Markets | Trading the "Bond Bubble"

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

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

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

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

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

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

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

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

Macro | Cross Asset Correlation Update

The markets seem to slowly leave behind the massive focus on fiscal impulse following the US presidential election, and the inordinate amount of stress and optimism about the US dollar rally. This is already reflected at least in terms of asset price behaviours, if not media and analysts focus yet.

Cross asset macro drivers for 2017 YTD (based on first factors extracted from principle component analysis for each asset class) looks much like H1 of 2016, which saw a cautious rally in risk assets following the early stress period - albeit now it comes with reduced influence of oil prices and volatility on risk asset prices. This stands markedly different from the H2 of either 2015 or 2016 - which saw a pick up cross asset correlation (with very different outcome, a risk-off move in H2 2015 and a risk-on rally in H2 2016). The MST charts below captures this dynamics pictorially.

Among the risk assets, DM equity factor shows increased positive sentiments to rates (i.e. increased yields leading to rally). Inflation has become more important for DM equities as well, while FX has virtually no influence. For EM equities, the latest trends has been a slight de-sensitization to rates and FX movement, although they remain significant. The credit factor also picked up its correlation to rates (and FX, which is mostly influenced by EM credits part), while retaining correlation to inflation.

This makes the rates and inflation path the most important determinants for risk assets at present - at least from Developed Markets equity investors' point of view. Markets will always react (or over-react) to tax cuts expectations and presidential elections. But we are now, it appears, back to the basics.

On this fundamental note, we have seen some recent encouragement in global inflation space. The left chart below shows GDP weighted CPI inflation (global top 20 economies as well as Developed Markets within that). Since the recent bottoming out at start of 2016, we have seen a secular rise in inflation, which is more pronounced for the DM case. However, the core inflation scenario (not presented here) is far from running hot. Core inflation in the US and China have improved from 2015 lows, but much less dramatically. Only in the case of Euro area this has been solid (from very low levels). One the other hand, global credit growth (right chart below) appears to have topped out in a secular manner. On the positive sides, the wage growth in the US (not shown here) has been encouraging and sustained.

If we consider these points, in the context of extraordinary monetary accommodation that exists across the globe today, we should be more hesitant to conclude we are heading towards a definite normalization anytime soon, in spite of strong sentiments. The rates market seems to agree. We have seen inflation recoveries in 2011 (remember the ECB hike mistakes) and also in early 2014. It was a misfire in both cases. A weakening credit impulse and barely normal inflation in the face of extraordinary monetary stimulus represents a global demand which is far from recovered. This makes the case for removal of these extraordinary monetary measures very difficult - most policy makers are still biased to err on the upside inflation naturally. That is unless we see the whites in the eyes of inflation - in which case, it either may be too late, or have to be too harsh and steep. For now, the forward looking inflation measures (both market based like break-even inflation and model based like Cleveland Fed now-cast) remain stable without any sign of worrisome upward pressure. This means the risk assets will largely avoid negative reaction by a possible June Fed hike (market probability of 67% as of date priced in). The key risk in this regard remains any (mis-)communication or premature taper on the central bank balance sheets.

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All data from St Louis Fred Database

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 | How Sustainable is the US Dollar Rally

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

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

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

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

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

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

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

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.

Central Bank Watch: FOMC Minutes (and RBI)

It is highly interesting to see the views and counter-views on the impact of  low rates on the DCF industry. I think both miss the subtle point here . All these DCFs and PVs and pretty much everything else depends on an assumption of properly functioning lending and borrowing market. The question is: if negative rate does persist for long, will that assumption breakdown, or will adapt.

Speaking of rates, the FOMC minutes released this week was very informative. It was a much ambivalent FOMC than we have seen earlier. It appears the September hold decision was a close call. So it is safe to assume it will be so in November and December (if no hike in Nov) as well.

On the major points that drives the"data dependent" FOMC, it seems the consensus is on the labor markets. Since the last meetings, we had more or less similar or slightly improved wage data. However, this week's job opening (JOLT) was a bit disappointing. On economic growth expectation, retails sales data from Friday was more or less on the mark, matching street expectation, and capital goods from earlier has shown improvement as well. Even the much discussed negative influence of foreign GDP has subsided. Eurozone forecast edged up to 1.3% from 1.2%, and UK forecasts from 0.50% to 0.70% (since Sep FOMC). 

However, surprisingly, on both of these parameters, Fed's own measure is going the other way. The Labor Market Condition Index and the Atlanta Fed's GDP now-casting have both nose-dived in recent readings.

On the inflation front, the both the CPI and PCE edged up since. The CPI is still suffering from energy prices drag. Given the recent moves in oil prices, this should have a positive impact on data before the next meeting. 

Overall, I expect the data to be neutral for both employment and growth and marginally hawkish for inflation for the November meeting. The possibility of a November hike is still lower. Partly, that will be a surprise for the markets - which currently prices in a 17% chance of a hike at November FOMC and a 64% at the Dec meeting. As I discussed before, Fed has never hiked before without a substantial chance priced in by the markets.

That said, one particular line of arguments stands out from the released minutes:

 A few participants referred to historical episodes when the unemployment rate appeared to have fallen well below its estimated longer-run normal level. They observed that monetary tightening in those episodes typically had been followed by recession and a large increase in the unemployment rate. Several participants viewed this historical experience as relevant for the Committee's current decisionmaking and saw it as providing evidence that waiting too long to resume the process of policy firming could pose risks to the economic expansion, or noted that a significant increase in unemployment would have disproportionate effects on low-skilled workers and minority groups.

There were only two major hike cycles not followed by a rise in unemployment in recent history. One was following the early 80s recession, and the other following the early 90s recession. 

This points towards a strong commitment of FOMC towards a gradual rate hike, even if the initial hike has to be brought forward in time. It will be very surprising if we do not have another hike by the end of the year. But this, along with the now-lower long term equilibrium rates, also means it will NOT be particularly threatening to US equities or rates in general (both slopes and levels). Fade the move if any respond violently to FOMC one way or the other.. Both equities and rates should depend less on FOMC and more on intrinsic and unexpected events.

Talking of unexpected evens, the one is of course the US presidential election. The general expectation is a sell-off if Mr Trump wins. Although I fail to see a rally even if it is Mrs Clinton. And of course market expectation can be wrong. In 2012, it was widely expected that a Obama win will be bad for equities, and indeed there was minor sell-off leading up to the election day. However the results marked the start of a long stretch of bull run.

October was also a historic moment for Reserve bank of India. It was a new Governor (following the exit of Raghuram Rajan) and its first ever Monetary Policy Committee decision. And it was a decision quite difficult to understand - an (mostly) unexpected 25 bps cut. RBI revised GDP higher, and both real rate and inflation lower. A lower real rate expectation usually means a lower potential GDP. That means a higher GDP will lead to a potential overheating. A lower inflation rate is not consistent with this, unless RBI is expecting substantial imported disinflation.

India's decreasing credit growth is a worry, but it is not clear higher rates are the culprit here. The decline is driven mostly by the industrial sector - which presumably has more on its plate than to worry about higher rates. And in any case the pass through of RBI rate cuts by the banking sector has not been exemplary in recent time -which has been mired in its own significant bad loan problems. It was appeasing to the markets (and politics perhaps), but hard to imagine how much, if at all, it will help the economy forward.

Markets: Volatility Ahead

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

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

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

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

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

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

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

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

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

Macro: The End of QE-topia

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

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

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

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

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

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

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

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

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

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