2015: Points to Ponder

As you gear up for the year end, here a list of things and points for the next year. To mull over, without any iota of attempts to forecast!

1. Oil: from peak-oil to freak oil. And how the story unfold will be driving a lot in 2015. IMF Direct (the blog from IMF) had a very interesting piece on this recently. They estimate unexpected lower demand can account for only 20% to 35% of the price drop. And they find little evidence of financialization. In this context what is surprising is the speed of adjustment. For 2015 most analysts maintain gloomy forecasts for oil. Perhaps rightly so. But a lot of that comes from forecast of continued lower demand from China and Europe. Given the lower contribution of demand in the price change (as above), and the still volatile geopolitics of a large part on the supply side, the question remains what if there is a strong come back of oil price in 2015? It will mostly reverse what we have seen in 2014. The hysteresis loss will be for new investments in oil sector with renewed long term risk assessment; and in Europe, especially if the ECB had not gone through with the QE by then.

2. Russia: very much related to above. Will they get out of it? yes if the oil price bounces back. What if it does not. That is the hard part to speculate. On the face of it Russia does not look particularly bad on economic parameters. Yes, the inflation is running a bit high, and the GDP has slowed down. But they have been there before. The missing links are current account weakness, ruble appreciation reversal, and the possibility of capital flight. Krugman explains the first two of them here. The last part is the hardest to explain and quantify. See here, for example. And in my opinion this is the most crucial make-or-break factor. Russia will survive in the short run if the oligarchs have a lot to lose otherwise, and if Putin survives.

3. Wage growth: That will shape the Fed policy to a large extent. We have already seen some encouraging trends. 2014 has been a great year for job growth in the US. 2015 might as well be a good (perhaps not great) year for wage growth. If that is supported by lower oil price, it is good. If that coincides with a sudden rise in oil price, that can spook the market and push up break-evens and rates.

4. Housing: One of the weakest part of the so far good enough recovery of the US, is the contribution of housing to the investment component and hence the economy. The flow of funds from the Fed has consistently shown continued deleveraging in mortgages while consumer credit picked up. The higher mortgage rates and increasing prices did not help it either. Historically the contribution of housing to GDP is near record low. And that to me seems like a lot of upside in 2015.

5. Europe: If we have a Grexit start of the year (or even a panic towards that), that will greatly ease Draghi's case for an all-out QE. European equities missed out a lot compared to elsewhere, and can benefit from both improved earnings and re-rating. As I mentioned before, I think people are unusually bearish on Europe now (just like they were unusually bullish a while back). If you think the US equities are done with most of the run, and Abenomics not really working for Japan, and missed out the Chinese rally and now scared of the EM, you do not have much choice. On the rates side, a lot of the curve flattening has been driven by global influence and a re-pricing of the long end. I do not think the rates market is nowhere near as confident of a QE as most analysts are. The European swap markets now looks hardly any different from Japan. And with much much better upside.

6. Abenomics: And speaking of Japan, which I frankly do not understand much, all I say I do not see Abenomics working. The problem with that is if Abenomics does not work, the challenge for the subsequent governments will be progressively humongous. What are the odds that we will stop to see the yen rallying in a global panic? And what are the odds we will actually see yen selling off in a panic? I will keep rolling my yen shorts. In good times or bad.

7. China: Perhaps most discussed. One good thing about China for traders and investors is that China, with its mighty central bank and strong command control hardly produces any large surprise for the markets. (Of course the antithesis is that when the surprise does come it will be huge and bad, but somehow I do not buy in to that yet). With the rally belying the economy, the central bank and policies will be in the driving seat.

8. The bull run in India: I am a believer. Well for one, the benefits of the large oil re-pricing on India is still totally lost in the panic about EM. In fact India has been a net importer of non-agri commodities. So recent secular weakness is a huge bonanza if they sustain. In terms of valuation it may not be cheap, but much scope remains for earning improvements. 

9. Return of volatility: A sustained period of low vol can be policy driven (when the central bankers become sellers of vols), or it can be just a phase of a complex system. Because low vols just happen some times. FX has already seen some uptick in vols. And yes, commodities of course. May be time for the rest.

10. What else: move away from rotation to diversification? a policy-driven liquidity crisis? year of the frontier markets? crisis in Europe? middle-east mayhem? HY melt-down? comeback from the UK? Wide open. As always.

Best wishes and a happy new year

NIFTY: Day traders Vs. Investors (+ A Christmas Present !!)

Here are some interesting charts comparing how S&P CNX Nifty has performed over last many years - split between day-session performance vs. overnight. The pattern is very interesting. In 2007-2008, the day traders dominated, both in profits and in losses. Be it the run up to the pre-crisis top in early 2008, or the crash. It was again the day traders who profited most in the comeback in 2009. This continued till the peak in 2010. 

However, after that, something changed. 2010 was the last great year for the day traders. Since 2011, the overnight returns dominated returns during the day session, far and steady. That was the case during the mild bearish runs in 2011, the sideways market in 2012. And the trend continues strongly in to the current bull period. 

The overnight returns now dominates day session so much that if this continues, going long overnight and shorting the markets during the day is now a super profitable strategy !!

What is driving this? Well to start with: the vols are down, and NIFTY (like most emerging markets) is perhaps influenced by the Feds and the BoJ much more than it used to be back in 2007. I would suspect most emerging markets will show very similar patterns. And this is VERY different than, say , S&P 500, where overnight and day-session has their fare share of misery and joy.

Will this continue? Well, the flow of funds that world-wide QEs initiated is still churning around, and will perhaps take a long time before the dust settles down. But it is an altogether different scenario if we enter a high vol regime in 2015, irrespective of market direction.

The tail piece: for folks looking for public source of intraday data on stocks - here is a quick and dirty R scripts. Feel free to use and modify as you please. Quantmod of course does a wonderful job for daily data. This routines are similar and extend to intraday.

Downloading intraday data from Yahoo or Google

. Merry Christmas and happy holidays everyone!

Freak Oil - Long Term Perspective

A long term look at crude oil price. And some fresh perspective.

Note the high correlation between bonds and oil price (correlation approx 90% on monthly differences)

And in spite the recent crash, oil still trades near all time high in terms of beer!!

Inflation - Oil and Bad Press?

"Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man" - Ronald Reagan

We had the last ECB before the holidays and before the market doubles down on its expectation of QE in January again. This is how Euro traded yesterday during the press conference

More dovish, and no actions. But action was hardly expected. We still have an TLTRO to go, and it is already almost Christmas. The positioning build up, both in Euro and in short end rates, before the meetings indicated there is a good chance of a disappointment move. And it played out more or less like that. But that should not budge the long term Euro shorts.

One important point was what Mr Draghi made clear about crude prices. For last one year, ECB has always downplayed the reduction in inflation due to energy prices, citing it as a transient and volatile component. This, for me at least, is the first time ECB showed a genuine concern that this transient impact may pass through to inflation expectation and become more permanent. ECB does not sound comfortable at all in the recent decline in crude, and in no mood to brush it aside citing energy as a volatile component any more.

This is exactly the counterpart of what happened in April 2011, when ECB unexpectedly hiked rates. ECB models are sensitive to pass through second order effect of energy inflation. This time it is acting in the favour of the doves. Keep your Euro shorts rolling.

Stepping back from ECB, and looking in to the inflation picture globally, it seems things are not as bad as made out to be. In spite of the oil crash. See these charts below

We had too much of press about deflation and disinflation this year. But globally, core inflation in fact picked up over last year (see Trend I), apart from Euro-zone. Of course the absolute level still remains uncomfortably low for many countries. And if you take a closer look you will see the chart in Trend III is remarkably similar to the first chart. Global core inflation picked up mostly driven by wage growth, in a classical manner. Change in exchange rate has lower significance on its impact on the inflation and same goes for classical money supply (note these excludes any QE or QQE).  And this also suggest the mere disparities between Euro area countries will require more innovative solutions than plain vanilla QE

ECB Today: Is Draghi Begging You To Short The Euro

I would say yes!

Especially since he labored so much on hammering home the point that "the most important message" is ECB, apart from having a balance sheet target, is committed to expand its balance sheet while other central banks are contracting. He opened with the phrase "diverging policy". It is difficult to imagine how he could ask to short the euro in a more direct manner

And I would also say listening to this man is wise. Always!

The Most Important Thing Now

Today's BoJ move sets up the tone for the rest of the year (discounting ECB, at max we can get a hint at balance sheet target). Overall, starts a new leg in carry trade and long end out-performance and general out-performance of risky assets. I would say, including European peripheries. Even if you point out risky assets are already very risky, there is not much trigger left for the rest of the year.

Now, the most important question remains. That is the price of crude.

This is not only about headline inflation, it plays an important role by pass-through effect on the core as well, plus help shape the future expectation. 

Till at least the first quarter of 2015, the best rates traders will be the best oil traders!

But there are many unanswered questions - why WTI is in backwardation, while Brent strongly contago. And how much of this represents supply and demand, and how much is carry trade. How the currently cartel will react. And what really is the break-even for US shale. Oversupply, or lack of demand, or just god damn positioning.

Points to ponder!

[EDIT 05-Nov-2014]: Ok, WTI slipped back to contago now. So one less puzzle that is.

Euro Glut: A Global Look

If you have not already read the latest note from Michael Pettis, then please do.

And also do read the note from George Saravelos on what he terms as "Euro Glut".

These are not particularly fresh new ideas, but definitely worth mulling over and have got much less attention in the media, as well as in the blogospehere, than the "new normal" and "secular stagnation" theories. In fact the original piece from George Saravelos also has a scary graph of the current account of Euro area, China and the US.

However, this graph becomes less scary in a slightly expanded perspective. Below is what I gleaned from IMF database (via Bloomberg) on excess domestic savings vs investment (equivalent to the graph mentioned above).

When you take a closer look, the "Euro glut" post 2010 is worryingly out of line. But if your focus is global, then perhaps you should also not miss the sharp drop for China post 2008 and Japan two years later. The gap between required investment and savings for emerging markets have grown stronger and the rest of the Anglo-Saxon world (the UK and the dollar-bloc) still provides a good demand for exported savings. Although it is not clear how much of it is sustainable in a world where Europe continues to build up and export excess savings. And China heads for a soft landing.

What is truly remarkable is the correction in the US, which is equivalent in magnitude in Europe. Nobody seems much concerned about it as correcting a negative current account balance is supposedly good for the economy. The question is if the US stops buying, then who else?

As pointed out in Mr. Pettis' note, there should be plenty of opportunities to invest surplus savings. The trouble will be if the excess savings export remains focused on the return of capital, than return on capital. And of course positive return investment globally can perhaps more than match exported savings from Europe in magnitude, but not necessarily in speed.

In the short run, it is speculative to worry about this. For one, apart from Europe, the world as a whole is already moving towards balance. And European imbalance is a recent phenomenon. It is not clear how long it will continue to build up. Even including Europe we are much closer to a balance than we have been in a long time among the developed economies. Which is good, as balance is good. Cheap capital for proper investment is good. But this is also a bad news, as the US apparently now have a lower capacity to absorb investments. The CAPEX figures from the Fed Flow of Fund data have been less than encouraging for years now. Excess savings in an environment of less investment opportunities mean basically a globalized version of Japan. So it all depends on if this will continue, and if yes, how much it will build up and where the savings will head to.

Of course, this assumes only the flow matters, but stock is important too. We do not know how much Chinese or European investment stock is on the sideline and waiting to be exported. (or conversely, how much unmet demand in peripheral Europe is being neglected by banks unwilling to lend, and how fast this "Euro glut" can reverse on active policy and optimism.) If they do flow out, it is positive for foreign assets in the short run. And if they do find a home in real positive return investments it is great in the long run too. If they overcrowd economies with little investment opportunities, it will push the real rate down and impact investment. So on the optimistic side, this is positive for emerging market economies (including India) in the long run. And as long as we can keep the global demand up, it is positive for pretty much everyone.

And finally, yes the absolute numbers are large. But when you compare them to world GDP, this total imbalance appears much less benign (less than 1% of world GDP for Euro area, China and Japan combined). In a world with perfect trade and capital flow, this should take care of itself. In real world, this is large, but not earth shattering!

So short the euro by all means, but not solely because of "Euro Glut". It is perhaps way too complicated than that. At least more than what Mr. Pettis seems to suggest how important the trade balance is. And more than just exports of savings. In fact in early 90s, the yen and the Japanese current account balance (as a percentage of GDP) moved in pretty much lock-step. In the way a simple trade model would suggest, currency strengthening in auto-correction when current account surplus builds up. Exactly opposite of what Mr Saravelos suggests.

People were way too complacent about Europe a decade back. And now way too pessimistic!

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!

Trivia: Updating My Blogrolls

I am lazy by nature, but sometimes I do update the list of blogs my RSS feed reader keeps listening on. And this time I am dropping Pragmatic Capitalism.

Off late, this particular blog has become a definite waste of time. It will be replaced by this . Much better to read about quadcopters from guys who know about it, than about economics and investing from people whose knowledge and concepts are questionable. Especially so as I have recently taken up some interest in drones and invested part of my vacation money in it this year!

Trivia: Extended Weil's Law of Hiring

It has been a busy month, and I am still on vacation. So no posts! But nonetheless here is an interesting thought exercise...

According to Weil's Law of University Hiring (via The Futility Closet)

Weil’s Law of University Hiring: “First-rate people hire other first-rate people. Second-rate people hire third-rate people. Third-rate people hire fifth-rate people.” (from French mathematician André Weil)

 Now let us generalise the hiring domain, instead of just universities, and also assume a uniform distributions of talent rating between say 1st to n-th. Given this, what talent bucket you should be to maximise your chance of getting hired! What if it was a normal distribution.

The Scottish Referendum: Do People Vote on Economic Rationale?

I guess hardly so. If they do, the Scottish Referendum is a no-brainer

But voting is much more emotional and political than based on objective for and against analysis

So take a break from all the talking heads on the net explaining to finest details on why the Scott should vote for NO. I think Felix Salmon got it closest

Thus are the lines drawn: on the No side, you have the hated Westminster elite, who have done a bad job governing the UK and a particularly bad job governing Scotland over the past 35 years. Many of them are Scottish themselves, which only really makes things worse. Meanwhile, the Yes side is young and angry and betrayed and proud and, most importantly, really Scottish: they live Scotland every day, and they want self-determination. They want to run themselves, to make their own decisions, rather than chafing under the rule of Londoners (of whatever nationality) who spend much more time thinking about Brussels or Berlin or Washington than they do about Glasgow or Aberdeen.

I still think it is close (being master of obvious!), but would lean on the YES side. That is of course not a preference, rather expectation of the outcome of the vote.

Probability Zombie Hunting: Mark Gilbert Edition

There are many ways to prognosticate what will the markets do

Getting the maths wrong is one of them. A bit lacking in intellectual support, but in any case as good as any other ways if you believe you cannot forecast the markets in the first place!

Here is an example. BTW, I have already written more on the underlying issue here

Unfortunately, Scotland has no bonds (or currency) of its own by which we might more clearly gauge the attitude of investors to the outlook for the country itself. Perhaps, then, the best guide is to be found among the bookmakers, still unanimous in backing the view that Scotland will reject autonomy, despite the recent YouGov poll that put the Yes campaign ahead for the first time. Betting five pounds on Scotland saying "no" will win you just two pounds plus your stake returned; a "yes" vote offers a potential profit of 9.38 pounds.

So on the basis that the house never loses, you'd back Scotland to stay in the union -- and you might also be tempted to buy pounds.

Well. Yes, the house never loses. That means they win if you get it wrong. Or if you get it right. And that is precisely why it gives no indication what so ever which outcome you should bet on! So you CANNOT ever bet on the "basis of the house never loses"!

Just to refresh your maths in case you need it (the author does, definitely!), The above odds means a (5/7) 71% probability of "no" and (5/14.38) 35% probability of "yes". The house always wins because the probability adds up to 106%, instead of fair 100%. So the house have a 6% advantage

All he probably meant that stick with "no", as "no" is priced in with a higher probability. In fact, that is also quite a useless investment thesis. It may have a higher probability, but it is compensated by a lower pay off as well. So your expected win (probability times the winning amount) should be same if the odds are fair (i.e. they add up to 100%). And since they are not in this case, actually the expected win is higher for betting on "yes"

And that is exactly the opposite of what the Mr Gilbert suggests!

The Scottish Referendum Trade: For AUld Lang Syne

Should one short the sterling pound betting on the Scottish Referendum? Even after the current sell-off?

Of the 4 million voting population, a 2% difference between the YES and NO means betting on 80,000 odd votes. The variation in expected turnouts may be more than that!

On the other hand the cable is naturally under pressure. With softer inflation and easing pace of recovery it is very hard to reason for a steady upward movement. The rates differential with the US has narrowed. The terms of trade does not point to any particular richness or cheapness. 

And as of latest data, the market positioning is favorable. The CME data shows the net speculative position even at the start of September was net long. So unlike yen and euro, not much pressure for a sudden short squeeze. 

If the vote is YES, there will be a large move for sure, at least in the short run. May be a sell-off worse than 5%. With a NO it can rally easily 3% to the 1.66 levels. So the odds offered will be a 37.5% chance of a YES vote.

The opinion polls put the odds at 50-50. But opinion polls are typically unreliable. Going by the wisdom of the crowd on public betting sites, the mood swung a bit recent time. The current going rate for the YES vote prices it at 32%. 

Either the wisdom of the crowd is skewed, or the market is wrong. Upside? quote a lot with the shock supported by the sell-off trends. Downside? Even if GBP goes back to the recent peak (which is, by the way, highest since 2008), it is 6%.

Pay off is asymmetric!

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

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)

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.

Trade Ideas: USD vs GBP Short End/ Belly Convergence

Following up on my last post where I promised a closer look at the convergence trade of USD and GBP short term rates

Based on the latest data on both (We have the latest June prints for UK consumer prices, US prints are till May, the next US prints are due this Tuesday). The US CPI has recovered from last year's lows firing on all major component - food, housing and transportation (partly driven by energy prices). For UK, CPI prints have softened. The energy component seem yet to pass through and food has been weak as well. The stronger components have been housing, education and restaurant + hotel expenses. On pure price terms, if the trends remain, US will soon catch up a lot with the UK inflation, and inflation expectations should be priced upward accordingly as well.

Crucially, the one of the core drivers of forward looking inflation, the wage growth and personal income growth, have been much robust in the US (part of the productivity puzzle in UK employment, where presumably a large part of the employment gain has been at the expense of productivity and wage growth). Neither of them particularly impressive, nonetheless the US is doing better in forward looking terms. The counterpart of the productivity puzzle of the UK employment has been the dropping participation rate for the US. However, a large part of that has been attributed to changing demographics (retiring baby boomers) and the latest such study (opens PDF) is from the President's Council of Economic Advisers. If that is the cause, the overhang on the inflation should be less.

Also, the credit side of the story is much better for the US as well. The household credit growth and credit demand picture also support a stronger come back of inflation in the US compared to the UK.

Ignoring jitters about the compression of the term premiums and the asset price bubbles, or the recent round of Risk Offs, US inflation is poised for an outperforming compared to UK. And this means trades for short end convergence in USD and GBP. The price momentum was against this trade even a few weeks ago, and now the weekly moving average of the spread (on 5y swap rate) has cross the 50 day MA. 

Time is ripe for this trade!

UPDATE: Another study on the participation rate concludes similar

Macro Views Series: 2014 H1 Quick Look-back

A quick re-look at the performances of the trades suggested at the start of the year (see here)

A mixed bag here, but overall, a really good performance given the rates rally that surprised most market participants. The 5s30s flattener in USD vs EUR is a huge winner, so is the short collar in EUR rates, and all carry trades in EUR. The AUD receivers outperformed as well. The losers are the long dollar trade and USD vs GBP convergence. These ideas are still valid. Especially the USD/GBP short end convergence. I will follow up with more on that

And totally irrelevant to the above, as you gear up for the World Cup 2014 final this Sunday, here is an excellent piece on why Lionel Messi is impossible!

NIFTY: Technicals - Choose Your Divination!

Now with the budget out of the line, we will be trading relatively event-less in near term more or less. So focus is less macro and more micro, stock-picking and timing the markets etc. In case you rely on technical indicators, here is a quick summary of what works and what does not among the weapons in the technical traders' arsenal for NIFTY. All data from Bloomberg.

The first chart shows the total performance of different strategies based on technical indicators, against simple buy and hold. The whiskers show the maximum and minimum annual returns, while the thicker bar s show the average annual returns in a trending market and in a range-bound markets (it is white if trending return < range bound return and black otherwise). The data spans 2004 to YTD 2014. The trending years are identified as 2004 to 2007 and then 2010 and 2014.

The second chart shows the relative rankings of strategies in a given year (1 is the best, 23 the worst). Again the whiskers show the best and worst ranks over the years and the thick bars show the average annual ranks in trending as well as range bound markets (again, it is white if the average trending rank is lower than, i.e. better than, average range bound rank)

So based on this if you believe we are in a trending market, NOTHING beats the simple strategy of buy and holds. And if you think we are in a range bound market, the best performing strategy is a variation of moving average (Triangular moving average - a three-point double-smoothed variation of the moving average method, with majority of weights in the middle point).

In general, you are better off following Ichimoku or different variations of moving average methods in a trending markets (if buy and hold is too simple for your taste!). And in range bound market also, the moving averages perform relatively better than other complicated indicators. But even then, they do not beat the simple buy and hold strategy by a large margin.

Of course, as we all know, past performance is not indicative of future returns.

Macro View Series: Cross Country Market Cap To GDP

Out of sheer lack of actions in the market (which I hope will change with the NFP and ECB tomorrow, the ADP came in great today), we take a look at cross country relative equity valuation. That is basically a vague sounding smartspeak for checking out the market capitalization of listed companies (as a % of GDP). Market cap to GDP is a quick and dirty way to compare fundamental valuations across countries, assuming fundamentals matters in your trade horizon (so we are talking long term here). Of course, this ratio will be influenced by, among others, share of unorganized sectors (inversely proportional) and proportions of productive companies listed (directly proportional), and claim on other countries' GDP (like Switzerland - a home of many multinationals, directly proportional)

We look at two aspects. First, the market cap to GDP vs real GDP growth rate - this kind of gives how the market prices in the expected growth in earning vs price. 

Also we look at the ratios with comparison to investment share of GDP. Note the countries are presented using internal country code (ISO 3166) here.

From the above we see a certain patterns. Most economies lie with reasonably narrow band no the 2nd chart. Look at the outliers - like on richer side Switzerland and Singapore. Both are financial hubs and home of many multinationals. So we naturally expect the market cap to GDP ratio to be higher. However, the South African and Malaysian markets are suspect of overvaluation. On the cheaper side you have Venezuela, Argentina and China. Venezuela and Argentina have their own pressing problems. And China is, well, China. So hop over them, and you see the suspects for cheap valuation: Kazakhstan and Czech Republic

Now the fun is to look in to more details of the specific economy and convince yourself. Happy hunting!

And here for the tail piece: the market cap to GDP ratio for India and US over the years (approximated from BSE 500 and S&P 500 market cap respectively)

No Merry Note, Nor Cause of Merriment

The revisions of US 2014 Q1 GDP so far. Comparing the contribution to real GDP

Contribution to real GDP in percentage points (from BEA)

Most of the revision is basically from PCE, and the rest from EXIM (both exports and imports worsened). This is just a point estimate, but will definitely cause some serious re-think on the recovery. The PCE has been the flagship of US recovery so far. And this prints definitely NOT good.

If US enters a recession, inspite of QE3, that will shake the confidence of the public in general, and will not be exciting for equities. Are we back to rates rally?

Most of the other data, including something that you can rely on, like Federal Reserve FoF data, still show encouraging trend. So I would say nothing to worry as of yet, but be watchful.

Macro Views Series: A Global Asset Shortage?

Following austerity and fiscal prudence across majority of developed economies, the budget gaps across countries narrowed considerably. This means bonds supply is going to be lower in future. US had the biggest squeeze in deficit, while Germany already runs a balanced budget. To top this, non-sovereign fixed income supply is low as well. Mainly driven by a large fall in mortgage related issuance in the US and Europe, still recovering from the momentary lapse of reasons before the financial crisis

This along with low interest rates, low inflation expectation,  and large central bank balance sheet size, means that not only there is a shortage of safe asset, there can as well be a shortage of assets in general

Most G7 economies offer negative or very low real return – apart from the longer end of European peripheries (based on absolute return (FX Hedged), US and UK the belly of the curves, seem still cheap). In a word, there is little left on the upside for bonds for long term investors. Especially if you are looking for upside and NOT the carry 

Granted equity valuation is anything but cheap on most parameters. But compared to low bond yields, the relative valuation is attractive.  Especially true if inflation picks up from these low levels (Note: the earning yield above is NOT adjusted for leverage).

So if you are not managing grandmas' retirement fund, the equity upside and valuation still remains compelling, compared to other alternatives. Especially from an absolute return point of view.

NIFTY: Inside Stories

Reported insider selling has been quite active lately for Indian listed equities. So we take a quick look at it

Looking at the graphs, here are some stylized facts

1) the inside selling activity has been most wide spread recently. Although the total value of gross and net insider selling has come off the peak in April 14, the number of companies involved is still much higher than last few years average

2) The aggregated inside selling does not appear to be a good predictor of the general direction of the market. It seems, the company insiders are usually happy to lock in a local maxima after a slump in price.

3) Give 1 and 2 above, it may not be time yet to worry about the end of the bull market

2014 H1: Top 5 Pain Trade

#1. Short Rates: USD, GBP (USD shown below)

#2. Short JPY vs USD: (and Long NKY)

#3. Flattener: in USD and in GBP (USD shown below, see short ED + notes vs long in long bonds)

#4: Long CNY Carry

#5 Short EM

And now after the ECB, we are back to carry trades

Rates: Preparing for An ECB Disappointment!

EUR 5s10s slope in swaps is too steep

Comparing EUR with all other CCY 2s5s10s fly is trading at a too high level. Even with own history, it is trading at all time high (see below). At the same time compared to JPY, the 5s10s30s too flat.

On top in recent time, the beta of 5y to change in 10y swap has been highly assymetric for large moves (see below)

The trades are

#1: Pay belly in 2s5s10s in EUR

#2: Pay belly in 2s5s10s in EUR vs receive belly in 5s10s30s

Will work good in case of a disappointment. And downside should not be great in case of expected actions. Now a shock and awe from Mr Draghi is a different matter. So preparing for an ECB disappointment is not a bad strategy, given - a) the amount of expectation and b) history of ECB

Of Secular Stagnation and Other Worries

We have seen quite a bull run in the bonds market since the start of the year. Which has caught many people off the guard. The usual suspects are flow chasing yields after equity peaking off the tops, and risk off from Ukraine crisis. But perhaps something more at play here, and we take a look about the secular stagnation and a global japanification that is priced in the rates markets now. After the good rally this week

The peak nominal equilibrium rate priced in is maximum for USD. This is in spite of the recent difference between GBP and USD. This prices in a convergence of UK and US inflation and a higher long term real GDP for US. The recent bullish phase has been less about re-pricing the pace of rate hikes, and more about the terminal rate, i.e. estimate of natural rate of interest. Except in GBP where there is a large re-price of peak rate time (by 3 years!)

This, in my opinion, reflect a much less optimistic re-assessment compared to last year. The terminal rates should be determined by the potential output of the economy, and the pace of hike is an estimate of central bank’s degree of dovishness. This re-pricing of terminal  rate shows a possible shift downward of potential output itself

This brings us back to the pricing of a possible secular stagnation and Japanification. We run a simulation assuming 1) a further 50bps reduction in the maximum future rates (secular stagnation) and 2) as mentioned under 1, but also the maximum rate is attained 8 quarters from the current priced-in pace of hikes. The effect of these on long end rates are obvious, both depress the long end further, and 2) is more severe than 1). 

However, the interesting point to note is how the curve slopes get re-priced. From current level, scenario 1) shows a flattening, while scenario 2) shows a steepening. Indeed the curve slopes in JPY are in general steeper than G3. I think any re-pricing of pace of hike is less likely, especially if inflation has indeed bottomed out (for USD and GBP). We still have a chance for re-pricing of pace of hike for EUR. So as I see it, flattening to continue in USD and GBP, and expect further steepening in EUR.

Oh, and there is this interesting piece from FT Alphaville. Do check the link. 

NIFTY: Are FIIs Really Overweight India?

I have my doubts

Here is an interesting article from the good folks from FTAlphaville

What is striking is that although the general feeling is that the FIIs have been "euphoric" about India and its' resurgence under Mr Modi as the PM, as I see, the data fails to show the same. Here are couple of charts to drive home the point.

So irrespective of what analysts at foreign banks says, I think a large part of the rally in the Indian equity markets so far this year has been driven by domestic buyers or may be even retail money. And a lots of potential FIIs flows sitting on the sidelines. Through the last phase of the election campaigns and actual elections, my perception is that FIIs have been cautious and decided to follow a wait and watch policy. And it would not take a dramatic positive results for NDA to kick start the next leg of the bull run. A simple confirmation of average exit polls prediction will do.

What Happened in Rates Today!

The euro swaps saw an almost parallel rally, continuing yesterday's move. The dollar swaps rallied with a slight flattening. And the awesomest moves were in sterling swaps, with a sharp rally and an equally sharp steepening across the curve, following BoE's report on inflation. Is it overdone? More likely than not. But fading still looks on the riskier side. Best to book profits on long steepeners and short payers. The next expected big move is not before June ECB.  But honestly I have no idea what is behind the  big sterling moves today. The report dashed the hope of imminent hike in bank rate, but was nowhere beyond expectation. And given recent moves and positioning to best of my knowledge, don't see any strong technical reasons either. Need to dig deeper. Something here is not consistent.

Yet Another India Vs China Story

A very interesting piece from IMF Direct blog!

It captures how the trade integration within Asia has phenomenal compared to other regions globally for last two decades, centered on the China growth story. And it also highlights how this has resulted in increased synchronization, and increased propagation of growth shocks between regional partners. This, is claimed, has given rise to a high correlation among Asian economies, as they provide this chart for quick evidence

And when I look at this chart, I find India has a pretty interesting position. In fact some might argue, based on this chart, that betting on a Chinese shocks can be structured through short Australia and Korea and long India and Philippines, adding statistical leverage.

Although I am doubtful this negative correlation in economies will translate to the correlations in markets in the event of a severe chines slowdown. Irrespective of how good or bad the economic story is, India will face consequences on international financial flows if we see a real serious slow down in China. The question is what happens when the dust settles down. India is a net importer from China, with some overlaps of export to other developed countries. So certainly will suffer much less directly through a slowdown in China. In fact can even benefit from reduced competition in global markets. But by any means economic downturn of the second largest trading partner is no good news, even if it runs a net trade deficit.

But if the slowdown in contained, I think there will be some focus on this issue and India will see some part of the flows from the Asia focused funds, trying to limit Chinese exposure

In fact, long-term market correlation supports this. NIFTY has been much more correlated to S&P 500 ...

... than Shanghai Composite