Markets | Bitcoin - The Hidden Optionality

A lot of things about Bitcoin defy conventional logic. For example, valuation of bitcoin can be treacherous and common sense ranges are a tad too wide for traditional economists or investors¹. "Exceptionally ambiguous", so to speak. Then we have confusions as captured in the tweet below.

Bitcoin investor: "I want to get rich really quickly. Oh and by the way, I think Bitcoin will replace fiat currencies." If you really wanted Bitcoin to replace fiat currencies, you would spend it on goods & services, not try to profit from it in fiat currency.

— (((FrancesCoppola))) (@Frances_Coppola) December 12, 2017

The attitude of the crypto-currency enthusiasts is best understood in terms of Keynesian beauty contest. It is not important to have a specific valuation in mind to HODL Bitcoin. All you need is your estimates of what others might value it at. It is not important to start using Bitcoin to pay for your morning coffee to realize the dream of replacing fiat currencies. All you need is to believe that enough of other people believe in doing so. The entire thing is a second order guessing game.

Theoretically, this set-up makes for an interesting characteristics of Bitcoin price. Since there is hardly any well-accepted valuation, a sudden rally or sell-off will not see the typical stabilizing intervention we see from value investors in other asset classes. Also since most (if not entire) valuation depends on the collective average of investors' expectation, a rally will see further buying and vice versa. This means the time series of price will show intrinsic characteristics of a momentum strategy.

The chart below captures this feature. The chart on the left shows the empirical distribution of MA(1) coefficients for daily returns for Bitcoin (black) and S&P 500 (red). The MA(1) coefficients can be interpreted as the response to a random shock in price. A series showing momentum nature will tend to magnify these moves, i.e. will have higher response coefficient. As shown in the chart, the Bitcoin response is highly skewed towards the right compared to S&P. The chart on the right similarly shows the response to a previous trends (AR(1) coefficients here). Here again the Bitcoin distribution is skewed towards the right. It even crosses the 1.0 mark, the upper limit of stationarity - turning in to what is called explosive process occasionally²!

The second characteristics of Bitcoin is its fat tails. The chart on the left below shows standardized returns across different asset classes (Bitcoin - thick red, equities - black, FX - blues, gold - gold, commodities - purple, rates - green, inflation - brown, VIX - orange, credits - grey). The peaked value and fat tails for Bitcoin far exceeds other asset classes (closest is the option adjusted spreads of AA credit). The right hand chart shows an easy to understand metric for fatness of tails. This displays the ratios of mean absolute deviation to standard deviation. Since standard deviation is a square root of square measure, it is more sensitive to large tail values than mean absolute deviation. The ratio of them shows the fatness of tails. A lower ratio means fatter tails. As the distribution approaches normal distribution (no excess kurtosis), this ratio approaches 0.8. Here we see by far, the ratio for Bitcoin is the smallest. It also shows strong positive skew.

The above two observation makes Bitcoin quite a bit of unique asset class. Nevertheless, we tried to explore which asset class comes close to it, in terms of time series characteristics. Here is the outcome - where Bitcoin stands among different asset classes based on a few measures:

There are multiple ways of clustering time series. One is "shape-based" - e.g. measuring a geometric distance like Euclidean distance. The top left chart shows the asset class hierarchy based on this measure. Bitcoins in this respect behaves similar to gold - very distinct from the carry assets block (VIX and credits), FX, rates, equities and commodities block. On "structural" measure (bottom left), like based on time series correlation, Bitcoin teams up with the commodities block. Finally, based on complexity or information based models (top right and bottom right), Bitcoin reflects the distribution and fat tails characteristics discussed above and behaves more like AA spread or VIX. On the whole, Bitcoin does not appear to be either digital gold, or a currency at all. It is more like a commodity showing fat tails similar to credit spreads and volatility.

In fact this fatness of tails, along with the momentum characteristics discussed above makes Bitcoin less like an asset class, and more like a derivative. Momentum strategies are comparable to options. Most  momentum trading strategies display two characteristics - many small losing trades and a few big winners. The big winners give rise to fat tails (with positive skew). And those small losing trades can be compared to carry cost of an option (theta cost or time value). This interpretation can be readily extended to Bitcoin as well. The good thing about Bitcoin is, given the upwards trends till date, the so-called carry cost has been positive!

Beyond the economists and valuation experts communities, I suspect most traders understand this optionality of Bitcoin by instinct. You invest an amount you are happy to lose, with a possibility of large upside - this is the optionality of Bitcoin without all these technical details. This says nothing about Bitcoin being a bubble or not. But a long position in Bitcoin in a positive trend (or a short position in a negative trend) is going to act like a long option position. A proper valuation of the Bitcoin, therefore, must include this embedded optionality.

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1. For example here is a rather ridiculous attempt. And a rather commonsensical overview.
2. Notice how the S&P AR(1) coefficients distribution gets truncated at 1.0, as it should be for stationary processes

Markets | Trading the "Bond Bubble"

One of the most confusing conundrum in recent time has been the curious case of stubbornly weak inflation and upbeat economy with low unemployment.

The US GDP number, while not spectacular, has been solid. Atlanta Fed GDP-Now picked up significantly in recent time. The consensus forecast for medium term GDP (2018) also improved from the start of the year and now stands at 2.3 percent. Unemployment rate remains near record lows, below pre-crisis number. According to JOLTS surveys, both quit rate and job opening rate matches or betters the pre-crisis cyclical highs. Even the relatively more pessimistic Fed labor market conditions index has improved significantly from the lows of early 2016. But both market and survey based inflation expectations are going the other way. The 5y treasury break-even inflation came-off ~40bps from highs of early this year and now stands at 1.65 percent. Similar is the story for break-even swaps markets. To match, the medium term consensus inflation forecast has come down from 2.4 percent early this year to 2.2 percent. The fall is even steeper for 2017 forecast, from 2.5 percent as recent as April, it is now at 2.10 handle. And this does not appear to be driven by oil or commodities. Both Brent and WTI have been range-bound since mid of last year. Even the set-back in general commodities prices (see Bloomberg Commodity or CRB index) early this year is now on the path of recovery. The Phillips curve is either flat, dead or was never there.

This conflicting development seemed to have a win-win impact on major asset markets. Instead of the fabled great rotation, we have seen strong money flows in both stocks and bonds - blame it on the re-balancing of portfolios, or general optimism.

The stock market benefited from solid economy and strong earnings, with valuation also supported by low rates. But the positioning remains cautious (with a correction in the gamma positioning as well).

A more interesting development is happening in the bonds markets. The bonds markets seem to have sided with the low inflation view - that no matter what the Fed does - inflation, and rates, are not going anywhere anytime soon. The over-all positioning remains solidly in the long territory. But the peculiarity is in the strong flattening bias build-up. Early this year we saw a massive swing in long maturity bonds positioning, from extreme shorts to moderate longs. This was presumably driven by the built-up and subsequent unwinds of the Trump Trade. As a side-effect, this has resulted in the extreme flattening positioning on the street. It appears everyone is positioned for a low pace of rate hikes from the Fed, and anchored low inflation expectation - resulting in a yield curve flattening. Last few times we had this kind of extremes (early 2010, mid 2012, around just before Taper tantrum and start of 2015) we had a very strong steepening that bloodied all these speculative position well and good.

Most of the players in the markets are already wary of overall bonds positioning. Some are calling out a bond bubble. Some are ready to take the opposite view. If you are in the markets to trade and not for punditry, it is hard to take a strong view. This extreme positioning in the curve provides a cheap (in terms of risk to reward ratio) way to position for a bonds sell-off. Or forget bursting the bubble, even a Fed balance sheet normalization can be the trigger. It is not at all certain balance sheet normalization will lead to increase in term premia and long term yields. But most theories say so. And if the Fed decides to hold short term policy rates during this normalization, this steepening can play out in both bull or bear scenario. And honestly, nobody has any clue how the Chinese are going to change their treasury buying patterns after the National Congress in the Autumn. If the current premier is able to stamp his authority, as generally expected, this may mark a definitive shift in policy from GDP growth target to economic stability. That, in turn, will have far reaching ripples for global asset markets.

At current level, the US curve is the flattest among all major currencies (except 5 year vs. 10 year area where JPY curve is flatter). A steepening in USD rates is a highly asymmetric trade - the trade to position for a bond bubble, whether you believe in it or not.

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1. Data source: ICI for funds flow data, CFTC commitment of traders for positioning data (latest 1st August)
2. Steepening position is implied from short end (2 year and 5 year) and long end futures positioning, expressed in equivalent (approximate) duration at 10 year point.

Markets | Quick Take on Presidential Inauguration

Next week's Presidential Inauguration is a much awaited phenomenon - for general public as well as for the financial markets across the globe. Dow 20K is mostly an arbitrary mark for a market index designed for pre-computer era (and some equally arbitrary Theoretical Dow has already crossed the benchmark). But it appears the entire market is somewhat directionless at present. Since the election, it has made certain assumptions on the policies of the upcoming government and has shown some very strong move across asset classes (see here, here and here). However, we still have very little in terms of concrete policy direction to rely upon. The latest press conference did not quite live up to the expectation of details on policies. A strong guidelines on future policy in the inauguration can provide a new direction to the market one way or the other. And this can kick start the next phase in the market.

The charts below show the market impact of Presidential inauguration since the post-war era (excluding first term of Barack Obama, which was in many ways an outlier). The X-axis is the number of business days from the inauguration day. The chart on the right shows normalized moves of the S&P 500 Index from 3 month before to 3 month after for each inauguration. The chart on the left shows the median line and the uncertainty around it. It appears more often than not, the markets usually rallies in to the inauguration, experiences a slight correction going in to the exact date, and tops out  around 1 or 2 weeks after the actual date before picking up its own course. (Note we have not corrected for the usually positive trends for the markets in general and hence we should not focus much on the trends here but change in the direction of the trends instead.) However we have quite an amount of uncertainties around this. Looking closely at the right hand side chart we see this pattern was more or less followed by around 10 or 11 times out of last 17 cases. (The legends on the right chart are initials of the presidents followed by a digit signifying the term, if required)

Overall positioning-wise, we have nothing extreme in either way. Post elections the leveraged funds (CTAs and hedge funds) and asset managers have increased their long (from CFTC reports). The dealers have become slightly short the markets - but all well within range. On VIX, however the dealers and asset managers remain long against the leveraged players.

This, and trend analysis of the recent intraday movement of S&P 500 suggests the street (i.e. the players who hedge) is mostly long gamma at this point. See the chart below (and see here for interpretation). This means a large sell-off is quite unlikely in the short term. On top of this, we have the asymmetric scenario on the policy clarity. If President-elect Trump does announce clear guidelines on his policies, this will likely confirm the market assumptions (very low chance of a major negative surprise) and market can have the next leg of rally. On the other hands, impact of rhetorics and vagueness will most likely be muted as there is always the next time. This suggests a long positioning for the equities. However the case of dollar is quite different. We have a very strong long dollar positioning from the leveraged players and any disappointment can be felt quite hard in the dollars.

Finally, while you can't miss the obvious market reaction to Trump's win, it is fairly easy to miss - what I think the most dramatic - real economy reaction. The NFIB small business optimism and outlook went over the top following the election, much more than the overall business outlook and optimism measures. The charts shows the standardized measure and the spread. 

I think in itself, this is quite significant. Historically, we have only two similar situations when the business indicators were significantly positive and small business optimism outperformed overall measures. Once was during the recovery of early 90s and secondly during the recovery of early 2000s. While we have too few data points to draw any statistical conclusion, in both cases we had sustained economic improvement and overall positive market performance. Of course small business optimism does not necessarily mean it will be realized, nor what is good for small businesses is also necessarily good for overall markets. But perhaps we have too many people bracing for a crash now?

Macro | 2017 - The Year Ahead

2016 has been the year of surprises - The Brexit, the US Presidential election, the Italian referendum, the massive de-monitization in India, the Nobel prize in literature - you name it. But perhaps the real surprise was how the markets shrugged off each of these supposedly to catastrophic events.

As discussed earlier, this year has been the year of the dollar. The chart below on the left compares volatilities across asset classes in terms of cumulative daily moves greater than 1.5x the daily standard deviation. The dollar has been the clear winner. But also notice the sharp pick up in rates (US 30y here) late this year, reflecting the sell-off after the US election. The chart on the right shows the reversal and continuation of trends across asset classes during the year. The solid performance of risk assets after the sell-off early in the year, in spite of the dollar rally, increase in yields and continued weakness in the Chinese Yuan, has been nothing short of unexpected.

Going in to the next year, however, much of it depends on the performance of the US economy - more specifically the continued strength of the private consumption components and the much expected revival of the investment expenditure. The charts below show what to expect in each of these going in to 2017. A simple linear model points to the strong dependence of the house prices, real rate and labor productivity. The biggest risk to this component of GDP from rising rate is the house price, which has been strong in 2016. The upside risk is of course a much awaited improvement of the productivity (without a runway inflationary pressure).

The investment expenditure, on the other hand, is largely driven by the inflation (NOT real rate, based on this empirical AR(1) model) and expectation about the economy (here represented by the Conference Board leading Index for the US). This part will be crucially determined by the policies of the new administration. The built-up expectation about fiscal spending and its impact on keeping the US growth engine running I think is a bit over-rated. In fact fiscal stimulus in an economy with tight labor market can be more inflationary than expected. The biggest upside may possibly be in the private investments front, which has been running remarkably low for a recovery compared to past episodes. A judicious mix of policy can change this. An improvement in tax regime and infrastructure spending may make US assets attractive not only for domestic, but also for overseas investors. On the other hand, the storm kicked up over trades and foreign policies can be unsettling for long term investments. This is too early to conclude in either way - but this will definitely be the major source of risks, either good or bad. And if this hypothesis is true, this will mean a decoupling of the movement of rates, risk assets and dollars, conditional on no extraordinary increase in inflation or inflation expectation.

The last bit about contained inflation is the base case scenario. Over-all 2016 has seen global inflation picking up in the second half of the year. This to a large extent is driven by the recovery in energy prices and commodities in general. We are still to see any thing on the core inflation that will be any cause of concern. In fact global core inflation is down marginally in the second half in 2016, with notable exception of China. The medium to long term inflation forecast remains stable. The recent rally in inflation break-even markets, while impressive, is coming off from a very low level. We have discussed before the weakening relationship of wage pressure and headline inflation. Nevertheless wage growth is least of any concerns. We do have decent growth in wages in the US, but they are hardly extraordinary compared to pre-crisis periods, and elsewhere globally it remains subdued.

2016 has also been remarkable in at least two other aspects. First, we have seen a definite improvement in global PMI, not only limited to the US anymore. And also the significant contraction in US (negative) current account balance since the post-crisis QE world has now turned a corner and we have a marginal expansion in US current account deficit again. This is all the while with an expansion of Chinese current account surplus along with strong Euro area balance and contraction in current account surplus in petro-dollars economies. If the recent recovery of oil prices sustain, we will see the last bit changing in to positive territories again. That leaves the post-crisis anomaly of the very large Euro area surplus. The global imbalance in trade (and alternatively net savings) is shown the chart below on the left. During the 2000s, the US consistently ran an increasing current account deficit and a shrinking interest rate differential (see the right hand chart below, weighted rates differential to Euro and Japan economies). The dollar more or less followed the suit, weakening during most part of early 2000s. If we assume the QE is more or less done for the ECB and in 2017 we will focus back on tapering in the base case scenario, then it is hard to see that rates differential widening any further. Add to this the massive current account imbalance of the Euro area, and 2017 might as well be the turn-around year for the Euro, instead of the consensus long dollar trade (barring political accidents).

Finally, one of the biggest anticipation in 2017 is the great asset rotation, investors fleeing the bonds universe from the rising rate fear and piling in to equities. Again, there is hardly a strong case for that. Firstly, the demographics in the developed world does not allow a strong return to equities. Secondly, the fear about overseas official accounts dumping treasuries is largely unfounded - primarily most of them have been snapped up by the private sectors, and if we have steady energy prices we will see a lot less selling of treasuries by the petro-dollar economies. China, of course remains vulnerable with a steady outflow, but the outcome is unexpected here. A large dumping of treasuries by China, driven by PBoC's need to supply dollar demand in the domestic economy, will mostly be a risk-averse move and will have the opposite effect on US yields than what a large sell-off might suggest (i.e. a flight-to-safety rally instead of a bonds sell-off). As far as the US households are concerned, they started the great rotation a while back already - as the chart below show.

Overall, we can conclude from above that the major macro drivers for 2017 will be 1) US house prices and US fiscal and trade policies 2) Euro area economic indicators, especially credit impulse 3) The uncertain role of the emerging market economies in face of rising rates and dollars and finally 4) The re-balancing of global excess savings. We should expect a limited rise of rates and inflation (and inflation expectation). Also risk assets face no immediate strong head-winds yet as we expect the upside risk to bond yields and inflation limited. Finally, as we near the end of monetary activism and divergence, going forward we will see a higher de-correlation among asset classes. The major tail risks remain the Chinese economy - where expected risks of accident are low (but with a large impact of course). Among idiosyncratic risks, the UK economy may be vulnerable to a dragged-on negotiation on Brexit, which also potentially may have some mirror impact on the Euro area.

Given this, here we list the top macro trades for the coming year. Note these are the major themes and ways to express them, not a fire-and-forget strategy to be executed on the first trading day of the year.

Economic Theme	Market Impact	Trade
US Policy Regime Shift – pro-business (tax friendly), pro-fiscal (infra spending) with a risk of foreign confrontation	Macro: Consumption (and employment) has limited upside, the main upside lies in investment pick-up. Downside for house prices and trades Market: Selectively positive for equities, negative for rates, Limited upside for dollars.	Pay USD rates against GBP Long equity options with knock-out on lower rates Forward vol around (1y5y5y or similar) through vol-triangle, or simply 1y5y vs. 1y10y vol spread to protect against unexpected inflation/ sharp bear flattening. Rates receivers with lower rates knock-in for hedging economic shocks (long equities hedge, positive carry on upper left on forwards levels)
European/ Global   Recovery	Macro: higher rates, higher Euro (against USD and GBP) and higher inflation – with political surprise downside for Euro Area. Normalization of EU trade balance.	Long Euro FX calls with knock-in on higher rates GBP vs. EUR inflation breakeven tightener (pay GBP breakeven) Opportunistic rates steepener convergence
Brexit Implication	Unsustainably high priced-in inflation in UK. Equities so far priced-in only sterling weakness (FTSE in dollar terms sold off same as GBP since Brexit, this does not incorporate any weakening of the economy)	Short FTSE 100 quantoed in euro vs. SX5E or beta-weighted SX7E (highly correlated to Euro rates) GBP vs. EUR inflation breakeven tightener (pay GBP breakeven)
China Put	A flare up of Chinese crisis. Chinese market prices more controlled, than dependent countries	China rates payer vs AUD Short EM bonds (especially if you see a strong dollar rally ahead of us)
EM underperformance	Dollar strengthening, and economies closely linked to dollar following the rates moves	Buy dollar against EM CCY basket Short EM bonds (especially if you see a strong dollar rally ahead of us)
Euro Area Crisis Hedge	Reversal of peripheral spread tightening	Long Germany break-even vs. Italy (follows  closely the CDS spread)
Run-away inflation cheap hedge	The (unlikely) scenario of central banks losing control or way behind the curve. The idea is while normal inflationary pressure will push real yields, runaway inflation will force monetization, given the debt-to-GDP ratios of major economies.	near-OTM rates payers vs. inflation, against far-OTM inflation caps against rates.

Have a great year ahead!

Markets | The Trump Trade?

Keynesian beauty contest is an interesting concept that shows a group of perfectly rational agents trying to predict the outcome of an event may not converge on the most expected case, provided their risk and reward depends on what most others think. I think something similar happens in the markets around a big event. Rarely it is clear what are the implications of different possible outcomes of such events. In such a scenario, a trader's immediate pay-off depends on how good he is at predicting market reaction (as opposed to the actual implications). As a result collectively the market ends up reacting in some ways that very few people may actually believe.

Next week's presidential election is such an event. There are strong evidences that economy has significant impact on election outcomes. however the reverse result is very weak if any. Performance of a large globally connected economy depends on more things beyond the control of the Oval Office than we give credit for. However the markets seem to have already formed an opinion and trading according to the poll results in recent week. This is not only the US market but across the globe. The common denominator is an expectation of underperformance with a republican win.

The consensus is more or less a status quo with a democratic victory and large uncertain changes with the republic candidate in office. Honestly, I think it is too early to say what will be the policy changes as we hardly have any clue on specific policies apart from election promises. For example it is usually considered republican victory will be good for defense stocks. However if Mr Trump carries out his promise on cutting down on NATO, will that necessarily be the case? He promised to unwind trade agreements. But sure there will be something to replace it, will that be very different than the existing one, and will that have really any significant impact on trades, prices and job? Or may be you should buy Apple? - he is sure to threaten EU to withdraw the taxation case and make America great again! My personal take is Mr Trump promised things, but post election (if he wins) it will be hard to deliver on many of them except in a much run-down version. Hence in the base case, sooner than later, we focus back on things like earnings and economy and inflation once the initial reaction is over.

However, the market is close to pricing in a crash scenario for an outcome favoring the republican candidate. The VIX (and volatility of VIX) are tad shy of last August peaks. The implied skew and (near-month) implied correlation in S&P 500 are racing sky-wards (and interestingly with a quite flat vol convexity, i.e. high skew and very low smile). There is a high amount of uncertainty. 

And if you are planning to take decision (being flat is one of them), I have already written about how to generally think about positioning under uncertainties before. If you are a hedger, you know what you need to do - that's quite it. And if you are a speculator, after all the analyses and mumbo-jumbo, basically you have to choose a side (rally or sell-off) and stick to it. And the only things that matter are:

1. what is your expectation and how that looks from risk-reward already priced in the markets and 
2. How to optimize your responses in case you are wrong.

The first one is commonly understood. At present the markets are definitely pricing a large sell-off. This is in the background of decent economic news and improving global PMIs. Technically most markets across the globe has or on the verge of confirming a bearish signal (see chart above). The asymmetric pricing in the downside suggests there are large price move expected, but at the same time it makes the risk-reward unattractive compared to the upside. And based on the past history in S&P which has breached a technical support recently, the distribution of near term returns favors the upside statistically (albeit with a rather large uncertainty spread around that). The chart shows the historical price distribution after such technical breaches (categorized in to three types of technical formation - megaphone, triangle and channel, and whether the existing trend was ascending or descending, and also if the breach is of resistance (up) or support (down))¹. We are in a down breach within an ascending megaphone (see the figure above).

As far as the second point is concerned, if you are positioning for downside and it turns out wrong, your responses are limited if you assume it will be a relief rally, (not a sustained one). Alternatively, if you are positioning for the upside and if you are wrong, you will have plenty of opportunities to react. We will sure enter a period of high volatility and there will be plenty of trading opportunities.

So it appears purely based on the second criteria, a long risk positioning is preferred². Of course this assumes the outcomes are fairly priced from criteria one and you do not have any strong view on either outcome.

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Note: 1) This is based on systematic technical analysis, for details see here, for code page go here. You can select or de-select series on this interactive chart
2) this is not an investment or trading advice, do your own due diligence, form your own opinion. See the disclaimer page.

Trade Ideas: Macro Trades - The Fall-Winter Collection

The speech from Fed Chair in the Jackson hole was quite uneventful. The far more interesting was this one. It was a while back the ever useful Michael Pettis hinted at how rate cuts can be deflationary - exactly the opposite of mainstream central bank thought process. This represents another argument, and how crucial fiscal participation is in delivering monetary objectives.

Talking of central banks, this month is another one for central bank focus. Starting with ECB next week, followed by BoE around middle of the month, and ending with Fed and BoJ towards the end, the mood of the market is expected to swing based on these policy outcomes. The general expectation is a hawkish Fed while the rest continues the dovish stance. Here are the top 5 trade to consider for the moment.

#1: Pay USD 10y swap spread: USD swap spread was hammered just after the last FOMC hike in December, but now on a slow yet firm upward trend. Theoretically, swap spread should be determined by the expected futures spread on GC rate vs libors. While empirically this had little influence for US treasury swap spreads in the past, still this is an important metrics. And if you have not been gone for long for the summers, it is hard to miss the sharp widening of the spot spread of GC vs libor - mainly influenced by the sharp increase in libor rate. There is a good reason for this, as the market regulations kicking in forced quite a few prime money market funds from bank-issued commercial papers to US treasuries, pushing up the borrowing cost for the banks. It appears so far this yet has to be passed through the swap spread prices in any form or substance. On top, a pay position in swap spread (pay swap, receive treasury) has been highly directional with general rates levels historically. Given this correlation and the current levels (near the bottom of the trend channel), this represents an efficient position for any FOMC hawkishness, especially unexpected ones. This also benefits from a positive roll-down. In addition, this position is empirically should be somewhat long volatility - quite an asymmetric position at current levels.

#2: Pay GBP 10s30s steepener: Following Brexit, the long end sterling curve steepened sharply, followed by an equally sharp flattening after the early August BoE. This is presumably a reaction from the QE announcement, but it is not entirely intuitive. While we had similar sharp flattening move in Euro after ECB QE in early 2015, the large difference in size between this two perhaps points towards a bit over-reaction (ECB's initial €60b per month, later €80b, compared to BoE's £10b per month, i.e. £60b over 6 months). Not only in terms of absolute size, the ECB QE is also larger in comparison with the supply - for example at the ECB capital key, Germany amounts to approx €20b per month currently, compared to a gross supply of around €16b per month (as per Bundesbank projection figures for this years). For the UK, this compares to £10b per monthly to £11b of monthly supply (as per UK DMO projections). This does not correct for the German securities trading at an yield lower than ECB depo rate (and hence not eligible for QE), and also the fact that ECB QE will extend beyond the BoE one, hence the actual difference in supply pressure is much more acute. The second interesting point to note is the maturity distribution (see chart below). UK has a squeeze in the middle segment (belly, i.e. 7 year to 15 year remaining maturities) of the curve, whereas the squeeze for ECB is mostly in the long end, putting a relative rally pressure in the belly UK Gilts curve. Add to this the facts that the market price of expected inflation spread between UK and Euro area (breakeven inflation swap) has actually widened following Brexit. This is presumably influenced by the sharp decline in GBP vs USD, but this inflation premium somehow has to be priced in the nominal rates which in general should exert a steepening pressure. This combination makes a steepening position for GBP 10s30s attractive. One of the possible reason for such a sharp flattening can be the expressed intention of the BoE governor to steer clear of negative rates and that remains a risk (somewhat mitigated by a still 25bps to go). Other risk is a sudden strong recovery in UK economy, which will weaken the case for steepening.

#3:  Equity bearish protection: For all those bears out there, shorting the all time highs have been as appealing as it has been money loosing since June. The equity markets around the world has been quite oblivious to shocks. FTSE 100 had one of the best runs in Europe. European equities have been less spectacular, but nonetheless not in correction territory. Nikkei 225 handled strengthening yen better than expected. Even EM had a decent run. The key has been the amazing resilience of S&P 500 - and appears everything is now pending on a breakdown in the US equity market. As a result, S&P is now trading at tad lower from all time high, and tad higher than all time low realized volatility. On top, last print from CFTC traders positioning shows the highest ever short positioning in VIX. But there are potential issues on the horizon to be cautious, FOMC in September is the obvious one, South African political situation may be a trigger, or sometimes things just happen. Fortunately, we also have the S&P calendar vol spreads around the highs. This present a good cautious positioning of buying the near term puts vs long term (e.g. 3m/6m) - relatively less damning long gamma position. A large downside move in the US equity market will almost certainly have repercussion across the globe, and if triggered by FOMC, especially across the emerging markets.

#4: Pay Cross-currency basis widener in EUR: One for the long-ish term - this is a reversal of Euro savings glut trade. Since the start of the financial crisis, the cross currency basis widened as everyone panicked after dollar funding. Subsequently during the period of European sovereign crisis, this basis remained under stress, and only started normalizing after the whatever it takes promise from ECB's Draghi. However, after peaking at around mid 2014, this basis (not only in Euro, but across major currencies like GBP and JPY), started widening again. My theory is: this time it has less to do with financial market panic and shortage of dollar funding from the liability side, and more with the savings glut on the asset side. In such a scenario, asset managers willing to invest in higher yielding assets (like US treasuries or equities) will swap their euro funding with a euro vs dollar cross currency swap (effectively a dollar loan against euro) and paying dollar interest vs receiving euro interest. As more and more money chase this trade, there will be a receiving pressure on the euro leg, pushing the basis down. The fact that this is asset driven and not liability driven is corroborated by a flattish slope in the basis for different maturities. During the panic days, it was a strictly inverted slope (e.g. 1y tenor wider than 5y), which is now reversed or almost flat. Given this, any recovery in the euro area (and indeed globally) consumer and investment spending will set the direction in a reverse trend. Currently the levels are near short term support. Also given the slope as mentioned above, this benefits from a positive roll-down. This is a relatively low risk and low cost of carry trade for global economic recovery. The alternative is of course that long-dated forward trade in euro. But I like this one better at the moment: the long dated forward can remain stuck even after normalization (i.e. end of savings glut), but the basis will surely feel the pressure. Plus the once juicy carry in those long-dated forwards are mostly gone. Reportedly, there is currently a dollar funding shortage, on account of the money market regulation change mentioned above. But also reportedly a large part of the switch from CP to treasury is done.

#5: The ECB Trade: ECB is not BoJ and Euro area is not yet Japan. The question is if you see them converging or diverging. The chart below shows market reactions in rates and FX for recent major central bank decisions in Euro area and Japan. Note how in recent time, ECB meetings followed a rally in Euro and a flattening in the curve. Also note how the similar the reaction was in BoJ. And finally, how the last one from BoJ in July end, which underwhelmed the market, reversed the flattening trend, with less pronounced effect and in fact a net steepening. The story of QE is perhaps running out of steam.

I expect similar reaction for ECB even if they announce a QE extension beyond September 2017. The standard trade will be fading the move, which is as of today expected to be a steepener. However, a rally in Euro may be more difficult in the short term as the focus shifts immediately to Fed.

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All data from respective treasury offices, and Bloomberg.

Markets: The Rise of The Vol Tourists

Since the Great Financial Crisis, the volatility market has undergone some significant changes. One major driver was an increased awareness about tail risk hedging. This was further aided by increasing acceptance of volatility as an asset class. Following the correlation one period during the crisis, the trend among asset managers has been risk factors based investment, moving away from traditional asset class diversification. This, along with the rising popularity of exchange traded funds and exchange traded notes, has given rise to a whole new set of demands for volatility products as an asset class.

Another impact came via the central bank reaction function route. The profound changes and the new normal condition following the crisis brought in a new set of players ready to supply (short) volatility - including those so called "vol tourists". But the appeal of systematic short volatility strategy has been strong following the crisis. As the unprecedented monetary stimulus created a huge yield chasing pressure, shorting volatility has become an important source. I have written about this quite a while back from rates perspective, but this is generally applicable to any asset class.

The left hand side chart below shows why shorting volatility systematically has been so popular. This tracks performance of a strategy that shorts the nearest IMM VIX futures and rolls just before expiry. The size is determined to match a margin of 10% of the invested capital (the approximate worst case loss). After the crisis, apart from a few hiccups (notably during the 2011 US debt ceiling crisis), the performance has been quite impressive. 

The result has been a discernible dynamics in the VIX futures market. The right hand side chart above shows the typical nature of VIX positioning that we have seen in recent time.

On one hand we have the asset managers managing the various ETNs linked to VIX. The left hand chart below shows the flows in to such ETNs (the short VIX ones are added with sign, reflecting net flow in to equivalent long VIX funds). These flows have typically been negatively correlated with VIX level itself. And the positions of these asset managers in the futures market have pretty much followed these flows - as shown in the right hand chart.

This has led to a situation where dominant players are the swap dealers (large banks) and leveraged money managers - the hedge funds - either discretionary or systematic short vol players. In fact, given the fact that after the introduction of tighter regulations since the crisis, most of the swap dealers positioning will be driven by hedges. So this leaves the leveraged managers as the only discretionary players in the VIX markets. 

This particular development in volatility markets - fundamentally driven by ZIRP policy of central banks, new regulations and the paradigm of risk factor investing - has resulted in an overall low volatility and high contago environment, even over and above what one can expect with a central bank puts. Apart from the China fear back in Aug 2015, the VIX level has remained remarkably tamed - below 25 almost always. Also the spread between front month VIX futures and the VIX levels itself has widened significantly since the crisis, as the most discretionary players have been systematically short in futures. The futures curve has been so steep that it is now very costly for long players to systematically roll macro hedges in VIX futures. In a normal market in a mean-reverting asset class like volatility, you would expect just the reverse.

The second impact, arguably, has been the feedback loop to S&P itself. As we have seen above, the VIX funds are flow driven. This means the leveraged managers are short against the large banks. The fact that most banks will have a hedged position, especially after the new regulations, make this positioning quite asymmetric. For the short VIX players, it is a linear position in volatility. However for the swap dealers - the opposite long VIX position will also mean a short option position as hedge. It is not important whether the short option position is the trade and long VIX is the hedge or vice versa. What is important that, a long VIX positioning will also mean a short gamma position. And the act of delta hedging will feed this into the underlying, i.e. S&P. If most hedgers are short gamma, as the underlying moves and the hedgers buy or sell to re-balance delta, they will tend to amplify the move. On the other hand, if most of the hedgers are long gamma, their delta hedging will introduce a stabilizing effect on the underlying. And this is captured in the following chart.

The chart shows the 20 day correlation (kernel-smoothed to capture the trend) of S&P 500 opening moves vs trading hours moves. This can be treated as a measure of the gamma effect above. We can treat the opening move as an impulse from overnight news. If the day move tends to counter that systematically, it is highly probable that the long gamma dealers are introducing a stabilizing effect. This means you would expect to show this up as an accompanying short VIX position for the swap dealers under such condition. Whereas if the day move amplify the open, this points to a short gamma position of the street (long VIX). So this correlation measure should move in steps with swap dealers positioning if we are right. And as we can see this is indeed the case, especially since 2014.

For a few days prior-to UK referendum, you must have noticed this phenomenon in practice. Taking a cue from the European markets, the S&P would open down more often than not, only to recover and more almost with statistical consistency during the trading hours. 

The rise of the vol tourists (and the short vol players in general) means watching VIX positioning and tallying it with the underlying moves has now become an important input for investors, even if you have nothing to do with VIX itself.

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all data from CFTC reports and Bloomberg

Markets : Brexit - Positioning Under Uncertainities

There are plenty of research notes and opinions around the possible outcome of and how best to position for Britain's upcoming EU referendum on Thursday. They vary from quite pessimistic to quite bullish on Sterling Pound and other risks assets. This piece does not intend to add to that crowd. I do not posses any special knowledge or skills to prognosticate a voting outcome. However, with that in mind, here are few points to note.

Firstly, positioning for the referendum is much less of an issue if it is for hedging. You really do not need to worry about picking a direction. It is about taking the position that reduces risk exposure of existing portfolio. The decision is then to design hedges that are cheap. I have written about some options a while back.

However, for a speculator, positioning for the referendum necessarily means picking a direction and hence having an opinion on the outcome of the vote - which is inherently uncertain. (This is also applicable for volatility trading, or anything else - here the direction is on the second order than underlying for vol trading). But even if you do not have a strong opinion on the possible result on Friday, a few consideration can help to form ideas about potentially profitable positioning.

And that mean picking trades based on 1) subjective probability (or expectation) 2) market prices (implied or average market expectation) and 3) opportunity costs. 

The first two are pretty intuitive and commonly practiced - basically compares what an investor expects the price distribution to be based on different outcomes, vs. the actual priced-in distribution. This is essentially a relative value analysis in a broad sense (which usually means a pair strategy in the narrow sense).

The third one, i.e. opportunity costs is arguably the most important consideration for decision under uncertainties. In the context of the referendum, let us assume that we have happened to choose to position of short risks. If the outcome is Brexit, our position will be profitable. But if it is not, we will lose on our short positioning. Worse still, if you assume that given the recent rally in risk assets, the upside is limited, then before we square off and initiate a long position, it is already too late. The upside from Bremain is a relief rally for status quo. The market will adjust upwards quickly and find a stable level. 

Now consider the reverse. If you are long and it is a Bremain outcome, again we are in luck. However, the opposite outcome is not same as before. A Brexit outcome will cost us initially. However, a Brexit outcome is far more uncertain than a Bremain outcome, and it is very difficult for risk markets to quickly price in all the consequences and find a proper and stable equilibrium very soon. We will have initial drag from our long position, but plenty of time to reverse that and catch the down-drift. 

The explicit assumption here is that from current levels, upside in risks assets are not great and market is more likely to find a stable levels on the upside than on the downside relatively quickly. If this assumption is correct, an analysis of opportunity cost tells us we should have a bias for long positioning.

In addition, the outcome of Thursday's vote will surely have a binary impact. I have written previously about how one should think about distribution when facing a binary outcome. If we believe in the assumption on the market dynamics above, along with the assumption of a binary outcome, we should base our estimates of the first point, i.e. subjective probability, on these assumptions to be consistent. These two assumptions gives rise to an asymmetric bi-modal distribution. Such a distribution will imply a thinner tail for upside outcome along with a heavy-tailed downside. Statistically this means on the upside we will have single jump probability, but multiple jumps allowed on the downside.

Practically this means we cannot use a single volatility model to price across the strikes on both sides of the at-the-money level. This also implies there is no realistic meaning of skew or vol-of-vol parameters as under these assumptions. The volatility dynamics are very different on the two sides and a single group of parameters valid across strikes on both sides does not make much sense. We essentially have to think about two sides as two parallel realities and combine them to arrive at a subjective price and then compare this to what the market is quoting.