic dislocation. The risk is that we get stuck in policy inaction in case of further deterioration of the situation. The spread makes positive PnL till about -0.5% (note: ball-park pricing here). Even for Japan the average inflation prints between 2000 till before the 2008 financial crisis was -0.5% (and much better post crisis). The upside also includes a sharp correction in energy prices. Alternatively, the trade can be structured as a real rate trade, by buying matching floors on the Euribors.