Trade Idea: A Contrarian View on GBP

During 2009, as the first signs of stability set in following the market crash the year before, there were two major macro themes doing the rounds. One was in rates. The idea was an unexpected comeback of inflation following the QE by Federal Reserve. Although hyperinflation and debasement of dollar were fringe ideas, a lot many asset managers and hedge funds were buying CMS caps. The other one was in FX, touted as the GBP/EUR parity trade. It was equally popular, following the QE unleashed by the Bank of England, as Europe apparently remained much less affected by the financial meltdown.

 

Of course both of them failed spectacularly. Almost a decade after, it is deflation and disinflation that investors are worrying about instead. And propelled by the European Sovereign Debt Crisis among other drivers, British pound had its best run against Euro since the beginning of the currency union. The original QE by Bank of England now stands dwarfed by the European version.

 

And somehow now the parity trade is gaining favor again. The market is quite concerned about the British pound. There is a chance of a Brexit on the horizon of course. And even disregarding that, some predict a serious downside to GBP in any case, pointing at the recent current account data released by the Office of National Statistics last week. This was the high deficit in record, as noted by ONS.

 

But the devil is in the details, as always. Here is a detailed break-up of the what is driving this record current account deficit and how this is getting financed.

It is clear that while trade deficit is a large negative number indeed, it is not the main culprit. In fact the trade deficit has stabilized and the long term trend is in fact marginally upward. It is the massive collapse in net income component of the current account that has been instrumental in pushing the current account deficit to this record number. Net income component in current account consists of net earnings from foreign investments (like profits from overseas companies and dividend and interests from loans and marketable securities). This collapse of investment income is highly correlated to the UK's outstanding direct investment position as shown below. The story here is: the trade deficit is being funded mostly by direct inward investments. As a result, more foreigners are pouring money in than residents are investing abroad. This has resulted in shrinking investment income, putting further pressure on the headline current account figure. Interestingly almost all the trade deficit of UK is from its trading relationship with the European Union. The trade balance with the rest of the world is in fact positive (goods and services together).

 

The question is: is this something investors should worry about? In general a deficit in current account is negative for the risk perception of the currency (if floating) or the economy (if a pegged regime). However funding current account with direct investment (which tends to be stable), and not with portfolio investment (aka "hot money"), is much better than other options. Unfortunately this has become a double whammy for a country that depends on investment income to a large extent to balance its current account. As explained above, this very nature of funding the current account with inward investment has led to increasing current account deficit itself. Given the stable nature of the funding, this is no immediate risk. Bank of England seems to have similar view (also see the latest report). It further notes the resilience of the UK's external balance sheet.

Looking closely at the net income highlights two more points. Firstly, looking at the spikes in the net income, we can also conjecture the net asset position for the UK is long risk assets (potentially UK residents holds more risky assets abroad, than foreigners hold in the UK). Secondly, to the extend the net income has exposure to fixed income, we should naturally expect this to shrink. UK nominal yields are much higher compared to much of the developed world, and more so across the channel.

This sets the stage for the guess work on what to expect out of the currency in this context. Most fundamental estimates for GBP value it (against USD) at around the fair mark after the recent sell-off. But most fundamental valuation methodologies are rather lines in sand. And more so for GBP. These valuations are usually based on trade balance, through some form of purchase power parity. As we have seen from above, UK current account balance, and hence the fundamental valuation of the currency itself, in the foreseeable future will be dominated by net interest income. This means it will be vulnerable to further deterioration in euro-zone economy and a general sell-off in risk assets. On the other hand, any pick-up in the hawkishness of the Bank of England will be a natural booster. In a complete risk-off scenario, with major trouble in Chinese economy or a real estate crash in the UK or something similar that can stymie the inward investment flows, we may have large downside risk for GBP. Otherwise the risks are pretty balanced as off now.

And given this, it appears a large sell-off expectation in Brexit is somewhat mis-placed. We do not have finer details about the inward direct investment flows - like country of origin etc. But if it is not from Europe, it is not likely to to be impacted to a great extent. Also a marginal devaluation of GBP is positive for UK equities, hence we probably will not see a large portfolio outflow either. On the trade balance side, a break-away from EU may actually work to balance the trade deficit with the EU partners. And as noted above, UK external balance sheet is quite resilient. Overall, barring investor sentiments or panics, there is no super-strong justification for a large sell-off in GBP.

But the market pricing in USD/GBP volatility and skew is quite different than this conjecture. As explained here, perhaps the investors are over-estimating the probabilities of a leave vote. And even if it is not the case, it appears the sell-off that is priced in is not fundamentally well supported. Market positioning wise, speculators are most short since start of 2015 (as from CFTC commitment of traders reports). May be it makes sense to go contrarian here and position for a GBP rally after the Brexit.

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All data in the figures are from the Office of National Statistics and Bloomberg.

Note To Self: Bear of The Dark

“Going negative is daring but appropriate monetary policy. But it is a sign of a terrible policy failure by fiscal policymakers.” - this succinct quote from former Fed official Narayana Kocherlakota captures the very essence of the limitation of the central banks today.

I started turning bearish - like most market participants - in early January. I turned neutral here, and bearishness followed. See here and here and here. That was mostly based on reading the market information and assessing them, subjectively. Which is NOT particularly a great way to develop an outlook. Here we attempt a more formal process.

A bad time to assess if the markets are turning a bearish corner is on days like today: the markets sell off a quite a bit. First thing one has to fight even before starting to reason are a whole bunch of cognitive biases!

Let's assume we have already done that. The next thing is to take an objective view, and establish based on the current information what are the chances of a bearish market setting its foot hold firmly.

First, the base rates: to start with, only the price information and no context whatsoever. First we notice we are in some kind of cusp. The 3 month, 6 month and 12 month performance of, say, S&P 500 are more or less similar within some tolerance. That means, we are not in a steady trend, yet, in either direction - bullish or bearish. In a steady trend, it is much easier (and almost useless) to establish if we are in a bullish or bearish phase. It is very difficult to predict a trend at the onset of it. Many investors spend considerably amount of time and effort trying to achieve this, and more often than not, they fail.

But looking at data, we can make some probabilistic observation. Here we look at the historical probability distribution of S&P 500 returns - over next 3 months and 6 months - when it behaved similar to today. That is: it sold of significantly (we look at 5%, 7.5%, 10%, 12.5% and 15% prior sell-off) and that happens in a turning phase (i.e. 3, 6 and 12 months performance are equivalent within some tolerance). Here is how it looks, since the post-world ear.

For next 3 months return distribution - on the milder sell-off side, the distribution tends to the usual - hardly useful to prognosticate. However, as the sell-off amount increases it tends to widen in a bi-modal distribution - tending to either settle down in to a bearish phase or come-back sharply. And only beyond 15% the upside skew tends to dominate. We are at around 12%. Looking at the next 6 months returns - the historical distributions are more extreme, and chance of an onset of bearish trends increases with increasing sell-off, till the upside skew tilts it in bull's favor beyond 15%.

The obvious conclusion here is we are not going to settle at this stage, and likely to move to one of the peaks. And we can also say, although with less conviction, the sell-off is perhaps not large enough to be perceived over-sold and is slightly tilted in favor of the bears.

Continuing with base rate case: Equity market is related but distinct from the underlying economy. One way to approach is to ask what are the chances of a sell-off given a recession, and also what are the chances the markets sell off anyways even without any recession in the economy.

Here is a list of historical recessions in the US since the great depression, and the corresponding market sell-off

So excluding minor recession introduced by sudden fiscal tightening or monetary tightening or the very distinctive dot com crash - the average sell-off has been around 12 percentage point per percent point of GDP lost. And roughly 30% on an average.

It can be noted that we had two occasions of a market sell-off (greater than 10% peak-to-trough) without any recessions - one during 1965-66, presumably under a credit crunch and followed by a recession. The other time was 1976-78, which was actually straddled by the 1973-75 recession and early 1980s recession. So the probabilities of a sustained bear markets without a recession is much less. But of course we are looking at a more globalized world now. Hence we can expect equity underperformance in the US even without a technical recession, if there is a large scale disruption else where in the world.

Overall conclusion - we have a considerable chance of a bear market setting in. Note, a 50-50 chance of a bear market is actually a much stronger conviction than it sounds. On a rough measures, since post war era till before the current phase, we have spend roughly a 30% of months in a bearish market. So unconditional probability of a bear market will be around 30%. And given the above observations, it should be higher than 30%. May be closer to, but quite less than 50%. A good number to anchor is mid-way at 40%. And this is a conditional estimate, without considering the context or forward outlook. It depends on the probability of a economic recessions, global or in a major economy. Which comes up in the next post.

As a tail-piece, here is how the classic equity risk factors are performing lately. This is in the US, but should be similar across the board.

The value is beaten down, and it is the momentum that is the last man standing.

Note to Self: The Peking Swan?

What are the probabilities of a Yuan devaluation in the range of 10%.? And given this may happen next week or next quarter or any time*, how to trade this and not bleed to death on carry?

 

The officialease from Beijing, indicating an apparent strong stance against this and favor for a stable currency, would have been highly suspicious, had it not been China. As for China doing a volt face, this will have a mighty kill radius. The swan may not resemble any before in recent past, alive or roasted.

 

Or it may happen much less dramatically in a series of devaluation-cum-depreciation (the much more likely case), which will have relatively benign impact on the markets in the short term but prime it up for more to follow. This can undermine PBoC.

 

The question is how best to position for this. Rates - may be, Equities - difficult to run the position for long time, Commodities - Oil in contago, but not in super-contago yet, FX - may be. Need to look closer.

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* The Uncertainty Principle, as applied to macro investing, says you cannot forecast the direction and exact timing of an even simultaneously.

Macro: The Chinese New Year

The gyrating market this week so far has more than done its bit to jolt people out of their holiday stupor. The Chinese equity markets and the law makers kept everyone, well, engaged. Late this afternoon we have seen some respite after the Chinese authorities repelled the stock circuit breaker rules. Equities rallied from day's low and bonds sold off. All fine and good. The question is, is it time to fade the market full of confused and panicked investors? Or should you panic yourself instead.

 

Whether the Chinese episode is something to worry about depends on the opinion about how in control the Chinese policy makers are, and what is their line of thinking. Chinese Yuan devaluation is not necessarily such a risk-off thing in itself. Arguably the Chinese authority looks at CNY against a trade-weighted baskets and not only dollars. And also in terms real effective exchange rates, Yuan is far from cheap, and a bit of regression to the mean (at whatever the authorities think it should be) should not cause so much pandemonium. Then again, it is not clear how much control the authorities have in executing these changes. Last year, and this year so far, most of the Yuan "devaluation" has been rather abrupt. This may be the communication policy of PBoC. But apparently that did not go well with the market. The re-balancing problem in China is a real thing. And it is just that, a re-balancing problem. If it can be controlled, with controlled devaluation and a smooth transition from investment based to consumption based GDP, and most importantly manage the debt from blowing off in between, this will be an adjustment.

 

If it is not controlled, it will be a crisis. Some are already calling it so. I tend to think it is not. Referring to someone who knows more about China than perhaps anyone else, there are encouraging signs in this rebalancing effort. The Chinese foreign exchange reserve is a hot issue in near terms. But more importantly, it is how they maintain the balance in the economy (low enough unemployment and no mass-bankruptcies) before they adjust to the new GDP paradigm is the most important question. And FX devaluation is a pretty smart and cheap way to achieve that. At a milder cost of a negative pressure on global inflation. Unless that creates a panic and becomes a self-fulfilling crisis.

 

Market seems to be focused on the second point of FX devaluation, fed by researches on where the level official reserve is and how much outflow it has seen in recent time. Remember how the Chinese market sold off massively in the June and rest of the world hardly noticed? And when that reversed in August when the PBoC revised CNY fixings. The question is how justified this fixation on FX is. The political economy in China is pretty much different than the developed nation or what we have seen in case of the Asian tigers or LatAms under sudden stop, The authorities, in principle, has much wider control on the economy. And if they do succumb to the sudden stop problem and that blows in to a full scale crisis with a collapse of asset prices, it will be felt far more geopolitically, than economically (apart from a certain global deflation, again). I would tend to assume so far what we have seen from the policy-makers are more likely to be mistakes and experiments than a sign of loss of control.

 

In the meanwhile, coming back to the original question, should to panic or fade? Statistically speaking, the odds are something like below (click to enlarge).

 

The charts shows the conditional upside and downside in representative equities after a given amount of weekly sell-off (the opportunity is the difference between upside and downside). It captures the next week's percentage move (vertical axis) given a percentage sell-off this week (x-axis). As we can see, with extreme moves come extreme opportunities. Equities so far sold off around 4% to 5% this week across markets. As you can see the time to jump in to wanton bullishness is still a couple of percentage points away, statistically speaking.

 

Note: these data sets excludes the wild days of 2008, but including them does not change the picture much.

Economics: The Myth of "Quantitative Tightening"

It is the latest populist theory doing the rounds in the financial media. Even the mainstream media is now flooded with this now. See here and here

To see why it does not make much sense, we need to understand what quantitative easing actually is, in terms of Economic models.

The standard Keynesian model is the famous IS-LM model. This captures the goods and money markets equilibrium simultaneously in an economy. The IS curve of the model, derived from the equilibrium of output and aggregate demand, captures the goods market equilibrium. It outlines the combinations of interest rates and economic output for which such equilibrium is possible. It is a downward sloping curve, as for a given level of external factors, a higher interest reduces the investment spending and hence output. The second part of the model is the LM curve. Derived from the demand of money, it captures the combination of interest rates and output for which the money market is in equilibrium. This is an upward sloping curve, as for a given amount of money stock, the demand for money goes up with higher income and lower interest. For more on this look here for a quick introduction. The entire economy is at equilibrium at the intersection of these two curves, which implies simultaneous equilibrium in goods and money markets.

However, I think to analyze QE, it is better to switch from IS-LM model to IS-MP. It is a variation of the IS-LM model which retains the same IS curve, but replaces the LM curve, by an MP curve (MP stands for Monetary Policy). The advantage is primarily two-folds. Firstly, unlike the implicit assumption in IS-LM model, most modern central banks do not target money stock, but rather a policy rate - which is explicit in the MP model. Secondly, the IS-LM is a bit ambiguous. Ideally the relevant interest rates for IS curve is the real interest rate, and nominal interest rates for the LM curve. So effectively it is a bit round-about to incorporate inflation directly in IS-LM. And as we will see QE is largely about (expected) inflation. For more details on IS-MP, look here (opens PDF and a bit wonkish)

Figure below shows a typical IS-MP curve. As mentioned before, the IS remains as it is. The MP is upward sloping. Which makes sense as most central banks uses a Taylor Rule approach to determine the appropriate level of real rate to target, balancing output and inflation. For a central bank targeting purely a real rate (i.e. inflation targeting), the MP curve will be horizontal.

In the IS-MP model, the economic shocks can be analyzed in a manner very similar to the IS-LM model. Suppose the economy is initially at equilibrium E0 with output at potential output of y0. If there is an external negative shock to aggregate demand (like the 2008 crisis), the IS curve shifts to the left (IS' in the plot), along with a drop in output y1 (which is below the potential output) at a new equilibrium of E1. The response of the monetary authority is to shift the MP curve towards right sufficiently (expansionary policy) so that the equilibrium point E1 shifts to E2, which brings the output back to potential, but at a lower real rate (r'). How the shifting of MP to right is actually achieved depends on many things. For a normal economy with sufficiently high nominal interest rates and stable inflation expectation, manipulating the nominal rate (setting fed funds etc) can achieve it. In case of a positive shock the dynamics works in the reverse. This is what central banks do in a nutshell.

The question is what happens if the nominal rates are not high enough (the so called liquidity trap). Or the initial shock is so large that to change real rate enough to reach the equilibrium E2, the nominal interest rate has to become negative (with a given inflation expectation). Obviously, this is not likely to work. Here the interest rate implies the general level of rates. Forcing the general level of nominal rates to negative territory is quite a challenge (if desirable at all), as people can just hold cash instead of bank deposits (thus avoiding negative interest rates, i.e. paying fees to park cash at banks).

The way out is to tweak the other component of the real rate. That is inflation expectation. If the demand is lower than potential, the inflation and inflation expectation has already started creeping towards a lower base. If the central bank can convince people that it is not going to stay low for long, and jack up the expectation, that can reduce the real rate, even at a zero nominal bound. Which in turn spark real activities. Quantitative easing is a tool to achieve just that. In fact we can express real interest rates as below (as a matter of definition):

Long term real rates = average path over expected future nominal rates + term premium - expected inflation.

Even at zero lower bound, the central banks can use tools to manipulate any of the three terms to achieve its objective. For example, the "forward guidance", adopted by Fed, is a tool to manipulate the first term. General asset purchase influence the second term. And depending on how the QE is planned and communicated it can influence the inflation expectation. In fact the standard way how QE works is mainly two channels - a) the portfolio re-balancing channel, which compresses the term premium, and b) the inflation expectation channel. And together they can work exactly like the expansionary monetary policy in the diagram above. Even at the zero nominal bound. That is pretty much what quantitative easing is. So by definition, "Quantitative Tightening" will work in reverse. 

But, we are not talking about quantitative tightening by the domestic central bank here (i.e. the Fed), but rather foreign central banks. To analyze that, we need to extend out model to an open economy.

Much of the things remain the same. The stuffs that change are two-folds. Firstly, the IS curve is now influenced by the real exchange rate (opens PDF, a brief primer). An appreciation of dollar in real term will make imports attractive for domestic consumers and export costly for overseas consumers. So this works like a negative shock to the IS curve (domestic output), a shift to the left. Secondly, we also need to incorporate the foreign exchange market equilibrium, captured in the line BP (abbreviation for Balance of Payment). This equates the demand for foreign exchange (import over export) and supply (net FX inflows, ignoring central bank reserve changes, which is only applicable for pegged currencies or managed floats). For perfect capital mobility, this will be a horizontal line, as we can have only one interest rate at which we can have equilibrium. At every other rate, large inflows or outflows will overwhelm and restore balance. For general capital mobility, we have an upward sloping curve. The equilibrium for an open economy is achieved in the intersection of all three curves - IS, LM and BP

In such a scenario, negative demand shock can be countered as before. Assuming a floating exchange rate regime, an expansionary monetary policy, reducing fed fund target or QE as the case may be, pushes the MP curve towards the right to MP'. Given the lower rates, the new point is below the BP curve, which implies an imbalance in the FX markets. In this case, the dollar becomes cheaper in real terms, leading to simultaneous increase in net export (IS shifts right to IS') as well as improvement in current account (BP shifts right to BP'). This changes the output from y0 to y1 at a lower interest rate levels. The equilibrium changes from E0 to E2. Notice the change in real interest rate is less than the previous case. A tightening works in the reverse.

Now "Quantitative Tightening" by PBoC or other central banks, (i.e. selling of treasuries) is a totally different beast. PBoC has NOT decided overnight that it is the monetary authority for United States, and is NOT trying INDEPENDENTLY to influence the monetary policy for dollars. Nor it can change the total dollar money stocks. It is selling treasury because of its own monetary policy aim, which is to maintain the Yuan trading range.

So in effect, in the above diagram, nothing changes. No dollar monetary base, nor real exchange rate, nor inflation expectation to move any of the curves. There is a potential of changing the term premium. But assuming it is selling foreign reserves for the purpose of exchange rate targeting, it must be selling not only treasury but all other reserve currencies as well. That means it will require a huge selling by PBoC to achieve a modest increase in the term premium. Which is unlikely. 

Also a QE or reverse for a large bond markets like US treasury (approx USD 16 trillion outstanding) primarily works through inflation expectation than portfolio re-balancing channel. For example, the episodes of previous QEs by the Fed actually saw a modest increase in treasury yields, but an overall reduction in real yields (as computed through breakevens). In addition, the Chinese FX reserve can be around USD 3.6 trillions on paper, but given the size of the economy and exports and imports, China must maintain a part of it as a safe guard as per IMF recommendation (opens PDF). So effectively a much less amount is available for this so called Quantitative Tightening.

And lastly, the entire point of treasury selling of China is maintaining the FX policy. The recent capital outflows increased the devaluation pressure on China, and PBoC is selling dollars and buying Yuan to protect the range. So effectively it is keeping Yuan artificially overvalued, one can argue. And that means, if they do not do that, i.e. stops selling treasuries, that will actually have an worsening impact on the US, as USD real exchange rate appreciates and shifts the IS curve towards left.

Now enough of theories. Let's look at some hard data. How much net selling is happening anyways in treasuries - based on TIC data as of end of June 2015.

Hardly anything that suggests "Quantitative Tightening"!

Although official ownership of long term treasuries has gone down, this is more than compensated by increase in private ownership. The only countries where we have seen total treasury ownership going down is Japan and the Switzerland + Benelux block. And on overall basis foreign ownership of treasuries is on a steady upward path, after a sizable reduction for a brief period of Taper Tantrum back in 2013.

Only Fed can do a real quantitative tightening. "Quantitative Tightening" by PBoC is mostly a nonsense.

Nevertheless, what is interesting in this entire model thingy is the dynamics. You might have noticed how the entire thing works. Any monetary policy changes in response to a negative shock in demand lowers the real rate. Similarly a positive demand shock will increase the real rate for the same potential output. Interestingly in recent times, the demand shock distribution has been highly negatively skewed (you can have a look at the real GDP distribution since 80). It is hardly a surprise ever since we have a constant downward drifts in general rates levels. Forget about secular stagnation and other interesting theories. Even in a perfectly normal economy, a negatively skewed demand shock distribution, along with Keynesian central bank, implies rates will have a tendency to drift down and eventually hit the zero lower bound and get stuck there. There are only two ways out. Either reigniting the animal spirits and optimisms of the industrial revolutions or the post-war period. Or a higher inflation target. Else downward yields are far more likely than a sharp sell-off in rates. No matter which foreign central banks are re-adjusting their FX reserve.

Volatility: A Cheat-Sheet for Traders and Investors in Rates

Volatility in rates shows one of the most interesting dynamics compared to other asset classes. Unlike FX and equities, the skew shows considerable variation, in magnitude and even in sign, with changing macro-economic conditions. On top, a comparatively large share of derivatives markets influence the vol and the underlying in feed-back look.

Usually at any given point in time, the rates market is in any of the following three regimes

• Sticky-strike Regime: Very tight range trading of forwards. Realized and implied vols are range bound, no significant dvega/drate changes on the street, overall uncertainties low/stable
• Sticky-moneyness Regime: Trending rates regime, stable realized/implied vols, stable risk aversions/ risk appetite
• Uncertain Regime: Everything else. Usually accompanied by high vol, high policy and macro uncertainties.

Here is a quick cheat-sheet for traders and investors to identify which dynamics at play, based on the behaviors of traded prices.

Negative Skew (Current Skew Negative)	Positive Skew (Current Skew Positive)
Sticky-Strike Regime Expected Behavior 1.       Fixed Strike Vols : Independent of level of swap rate (or forward swap rate) 2.       ATM Vol: decreases as the swap rate increases	Sticky-Strike Regime Expected Behavior 1.       Fixed Strike Vols : Independent of level of swap rate (or forward swap rate) 2.       ATM Vol: increases  as the swap rate level increases
Sticky-Moneyness Regime Expected Behavior 3.       Fixed Strike Vols : increases as the swap rate increases 4.       ATM Vol: independent of swap rate level	Sticky-Moneyness Regime Expected Behavior 3.       Fixed Strike Vols : decreases as the swap rate level increases 4.       ATM Vol: independent of swap rate level
Classical Uncertain Regime Expected Behavior 5.       Fixed Strike Vols : decreases as swap rate increases 6.       ATM Vol: decreases	Classical Uncertain Regime Expected Behavior 5.       Fixed Strike Vols : increases as the swap rate level increases 6.       ATM Vol: increases

Speaking of volatility, here is an update of the cross asset volatility chart (see here for details, click to enlarge).

This chart presents volatilities across different asset classes in a comparable manner. Since the spurt of vol in rates since May this year, the volatility has switched back in to risk assets (commodities and equities) on the back of the Chinese Yuan devaluation. This supports the case that while positioning is important for rates, ultimately it is less about foreign central banks selling reserves, and more about which way the risk assets are heading. Historically that has been a better yardstick for directional calls on rates.

Equity Sell-Off : Looking Back

Histogram of S&P 500 one-month (20 days) move following a 3% or more sell-off, since 1960s. This shows historical probabilities of a recovery or a worsening sell-off during the next month, conditional on a 3% or worse sell-off today. Index is scaled to start at 100 after the first down move on day 1.

The worst 5 recoveries are all in 2008 Sep to Oct, except once in 1987 flash crash. The best 5 recoveries are mixed across time.

The cumulative probability of continued sell-off is 37.5%, Cumulative probability of 5% or more recovery is approx 40%. Median move is 1.9% rally. On cases we had further sell-off, the median sell-off is 6.6%, The median for rally case is 5.6% (so the distribution is skewed, as obvious from above). However, this skew disappear if you take out the tumultuous period of 2008 following the Lehman Brother failure. In that case the moves are slightly positively skewed, 4.6% sell-off vs. 5.4% rally. Also the cumulative sell-off probability drop is around 30%

But with all hard numbers, it is hard to keep calm when everyone else is in panic mode. 

Macro: The Total Perspective Vortex

What is driving the risk markets? Minimum Spanning Trees for risk assets below.

For global equities (based on correlation since Jan 2015)

And for global FX (based on correlation since May 2015)

Yes. A rather rhetorical question.

Trading Places: The Eagle and the Dragon

The question is: if China becomes US in 2008, can US play the role of China in 2008?

What are the bazookas the Fed left with that would really impress the market in such an event? Buying risky assets (i.e. equities) is a potential candidate. What else?

Further on China

As usual, a very good piece from Michael Pettis on China. Must read if you have not already.

Somewhat in line with my previous posts on this (esp the motivation behind the devaluation, the risks of capital flight and the re-distributive nature of different choices, see here and here). He does not talk much about risk assets though.

Note to Self: China M-Policy Choices

Which one is better?

Maintaining a dollar peg, while easing policy rates to counter peg-induced tightening? And promising Yuan will perhaps appreciate from here? In short, ask the savers to suffer, the conscientious borrowers to pay down the debts, the risk takers to continue their carry trades and corporate sectors to go fend for themselves.

Or let the currency adjust, and support with policy easing. Market mayhem and overshoot for a while. In the end it dies down. Effectively take money from importers/ foreign currency borrower and would-be tourists and give it all to exporters and foreign currency lenders. Kill the carry trade (and traders). The downside is huge vol now, and a very hard time convincing the markets if you need the peg ever in future (fool me once etc.). The outcome hinges on credibility and strength of FX reserves entirely.

Lastly, let the devaluation drag on a little at a time. Highly credible. Less volatility, and that too most of it elsewhere (EM). Pernicious if "no further devaluation" not credible, as expectation of further devaluation put pressure on capital outflow. The entire thing gets leverage out of the Impossible Trinity, potentially ending similar to above, but with PBOC looking like a fool.

Most agree CNY is overvalued. If PBOC does a full devaluation at one go closer to the fair value and promise no further action, most will be willing to believe. The question is can they? With Fed yet to decide, and other central bankers yet to see the market response, it is hard to see what is full devaluation.

There is a chance of a further devaluation in CNY once the Fed is done with their move. This present one was perhaps an unwanted and ineffective decision. Or PBOC's way of testing market reaction/ warning market participants. Or PBOC trying to fore-warn the Fed. Or whatever.

Take your pick.

Note to self: The "Surprise" Part of Yuan Devaluation

A little yuan devaluation created a strong reaction in markets around the globe. A less than 2% devaluation in CNY is not probably going to make Chinese companies overnight super-competitive in exports - they already are reportedly, and CNY is still way below recovering its appreciation against USD for last two years. Nor the foreign investors will worry about a 2% hit in their portfolio. The swings in Chinese equities demand their undivided attention. And no way this is going to spiral in to a currency crisis in a typical EM style with large external debt. This has a mere ~USD 20 Billion impact on Chinese external debt, even if you assume the entire pot is dollar denominated. That pales in comparison to recent capital outflows from China.

The surprise move is rather across global equities - which according to Bloomberg are selling off because of these Chinese incident.

Seriously? Germany has a large CA surplus against China, so yes, DAX should get a hit, UK has a large deficit, so FTSE should go up? Oh wait, what about less Chinese tourists, of course. Rhymes and reasons.

This is China trying to get more market in FX fixings, perhaps with an eye for SDR node from IMF. This has nothing to do with export competitiveness, or currency wars or anything.

What will be more worrying, indeed, if this has got anything to do with recent large capital outflows. If there is a large capital inflow in a country, the local currency should shoot up against dollars. To maintain a peg, the central bank must buy the foreign currencies (and invest in treasuries) and thus inundate the economy with liquidity in local currency. Quintessential Chinese story until very recently. The thing is: this machine runs in reverse for capital outflows. Now in this context, if today's devaluation, recent capital outflows and selling of treasuries by China (presumably the central bank and the sovereign wealth fund) are all related, then there is a little to worry there. In China you never know. But I would still not lose sleep over it.

US Asset Flows + The Thing That is Chinese Stock Market

Flows into/out of/ within the US. Treasury released the TIC data last week (for May). This is how it looks (international flows in to the US)

 

 

International flows in to treasuries picked up this year since Q3 last year, mostly driven by private flows (as opposed to official, i.e. other central banks and sovereign wealth funds). The total official year-on-year growth in flows in negative territory for the first time (apart from a flirting with it early 2014). However total flows still positive, money continues to be pumped into treasuries by foreigners. Negative flows since March this year mostly driven by the financial centers, i.e. the UK, Belgium, so is China (Mainland) and Hong Kong put together. However, Caribbean (presumably a good proxy for hedge fund flows) has been quite positive.

 

On other assets, the corporate bond turned a corner and now in positive territory, while equities outflows continue.

 

On domestic front, the total equities flows to mutual funds flattened out mid last year, but allocation to world equities still strong. And bonds funds flows have seen a comeback since start of the year, after a minor hiccup Sep last year (which is interesting, as that coincides with a strong sell-off US equities). Also money markets flows picked up, perhaps pointing towards a more defensive stance among fund managers and other institutional allocators. Flow to bonds outside US (including ETFs) has diminished quite a lot since Jan, after a strong pick up last year around March (not shown here).

 

 

Key takeaways: 1) treasuries are yet to be become hot potatoes among investors in view of rising rates 2) too many folks missed out the strong sustained equity rally in the US and in no mood to get back 3) overall institutions seems to be holding most cash in recent times. This hardly makes a case for a sharp correction in US equities - not by a rate hike at least. A force from outside is a different matter altogether.

And on the later point, here is a comparison between NASDAQ Composite and Shanghai Composite from a long term investing point of view. This shows average growth of the cash indices vs. volume weighted price (VWAP) since beginning July last year (when the Chinese equity rally took off, click to enlarge).

 

The point is, Chinese equities are still up on YTD basis, even after the recent carnage (15% YTD and 83% if you invested start of last year). One way to estimate the damage is comparing the VWAP price with an average price. The scenario of VWAP being lower than average price is a really bad one, as that signifies volumes in selloff was larger and on a net basis offsets the gain during the rally. In plain English: more people lost money than gained. The chart above captures this. The VWAP and average lines are close to each other for NASDAQ composite but the VWAP is outperforming the average for Shanghai Composite so far. So as of now, the market is still up in China, and no hidden catastrophic pain than it appears. Of course two things can offset this conclusion: Who came in last? If it is the regular Joes (with a higher marginal consumption to income ratio) then it is bad for consumption part of the GDP. Secondly we have the recency effect, this kind of sell off is unnerving. Where do you invest in China if you are the little guy? real estates are not looking great, bank deposits is value eroding, and equities, they simply has taken you for a ride. Increase in central bank liquidity is not that effective in a risk-off scenario.

Upcoming bid data release: US Q2 GDP advance estimate and Employee Cost Index, both on this Thursday.

Move Over Greece: The Down-Under Version

Since the surprise start of the week, and large rally in rates, rates are almost back to the levels it lost, with steeper curve, especially in Euro. Break-evens are little budged (except a sort of swing in sterling) and dollar marginally stronger and Euro marginally weaker. Only equities still nursing the wounds so far.

I think my optimism about UK turned out to be justified so far. Data-wise US, UK continue on strong data flow. At the same time, I think we are focused on Greece more than it deserves and missing other big thing in the bargain - the unraveling of the Chinese stock markets. This will definitely have a strong influence on the Australian rates markets. I have argued before that the AUD curve is to steep and has to flatten. Since then it flattened from 100+ to 70bps level and now back to 105 (in 5s30s).

We can propose a simple model of the factors that drive the slope in line with similar models for Euro and USD. The explanatory variables are the terms of trade (CTOTAUD Index on Bloomberg), RBA policy rate, and the China current account balance (GDP is also somewhat significant, but not included, inflation not much significant). The estimates are as below.

The model fits as below (click to enlarge)

Post-crisis there is a change in unconditional expected level of slope, which is higher that what it used to be before 2008. But also a couple of changes interesting: a higher sensitivity to China current account balance (as percentage of GDP) and RBA policy measure. The RBA part is as expected. On the China sensitivity, one conjecture can be that current account balance shrunk in China primarily as exports reduced, along with a reduction in imports. That directly impact Australia, and builds in pressure for bull flattening.

This, along with the current directionality of rates with slopes means a very asymmetric positioning for a AUD flattener. If we see a strong return of job growth and commodities inflations, we will see a more hawkish RBA, leading to a flattening. If we see a further worsening in sentiments from China, but no deterioration in inflations, the correlation should lead to a bullish move. A separate estimates shows for each 1 percentage point reduction in China current account balance (% of GDP) leads to a 30bps rally in 5y and 17bps in 30y in AUD.

Given this, and the recent steepening and sell-off in AUD rates, it is a good opportunity to enter a trade. It can be either a flattener (probably balanced by a 5y point to take care of the directionality) or it can be a 5y or 5y5y outright receiver. And all of this will have a positive carry. Which can be used to pay for a sell-off protection in either EUR, GBP or USD long end.

All good, then there is this one possibility of course.

Trade Idea: 2015 Top Trade Ideas To Start (Rates only)

This is exclusively rates only piece. Others may follow soon.

Trade Idea #1: Buy EUR 10y30y 2% payer vs 10y5y 4% payer (Macro)

Rational: The Euro long end is ridiculously low. Lower than even Japan. Even the long-dated real rates are trading negative. This is a great trade to position for any correction whenever that happens. The extreme bottom right of the vol surface has developed fantastic vol carry vs. other points on the surface. The forwards are near-about the same (and historically they have been same). The spread has moved in negative correlation to 10y swap rates in post-Lehman era. Now it is near historical average. Given current level of rates, we will see a break-down of this correlation in a rally (i.e. the spread does not move much, the trade benefits from carry). In a sell-off the trade benefits from delta. The trade also benefits in a steepening scenario if Euro area moves further close to Japan. The adverse scenario is a bull flattening. Given the current levels, a large move in that direction is unlikely except a) another euro crisis b) strong yield chasing flows in to the longer part pushing 10s30s down. The trade will be net long gamma in any case. So a strong convex pay-out which costs nothing to carry.

Trade Idea #2: GBP 5s10s steepeners against  USD 5s10s (Cross market)

Rational: The convergence and the relative rally of GBP rates compared to USD last year was mostly a correction of the over-optimistic inflation pricing in GBP. However the underlying growth numbers for the UK has remain quite solid in terms of private consumption and capital formation, apart from a few misses in PMIs. This year, notwithstanding the election, this should continue or even pick up in speed. However, given the influence of the Euro area economies (largest trade partner for UK) , the pressure on inflation will remain on the lower side. Also the sensitivity of UK inflation to oil prices are comparatively low. This will keep front end rate hike pricings in check and may lead to a steepening in 5s10s on the back of solid economic growth. On the other leg, the US is more closer to a hike and the Fed may indeed go ahead with policy rate hike mid this year. This will lead a solid performance of this trade.

Trade Idea #3: 20y1y vs 4y1y steepener in swaps (Carry)

Rational: Unless we have something really surprising, Europe is potentially in the area of low-for-long for a while. That makes having a carry trade in the portfolio an absolute necessity. This combination is one of the sweetest spot, in terms of the carry generated per unit of risk taken. This spread in particular has also seen a sharp flattening from around 150+ bps to 85 bps area. This brings it back to about the same levels of the pre-crisis average. This presents an opportune timing to enter this trade.

Trade Idea #4: EUR Long-end ASW (Macro)

Rational: The long end ASW in Euro (swaps vs. Germany) has recently shown excellent correlation to vols, not only in rates, with equity and FX vols as well. Given the massive QE from ECB compared to Germany supply, and given the positioning in the market, the long end ASW should widen from here. In a rally, Germany long bonds have still room for yield compression and flows should work for the trade. In a sell-off, given the strong long positioning in rates, the hedging pressure will force ASW widening across maturities. Therefore the long-end offers a convex bet. Plus the correlation to vol, if continues, gives excellent way to position for long vol, as the trade will carry positive.

Trade Idea #5: Pay EUR in 10s30s (steepeners) vs USD (Cross-market)

Rational: The EUR 5s10s30s fly is too cheap, primarily driven by the too flat 10s30s leg. With the Japanification of Europe, the front-end of EUR and JPY swap curves have settled in to similar patterns. The anomaly lies in the long end. Any normalization from here will support this steepener on the EUR leg. On the USD leg, a possible re-pricing of rates (terminal rate) will keep the flattening pressure. Over the latter half of the past year, the major changes in the rate hikes pricing has been a front-loaded timing along with a lowered terminal rate. Any surprise in wage will impact the terminal rate upwards and will help the trade. On top, any long end carry related flows in to treasuries, buoyed by liquidity from ECB, BOJ and other central banks, will add to further flattening pressure even in a rally. The package can be done either through payer swaptions or through swaps. The swaps version carries better. A more efficient version will be expressing the views through the 5s10s30s fly (instead of 10s30s), which is almost flat to carry. However, the better carry comes at an increased risk of a 5y led sell-off in the US.

Trade Idea #6: Buy USD 2y1y 2%/ 2.5% payer spread (Macro)

Rational: The current ATMF is 50 bps cheaper than the minimum policy rate from the FOMC committee projection for 2017 as of Dec 14 (last available projection). This trade attempts to capture the good chance that the market is behind the curve from the FOMC. The structure takes advantage of the high payer skews to make a 4:1 pay-out ratio (max) if the view realizes. The carry is negative but tolerable.

Trade Idea #7: Buy 6m30y straddle in EUR vs 6m5y5y midcurve (Tactical)

Rational: The recent uptick in vols in most asset classes can extend its scope and bring back the missing vols in rates. Given the rates level, most of the action will be in the long end, in either direction. This trade presents an efficient structure to get long gamma on the long end while selling the expensive midcurve vol on 5y5y. The ratio of 10y to 5y vol is near historic high, making the midcurve attractive to sell. A premium neutral trade will be net flat vega, carries flat initially, and long gamma on the slope (and significantly long gamma on rates levels on the rally side). In recent time the 10s30s slope has been dominated by 30y (than 10y) and this presents an effective long gamma trade with little cost to carry. The downside is of course flipping correlation and 10y whipping around instead of 30y. The main scenario under which this can happen is an exogenous (led by the US perhaps) general sell-off in rates.

Trade Idea #8: Global Commodity Slump trade - Buy AUD receivers Vs USD (Macro)

Rational: The global commodity slump will stay here for a while. This is not helped by a Chinese slow-down, which may grow even lower than 7% depending on how the policy makers steer ahead with liquidity. The result is a global glut of liquidity and rally pressure on all commodity currency economies. The ones affected most will be ones with starting higher level of rates and large and relatively free economies. Australia is in the preferred choice. The sweetest spot in terms of carry should be in intermediate left. However even 10y or belly receivers should work. Outright, or against the USD rates (or GBP rates, i.e. economies in general poised to gain from lower commodity prices and higher liquidity).

Trade Idea #9: Currency Peg Trade - Buy DKK belly receivers against EUR (Macro)

Rational: The massive QE will put pressure on all currencies pegged to EUR. Unlike SNB, the Danish central bank has been maintaining peg since the Deutsche mark era. So it is indeed a tail event to remove the peg. However, the more plausible way to fight pressure from Euro is even more depressed rates. We have not yet seen the pressure on DKK in scale, evident in the FX reserve change in Nationalbank balance sheet vs SNB. When that does build up we will see further rate cuts, possibly into deep negative territory.

Trade Idea #10: Sell forward Euro HICP floor spread, strike 0% and -1% (Tactical)

Rational: The recent deflation fear made the Euro HICP 0% floor to blow out with a large spike in inflation vol. Given the ECB action and the still positive core inflation (and the downward price + wage rigidity), this is an opportunity to cash in on the panic dislocation. The risk is that we get stuck in policy inaction in case of further deterioration of the situation. The spread makes positive PnL till about -0.5% (note: ball-park pricing here). Even for Japan the average inflation prints between 2000 till before the 2008 financial crisis was -0.5% (and much better post crisis). The upside also includes a sharp correction in energy prices. Alternatively, the trade can be structured as a real rate trade, by buying matching floors on the Euribors.

Macro: Europe Leaking, A Rate Hike to Fight Deflation

Things you must not miss reading this week

1) From the ever-impressive Flow team from JPM (via FTAlphaville) on how Europe is Leaking...
2) A brilliant observation from Michael Pettis on why PBoC should hike rates to fight deflation...

2015: Points to Ponder

As you gear up for the year end, here a list of things and points for the next year. To mull over, without any iota of attempts to forecast!

1. Oil: from peak-oil to freak oil. And how the story unfold will be driving a lot in 2015. IMF Direct (the blog from IMF) had a very interesting piece on this recently. They estimate unexpected lower demand can account for only 20% to 35% of the price drop. And they find little evidence of financialization. In this context what is surprising is the speed of adjustment. For 2015 most analysts maintain gloomy forecasts for oil. Perhaps rightly so. But a lot of that comes from forecast of continued lower demand from China and Europe. Given the lower contribution of demand in the price change (as above), and the still volatile geopolitics of a large part on the supply side, the question remains what if there is a strong come back of oil price in 2015? It will mostly reverse what we have seen in 2014. The hysteresis loss will be for new investments in oil sector with renewed long term risk assessment; and in Europe, especially if the ECB had not gone through with the QE by then.

2. Russia: very much related to above. Will they get out of it? yes if the oil price bounces back. What if it does not. That is the hard part to speculate. On the face of it Russia does not look particularly bad on economic parameters. Yes, the inflation is running a bit high, and the GDP has slowed down. But they have been there before. The missing links are current account weakness, ruble appreciation reversal, and the possibility of capital flight. Krugman explains the first two of them here. The last part is the hardest to explain and quantify. See here, for example. And in my opinion this is the most crucial make-or-break factor. Russia will survive in the short run if the oligarchs have a lot to lose otherwise, and if Putin survives.

3. Wage growth: That will shape the Fed policy to a large extent. We have already seen some encouraging trends. 2014 has been a great year for job growth in the US. 2015 might as well be a good (perhaps not great) year for wage growth. If that is supported by lower oil price, it is good. If that coincides with a sudden rise in oil price, that can spook the market and push up break-evens and rates.

4. Housing: One of the weakest part of the so far good enough recovery of the US, is the contribution of housing to the investment component and hence the economy. The flow of funds from the Fed has consistently shown continued deleveraging in mortgages while consumer credit picked up. The higher mortgage rates and increasing prices did not help it either. Historically the contribution of housing to GDP is near record low. And that to me seems like a lot of upside in 2015.

5. Europe: If we have a Grexit start of the year (or even a panic towards that), that will greatly ease Draghi's case for an all-out QE. European equities missed out a lot compared to elsewhere, and can benefit from both improved earnings and re-rating. As I mentioned before, I think people are unusually bearish on Europe now (just like they were unusually bullish a while back). If you think the US equities are done with most of the run, and Abenomics not really working for Japan, and missed out the Chinese rally and now scared of the EM, you do not have much choice. On the rates side, a lot of the curve flattening has been driven by global influence and a re-pricing of the long end. I do not think the rates market is nowhere near as confident of a QE as most analysts are. The European swap markets now looks hardly any different from Japan. And with much much better upside.

6. Abenomics: And speaking of Japan, which I frankly do not understand much, all I say I do not see Abenomics working. The problem with that is if Abenomics does not work, the challenge for the subsequent governments will be progressively humongous. What are the odds that we will stop to see the yen rallying in a global panic? And what are the odds we will actually see yen selling off in a panic? I will keep rolling my yen shorts. In good times or bad.

7. China: Perhaps most discussed. One good thing about China for traders and investors is that China, with its mighty central bank and strong command control hardly produces any large surprise for the markets. (Of course the antithesis is that when the surprise does come it will be huge and bad, but somehow I do not buy in to that yet). With the rally belying the economy, the central bank and policies will be in the driving seat.

8. The bull run in India: I am a believer. Well for one, the benefits of the large oil re-pricing on India is still totally lost in the panic about EM. In fact India has been a net importer of non-agri commodities. So recent secular weakness is a huge bonanza if they sustain. In terms of valuation it may not be cheap, but much scope remains for earning improvements. 

9. Return of volatility: A sustained period of low vol can be policy driven (when the central bankers become sellers of vols), or it can be just a phase of a complex system. Because low vols just happen some times. FX has already seen some uptick in vols. And yes, commodities of course. May be time for the rest.

10. What else: move away from rotation to diversification? a policy-driven liquidity crisis? year of the frontier markets? crisis in Europe? middle-east mayhem? HY melt-down? comeback from the UK? Wide open. As always.

Best wishes and a happy new year