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.