Macro | How Sustainable is the US Dollar Rally

The dollar rally that started since the conclusion of US presidential election shows not much signs of abatement. 2014 was the year of crude oil, when the fantastic sell-off in crude set much of the moods prevailing in the world economy - from equities to rates. In 2015, this slowly turned over to dollar, partly through the surprise CNY depreciation, and later through Fed rate hike expectation. And without any doubt, despite all the noises around the Brexit and Italian referendum votes (early Dec), the dominating factor for risks is again US dollars. The figure below shows a quantitative look at the cross market risk drivers using Minimum Spanning Tree methodology (based on correlation). It shows clearly the dollar is in the center of the cross market driving force. A very similar situation to what we had back in 2013, but more concentrated role for the dollars to set the market sentiments. We already had a not-so-quite riot in rates following the dollar strength post election. The emerging market currencies and equities have taken significant beatings. And top houses are calling for this dollar strength to be one of the top trades in 2017. Naturally it begs the question how much leg is still left in this dollar rally.

To take a long-term look, the dollar rally is by no means extreme. In nominal terms the broad-based trade weighted dollar index is near its historical highs. However, when we compensate for the inflation differentials between the US and its trade partners, the rally is well within the historical range (still 13% off from the 2002 peak) - as the chart below shows. Note the rally in dollar since 2014 has been almost equal for the real and nominal exchange rate - 17% vs 20%.

But while this rally may not be extreme, it may not be sustainable either. A large part of the recent dollar strength has been on the back of expectation of US policy change, specifically a possible fiscal stimulus. The economic argument behind is that a fiscal stimulus, coupled with a budget deficit will increase interest rates and hence the exchange rate. In fact this is what was observed during early 1980s in the US (although it has not much support from observations in other non-US advanced economies). The actual mechanism is far from clear. There are extensive studies on budget deficit reduction and its impact on exchange rates, but reverse studies are rare. Theoretically, the direct impact (of increasing budget deficit) goes through the interest rate and asset return channel above and lead to a higher exchange rate (as demand for higher interest assets goes up among foreigners). On the other hand, increased budget deficit can increase the long term inflation expectation and hence expectation of future dollar depreciation. The second part of the policy is trade - which is basically a tightening pressure on the US current account deficit - if President-elect Trump follows though his promises. Typically for the US the current account in recent history has been driven to a large extent by demand for financials assets from overseas investors. This means a tightening of current account will have to be matched by reduced demand for US financial assets by foreign investors, resulting in a currency depreciation now (and possibly an appreciation later). In fact the post-crisis dollar weakness has resulted in a significant tightening of current account for the US already. A further sustained tightening in general may not be great for either the US or global economy. The other possible factors, i.e. the overall demand (or GDP differential) or real rate differential with major trading partners are relatively straightforward, an increase in both leading to a stronger dollar.

Looking in to the above set of arguments empirically, we run a quick vector auto-regression estimates with real dollar exchange rate, real rate differential, current account (% GDP), budget balance (% GDP) and GDP differential as endogenous variables (differential with GDP-weighted Euro area and Japan data representing rest of the world). The results are as shown in terms of impulse response - i.e. response of dollar real exchange rate for unit positive move in budget balance (FD), current account balance (ca), real rates differential (rates) and GDP differential (GDP). It seems at least for our data (spanning 1995 to 2014, quarterly), Trumps policy of budget deficit (negative fd) and tightening current account (positive ca) has off-setting impact for dollar real exchange rate. In fact there are good chances the current account tightening impact (negative for dollar in near term, positive long term) can overwhelm. An increase interest rates may make US assets attractive among foreign investors, but without matching trades the flows in to those assets will be difficult to sustain. Among other drivers, while inflation in US has been steady, including wage growth, we have seen some early signs of a come back of inflation in the Euro area. The main thing to look out there is the pick up in Euro area credit growth after a stall start of this year.

Given this ambiguous impact of policy, and hopefully a declining need for policy divergence and a head-room for trade-weighted dollars of only ~13% to reach all time high in real terms, it does not look like the dollar rally has much room left. one of the surprise trigger can come from ECB and/or BoJ in December, with QE in Europe still priced in. And the Dec Fed hike - which is almost a certainty now - will act to defuse this rally. 

Interestingly, while from the emerging market point of view, the recent dollar rally was kind of risk-off, it was hardly so for Euro. Euro - which has lately became a funding currency like the Yen, sold off steeply. Arguably there was not much positioning to blame either, so this makes it a very interesting move. The Euro area as a whole has accumulated a huge current account surplus in its glut for savings in the post-crisis period. A substantial change in trade relationship with the US may start to unravel that. If you are positioning for the consensus Euro dollar parity, think again. 2017 may see a major reversal in Euro instead dollar.

Note: all data from the St Louis Fed FRED database.

Markets: Volatility Ahead

Finally we had a little bit of excitement back in the markets, and a vindication of sort for the numerous bears. Analysts from Citi confirm the macro drivers to blame. Indeed the cross market correlation has been on the rise. Below table shows the current cross market correlation¹. As it shows, rates and inflation still remain the major drivers, along with a very high level of correlation between commodities and currencies.

The chart below shows average correlation across asset classes. The recent spike is still far away from the levels around August 2015, but clearly captures the market sentiment.

And this sentiment is what is reflected in the latest AAII release last week. The market neutrals and bears remain significantly above the historical average as we have during most of this post-crisis bull runs. The change to highlight is an increase in bears at the expense of mostly the neutrals. 

For a contrarian, this would signal a limited scope of continued sell-off. However the other factor is positioning on the derivatives side. I have written about this before, but you must have already observed the change in the intraday price patterns in S&P. During much of last few months, it showed a strong mean-reverting characteristics (opening price shocks reversed during the day). For last few session starting from the 9th sell off, it seems the intraday trends are self sustaining now. That is confirmed on more quantitative measures as well. The chart ² below shows two approximate indications of short gamma positioning of the dealers. The idea behind this is in a market where the dealers (i.e. the hedgers, as opposed to players who hold options positions unhedged) are short gamma (net sellers of options), the natural hedging activity will create price pressure that will tend to amplify a price move (a up move in to a sustained rally and vice versa). On the other hand, when the dealers are net long, this will tend to stabilize price moves. Much of the stability in S&P intraday move for past few months can, at least partially, be attributed to net long position from the dealers, which appears changing now, as the short term intraday trends get stronger and sustain longer.

On the valuation side, however, S&P is still not screaming over-valued. Below chart shows world equity markets valuation vs trends (past 1-year returns) in two measures. The left one is the regular P/E measure, on which S&P is quite in the red zone, along with India and only second to Mexico. However, just going by historical P/E in a world of zero rates can be highly misleading. In terms relative valuation to bonds, S&P is quite in the middle.

If you followed the trades from my last post, it would have been a good couple of weeks capturing most of the major moves in the markets in the right direction. Looking ahead, if you are a bear, the investor sentiments and the valuation is not at a very helpful support to go big short at current levels. On the other hand the change in the gamma signature of the markets tells us unless something changed after Friday's expiry, we will continue to see decent swings and volatility will pick up. Although vols are not particularly cheap (relative to realized, yet), and I think given the reasons discussed before, it still makes more sense to buy options than to buy VIX here.

A traders' market after a long time. Brace for the upcoming Fed, but more for the BoJ. Going beyond equities, the major moves in rates (one of the major driers across asset classes now) has been set in motion by BoJ arguably. The recent bout of steepening in fixed income started with a bout of sell-off in JPY rates markets. This transmitted to rest of the world following ECB, with sharp steepening across EUR, USD, and GBP. The built up to the month end BoJ is almost palpable, and if not FOMC, at least this is almost certain to be an interesting event.

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1. This is based on smoothed data (Gaussian kernel smoothed with 5-day bandwidth) to capture medium-term correlation.

2. The left chart is based on identifying trends quantitatively using change point techniques. The idea is as trends become more sustaining the ratio of max to median trends will increase, as shown in the chart. The right hand chart shows absolute value of beta in a simple regression of intraday price to time, capturing the strength of the trend (if any) irrespective of its direction (rally or sell-off).
3. Data from Bloomberg and Google Finance

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.

Macro: The End of QE-topia

Negative rate is much more than what it says on the label. One of the cornerstones of modern finance is what is called present value (PV). PV is used to evaluate real projects, value financial investments or price derivatives, you name it. Surprisingly, based on my personal experience, it appears many practitioners and investors are unaware of the fundamental assumption on which this all encompassing concept of PV is delicately balanced - an assumption of a properly functional lending and borrowing market. Without that, there is no mean to transfer values across time back and forth, and PV loses its real meaning. Negative rates makes one question the validity of this assumption.

Central banks, it appears, are having a hard time. Last week's BoJ's underwhelming policy outcome was scorned off by the markets with an emphatic rally in Yen and sell-off in JGBs. This week BoE is widely expected to kick-in with some Brexit easing, and the markets so far has greeted the possibility with a renewed sell-off in FTSE 100. ECB is also expected to up the ante with another QE extension sometime later this year, and the European equities do not seem overjoyed about it. To contrast, S&P 500 seems pretty much nonchalant about a plausible Fed hike. The usual QE-led risk rally, it appears, are drawing to an end. In fact a few are already calling out for a regime change - from QE to deflation dominance (or lack of demand).

In the wake of the Great Financial Crisis, most central bank carried out a massive amount of monetary stimulus. One way to track the global monetary stimulus beyond policy rates is to track the combined balance sheet of major central banks¹, as we see below.

Few would argue against the unprecedented monetary stimulus led mostly by the Fed which served a crucial purpose during and after the crisis to restore confidence, liquidity and growth conditions. However, the effectiveness of QEs from other central banks have arguably been much weaker. ECB QE is so far hardly "successful".

Also, over time, the impact to real economy has grown visibly less dramatic. Below chart (left one) shows the growth in global major central bank balance sheet  vis-à-vis growth in M2 money supply as well as bank lending across major economies². Since the abatement of the European Sovereign Crisis in Q3 2012, all the measures have started moving in lock-step. What is more, the magnitude of global M2 growth has been lower than central bank balance sheet growth, meaning less bang for the QE bucks. The bank lending growth has been even lower than that. It is hardly a surprise we started to have quite a bit of noise around the effectiveness of QE and monetary stimulus around that time and since.

It is not hard to see why. As the right hand chart³ shows, irrespective of what the central banks have been doing, the global private sector still continues with deleveraging (with some exception, like US corporates). The excess savings - especially for Euro area (and a large contraction in dis-savings in the US as well) clearly underscores the problem. This arguably is an expected outcome of a balance sheet recession - wherein the private sector, afflicted with too much debt and in a process to repair their balance sheet, will try to increase savings and desist from borrowing no matter how low the lending rates are pushed down by QE. This is less a question about pricing and more about the capacity and willingness to borrow. On top, the increased regulatory burdens and negative interest rates certainly did not help the banking sector much to upsize their loan books. The combined effect - anemic global demand and as a result, stunted global investments (not helped by pre-crisis built-up over-capacity in certain sectors) - was given a new moniker, secular stagnation.

Economies can be stimulated using many forms and jargon. But in any case, to boost demand it must work to enable the demand side to afford it. And this increase demand must be paid for by either increased debt (i.e. borrowing) or equity (like increased transfer or wage). Monetary policy, in practice, mostly tend to fund this increased demand through debt in its standard transmission channel through banks. In a scenario where many are focused on reducing leverage, it is no surprise that this will have a less-than-expected impact. Monetary policy can enhanced equity based spending as well, like through wealth effect or inducing an increase in wage through increased inflation expectation. While this has worked in the US, for the rest of the world, especially in Euro Area and in Japan, this has hardly been the case. The dis-inflation remains very much alive.

There are some recent trends, however, that is slowly becoming a theme - and it involves the other side of the stimulus coin. 2015 has been the first year after the extra-ordinary time during the crisis, that major global economies have experienced a reversal of a combined fiscal tightening (see below⁴ on the left). We are past the fiascoes like sales tax hike in Japan and the excessive focus on balanced budget in Europe. And a few countries like Canada and Japan have already stated fiscal stimulus as their explicit policy tools. US may see similar moves after the election. Of course the downside of the government playing the role of "consumer of the last resort" is that this comes at a cost of debt concentration at government sector. 

We are on a cusp right now. Global consumption, despite all the allegation, has shown considerable resilience (although much away from their pre-crisis period, see chart⁵ above on the right). What we want now, more than ever, is avoiding any policy mistake. Given the fragile nature and very low margin of error on the policy side, it will be hard to recover from one. We are past the days of equity rallies with every new round of monetary easing. Markets will focus more and more on the underlying growth. This growth will of course have some costs - the key policy issue will be how to allocate that in a balanced manner between the fiscal and monetary side of this. One-sided efforts from central banks - increasingly larger asset purchase from a rather finite pool in a world characterized by negative interest rates and safe asset shortage - is perhaps past its used-by date.

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1. source: national central banks
2. source: national central banks, IMF, Bloomberg
3. source: national statistics offices, IMF
4. source: national statistics offices, national central banks
5. source: national statistics offices, Bloomberg

Macro | The Aerodynamics of Helicopter Money

As a former rotor-craft specialist I do have some experience with helicopters and its dynamics. It is a machine not supposed to fly, but somehow it does. And for some missions it is immensely more useful than the traditional stuff - fixed wing aircraft.

The next best thing to QE is already in town. Ever since former Fed chairman Ben Bernanke had a discussion with Japanese leaders last week, this has captured the attention of mainstream media. Although the BoJ Gov. Kuroda has effectively ruled out "helicopter money" (HM) on Monday, nobody missed the phrase "at this stage" in his statement. With increasing market frustration with the now-standard QEs, HM appears a real possibility in future policy adventure should things get much worse.

As is famously known, the term was originally described by the famous monetarist economics Milton Friedman to describe a permanent money creation and direct distribution to general population by central bank. In recent context, the meaning has changed more to monetary financing of fiscal stimulus. Nonetheless, it is interesting to see how this policy compares to other central bank tools like policy rates or QE.

There are two ways to look at, one from the accounting perspective and the other from economic perspective. From accounting point of view, HM is markedly different than other tools like policy rates or QEs that goes through what is known as open market operation (OMO). A central bank balance sheet, very roughly, can be thought as below. 

In traditional policy operation, the central bank announces a target rate and use standard OMO to adjust the level of treasury holding (asset side) to affect corresponding changes in commercial bank reserves (liability side). Tight monetary policy reduces the available reserves and hence put pressure on the fed fund rate (the rate at which commercial banks lend reserves to each other). QE in operation is similar to this, only the central bank buys a much larger quantity (and longer maturity) of treasuries (with a corresponding large increase in bank reserves). While the operations are similar, the channels through which they impact the economy are quite different. In case of regular OMO, the channel is mostly interest rate channel, where the long term interest rates are assumed to be affected by short term rates. In case of QE however, there are multiple channels, with the most important ones being inflation expectation, interest rate (portfolio re-balancing) and wealth effect. See here for a more detailed view.

HM is quite different than either of these. In the original scenario propose by Milton Friedman, the central bank simply prints money and distributes to the public. From accounting angle, this means an increase in currency in circulation (liability). It is clear the only change that can balance this is a corresponding decrease in capital of the central bank. Technically a central bank can run a negative capital indefinitely, as it can print money to fund it. However, in practice this may be limited due to legal rules (if any) and public and political perception among other things.

The current avatar of HM is different. The proposed method is government issuing perpetual zero coupon bond (appearing on the asset side of the central bank against a balancing liability entry for government account) and then using the proceeds to fund tax cuts or pay for infrastructure programs (ultimately money in government account from the last step disappearing in to accumulating commercial bank reserves). Prima facie the net effect has the appearance of a QE process as outlined above (treasury holding goes up, reserves goes up), But the dynamics is quite different. In QE, the money created will hit the commercial bank reserves directly. Now it is up to the lending intention of the commercial banks (and of course the ability and willingness of the general public to borrow) if this will just sit at the reserve or will actually enter the real economy. However, for HM, it is the other way around. The money created first goes to (via government) the general public and finds its way back to the banking system and reserves as the public either spend or save it. In this sense this monetary financing of fiscal expenditure is closer to the original HM concept in spirit.

The key difference is that QE or other OMOs are essentially asset swaps, swapping treasury for bank reserves - a swap between the two sides of the balance sheet. While HM is essentially swapping central bank capital for base money (currencies in circulation or bank reserves). In the above example, technically we recognized the zero coupon perpetual bonds issued by the government on the asset side at acquisition cost. But clearly such a bond has zero value, and a fair value treatment will create a hole in the capital, exactly like the original HM. The other key point to observe is that while QE is an increase of monetary base, its permanence is a function of central bank's credibility. Some may legitimately believe the central bank will withdraw this (sell QE assets) once the situation normalizes and hence factor that in into today's decision. However, HM is fundamentally an irrevocable permanent increase in base money. There is no way to reverse it unless central bank destroys currencies in circulation (reverse HM?) or forces the government to redeem those zero coupon perpetual bonds. Both seems highly unlikely under most scenarios conceivable.

Now on the impact of this policy on the broader economy - well since economics is not an exact science (and many assumptions are not even falsifiable), you can pretty much successfully argue for whatever you believe in. An HM operation can cause the interest rates to go down, as this means a large money supply in the economy. It can make things even worse if more people choose to save the money they get than to spend it, fearing an even lower interest rate and trying to keep interest income constant (think of retirees). You can argue for an increase in interest rates as well, as an injection of money in such a manner may increase inflation expectation. You can postulate that HM will cause GDP to increase - as a result of the direct fiscal expenditure and also through the fiscal multiplier. Or you can invoke the crowding out (and with some labor even the Ricardian equivalence) to assume no change at all.You can follow the thread of a heated argument here. However to give some method to the madness, we can arrange our thoughts in the IS-MP framework.

HM can be explained in this framework (see the figure below). The story is, in the beginning the aggregate demand is such that the output (GDP) is at y, below natural rate (y*). This causes inflation to fall. The central bank responds with a rate cut, to reduce the real rate, and pushes MP to right (expansionary policy), but hit the nominal zero lower bound. Then HM comes along and jacks up the inflation expectation (assuming that is the dominant dynamics, see above). This pushes the MP curve further to the right to MP1, beyond the possibility of zero lower bound. Then the fiscal stimulus component kicks in and moves the IS to the right at IS1 as well, bringing the output back to potential level of y*. Note the model suggests a final (real) interest rate levels higher than a pure play monetary policy response (only MP shifting to the right).

Theories apart, from market perspective a few things are more certain than others. Firstly, unless there is a crisis of confidence (or potential), fiscal stimulus is usually good for an economy, especially so at a zero rates environment when traditional monetary policy faces serious constraints, and at a time when economy can do with a booster dose or two. The fiscal stimulus component of HM therefore should be positive for markets and economy. One can argue why monetary financing is necessary when the government can borrow at such low rates. This is an excellent argument which the BoJ governor seems to like, at least for the time being. Nonetheless this part is positive for equities and risk assets. For FX markets, note the possibility of both the rates going down and up as noted earlier. Interestingly, this affects different parts of the curve differently. The part that will tend to go down will be short dated rates and long end will tend to push up. As a result FX (which is mostly influenced by the shorter end of the curve) will go down. And as for rates, assuming the market perception of HM is positive, this will mean 1) a re-pricing of the terminal rate upward as well as 2) increase in inflation expectation pricing. This will mean a bear steepening of the curve (increase in rates led by the long end on the balance).

The other aspect is of course the political risks of monetary finance. Some central banks absolutely abhor monetary financing (Bundesbank!), and many are potentially legally unable to do so. But leaving aside the muddled politics and economics, the key takeaway here is that in case of the next Lehman Brother scenario or a China bust, this talk about HM should assuage investors' collective concern that central banks are running out of options.

Markets: The Yen and The Yang

A shaky market trying to forget the early Q1 blues just need another focus shift to scare itself in to another round of sell-offs. And the BoJ action today may as well be the catalyst.

BoJ has very few solid reasons not to act today: The inflation prints have been horrible, in the negative territories. Even the core inflation (ex fresh food, the measure BoJ prefers) registered negative. If I am not mistaken that will be lowest since BoJ expanded the QE in line with Abenomics in 2013. The market actions, either from the  breakeven inflation markets, or the recent rally in yen, does not support any case of enthusiasm there either. Negative rates so far is quite untested for jacking up inflation expectation. They have been successful for exchange rates policies in smaller European nations, but for Japan the market has given a clear thumbs down with yen rallying instead. And the Japanese banks have not been much amused with it either. That, and many other things (jump to first of Q&A), will possibly floor the use of negative rates in future.

There are three possible interpretation here. The first one is that BoJ gave it a pass to focus in June, by which time a Fed course of action will be clearer and probably priced in - this implies a question of time. Second, BoJ is really more optimistic than markets, which implies a question of further data. And lastly, BoJ is running out of options. This is the worst of course. In principle it is hard for a central bank to run out of options. But honestly, looking ahead for Japan, one can be hardly optimistic about the effectiveness of a monetary lever.

Whichever the case, if markets interprets things more in the line of the third, it is not going to be nice.

ECB March Meeting: Front Running

The expectations are high for March 10 ECB (Fed and BoJ will come in quick succession in the following week as well). ECB President promised action (or consideration to be precise) in the last meeting. And ever since inflation breakevens have nose-dived. This week's inflation data almost takes away the last bit of uncertainties around some action at least.

 

However, the major question this time is not if, but what. In the face of an unrelenting fiscal pressure, the ability of central banks to surprise and exceed expectations are increasingly under pressure. The limits of negative rates are already in mainstream discussion. Policy rate cuts are easy, but they are already on the brink. A tiered negative depo rate can be viewed positively (even for bank stocks), but that avenue is not really a surprise. Market was half expecting it back in December anyways. Any other combination of policy rates adjustment will hardly be exceeding expectation.

 

On the other hand, QE has more potential in this regard. For one, extending asset based (say equities) will be a really large surprise. But it is highly likely that such bazooka will be reserved for a real crisis. Not now. Other options include increasing the QE timeline (already done once), and increasing the monthly purchase amount.

 

We have discussed before what left in the central bankers' toolkit. For March, the most potent and practical option is the second one in the above paragraph - upsizing monthly purchase. Here it has to be both credible and effective. Given the outstanding amount of sovereign issues (I think Germany will be the limiting criterion), hitting the balance is tight. A sizable increase puts in to questions the achievability of the plan, given the current capital key ratio rule of purchase. On the other hand, a token increase will most likely be a dud. The most effective thing for now will be to hint a possible reevaluation of the capital key constraint. That will give way to a very credible QE in future from Europe perspective. This is especially true as we have seen a recent increase in peripheral spreads. The crisis has moved a little closer home already.

 

Here is a quick recap of last few ECB actions.

Date	Action
Jul-12	25bps cut in key rates
May-13	1. Main refi from 75bps to 50 bps 2. MLF from 150bps to 100bps
Nov-13	1. Main refi from 50bps to 25bps 2. MLF from 100bps to 75bps
Jun-14	1. Main refi from 25bps to 15bps 2. MLF from 75bps to 40bps 3. depo from 0 to -10bps 4. TLTRO announcement
Sep-14	1. Main refi from 15bps to 5bps 2. ABS/ covered bonds purchase program 3. depo from -10 to -20bps 4. MLF from 40bps to 30bps
Oct-14	Details of ABS purchase program
Jan-15	1. QE 60b till Sep 16 2. TLTRO pricing change (flat from 10bps over MRO)
Mar-15	Announcement of QE details
Sep-15	Increase in QE issue share limit (33% from 25%)
Dec-15	1. Depo from -20bps to -30bps, 2. QE from Sep 16 to Mar 17 3. reinvestment principal payments

And here is how the markets reacted historically to ECB meetings. The charts show the movements in corresponding markets over a period of 5 days before and 2 days after the ECB meeting, measuring the move in terms of number of standard deviation (then prevailing).

 

 

Observing from the graph, we see a strong positive bias for euro to respond to ECB (positive bias used to mean a rally during 2012 euro crisis and a sell off in more recent time!). At the same time  risk assets like Euro Stoxx also shows a positive skew. On the other hand, the response from rates world is much more nuanced, and has been mostly disappointing for rates levels (failure to sustain rally), and less so for less slope (sustained steepening on the back of policy easing).

 

This pattern is validated when we look at the relative rates spreads. These charts below shows the USD to EUR 10y swap rate spread and 5s30s steepener spread (USD less EUR). In relative terms, the slopes performed even more consistently.

 

 

Given this back ground the asymmetric tactical trades are:

 

1) shorting euro and long equities

2) positioning for a steepening in 5s30s.

3) And hedge the position with a short rates on the long end.

 

This is especially attractive given the recent risk rally in euro and flattening of the euro curve. Fine tune this based on the degree of surprise you expect. This is a tactical positioning. With little fiscal support, a monetary response will probably be still wanting in the face of deeper issues that remains. And following week can unwind the whole thing, especially after BoJ.

ECB Action: The Jedi Tricks Still in Store

So ECB is almost "pre-committed" on some action in the March meeting with all the talks going on. If you are not convinced, remember how Mr. Draghi went out of turn in the last press meeting in January, to remind everyone that the decision to "consider" action in March was an "unanimous".

 

Since then the stock markets sold off a lot, break-even inflation went downhill (although Euro are inflation was not that much disappointing) and BoJ announced negative interest rate policy, first time in its (rather long) history of monetary stimulus.

 

But in spite of all these actions and promises from central banks, the response to monetary stimulus is already waning. The equity markets unwound the second round of monetary stimulus from BoJ in months, and the latest round in days in fact. And even with such a strong promise for action from ECB and relatively dovish Fed, you would have made money if you shorted euro rates vs. USD.

 

The question is what else the central banks are left with. Well, I think it is too early to say they are out of options.

 

Firstly we still have quantitative easing. It may have some limited effect on markets already under pressure from such measures, like Japan or Euro area, but in places like the US or the UK it is still very much potent. [EDIT] Even in case of the others, QE can still be very impactful, at least on the markets, in case the underlying assets are extended to other asset classes - like bank stocks!

 

Then the negative interest rates. This is the one I like the least. Firstly it is NOT very clear what it exactly does for the "general level of rates" in the economy. If everyone is super-rational and able to free his or her mind from this weird concept of having to pay to park cash, life can goes on as usual. But that is a lot to ask. Firstly the banks cannot pass on negative interest rates to customers effectively. This harm the banking sector profit in a big way, as we have seen in the large re-rating of banks across markets recently. Plus if your economy is dependent on banking sector lending (as opposed to direct capital market access) this can be a dangerous move. Facing negative interest rates, banks have incentives to either improve bottom line by cutting costs, or reduce lending business altogether - focusing on either best of their clients and/ or riskiest names. This is not bad for big corporates. This is not bad either for riskiest customers. But this is bad for the ones sitting in the middle, which is the vast majority of the small and medium sized business. Besides, negative interest rates are politically unpalatable, especially in election years.

 

Then we have the yet un-tested weapon: the ultimate Jedi mind-trick - enhancing the inflation target. The trouble is there is no fast mover yet. And it is hard to be experimental with this unless one is forced to. A bad move can displace the inflation credibility that most central banks fought hard to achieve.

 

I think how the central bankers will react will depend on the nature of problem they are reacting to. A minor risk-off or continued commodities sell-offs will most probably elicit a (now) conventional reaction of QE or increasing NIM. But a only a real full blown crisis will bring in the inflation retargeting (along with host of other measures presumably).

 

And given the specifics of the various institutions and home politics, I would bet in such a full blown crisis - the governor of the Bank of England is the most likely candidate to take the first step. And ECB will likely be the last.

 

Wave the hand and say inflation should be 4%, and leave the rest to the Midi-chlorians.

 

So if you are an investors from EU area looking for a tail risk protection, a relatively cheap hedge is paying 5s30s in GBP vs. the Euro are. And most likely this will be Brexit proof. If indeed we have such an outcome, probably a selling of the long end of curve by non-UK investors will lead to a steepening of the GBP curve.

 

The spread has tightened recently but still near recent lows.

 

 

 

 

ECB Meeting: Front Running

There are expectation in certain quarters of further actions from ECB next week. While this is possible, I think it is not likely. The question is less about whether they "should" and more about if they will. ECB historically never did strong actions back to back, based on their premise that it needs time to see the effect of the last action. A back to back action in current situation might as well signify a certain amount of crisis perception at the ECB. In retrospect we will be wiser if indeed we are in a crisis or not, but it is highly unlikely the ECB will be willing to send out any such message yet.

 

The opening of the year has seen some wild actions across markets. However the underlying macro stories remains more or less the same, although admittedly towards the downside. The US is holding up strong on employment. The inflation weakness, when looked at the US only is reminiscent of the recovery from early 90s recession. On the GDP side there has been considerable revision (for example Atlanta Fed GDP now is considerably revised downward, so are the PMIs). Euro area itself has also undergone GDP downward revision, but the PMI has been quite strong and steady. Nevertheless the inflation expectation has remain stubbornly low. And China has hogged the headline in recent times, but that is arguably more because of policymakers actions than data surprise. The capital outflows continue and the economy remains in a need for rebalancing. In fact most of the Chinese Economic Surprise index ticked upward in recent times (see for example Citi Economic Index).

 

But nonetheless, the markets have been really shaky, especially in equities. The chart below shows volatility skews implied from index options across markets. They shows a strong return of fear (although much less than last August). Note the right hand chart plots the ratio of average skew to average absolute deviations, a measure of average fear as implied from the options market.

 

 

The technicals and price actions may well be in the bear zone, and probably we are poised for further corrections from here. For some markets, the January move is reminiscent of what happened in 2008 in January and then what followed. But however there are reasons not to worry about a large crisis like crash in risk assets. For one, we see no evidence of mass euphoria in equities as we saw in case of both early 2000s and also in 2008 among retail investors (left chart below), and speculative position is far more cautious.

 

Also, this is confirmed by flow data from ICI. The equities flows have turned a new negative early last year, after the high yield lost its charm in 2014. Lately even fixed income has seen a turn in the sustained positive flows. Similar flows can be observed for emerging markets funds. This is definitely risk averse positioning rotating in to presumably more cash.

 

Given this back-drop, it is less likely to have some fresh actions this meeting from the ECB. On that front, the expectation is further depo cut and/ or increase in QE. We already have some political misgivings on this, so any action perhaps have to wait. Euro rates are so low it is difficult to push it significantly lower - compare the reaction of the 2014 QE expansion from BoJ, where the initial reaction of around 20bps in 10y rate was unwound in the space of a few months. On top, given the political situation, sudden sell-off is perhaps equally likely and but with better risk-reward outcome. In fact the top risks in Europe is not disinflation. That is pretty much global (and will be more so if Chinese deflation export increases following sustained CNY devaluation). The top risk is the refugee crisis which has distorted the focus on integration of Euro area as a whole. On top we have un-resolved Spanish situation, and the distant, but no less real, possibility of Brexit. The underlying theme of global rate convergence cannot be indefinitely put off by outperformance of the US economy! When Japan had the so called "lost decade", it was pretty much alone (apart from, may be, an internal unraveling of the erstwhile Soviet Republic).

 

Technically, long term technicals on USD rates suggests most rates are range bound, with last bearish signals around 2014 to 2015, the long end being the last to be fired. On the slopes, 2s5s is poised for a steepening quite strongly unless there is a change in the macro story. So is the 5s10s30s fly.

 

long term technicals on EUR rates are similar to USD, most rates are range bound, but has a smaller tendency to revert back. Also most slopes are near the higher area of trading range, especially 10s30s and also 5s10s. Sterling rates signals are mostly bland with few long term signs.

 

On shorter term, USD Rates long end shows a poise for comeback from recent rally and a strong steepening in 2s5s. Euro rates has weak signals of an impending sell-off in 30y and also in 5s10s30s fly (belly sell-off). Sterling rates shows some poise for a steepening in the front end (2s5s area) as well, along with a flattening of the 5s30s and 10s30s

 

Cross markets technicals supports the story of USD slopes steepening vs. Euro slopes.

 

Trades here:

 

1. USD steepening 5s30s outright or conditional (EDIT: vs. EUR, changed from 2s5s to 5s30s for leverage on 1st Feb)
2. BP Box of 2s5s10s30s (2s5s steepening vs. 10s30s flattening)
3. USD EUR long term rates convergence in limited size.

 

EUR/USD will most probably remain range-bound. Any large move without any action to fade.

 

In many ways, the current global situation looks like the long recovery in the 1990s (see here for example). We had a similar balance sheet crisis of sorts, and late in the recovery we had Russia and Asian Crisis doing the China now. That signified the bottom of a bust in commodities then. After that, a frenzy of dotcom stocks and a boom in globalization and commodities ended up in a sustained rally in risk assets. Although we have arguably a technically focused start up frenzy around now, they are mostly outside the scope of the general equities market (see the over-exposure to manufacturing in equity indices, compared to the economy from a recent Goldman reports). And the commodities are doing the reverse this time.

 

Week Ahead: June 15 to 19

Front running for the week

Euro area - Wednesday CPI reports, followed by ECB bulletin on Thursday and Euro group meeting where Greece will be a hot topic.

US - Empire state on Monday, and capacity utilization, followed by FOMC 16-17. Thursday CPI from BLS as well as Philly Fed. 

UK - PPI and RPI on Tuesday, followed by MoM of BoE and labor data on Wednesday and retail sales on Thursday. 

Japan - BOJ on 17

Overall, there is enough data points to keep the vol machine churning. UK core CPI has been running below survey expectation for a full year now. So upside will be something to watch out for. Also, in EU the core CPI is much more volatile than US and UK. Last print was spectacular, and looks like we may be in for some corrections downwards. And Fed is expected to reiterate the data driven policy. 

Technically, Euro rates, esp 10y does look oversold, and so is SEK rates. A bad CPI print of euro zone will lead to a correction. However, not to the levels seen in April perhaps. And seems overall the GBP rates are trading rich compared to Euro and USD, which not in complete sync with USD/GBP. So is the case for vols, where EUR looks a tad too pricey compared to sterling (and even dollar). Although recent data has not been particularly strong from the Queen's land.

On the equities side, last week has been soft. VIX remains around 3 points above the 5 year low. The recent vols in FX and rates has failed to budge any excitement in Equities.

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.

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.