This is NOT Nuts, Where is the Crash? (II)

With dollar index on record highs, emerging market equities (except, of course, China!) getting bullied around on fed hike scare, and as the Greek saga continues, investors around the world are beginning to worry about risk trades. Especially equities and high yields. IF I am not mistaken, the latest Bloomberg investors survey points to that direction. Well, it seems we need not worry, not as yet! The Risk-On is going still very much strong.

I take the major equity indices around the world along with treasuries and internal sovereign ETFs (iShares) as well as high yields, and run some PCAs. The correlations as below.

The first one is obviously the risk-off/ risk-on factor. The second one is more like a fixed income allocation factor. The last one is domestic (US) vs international factor. We pick up the first factor and run it through a regime switch model (a Hidden Markov Model). The results below. The figure shows S&P Performance (orange) vs. the probabilities of different states we may be in. State 3 (bottom-most in black) represent Risk-On, state 2 (middle in black) is the Risk-Off state, and state 1 (top most in black) can be construed as Risk-Moderation state for lack of better words. As we can see, we are very much in Risk-On (click image for bigger picture).

Given the general nature of flows, esp smart money flows, chasing asset price momentum, we can say that much touted crash/ correction is a bit further away in to the future. Interestingly, similar analysis for other factors along with the assumption above means, for domestic investors, US fixed income is becoming increasingly less attractive, and foreign FIs more so.

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1. if you are wondering about the title, part I is here)

2. data from 2010 onward, analysis and plots by depmixS4 and Quantmod package on R 

ECB: Negative Rates Strikes Again!

On the occasion of 3 month euribor turning negative for the first time in history, here is a quick look at the policy rate corridor in Euro Area

What you see before the 2008 crisis is the original intention. The eonia and euribor tracking each other and the policy rate (refi rate) closely. The deposit rate and and the marginal lending facilities are uncollateralize lending and borrowing rates for bank with ECB. So naturally they straddle the other market and policy rates.

Then something changed after the crisis. Immediately after, and more emphatically in later half of 2012, the market rates (euribor and eonia) decoupled from the policy rate (refi). Finally ECB caught up in 2013. But eonia still trades below zero consistently. And today 3m euribor fixes below zero for the first time. Germany is negative till 8 year. 10y bunds on its way to trade below zero. Investors are ready to lend money to Germany for a meager 50bps for 30 year!

And we have quite a few months of QE left for ECB! A few more possibly if the inflation remains stubbornly moribund beyond 2016. Draghi categorically mentioned no further cut in depo. ECB under Draghi has been less prone to make statements in advance, or as Mr Draghi says, "pre-commit", without solid reason. So we can, for the moment, assume depo stays at negative 20bps.

The success of ECB QE is ultimately measured in inflation and inflation expectation. On this measure so far it has been moderate (see here). It remains to be seen if the bonds shortage issue come up in near future how ECB is going to handle that, without further cutting depo rate. 

Meanwhile we can assume they will not, and paying eonia on that assumption is the natural trade.

Widow Maker : The Latest Avatar?

Ever since Draghi declared "whatever it takes" in 2012, traders have constantly put their bets on euro rates long end normalization. The arguments were many - take your picks from below 

1) a pick up in credit situation (touted since 2012, there are early signs appearing this year)

2) resolution of debt crisis (it is perhaps not a "crisis" any more, but certainly not resolved either)

3) pick up in growth (we have seen consumption recovered a bit, but not enough) and general good feeling/ green shoots

4) add your custom reason here ... (bond vigilantes, anyone?)

Since then, the euro long end rallied a 170-180bps (swaps and Germany long dated papers). To be fair the rally started in full throttle in 2014. But even then, the euro long end normalization trades have hardly paid off. This year itself, the euro long end rallied another 70+ bps, with no sign of a reversal. The question is will the inflation and QE chase each other out and make the long end "normalized" sometimes in near future, or are the long ends already normalized at current levels and we do not know it yet.

In Japan the 30y swap trades around 1.3% area, whereas in Europe it is down to around 0.70%. The 5s30s yield curve spread at 110bps for Japan vs a meager 55bps for Euro. And the reason is as below

Japan and Euro area has similar amount around 10y and more, but Euro area is more skewed towards long dated. On top, ECB QE has had a much stronger impact than BoJ, partly because initial BoJ QEs were weak in comparison. In a yield chasing environment, 10y point on JPY curve sounds a more suitable comparison point for 30y euro swaps. And to get there, we have some ways to go. The JPY 10y swaps trade at 0.50%, and the JPY 5s10s at 25bps. To do a Euro long end normalization trade two things are required. A stop loss large enough to see the bottom, and patience. 

So the message is simple: if you are not in a downside protected positive carry trade with a longer term trading horizon, you probably should not be in it.

And for this same reason (economies aside), UK long end is more vulnerable to further rally than the US.

ECB Dictatorship!!

What on earth was that!!

Contrarian: Short EUR to hedge Grexit! Are You Sure?

Sounds rhetorical indeed. But does it? 

Two charts below on EUR/USD vs Italy benchmark 10y yield below. The first one shows YTD move, the second shows the relationship back in 2011-12, during the height of European debt crisis. 

It is true the general yield compression and euro sell off is driven by the same force, i.e. QE. However that does not explain the sustained correlation on the other side as well, i.e. periphery sell off along with euro rally. 

This puts a question-mark to the theory that a Grexit will result in a large euro sell off. It depends what safe assets you buy when you panic. But whatever it is, we will see a large move for sure.

Trade Idea: The Short Story of the Long End (USD/GBP/EUR)

Post FOMC minutes, here is a quick look at the current levels of the yield curves across USD, GBP and EUR. Below table gives a snap of how the market currently prices the start of the rate hike cycles (lift-off), the pace of hiking, and the terminal equilibrium policy rates.

As we can see the terminal rate, as well as the pace of hike is highest in case of the US, followed by the UK and the Euro area. This is interesting, esp the change in these since start of 2014. The repricing of lift-off has been large for Euro, by 11 quarters (which is mostly explained by ECB commitment of 2 years worth of QE). For others the lift-off re-pricing has been rather small (almost none for the US and 3 quarters for GBP). What has been remarkably massive is the re-pricing of the terminal rate. Around 190bps for Euro, 145bps for the US and 120bps for the UK. Also note the large re-pricing of the UK pace of hikes, Which is evident in the large push-out of the peak rate timing for (this may be influenced by mismatching supply demand of long end gilts).

I further took these current curves and applied some scenarios on the base case. The scenarios are 1) a 50bps sell-off in terminal rates with faster than expected rate path (the optimistic scenario) 2) a 50bps sell-off in terminal rates with slower pace of hikes (growth with subdued inflation) 3) a 25bps downward revision of terminal rates (a recession scenario) and 4) global convergence - the large global economies converge to a common overall long term rate based on GDP weighted long term nominal trend growth (which turns out to be around 2%).

Overall, the market seems to agree with the secular stagnation theorists more than ever. It also prices in a convergence of global inflation. We indeed have a core inflation convergence (somewhat) for UK and US already. And given UK imports a lot more from Euro area than exports, the case of imported disinflation is strong. The US is more likely to have a higher potential growth than the UK, and is less burdened with Euro area disinflation. Add these up and we may have more that 50bps that is currently priced in, room for long end divergence.

On a relative basis, I think the pricing of terminal rates are okay, except may be a bit too pessimistic. The pace looks balanced too, with an upside risks to faster hike if inflation picks up unexpectedly. Individually, the lift-off for UK is perhaps too early and the pace is too low. I would rather imagine BoE avoiding hiking unless they must. There has been much less talk about bubbles in the UK. And even the London house prices seems to be on course correction. For the US, the lift off seems more or less fine, and the pace possibly as well. But the terminal rates a bit too pessimistic. Given post crisis average nominal GDP in excess of 3.7%, a terminal rates around 2.5% denotes upside around 100bps. On Euro area, well we have QE. It is still not clear the long end has found a support at the current levels. Not to mention Greece and other distraction. And if we have QE extended beyond what is currently promised then everything looks pretty much fair there. Except we have very little downside to go short rates at these levels.

Trade #1: USD 10s30s steepener vs GBP - rationale: see the point on imported disinflation. Also the tight supply and natural long end gilt demand, and a historically tight spread all support this trade. Also historical market rates over the policy rates has been higher for USD than GBP. I prefer 10s30s than other points for this steepener trade. 

Trade #2: Buy USD 1y30y payers vs GBP - rationale: Similar as above, structured through 30y rates, selling the GBP 30y payers. The USD vs. GBP 1y30y vol spread is historically near the tightest levels seen. The election perhaps does not justify all of it.

Trade #3: Long end upside in EUR - rationale: Well we can't go much lower than this and NOT have a prolonged recession. On the brighter side, we can go up quite a bit. The best way to express is outright on the long end. As this has the most asymmetric upside. Can be structured as positive carry trade through bottom right payer spreads. Else through mid-curves at zero cost to carry through 2y in to bottom right forward payer spreads. The vols are relatively cheaper beyond 2y expiries.

Trade #4: Pay UK 2s5s vs US 2s5s - rationale: in case the lift-off date and the pace gets corrected in the UK after the election. And by that time US gets nearer to the lift-off date, leading to relative under-performance of 2y to 5y.

Trade #5: Pay EUR 5s30s vs US - rationale: Euro normalization, vs. downside protection in US for a recession. It is more efficient to express this view via spread options than outright swaps, with chances of large adverse surprise

Finally a brief history of significant sell off in US rates since the 90s. Table below shows change in rates and spreads in bps (Equity is change in S&P in percentage points) over the period of the sell off. The rows highlighted shows cases where long end rates sold off while the policy rate was actually lowered.

All data from Bloomberg.