Markets | Positioning For The UK Election

UK goes in to elections this week. Since the surprise announcement in April, the polling has narrowed quite a bit between the two major parties. (See chart below - although note a large part of Labour gain has been at the expense of smaller parties, especially UKIP). However although the markets had a sharp initial reaction to the announcement, the moves subsequently have been more cautious. The outcome of the election is touted as determining the direction of Brexit negotiation. And markets appear to be waiting to assess the situations once the results are out. However, what the market will focus on in Thursday evening is not only the UK's divorce from the European Union.
 

 

Looking past the Brexit, the major differences between the Tories and Labour campaign is their respective stance on tax and government spending. If conservatives have their ways, it will basically continue the status quo, without any significant change in taxation or spending.

 

On the other hand, the labor plans to increase taxation (focused on corporates and top earners) as well as infrastructure spending. The National Transformation Fund with a corpus of £250b proposed by the Labour compares to a £23b National Productivity Investment Fund of the Tory government. The net effect is an increased need for borrowing, put at 45b estimates by the Tories. The other major campaign difference will perhaps add to this bill. The Labour maintains a so called "soft Brexit" approach, and a change in government in London may actually increase goodwill in Brussels. But Labour's negotiation aims also implies the UK may actually end up footing a substantial Brexit bill.

 

Put together, these means increased issuance of Gilts for a Labour government compared to the Tories. So in an unlikely scenario of a major Labour win, all the market forces and economics fall nicely in place. Gilts will sell-off on the back of fiscal plans - along with a steepening of the curve. Sterling pound will rally, supported by both the new Brexit stance and a rising yields. Equities will sell off, triggered by both taxation and a rallying pound and rising yields. For a strong conservative win, the impact is mostly in market sentiments than any dramatic departure in economics.
 

As we see from the charts above, the correlation in Tory polling vs. GBP and Gilts have mostly switched to negative off-late (and to rather positive territory for Labour). These correlations implies a Tory win will have some downside impact for GBP. But strong win may even see a small upside driven by a reduced political uncertainty before the economics kicks in. Gilts have little scope to respond vigorously, facing the inflation pressure on one hand and a more than expected Dovish BoE on the other - marginally positive for Gilts (yields go down). Equities will perhaps shrug off all of it.
 

That leaves us with the scenario of a Labour-led coalition government. This will in general hurt the market sentiments, with a higher chance of a addled up Brexit negotiation and potentially another election around the corner. This will be a sort of risk-off moment for UK, with sell-off in pounds and equities and a rally in gilts. This will also be a shock event - as at present the betting markets prices in a 90+ % probability of a Conservative majority. Assigning some reasonable probabilities to various outcome, the pay-off matrix looks like below. And it suggests a short GBP position before the election.

 

 

Position-wise we have seen a large reversal of positions in futures (as per CFTC reports) after the election announcement - a large decrease in net speculative shorts in Sterling pound. On the other hand, the currency options market shows a significant increase in negative skew pricing (demand to protect from a sterling crash). In fact the GBP 1 week 10 delta risk reversals is near the highs around the Scottish referendum in 2014 (although much less than the highs reached around Brexit referendum). So it appears we have some options positioning (or at least demands) - indicating a position switch from futures to options. Assuming most dealers in the FX markets will have the opposite position, this adds to a negative bias on Sterling.

FOMC | The Ides of March

We have quite a bit of built up anticipation for the March FOMC. The Fedspeak analysis of "Fairly Soon" has been interpreted by most as leaning towards a March hike. Some are even claiming the rates markets are underestimating the probability of a March hike.

The chart above shows implied 3-month treasury forward curve term structure since the 2014 (after the highs from 2013 Taper Tantrum). In early 2014 the market estimates of long run equilibrium rates were just about 4 percent. Since then we have come a long way. As we see we have three major clustering of market estimates - one at around sub 2 percent (during Brexit rally), another just above 2 percent (early 2016) and the most common level at just about 3 percent. The sell-off after the US presidential election has just brought us back to this 3 percent level. Coincidentally, after disagreeing with the markets on this long run terminal rate for a long time (erring consistently on the upper side), the FOMC also now more or less agrees with this level. So after quite a while markets and the FOMC seem to have converged in outlook. 

Given this background, I think whether the FOMC hikes in March or not is now a far less important question than what it used to be a couple of years or even a year back. Before March FOMC, we have a round of PCE (Fed's favored measure of inflation) as well as employment and GDP data release scheduled. Unless we have a major upward surprise, March probably will be a no-hike meeting. And more importantly, given the improving economy, markets are in a much better position to absorb a hike anyways. The US and global inflation are improving, but it is much tamed than the "reflation trades" coverage makes it sound. Inflation was a worry (on the downside) before, now slowly it is ceasing to be so. There are few signs the FOMC is behind the curve as of now.

What can really take the market off-guard, is however, the question of Fed balance sheet. If and when FOMC plans to reduce its QE-bloated balance sheet, and how they communicate this point. Hiking is a way of tightening. But a controlled balance sheet reduction is also another way. While the former affect the short term rates more (a bear flattening), the later should be more prone to affect the long end rates (bear steepening). A reason why FOMC may actually opt this is to address the historically compressed risk premia - see the left chart below. Even with the recent sell-off, the risk premia remain at a depressed levels. The short end pressure felt on the back of FOMC moves more or less leaned towards a flattening of the curve than any significant correction of risk premia. While the European and Japanese bonds are trading at super-depressed levels, perhaps it is not entirely to the Fed to correct this. But adjusting balance sheet is definitely a direct way to address this.

The most important reason NOT to do this it the unpredictable potential impact. This has the strongest potential to send confusing signal to the market, perhaps resembling a taper tantrum version 2.0. The right-hand chart above shows a quick check to identify the pain points based on the current Fed holdings vis-a-vis supply. The vulnerability is concentrated in the long end, especially if this is adjusted for the duration risk (not shown here). The primary reason this may create unwanted responses is that it is not at all well understood. Balance sheet reduction after a massive QE is a completely new thing for both the Fed and the market. The last FOMC minutes (published last week) discussed this issue explicitly for the first time, if I remember correctly. So it is fair to expect this will definitely come up in the March discussion as well. At present FOMC expects re-investing to continue "until normalization of the level of the federal funds rate is well under way". The most important event for the markets from the March FOMC will be any potential change on this view. 

Realistically, this can be the trigger that can bring us back to the 4-handle level of long term equilibrium rates we had at the end of 2013. Trump fiscal push blow ups and run-away inflation seems pretty far-fetched at present. The asymmetric positioning here is bear steepening.

Similarly on the equity and risk assets side, this can have the most unexpected and damaging impact than a regular FOMC hike. Possibly more than even an adverse French elections. The National Front candidate Marine Le Pen, even if elected as the President against all odds, will find it hard to muster enough support in the parliament to call for a national referendum to leave the Euro area. And even if the referendum is held and a majority votes to leave, it is not clear that will actually be followed through - going by the outcome of the 2005 referendum.

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all data from Federal Reserve and US Treasury.

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!

Macro: The Quiet Riot - Continental Version

For the past few weeks, the fixed income market has seen a significant change in moods.

The earliest trigger was in the JGBs market in late July, then it was the Gilts in late September following a pause from BoE. This week it definitely felt like the Bunds. Treasuries are down too from July highs, but in a much gradual fashion compared to the rest.

Now while we do have individual explanation (with the 20/20 hindsight) for all these (BoJ steepening chatter, Brexit, ECB QE rumors and, of course, Fed hike expectation), these moves signals some fundamental changes common across the markets as well. For one, this sell-off in rates is markedly different that recent large moves or the 2013 taper tantrum in terms of the accompanying movement of the inflation expectation. This is the first large sell-off in rates where the real rates (I used 10y yield less the 5y swap breakeven rate) were stable. Clearly the common thread has been inflation expectation - led by the Sterling inflation market, in response to a weakening currencies. But this was not limited only to GBP. Backed by the strong recovery of the commodity prices and oil, inflation markets across regions rallied, recovering from the bottom in Q1 this year. Even the Euro inflation is  flat on YTD basis after this recent move.

However, it is still too early to say if this points to an inflation scare. We are far off from seeing the white of the eyes of inflation. Large part of the recovery in inflation is driven by commodity prices which just came off multi-year lows. With over-capacity in many sectors, and a new cost/ supply equation for oil (see here too), there is no strong case for the commodity rally to overshoot substantially from here. On the demand side, apart from the healthy wage growth in the US, things are not significantly better. UK is still trying to figure out the consequences of Brexit. The collapse of the credit impulse in the Euro area late last year is yet to recover and Japan seems increasingly stuck.

The suddenness of the move suggests a large driver of the sell-off may be positioning, especially in Euro and GBP. Bunds open interest on Eurex were near historical high since 2008 before the selloff. This was definitely not helped by a rather tight-lipped Draghi on the last ECB. ICE Gilt positioning also indicated asymmetry with position build-up after Brexit. For core rates, this means the recent sell-off will stabilize as the pressure from positioning is diffused eventually. However, it is clear that we are approaching near the end of the era of quantitative easing. The next big move in rates will not be triggered by Fed. It will be the policy announcement from BoJ in Nov, followed by ECB's decision on QE in Q1 next year. Fed is priced in, and with all probabilities, will carry out a measured hike in December. It will be mostly a non-event.

What is rather interesting is how the current monetary policy plays out for the curve. It is clear we are increasingly approaching the end of QE-topia, with some central banks moving to normalize, and some still leaving considerable liquidity in the system and trying to lean on the next lever. This apparent divergence in the first order (the level of rates) is leading a convergence drive in the second order (the yield curve slope). BoJ is actively seeking to steepen the curve to alleviate concerns of the banking sectors, among other things. ECB will be glad to have the Euro area curve steepen back. The Fed is allegedly getting in the same business. The latest round of rates sell-off, unlike most before in recent time, was mostly a bear steepening move. Unfortunately, steepeners are not as juicy as they used to be in terms of carry a couple of years back, but still this is the trade to be in for the medium term - either in absolute term or cross-markets.

On the equity side, contrary to general view, this is not at all negative. Inflation recovering from current levels shows strength of the macro drivers. In fact in recent years, S&P 500 has shown more asymmetric correlation to inflation expectation than outright rates itself (see chart below). The thick tail on the right hand side has been dominated by inflation downside (i.e. correlated sell-off in equities with collapse in inflation expectation). A recovery in inflation expectation should be positive, at least initially, and ultimately uncorrelated to equity performance (runaway inflation is still a distance myth). This is especially true given the strong commitment from the Fed on its intention of slow paced hikes.

The S&P appears to be in a consolidation state - in a typical triangle formation, before the next leg (usually up from here).

The downside for equities from here is in fact event risks, and not macro. The US presidential election is one -although apparently the market does not care. Italian referendum is another - and again the history does not make a strong case for it either, if you go by the off-hand manner in which market digested the outcome of recent southern European election outcome.

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 : 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.

Trade Ideas: Cheap Brexit Hedges

The Brexit noise and fear in the markets are getting ever louder. Handful of opinion poll results have led to extreme volatilities in currency and equities markets. It is something that no longer can be written off and hoped against. Unfortunately for investors, hedging such a macro event is neither easy nor cheap.

 

This blog discussed about a cheap Brexit hedge previously, here we take a more systematic approach.
 

Hedging macro event such as Brexit involves defining scenarios and associated outcomes in terms of market variables in each scenarios, and then picking the outcomes we want to hedge against. Then it becomes an exercise in balance between the cost of hedges and the residual risks (including basis between investor portfolio and hedge as well as the risk of the particular scenario/outcome assumed not realizing). Defining expectations about scenarios and outcomes of a such an uncertain event is not straightforward. Beyond economic analysis, what matters most in near terms is what market participants perceive as the possible impact, and also what they expect others to expect as possibilities - and make the most out of it. The resulting outcome can turn out to be quite different than what is based on pure economic outcome. However, at present, it is generally agreed that in the event of a Brexit, sterling pound will sell off considerably.

 

Taking this as an anchor, we analyze cross asset markets for their correlation (rolling weekly) to sterling pound. The figure below shows the outcome. On vertical axis, we have the correlation to sterling pound (GBP) in percentage point. On horizontal axis we have the relative rich/cheap position of each asset (z-score since 2014 beginning). If our assumption is right about a GBP sell-off and if these correlations hold, to hedge positions one would short the assets on the top half and go long on the bottom half. Also from relative value point of view, you want to short assets as far to the right as possible (rich) and reverse for longs. Hence the ideal hedging assets will be diagonal from top-right to bottom-left.

 

The motion chart captures time evolutions of these correlations. Drag the slider to the latest date. As we can see the most effective hedges (apart from shorting GBP/USD of course) is shorting GBP/EUR. However, in terms of cheapness the GBP 5y cross-currency basis swaps fares much better. In equity space, shorting FTSE vs. EM is attractive too. In rates space the best is shorting USD vs. EUR  10y swap rates (pay EUR swaps). On the bottom half, the best hedge is long euro FX volatility.

 

Looking around, to position for upside, shorting FTSE vs. Euro Stoxx looks quite attractive.

 

The trades here:

 

#1: long calendar spread in Euro FX straddle: discussed in more details here.

#2: short EUR 10y vs. USD in swaps: With Germany 10y hitting negative for the first time, there is very little scope of move further down here. On the other hand, in the event of an actual Brexit happening, any substantial margin calls can transmit risks asset selling pressure to safe assets. This appears more true as it does not look like there is a high amount of defensive positioning around the event. And given the expected tight liquidity in such a scenario, this can very quickly lead to a significant sell-off in euro rates. On the monetary policy side, a Brexit will definitely push down US yields further, pricing out any Fed hike (or even active easing). ECB, on the other hand has little traditional room to push rates down. My theory here is that a policy rate cuts has much less latency in market reaction than asset purchase can ever achieve in a stressed situation.

#3: short GBP short term (2y or 5y) cross currency basis swaps. In  the event of a Brexit, potentially we will have a significant demand in USD funding from UK players. In fact a more risky version of this trade is to short GBP basis vs. EUR. The former is trading far richer compared the later. And presumably given the cross-border exposures of UK to Europe, we may see a significant spike in euro demand as well to fulfill near term obligations of UK financials institutions.

Equities do not offer much attractive hedges after the recent sell-off (although shorting FTSE vs. EM equities can be considered). Equities however offer more attractive upside positioningfrom these levels (see above).

 

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1. All data from FRED database/ Bloomberg
2. Symbols Key in the Chart - GBP10Y: GBP 10y Swaps, GBP5S30S: GBP swaps 5s30s slope, GBPBS5Y: GBP 5y cross currency basis, EURBS5Y: EUR 5y cross currency basis, GBPMMSPREAD: GBP 1y1y money market vs. libor spread, FTSE: FTSE100, VIX: CBOE VIX, GBPEUR: GBP/EUR cross, GBPJPY: GBP/Yen Cross, PERIPHERAL: Germany/Italy 10y bond spread, INFLATION: GBP 5y breakeven inflation, EURVOL: EURUSD 3M Vol, USDEUR10Y: USD/EUR 10y swap spread, GBPEUR10Y: USD/EUR 10y swap spread, USDGBP10Y: USD/EUR 10y swap spread, USDGBP5S30S: USD/GBP 5s30s Spread, USDEUR5S30S: USD/GBP 5s30s Spread, FTSEEU: Long FTSE vs. Euro Stoxx, FTSEUS: Long FTSE vs. S&P500, FTSEEM: Long FTSE vs. MSCI EM Index.