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.

---

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

Markets: The Yen and The Yang

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

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

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

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

Macro: FOMC Dot Plots, The Secular Stagnation Illusion

One of the major surprises in the March FOMC meeting was the re-marking of the long term rates as expressed by the Fed dot plot.

While most speculators were cutting their short bets on the 10-year treasury (as per CFTC commitment of traders reports) and were actively going bullish on the long-end, the short end short positioning was mostly maintained. This was especially supported by the up-tick in the inflation data in core and headlines before the FOMC (as well as inflation now-casting from the Cleveland Fed).

There are conspiracy theories about the Fed's worry and motivation for a weaker dollars in response to the bold liquidity enhancement actions from other major central banks. However, if we really take a deeper look in to it, a different story emerges⁽¹⁾.

FOMC started publishing the dot plot in 2012, between the QE2 and the QE3 phase. Looking at the evolution of the dot plot implied fed fund term structure, there have been two major changes since. First one happened just before the start of the QE tapering. That was the beginning of a steady upward shift for the fed funds rate in the near horizon (~3 year), where they stabilized. The second set of changes came in later half of 2014, which resulted in another gradual move. This time it was a downward shift of the long term rate forecast. From the peak of 2014, the FOMC estimate of long term fed fund rate is down by 75 bps. (Note I have projected the long term rates from the dot plots to 5-year maturity bucket.) Some suggests the Fed is slowly embracing the secular stagnation theory.

There are certain amount of merit in that hypothesis. The current projection implies, assuming Fed's target inflation of 2 percent is realized, a long run real rate of 1.25 percent. And irrespective of your view on the r-g model, a lower r does signify a lower level of long run real GDP growth. For the balanced case of r=g, this implies a growth rate of 1.25 percent.

This seems pretty pessimistic from the recent trends in real GDP. Figure⁽²⁾ below shows the trend in real GDP (normalized at 100 at the beginning).  The post crisis slope (since 2013) is definitely flatter than early 2000, but not by a huge margin (except Euro area). Add expected inflation to this numbers to get the long run nominal rates. Depending upon your preferred choice (10-year and 5-year swap market breakevens at 1.8 and 1.6 percent respectively, 5y5y TIPS breakeven at 1.66), this seems to imply a long-run rate in the range of 4.1 to 4.3 percent. Almost a full percentage point above FOMC dot plot.
The market seems to be even more pessimistic. The chart⁽³⁾ shows the spread of 1 month USD Libor (implied from the euro-dollar futures and swap curves) vs the FOMC dot plot. The 2013 taper tantrum was the only time when the market got spooked with a rate hike and over-estimated the future path of rates. Since then, it has steadily become more and more pessimistic to the FOMC prediction. The largest disagreement is in 3 years and beyond.
This level of suppressed nominal rates means either the market is pricing a marked departure in the growth trend from what we have seen even post-crisis so far. Alternatively it means a near term recession and/ or more liquidity measures from the central bank. Or at least it is pricing in the Fed's inability to hike rates substantially given the situation in China and Europe and Japan. So far the Fed has been doing the catch-up to the markets pricing.

The first possibility is what secular stagnation is all about. So far most of the evidences have been important and potentially even supportive, but at the same time inconclusive. It is not certain the impact attributed to secular stagnation is really a not cyclical effect attributed to a long run structural change. In fact Larry Summers, who revived this idea of secular stagnation in 2013, is himself very much aware of this. See the disclaimer in the last paragraph here. There has been many different views on this, for example see here for the counter-view from former Fed Chairman Bernanke. Real-time economics is hard. It will be much easier to settle this debate after a decade or two. But right now, I think the biggest argument against secular stagnation is the prior probabilities. The long run world growth rate data (for example see here) shows a staggered improvement, with last great bottom around just before the Industrial Revolution.  All recent variation in world GDP since post war seems more or less cyclical phenomenon in this scale.

And the other possibilities to justify such depressed nominal rates are definitely cyclical. In fact the FOMC statement and general stance so far, downplaying secular stagnation and emphasizing inflation, clearly shows the Fed is eager to keep its options open. Secular stagnation is a rather long-term commitment to a particular view around equilibrium rates, GDP and inflation. It does not come handy to set appropriate monetary policy expectation and maintain credibility at the same time in real-time economics.

And in that scenario, near to medium term growth and inflation outlooks are much more critical. This also means a higher volatility and data dependency as the markets as well as the Fed react to data. The recent inflation uptick has been feeble, but definite. The fear of Yuan devaluation has subsided significantly. Given Fed's stance, it is perilous to believe the only move for the long term rate for the dot plots are down.

---

(1) data from Federal Reserve
(2) data from BEA, Office for National Statistics, Eurostat
(3) data from Federal Reserve, Bloomberg

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.

Inflation: It is Still a Long and Winding Road Ahead

With the commodities seemingly bottoming out, we have quite a strong reversal of moods in the market about deflation. Suddenly there is lot less worry about disinflation and lot more chatter about rate hikes. It is true since the bottom in Jan, Brent is up 42%, WTI  36% and the broader CRB commodity index is up `9% since the troughs around middle March. And breakeven inflation market followed the suit across markets, in EUR, USD and GBP. 

However, we are perhaps far from writing off the disinflation fears. The goods prices, including energy prices, have bounced back from the bottoms, but the services shows a very different story. And I believe this is the story of the underlying inflation pressure once the base effects and transitory effects settle down.

The Euro area is really really far from coming out of dis-inflationary pressure. The MUICP service YoY prints has been, and still is, steadily going down in a trend that started mid 2011. There was an interesting article from the excellent IMFDirect blog about the NPA dead-weight on the banking sector. This is definitely NOT helping. As mentioned earlier, the QE impact in Euro has been less successful in terms of inflation and real rates, spectacular as it was in terms of nominal levels and exchange rate.

And as expected, UK services are quite in sync with the Euro area following the downward trend. The only one robust among this is US. 

Last week's large sell off in rates was triggered by Euro zone rates (perhaps supported by the M3 and the ECI prints from the US). However, this is no repricing of economic outlook. The sell off has been entirely in real rates, with breakeven hardly moving much. This shows the sell off was definitely driven by QE positioning. Most likely the players front running ECB has a sudden change in mind and scampering to get out, triggering lots of stop losses. 

And as Goldman Sachs explains, this can definitely be a self-fulfilling cycle. ECB pledge to buy papers floored at negative 20 bps means players can push the price of any papers subject to that floor (unlike long term investors who will abhor the negative yields). So as more and more bonds get in to negative zone, less and less papers are available for ECB to buy. So this will push down the prices of longer and longer dated papers down without any concern about fundamentals. And unfortunately it works in the other direction as well. A significant sell off can trigger further sell offs.

And this makes taking directional views on euro rates very hard. 30y swaps moved from a bottom of 72 bps to current 113 bps in merely a week! This makes the whole market very sensitive to issuance calendar determining supply. 

ECB: Negative Rates Strikes Again!

On the occasion of 3 month euribor turning negative for the first time in history, here is a quick look at the policy rate corridor in Euro Area

What you see before the 2008 crisis is the original intention. The eonia and euribor tracking each other and the policy rate (refi rate) closely. The deposit rate and and the marginal lending facilities are uncollateralize lending and borrowing rates for bank with ECB. So naturally they straddle the other market and policy rates.

Then something changed after the crisis. Immediately after, and more emphatically in later half of 2012, the market rates (euribor and eonia) decoupled from the policy rate (refi). Finally ECB caught up in 2013. But eonia still trades below zero consistently. And today 3m euribor fixes below zero for the first time. Germany is negative till 8 year. 10y bunds on its way to trade below zero. Investors are ready to lend money to Germany for a meager 50bps for 30 year!

And we have quite a few months of QE left for ECB! A few more possibly if the inflation remains stubbornly moribund beyond 2016. Draghi categorically mentioned no further cut in depo. ECB under Draghi has been less prone to make statements in advance, or as Mr Draghi says, "pre-commit", without solid reason. So we can, for the moment, assume depo stays at negative 20bps.

The success of ECB QE is ultimately measured in inflation and inflation expectation. On this measure so far it has been moderate (see here). It remains to be seen if the bonds shortage issue come up in near future how ECB is going to handle that, without further cutting depo rate. 

Meanwhile we can assume they will not, and paying eonia on that assumption is the natural trade.

Widow Maker : The Latest Avatar?

Ever since Draghi declared "whatever it takes" in 2012, traders have constantly put their bets on euro rates long end normalization. The arguments were many - take your picks from below 

1) a pick up in credit situation (touted since 2012, there are early signs appearing this year)

2) resolution of debt crisis (it is perhaps not a "crisis" any more, but certainly not resolved either)

3) pick up in growth (we have seen consumption recovered a bit, but not enough) and general good feeling/ green shoots

4) add your custom reason here ... (bond vigilantes, anyone?)

Since then, the euro long end rallied a 170-180bps (swaps and Germany long dated papers). To be fair the rally started in full throttle in 2014. But even then, the euro long end normalization trades have hardly paid off. This year itself, the euro long end rallied another 70+ bps, with no sign of a reversal. The question is will the inflation and QE chase each other out and make the long end "normalized" sometimes in near future, or are the long ends already normalized at current levels and we do not know it yet.

In Japan the 30y swap trades around 1.3% area, whereas in Europe it is down to around 0.70%. The 5s30s yield curve spread at 110bps for Japan vs a meager 55bps for Euro. And the reason is as below

Japan and Euro area has similar amount around 10y and more, but Euro area is more skewed towards long dated. On top, ECB QE has had a much stronger impact than BoJ, partly because initial BoJ QEs were weak in comparison. In a yield chasing environment, 10y point on JPY curve sounds a more suitable comparison point for 30y euro swaps. And to get there, we have some ways to go. The JPY 10y swaps trade at 0.50%, and the JPY 5s10s at 25bps. To do a Euro long end normalization trade two things are required. A stop loss large enough to see the bottom, and patience. 

So the message is simple: if you are not in a downside protected positive carry trade with a longer term trading horizon, you probably should not be in it.

And for this same reason (economies aside), UK long end is more vulnerable to further rally than the US.

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

Inflation - Oil and Bad Press?

"Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man" - Ronald Reagan

We had the last ECB before the holidays and before the market doubles down on its expectation of QE in January again. This is how Euro traded yesterday during the press conference

More dovish, and no actions. But action was hardly expected. We still have an TLTRO to go, and it is already almost Christmas. The positioning build up, both in Euro and in short end rates, before the meetings indicated there is a good chance of a disappointment move. And it played out more or less like that. But that should not budge the long term Euro shorts.

One important point was what Mr Draghi made clear about crude prices. For last one year, ECB has always downplayed the reduction in inflation due to energy prices, citing it as a transient and volatile component. This, for me at least, is the first time ECB showed a genuine concern that this transient impact may pass through to inflation expectation and become more permanent. ECB does not sound comfortable at all in the recent decline in crude, and in no mood to brush it aside citing energy as a volatile component any more.

This is exactly the counterpart of what happened in April 2011, when ECB unexpectedly hiked rates. ECB models are sensitive to pass through second order effect of energy inflation. This time it is acting in the favour of the doves. Keep your Euro shorts rolling.

Stepping back from ECB, and looking in to the inflation picture globally, it seems things are not as bad as made out to be. In spite of the oil crash. See these charts below

We had too much of press about deflation and disinflation this year. But globally, core inflation in fact picked up over last year (see Trend I), apart from Euro-zone. Of course the absolute level still remains uncomfortably low for many countries. And if you take a closer look you will see the chart in Trend III is remarkably similar to the first chart. Global core inflation picked up mostly driven by wage growth, in a classical manner. Change in exchange rate has lower significance on its impact on the inflation and same goes for classical money supply (note these excludes any QE or QQE).  And this also suggest the mere disparities between Euro area countries will require more innovative solutions than plain vanilla QE

Euro Glut: A Global Look

If you have not already read the latest note from Michael Pettis, then please do.

And also do read the note from George Saravelos on what he terms as "Euro Glut".

These are not particularly fresh new ideas, but definitely worth mulling over and have got much less attention in the media, as well as in the blogospehere, than the "new normal" and "secular stagnation" theories. In fact the original piece from George Saravelos also has a scary graph of the current account of Euro area, China and the US.

However, this graph becomes less scary in a slightly expanded perspective. Below is what I gleaned from IMF database (via Bloomberg) on excess domestic savings vs investment (equivalent to the graph mentioned above).

When you take a closer look, the "Euro glut" post 2010 is worryingly out of line. But if your focus is global, then perhaps you should also not miss the sharp drop for China post 2008 and Japan two years later. The gap between required investment and savings for emerging markets have grown stronger and the rest of the Anglo-Saxon world (the UK and the dollar-bloc) still provides a good demand for exported savings. Although it is not clear how much of it is sustainable in a world where Europe continues to build up and export excess savings. And China heads for a soft landing.

What is truly remarkable is the correction in the US, which is equivalent in magnitude in Europe. Nobody seems much concerned about it as correcting a negative current account balance is supposedly good for the economy. The question is if the US stops buying, then who else?

As pointed out in Mr. Pettis' note, there should be plenty of opportunities to invest surplus savings. The trouble will be if the excess savings export remains focused on the return of capital, than return on capital. And of course positive return investment globally can perhaps more than match exported savings from Europe in magnitude, but not necessarily in speed.

In the short run, it is speculative to worry about this. For one, apart from Europe, the world as a whole is already moving towards balance. And European imbalance is a recent phenomenon. It is not clear how long it will continue to build up. Even including Europe we are much closer to a balance than we have been in a long time among the developed economies. Which is good, as balance is good. Cheap capital for proper investment is good. But this is also a bad news, as the US apparently now have a lower capacity to absorb investments. The CAPEX figures from the Fed Flow of Fund data have been less than encouraging for years now. Excess savings in an environment of less investment opportunities mean basically a globalized version of Japan. So it all depends on if this will continue, and if yes, how much it will build up and where the savings will head to.

Of course, this assumes only the flow matters, but stock is important too. We do not know how much Chinese or European investment stock is on the sideline and waiting to be exported. (or conversely, how much unmet demand in peripheral Europe is being neglected by banks unwilling to lend, and how fast this "Euro glut" can reverse on active policy and optimism.) If they do flow out, it is positive for foreign assets in the short run. And if they do find a home in real positive return investments it is great in the long run too. If they overcrowd economies with little investment opportunities, it will push the real rate down and impact investment. So on the optimistic side, this is positive for emerging market economies (including India) in the long run. And as long as we can keep the global demand up, it is positive for pretty much everyone.

And finally, yes the absolute numbers are large. But when you compare them to world GDP, this total imbalance appears much less benign (less than 1% of world GDP for Euro area, China and Japan combined). In a world with perfect trade and capital flow, this should take care of itself. In real world, this is large, but not earth shattering!

So short the euro by all means, but not solely because of "Euro Glut". It is perhaps way too complicated than that. At least more than what Mr. Pettis seems to suggest how important the trade balance is. And more than just exports of savings. In fact in early 90s, the yen and the Japanese current account balance (as a percentage of GDP) moved in pretty much lock-step. In the way a simple trade model would suggest, currency strengthening in auto-correction when current account surplus builds up. Exactly opposite of what Mr Saravelos suggests.

People were way too complacent about Europe a decade back. And now way too pessimistic!

Mostly Inflation? The Week That Was!

Kind of stabilized after the sudden panic in world markets last week. Pretty much everything sold off, except high quality sovereign bonds - in a classic risk off move. And surprisingly the moves were much more magnified in rates than in any other asset classes. I have never seen such a scale of intraday move in rates since Lehman. May 2012 Euro crisis comes close (just before Mr Draghi gave it whatever it took). Possibly everyone scampering out of risk assets into safe haven. Or may be just exacerbated by leveraged players getting margin calls. I do not know. But what I do guess is at least in rates space the moves were supported by volumes. Not a random move without any prints. I think it is true many came in late Friday to fade the move and sell the panic. But I do not think it is over. 

Not with the ECB Asset Quality Review around the corner. And oil! Oh oil! It is anybody's guess what is happening there. A supply glut or a demand shortfall, or as this excellent piece  claims, a "future" demand shortfall! Or commodity carry trade unwinding. Surprisingly none has yet focused on the last possibility. At least I have not read about it.

One major reason was definitely inflation. Or rather lack of it. In US and UK, basically these moves bring back the real rates back to unchanged on YTD basis. Before June, CPI was moving towards 2%, and the street was worried on inflation. Now perhaps 1% is closer than 2%, The sharp change in break-even end of July pushed real rate higher. And now it is catching up. 

I wont be worried about that, rather this is an opportunity. If oil can crash, it can rally as well. There is no great economic force putting downward pressure on underlying wage and price inflation. For Euro area, it is just downhill though.

And that is worrisome. The question is can the global markets handle two large economies like Euro zone and Japan being basically moribund for a long time (with China heading for a soft landing)? And will ECB turn up with the print press and fill up the void (expected to be) left behind by Fed. See another interesting piece here

Flows and positioning was the second culprit I would surmise. Weeks leading up to the last, we have seen out-flows in short end Euro area bonds matched by strong inflows in the US fixed income and also UK to some extent (carry trade? probably yes). Elsewhere on the US curve flows were rather range bound, with relatively stronger inflows in the 10y+ long end. In the UK, the gilt short positioning in ETF space is now flipped to small long in fact. On the exchange, Eurodollar shorts started to cover even before the last week's large painful moves, and 10y note short positioning conviction was crumbling anyways. On the equity space, we have seen a secular outflow starting late August, strongest in Europe and also in the US tech stocks and the EM. In FX, EUR and JPY shorts, with new interests in AUD shorts, less enthusiastic USD shorts and quite convinced GBP and NZD longs were seen leading up to last week. Crude shorts were way out of line. 

So all the pain trades moved violently as stop losses kicked in - the JPY shorts, the ED shorts (rates shorts in general), and leveraged long equities. And I would not assume the slate is clean. These trades are still out there.

The trades going forward? stay long flattener in US, last week is hardly reason enough for the Fed to come up with QE4. Also I expect a short real rate position to pay off handsomely.

And for those long shot trades for a hit-or-miss go at the year end targets, here are two from me

1) long 5s10s steepener in EUR: I think 10y is much more prone to a break-out than 5y (whichever way). This supports a USD based sell-off in rates in Euro 10y which will lead to a steepening of 5s10s. This will also benefits from a higher take up in Dec LTRO and any strong move towards QE by ECB. Go for options to leverage it up. Dual digital with EUR adds further to it (a steepening in 5s10s without EUR/USD weakening is a relatively unlikely scenario)

2) pay SONIA 12x24 for long break-even trade (alternatively long US 2s5s through options). The correlation has been steadily high. The Sonia 12x24 is cheaper compared to the break-even (based on regression). SONIA 12x24 spread to Libor (1m, 3m, 6m or 12m) is at or below levels seen before the rate hike cycles since 2000.

And both need some support from your digestive track to put on as well!

Macro Views Series: 2014 H1 Quick Look-back

A quick re-look at the performances of the trades suggested at the start of the year (see here)

A mixed bag here, but overall, a really good performance given the rates rally that surprised most market participants. The 5s30s flattener in USD vs EUR is a huge winner, so is the short collar in EUR rates, and all carry trades in EUR. The AUD receivers outperformed as well. The losers are the long dollar trade and USD vs GBP convergence. These ideas are still valid. Especially the USD/GBP short end convergence. I will follow up with more on that

And totally irrelevant to the above, as you gear up for the World Cup 2014 final this Sunday, here is an excellent piece on why Lionel Messi is impossible!

Of Secular Stagnation and Other Worries

We have seen quite a bull run in the bonds market since the start of the year. Which has caught many people off the guard. The usual suspects are flow chasing yields after equity peaking off the tops, and risk off from Ukraine crisis. But perhaps something more at play here, and we take a look about the secular stagnation and a global japanification that is priced in the rates markets now. After the good rally this week

The peak nominal equilibrium rate priced in is maximum for USD. This is in spite of the recent difference between GBP and USD. This prices in a convergence of UK and US inflation and a higher long term real GDP for US. The recent bullish phase has been less about re-pricing the pace of rate hikes, and more about the terminal rate, i.e. estimate of natural rate of interest. Except in GBP where there is a large re-price of peak rate time (by 3 years!)

This, in my opinion, reflect a much less optimistic re-assessment compared to last year. The terminal rates should be determined by the potential output of the economy, and the pace of hike is an estimate of central bank’s degree of dovishness. This re-pricing of terminal  rate shows a possible shift downward of potential output itself

This brings us back to the pricing of a possible secular stagnation and Japanification. We run a simulation assuming 1) a further 50bps reduction in the maximum future rates (secular stagnation) and 2) as mentioned under 1, but also the maximum rate is attained 8 quarters from the current priced-in pace of hikes. The effect of these on long end rates are obvious, both depress the long end further, and 2) is more severe than 1). 

However, the interesting point to note is how the curve slopes get re-priced. From current level, scenario 1) shows a flattening, while scenario 2) shows a steepening. Indeed the curve slopes in JPY are in general steeper than G3. I think any re-pricing of pace of hike is less likely, especially if inflation has indeed bottomed out (for USD and GBP). We still have a chance for re-pricing of pace of hike for EUR. So as I see it, flattening to continue in USD and GBP, and expect further steepening in EUR.

Oh, and there is this interesting piece from FT Alphaville. Do check the link.