Tuesday, May 31, 2016

Trade Idea: Top Thematic Trades For June

Trade #1: Positioning for Fed: Pay 2s5s in swaps (pay 5y point).

Rationale: After the latest minutes release from FOMC last week, we have seen a huge positioning for a rate normalization (we discussed this before). But in some sense, normalization in dollar rates already started a while back. Although the policy rate is still stuck at very low level, the shadow rate (Wu Xia shadow rate), a representation of effective policy rate has tightened a lot since late 2014. Also in nominal space, although the rates levels are historically low, we have seen considerable normalization in slopes and curvature.

As the charts show (the left: range since 2000; right chart: range of average rates through different rates cycle - hike, cut and neutral, red triangles mark the current values; data from FRED and Bloomberg), in most measures of higher orders, the current yield curve is not far from normal. There is little scope for a further significant flattening of the curve to price in further rate hikes expectation. Add to this, there has been a large increase in short euro dollar positioning lately for FOMC. Given this, the best way forward is not to position for the next hike, but rather the ones that may follow. The next round of normalization (if at all) will be in rates levels and especially in long term equilibrium rates (terminal rate). The ideal way to position for this to take advantage of the historically tight 2s5s. The spread difference prices roughly only one rate hike between 2 year and 5 year. This levels are usually seen around recession time - or a scenario of "few and done" as some may argue. If you do not believe we have a recession around the corner, this is arguably mis-priced. On top this can benefit asymmetrically for a much more dovish Fed than expected, as the front end positioning unwinds.

Trade #2: ECB on Thursday : Long Euro vs GBP in FX

Rationale: The latest balance of payments data (released end of May for March 2016) from ECB points to continued net outflow from Euro area fixed income markets (chart below; data from ECB database). This flow is massive. The Euro area has seen a net outflow of almost €580B since 2015 in debt instruments. This is roughly at $40B per month, a pace higher than the FX reserve depletion of PBoC of China. This, from pure flow point of view, puts upward pressure on long end yields. However, the QE from ECB has been more than effective to counter that. But on one hand, as this exports the downward pressure on yields to international bond market (similar to Japan), it also makes the long end yields vulnerable to technical sell-off from time to time. However, with FOMC around the corner and the negatively carry, it may not be the perfect timing now to position for such a move.

On Thursday, ECB is little expected to surprise the market. Euro area inflation print continues to print in the negative territory. However, given the recent recovery in commodities, with all probabilities the ECB economic forecasts on Thursday will not paint a dire picture requiring immediate further policy measure. This should put technical pressure on Euro for a tactical leg upwards. This is best expressed against GBP whose recent strength and technicals make it poised for a corrective move. Alternative positioning is on the long end of the Euro rates as discussed above.

Trade #3: Brexit hedge: Buy EUR/USD calendar vol spread in straddle

Rationale: The basic idea for this hedge is to avoid directionality and buy gamma instead. Since the cross-asset vol spiked early this year, we have witnessed most vols across asset classes getting cheaper (the chart shows 3m rolling average of number of 2σ moves in each asset class for one-to-one comparison; data from Bloomberg). Also, rates and equities vols are much cheaper than FX and commodities in general. Still it makes sense to express this hedge in FX. The relative performance of FTSE (compared to DAX, Euro Stoxx or even S&P) has been quite impervious to Brexit hopes and fears, and there are few reasons to assume we will see an effective hedge in the equity space.

However, in FX space, there appears to be a mis-pricing: Given a Brexit outcome, it is hard to believe we see a large move in the cable, without any commensurate move in EUR/USD. And EUR/USD vol, especially the calendar spread at flat log-normal vol points, is a much cheaper option to position for a hedge.

Trade #4: Brexit upside: USD 5s10s steepener vs GBP 

Rationale: The spread between USD and GBP swap curve slopes, e.g. 5s10s, is at historical low. 5s10s in dollar rates flattened a lot since last year pricing in an expectation of rates normalization (as discussed above). But what is still quite a bit away from "normal" (apart from the rates levels of course) is the level of curve risk premia - for example the ACM term premium - at historical low. Yield curve slope (adjusted for the level of rates) captures a large component of this term premeia. And it appears even conditional on the much lower term premium, we have some parts of the yield curve relatively flatter, like 5s10s vs 10s30s in dollar rates.

On the sterling rates side, however, all these actions have been missing - partly because of softer economic data, and partly because of the risk of a Brexit. This has led to a historical level of the 5s10s spread in dollar vs sterling rates. The USD leg has little further room to flatten, while a remain outcome in Brexit may lead to some bear flattening of the sterling rates. This can further be supported by better than recent prints for UK economic data once the Brexit is over.

This is also an asymmetric positioning. Even if we have a Brexit outcome, there is a good chance of dollar spread sharply steepening in a risk-off mood, and sterling undergoes a panic bull flattening. The structure above will be benefit from that. 

The ideal structure is at least the GBP leg through swaptions, i.e. conditional bear flattener (sell the payer on 10s). Even though it is themed around Brexit, longer expiry is preferred. to take advantage of bull flattening in adverse outcome and better economic data in favorable outcome as discussed above.

Saturday, May 28, 2016

Macro | Oil Rally - Not A Dead Cat Bounce

The recent rally in oil, which started with general risk asset rally in early February this year has been a solid one. This blog discussed about the bottoming out in oil and a potential come back in the past. It played out quite well (although it apparently surprised a few). Along with equities, it has initially benefited from the softening of Fed hike expectation. And then went on braving an increased Fed hawkishness. I discussed the policy expectation re-pricing, and also noted the potential decoupling in correlation. Nonetheless, the strength of the oil rally in the face of more than doubling of a June hike probability is remarkable. 

In some measure it has been a bit different than the earlier dead-cat-bounce rally we have seen last year around this time. Here is a chart tracking who made what from the oil price gyration for last couple of years in the (zero-sum) futures market (from CFTC reports).

As you see, apart from producers (who are supposed to be hedgers), the biggest gain in the oil sell-off in 2015 was captured by the swap dealers (large trading houses like BP and Shell and a few Financial Institutions still left in the business of commodities). Most of the pain went to presumably the CTA community and non-reportables (individual investors and smaller hedge funds). You would expect that - as most large trading houses have considerable advantages of information and physical stocks (even over large banks, many trading houses are trading arms of large producers), they are the people who should be in the know.

During the false rally last summer, those big players were still short and did not mind taking losses (which of course paid off in the second leg of the sell-off). This time around while most of the money seem to have gone to the CTA/ non-reportable communities, the big players are flat.

In this light, the recent interesting piece in WSJ is true on facts but perhaps paints a wrong picture of a rally fueled by dumb money. It is an expected bounce of an overly sold market, where smart money just stayed out, not actively betting against. This will last beyond the driving season with all probabilities.

I would not expect another leg of sell-off, nor a continued upward movement from here. While this rally cheered the economy-is-all-good signal from Fed, it is hard to keep it going. The still significant inventory, a possibly weakening OPEC, and the cost and operation structures of shale producers make it a long shot to take us back to 100 or even 70 oil. Over the past years, as the oil price tumbled, so did the breakeven for Shale. 

I think the real implications from this cycle in oil price are mostly two - firstly the conventional high-cost producers got a raw deal. The thing is, unlike shale, for traditional high-cost producers, it is easy to turn off the tap, but not so much to turn it on back again. That involves time and cost. The distribution of the gain and ruins from this price gyration will be uneven and shale producers may not be the most damaged lot when the dust settles.

Secondly, while few producers reduced output significantly, the most obvious victim of the sell-off and associated cost reduction was exploration. And this meager rally so far has done little to change that significantly. Most producers and service companies are now shifting from a strategy of hope to a strategy of low for long. But this also means an increased sensitivity of prices to the inventory levels (as future inventories are compromised). Unless we have settled down in to another recession by then, I expect another leg of this rally in medium term, in 2017 or 2018. When we feel the pinch.

Friday, May 13, 2016

Macro | US Retail Sales Points to Higher CPI Prints

The US retail sales figures this morning was a positive surprise. The total printed at 1.3% vs. March '16 (MoM) figure of -0.3%, and a street expectation of 0.8%. It is a much better print compared to last month.

Here is a break-down of the components on YoY that shows the contribution of each of the underlying components (since 2012 June, seasonally adjusted data).

Compared to March, all major components were better (except food services). compared to last year, the picture is mixed. A contraction in auto sales and food and food services offset largely by gas station spends, housing materials and e-commerce. Going forward, I expect the auto component to improve further and gasoline spending to firm up further.

It is interesting to contrast this with headline CPI numbers. Roughly speaking, the comparison is below.

Retail Sales
Foods and Beverages
Housing related
Gasoline related
health care related
apparel related

And the chart shows the recent history of component contribution. We still see sign of general price weakness. But given the improvement in the energy component of the retail sales and solid housing markets, I expect quite a good print of CPI headlines next week.

That may mean a re-pricing of Fedspeak in the next FOMC, and perhaps not much merry notes for risk assets in the short term.

All data from US Census Bureau, US Bureau of Labor Statistics and Bloomberg

Thursday, May 12, 2016

June FOMC | Last Chance of Fed to Make Room for Two Hikes This Year

The June FOMC hike is now totally priced out by the market. Even without looking at economic data since last meeting, we can confidently say there is very little chance of a hike. The chart below shows Eurodollar futures (or Fed Fund futures from 2013) implied probability of a 25bps hike on the first day of the month of FOMC meeting. The chart is not marked against dates, but rather against numbered moves since 1995.

Fed has never moved on policy at this level of expectation. Since 1995, Fed has never moved first time without at least substantial expectation priced in (not less than approx. 39% historically). And given the current FOMC board has no resemblance to ECB in 2011, the chance of a surprise is virtually zero.
However, what will be more interesting to see is if they choose to prepare markets for a July hike. If they miss July, there are only 2 meetings left this year with press conferences (and another without). Missing July will largely rule out two hikes this year, as otherwise it may contradict the promise of slow pace of hike. And if they miss preparing the markets for a July hike at this meeting, July will certainly not see a hike.
A very good take on current Fed thinking is this recent piece by Gavyn Davies on FT Blog. Given the diverging state of monetary policies across the globe and the claim of increasing data dependency, there is a risk that FOMC actions will now resemble more like the 80s and 90s in terms of direction (and even possibly size), and less like the 2000s (when all actions came in packs - series of hikes or cuts).
This means a more nimble Fed, which is great. But at the same time, FOMC also runs the risk of confusing the market.
And if they want to maintain the record as above from the chart: they will risk being held to ransom by financial markets.