Macro | A Paradigm Shift For India's Retail Investors?

The Indian economy is at an interesting point. We had two large scale policy moves in recent time - the much controversial Demonetization in November last year, and the implementation of (a somewhat rundown version) of Goods and Services Tax regime this year. Early this month, we had the first GDP print following these two major steps. The headline prints came in lower than consensus - 5.7 percentage for Q2 vs. 6.5 (and 6.1 last quarter). This was followed by equally weak Industrial Production release. A stronger than expected headline CPI prints did not help, as this squeezes the room for any rate cuts from the RBI.

A closer look at the GDP data (see component break-down in the chart below) shows some serious weakness. The private consumption part (C) has weakened significantly following the demonetization (the vertical red dashed line). The investment component (I) has been weak for a while (although staged a comeback in the last quarter). Exports growth was not helped by a strong rupee. In last few quarters, government expenditure helped the headline a lot. But the sustainability of this is questionable. We will have the fiscal deficit data out later this month. But the street does not expect anything great.

The story of the IIP paints a similar picture (see chart below, overall IIP, manufacturing, base materials, consumer durable, consumer non-durable, capital goods, electricity, intermediate goods and mining respectively). While demonetization appears to have caused a negative shock, in general most of them peaked out before that, around early 2016 to be fair. The capital goods, which staged a minor comeback since bottoming out in 2014, again resumed the downward trend, along with most (except consumer durable, and to some extend mining).

This is all in a relatively benign global macro scenario. In spite of the Fed taper 2.0 announcement, we have little jitters in the markets. Rates, both global and local, are relatively low and volatility remains subdued. Oil prices remain range-bound. A rally in oil along with a weakening INR following Fed and expected ECB taper later this year can worsen the scope of fiscal stimulus. Most in the business sectors does not expect private investments to turn around before end of this year at the earliest. The investment exuberance back in 2004-06 left many corporates laden with unmanageable debt burden and bank balance sheets with NPA.

In this background of weakening macro story, the Indian equity markets is in a tear. The flagship NSE Nifty Index posted a YTD 21%+ gain, among the best globally and compared to it's own history. The trailing 12-month PE ratio is looking worryingly high. High valuation remains a big concern among investors in this, and most other traditional metrics (a bit better in terms of price to book).

However, comparing the PE ratio to its historical average is not very good way to capture everything that goes on to determine fair price. In the most basic approach, the price of equity is a function of market risk free rates (say the local sovereign bond) and equity risk premium. Following the approach in this paper from AQR, I modeled the BSE SENSEX P/E based on the risk factors - the bond yields as well as the equity and bond volatilities (as in the original paper) along with current account balance as a percentage of GDP (reflecting the fiscal risk of the economy) and spread of bond yields to US Treasury (captures the flow risks). The last two are more relevant for an emerging market economy like India. The time-series shows a marked shift in relationship between pre- and post-crisis era. I fitted the model only on (monthly) data from 2010 onward to capture the recent dynamics. As it turns out, the bond vol has little contribution to market risk premia for India. The bond yield and equity vol shows significant but low correlation, whereas the CA deficit and spread to treasury captures a significant portion of the variance. The chart below shows the fit on this model (adjusted R-squared ~0.72).

According to this model, the PE ratio is only slightly on the over-valuation side - not a cause of great alarm. According to this model, the market was highly over-valued around late 2011, and early 2015. We saw corrections in both cases. Also the under-valued period, early this year, was followed by upward corrections as well. This model does not forecast a large correction anytime soon unless we rally up a lot quickly from here (obvious caveat: these are in-sample results).

But what is most interesting, and perhaps most significant is the recent flows that we have seen in Indian equity markets. Traditionally, the equity markets in India has been shunned by a large portion of retail investors. The experience of scams in 1990s and the melt-downs, once during dot-com busts and another in 2008, did not helped. The foreign portfolio investors dwarfed the domestic flows in cash equities for a long time (although it is a different story in F&O). But since 2014, something changed. The extra-ordinary flows in to the equities markets, led by domestic mutual funds (presumably on the back on retail savings channeled to equities) completely outpaced the foreign flows.

Is this a mass optimism following the 2014 election outcome and equity rally? Or are we witnessing a major shift in the savings behaviour of retail investors in India. The retail money has missed the initial come-back equity rally following the 2008 crash, and a part of the early 2014 rally as well, where the foreign investors made out handsomely. But much of the late rally in Indian equities has gone to the retail pockets. Is this dumb money chasing recent gains? We do not know for sure, but as we argued above, we are some distance away from any valuation melt-down in Indian equities. And the flow signifies the loss tolerance of the retails - who are sitting on some comfortable profits - has quite a bit room before panic. And finally, the weakening property markets and demonetization may have incentivized a permanent change in retail behaviour.

We do not know for sure. But what is the implication if it is indeed a fundamental shift in savings behaviour? As argued above, the macro in India is down, but with policies properly executed, the turn-around can be sharp. If oil remains range-bound and the Fed and ECB do not stray afar from the implied forward curves, we will have little in terms of global shock to upset the local economy. On the other hand, the efforts to put banking sector NPA in shape, along with the full kick-back of the GST regime should significantly improve the badly needed private investments. Add to this mixture this retail savings paradigm shift, and we are looking at the very beginning of a multi-year rally in Indian equity markets.

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.

Markets | VIX - Waiting For Godot

By now everyone and their cats are aware that volatility across markets and asset classes are low, been so for a long time, and shows no signs of reversal. VIX, the US market benchmark vol index is around it's historic lows. The MOVE Index - the bond markets benchmark from BofA/ML - is no better. CVIX - an FX benchmark from Deutsche - is doing a bit better but nothing assuring. People have punted, hoped and feared a come back of volatility, but so far we have not seen any sustained sign of it.

The reasons and the expectations from analysts come under mainly two flavours. The first narrative is that volatility is artificially suppressed by big league volatility sellers (speculators, but more importantly those ETFs folks and systematic risk factors people). The second narrative is market in general is going through a hopeful optimistic patch supported by central bank puts. Both groups believe volatility is going to explode sooner or later. According to the first narrative, a potential driver is a random shock, that will force re-balance in ETFs and risk factors strategies and will amplify the move. The second version is we are just a few bad economic prints or some geo-political mis-steps away from a runaway volatility.

While both of these narratives have some merits, none of them is either sufficient or complete. Or even useful for any practical purpose. There are different opinions, but I tend to side with the arguments from risk factors people (like AQR) that this line of arguments vastly over-estimates the impact of risk factors portfolios. And it is hardly fair to blame some folks for selling vols in a steep roll-down scenario as we have these days (we have written about it before). On top there is certainly some influence from street positioning. As we have written about before, for a long time now, the dominant positions of the big hedgers (read big banks and market making houses) in the markets have been long gamma, putting a stabilizing effect and pinning the vol down. The second "complacency" narrative appears less plausible, but of course cannot be ruled out.

But irrespective of which one (or may be even both) you believe in, none is useful to take a position in volatility. Essentially the argument is: volatility is trading in a distorted way and we need an external event to set it right. It is cheap since such an event will surely come some time in future. Unfortunately, by definition, we cannot predict much about the timing of an unexpected external event. And presumably you do not have the luxury of an infinite stop-loss on the bleeding you will have while you wait for that vol exploding event to materialize.

In fact the only predictable statement to make about the direction of volatility is: when the rates go up, VIX will follow. And here is why.

To start, note that although the VIX is near historical lows, it is not cheap. The realized has been lower. And the second fundamental thing to note that in the post-crisis world, the volatility has transcended its status as just a "fear gauge" and has become an asset class in its own right. And in this world of unconventional monetary policy and low rates, volatility has become intrinsically tied to the level of rates. The chart below captures this point.

We talked about this point way back in 2012 (from bonds markets point of view). When you treat volatility as an asset class (where selling volatility is a surrogate carry strategy) it becomes clear to see the connection. Consider an asset allocator who has an option to either sell volatility and collect the premiums, or buy some equivalently risky carry product, e.g. a high yield corporate bonds portfolio.

To make apple-to-apple comparison, we can think of a hypothetical "volatility bond". Given the existing spread of risky (BBB) bonds to treasury, we can deduce the probability of default of such an investment. From this, we can hypothesize a volatility bond, which consists of selling an out-of-the-money (OTM) call spread and put spread on S&P 500, each 100 point wide. The strike of the short options are such that the probability (implied from volatility) of them ending up in the money is equal to the probability of default of the high yield portfolio above (worth 100 in notional). In both cases the maximum we can lose is $100 (note in the case of short vol strategy, only one of the call or put spread can be in the money and exercised against us). So the yield from the high yield portfolio, and the premium collected (let's call that volatility yield) are comparable returns from portfolios with comparable risks. The chart above shows the yields from these two roughly equivalent portfolios. As we can see, in this rough approximation, the vol yield has in fact been higher than comparable BBB yield through out the post-crisis period, and moved in steps. The relative value before the crisis was unbalanced. It would have paid to buy OTM options spreads, funded by a high yield portfolio (anecdotally, there was an equivalent popular trade there during that time, but in the wrong market - the infamous Japanese widow maker). But at present the markets are pretty much in sync with each other and appear efficient. Far from the "distortion" argument in the narratives above.

The only way the vol can rationally go up from here is if the general risk portfolio yields also go up. That can happen in two ways. Either spread to risk-less rates (like treasury) increases (signifying a risk-off event like in the narratives above). Or through a secular rise in rates - which basically takes us back to Fed and inflation. As argued in the last post, pretty much everything we can expect now hangs on future inflation path.

The results are outcome of an approximate analysis. We obviously ignored some important issues (like skew and convexity of these deep OTM strikes) and made some shortcuts (a digital set-up is more appropriate than a options spreads as in here). We also missed a bit more fundamental point here, which is correlation. S&P 500 is a much broader index than the high yield universe, and the comparison above is more appropriate as the market-wide correlation goes up. As the correlation goes lower, we can afford to sale closer to the money options spread in S&P to retain the same riskiness in the portfolio, thus making the volatility yield even higher. And as we have it, the correlation (again see the last post) is down off late. But the main point remains unchanged - Vol is low but NOT cheap (although last few points in recent time in 2017 points to some relative cheapness).

Perhaps it is a good time to stop complaining about low VIX prints and watch those HY spreads and inflation development carefully instead.

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All data from CBOE website/ Yahoo Finance/ Bloomberg

Markets | The Most Peculiar Positioning Build Up Since US Election

Last week's S&P sell-off was apparently a big news. We had some serious analyses why it happened like here and of course the usual noise about end of Trump trade and reflation trade. Also the indomitable cottage industry of the permabears quickly felt a sense of vindication. However, the real surprise was why it took so long for S&P 500 to suffer a 1% down day. If we have only one 1% down day since October (roughly say 100 trading days), it is equivalent to an approx 7% annualized vol. VIX has been near record low, but at the 12-13 handle, looks quite rich given this 7% realized (or a bit over 8% if the standard deviation of daily returns is used to calculate the annualized vol). In fact the realized volatilities are very very timid and just barely off the historical lows.

In this light one the most interesting development that I suspect few has noticed is the curious build up of S&P option positioning. CFTC publishes the participant-wise positioning data at both futures and combined levels. The combined data is calculated by adding the futures equivalent option positioning (delta equivalent) to the futures data. So the difference between these two shows us the net option positions in delta equivalent terms. And as the chart below shows, it has never been more peculiar.

Among the major categories in CFTC reports, asset managers at present have a historically large short positions in options, against the dealers and the CTA/ leveraged  money managers. This is a remarkable build-up of positions since the US presidential election. It is interesting to note the usual trading incentives of these major players. The dealers are mostly market makers and their positions are in general reflective of other players' views. Leveraged/ CTA funds, to a large extent, are momentum driven. The asset managers on the other hands perhaps represent the most discretionary part, although most of them will be long-only players. In fact they as a group have built up a combined long position after the US election results - no surprise there. Along with this particularly interesting short build up in options space - quite unexpectedly.

The large short delta equivalent option positions from asset managers can be built in two ways. Buying puts - which is a common hedging strategy for the asset managers, or selling (covered) call - which is again a very standard income strategy. But their impact on the market dynamics are quite different. We do not have enough information above to see which one is more dominant. So to do that we look at what the behavior of S&P 500 price itself tells us.

From the chart above, we see the dealers positioning mirrors that of the asset managers. If the asset managers are mostly long puts, that will mean dealers are short puts and hence short gamma. On the other hands if the asset managers are net short delta equivalent in options through short calls, the dealers will be net long gamma (long calls). And since the dealers, as market makers, will tend to run a hedged book - this will lead to some expected gamma signature in the market dynamics. When the dealers are net long gamma, they will tend to sell in a rally and buy in a sell-off (sticky gamma). This will have a stabilizing effect on S&P. The reverse is true when they are net short gamma (slippery gamma), a move reinforcing itself away from stability. We compute an approximate measures of this relationship. First we see the how much the open to low move is reversed by low to close move for each day in a given time period (20 days) for S&P 500. Then we use least square regression to estimate a beta between these two moves. This beta signifies how likely in a given day, a down move will witness opposing flows to reverse it completely or partially. A high beta signifies a large pressure of opposing flow (beta = 1 means all downside move reversed by day end). The major drivers in this reversal will be the dealers long gamma hedging activities and potentially the buy-the-dip or momentum flows from other players (apart from other flows which we assume to have a zero net effect on the balance over a time periods). We call this beta (kernel-smoothed to capture the trend) downside gamma. The chart below shows this juxtaposed with the above positioning data, as well as S&P 500.

The interesting thing to note that during the last large short delta equivalent option positioning build up by asset managers (following Brexit), the downside gamma measure actually dipped, signifying a net short gamma for the dealers, and hence long put positioning from the asset managers. The current positioning, following the same logic, points to a large short call positioning from the asset managers. In fact there were some noises around this in February as well. As a result of this, the recent moves in S&P has been remarkably resilient. However as of last Tuesday's (21st March) data, it seems this long gamma positioning is coming off from the peak. Which has also coincided with a reduction in net short delta positioning of the asset managers in the option space. Theoretically, this means we can now expect a pick up in realized volatility in S&P. And it is time to shelve the buying-the-dip intraday strategy till the next opportunity comes.

Markets: The Rise of The Vol Tourists

Since the Great Financial Crisis, the volatility market has undergone some significant changes. One major driver was an increased awareness about tail risk hedging. This was further aided by increasing acceptance of volatility as an asset class. Following the correlation one period during the crisis, the trend among asset managers has been risk factors based investment, moving away from traditional asset class diversification. This, along with the rising popularity of exchange traded funds and exchange traded notes, has given rise to a whole new set of demands for volatility products as an asset class.

Another impact came via the central bank reaction function route. The profound changes and the new normal condition following the crisis brought in a new set of players ready to supply (short) volatility - including those so called "vol tourists". But the appeal of systematic short volatility strategy has been strong following the crisis. As the unprecedented monetary stimulus created a huge yield chasing pressure, shorting volatility has become an important source. I have written about this quite a while back from rates perspective, but this is generally applicable to any asset class.

The left hand side chart below shows why shorting volatility systematically has been so popular. This tracks performance of a strategy that shorts the nearest IMM VIX futures and rolls just before expiry. The size is determined to match a margin of 10% of the invested capital (the approximate worst case loss). After the crisis, apart from a few hiccups (notably during the 2011 US debt ceiling crisis), the performance has been quite impressive. 

The result has been a discernible dynamics in the VIX futures market. The right hand side chart above shows the typical nature of VIX positioning that we have seen in recent time.

On one hand we have the asset managers managing the various ETNs linked to VIX. The left hand chart below shows the flows in to such ETNs (the short VIX ones are added with sign, reflecting net flow in to equivalent long VIX funds). These flows have typically been negatively correlated with VIX level itself. And the positions of these asset managers in the futures market have pretty much followed these flows - as shown in the right hand chart.

This has led to a situation where dominant players are the swap dealers (large banks) and leveraged money managers - the hedge funds - either discretionary or systematic short vol players. In fact, given the fact that after the introduction of tighter regulations since the crisis, most of the swap dealers positioning will be driven by hedges. So this leaves the leveraged managers as the only discretionary players in the VIX markets. 

This particular development in volatility markets - fundamentally driven by ZIRP policy of central banks, new regulations and the paradigm of risk factor investing - has resulted in an overall low volatility and high contago environment, even over and above what one can expect with a central bank puts. Apart from the China fear back in Aug 2015, the VIX level has remained remarkably tamed - below 25 almost always. Also the spread between front month VIX futures and the VIX levels itself has widened significantly since the crisis, as the most discretionary players have been systematically short in futures. The futures curve has been so steep that it is now very costly for long players to systematically roll macro hedges in VIX futures. In a normal market in a mean-reverting asset class like volatility, you would expect just the reverse.

The second impact, arguably, has been the feedback loop to S&P itself. As we have seen above, the VIX funds are flow driven. This means the leveraged managers are short against the large banks. The fact that most banks will have a hedged position, especially after the new regulations, make this positioning quite asymmetric. For the short VIX players, it is a linear position in volatility. However for the swap dealers - the opposite long VIX position will also mean a short option position as hedge. It is not important whether the short option position is the trade and long VIX is the hedge or vice versa. What is important that, a long VIX positioning will also mean a short gamma position. And the act of delta hedging will feed this into the underlying, i.e. S&P. If most hedgers are short gamma, as the underlying moves and the hedgers buy or sell to re-balance delta, they will tend to amplify the move. On the other hand, if most of the hedgers are long gamma, their delta hedging will introduce a stabilizing effect on the underlying. And this is captured in the following chart.

The chart shows the 20 day correlation (kernel-smoothed to capture the trend) of S&P 500 opening moves vs trading hours moves. This can be treated as a measure of the gamma effect above. We can treat the opening move as an impulse from overnight news. If the day move tends to counter that systematically, it is highly probable that the long gamma dealers are introducing a stabilizing effect. This means you would expect to show this up as an accompanying short VIX position for the swap dealers under such condition. Whereas if the day move amplify the open, this points to a short gamma position of the street (long VIX). So this correlation measure should move in steps with swap dealers positioning if we are right. And as we can see this is indeed the case, especially since 2014.

For a few days prior-to UK referendum, you must have noticed this phenomenon in practice. Taking a cue from the European markets, the S&P would open down more often than not, only to recover and more almost with statistical consistency during the trading hours. 

The rise of the vol tourists (and the short vol players in general) means watching VIX positioning and tallying it with the underlying moves has now become an important input for investors, even if you have nothing to do with VIX itself.

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all data from CFTC reports and Bloomberg

Macro: Quantitative Tightening - Revisited

Here is a fresh look on the topic from the excellent sober look blog. It also refers to a post on this blog back from September last year.

The sober look piece presents some insightful charts and raises questions that needs further re-look. One thing to add here on the top of my head - it has been alleged that petro-dollar sovereign wealth funds have been selling more of equities, sparking a flight to safety move towards the US Treasuries.

Quite the opposite what many market analysts expected.

ECB Meeting: Front Running

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

 

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

 

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

 

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Trades here:

 

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

 

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

 

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

 

Trade Idea: Positioning For ECB

The expectation for the next ECB is running high. Many from ECB, including Mr. Draghi, has already talked up further measures. There are already talks of telescopic monetary policy taxation in the air. And a lot of speculations to follow.

The ECB announced QE at the end of Jan this year. Then the market priced in QE aggressively as well, and yet ECB over-delivered. The continuation of the movement past the announcement and well past the start date is a proof of that. This time as well the market has priced in possibilities of further measures aggressively. The question is this time, will they deliver, or over-deliver?

The recent moves in the market in many way resembles the time period before the last QE announcement. And at the same time differs in some crucial details. The major similarities: 1) selling off in Euro, 2) rally in the front-end and major differences are 1) remarkable steadiness of the long-end and 2) steepening of the curve. In the figure below we show the excess moves in rates and slopes (relative to the US). The Blue columns are the move in the last QE. Red one current moves and the green columns shows what the current move should be if we adjust for the move in Euro (that is we assume the euro move correctly prices expectation and compare rates move based on that). As we can see the move in the front end much stronger than before, and reverse for the long end. In fact corrected for euro, the move in 10y is about fair. While 8th euro futures rallied most and 30y did much less than expected.

The bone of contention here is of course what exactly will the ECB do. As clear from the picture above, the market is fully or to a large extent pricing in an action in the front end, that is, a significant depo cut. And with all the stories of -20/-50 tiers or -35 flat or all other possible combination, it is hard to say what happens if ECB does a significant deposit cut. There is no reason to believe they cannot exceed expectation. So perhaps short end move is justified.

But here is the key. Whatever be the depo cut, it is in itself not important. It is plausibly true that the point of this depo cut is simply to make the QE program more tenable. With 15% of euro area govies trading below current depo, the ECB has a strong incentive. The question is if they do deliver, what does that mean for long end. It does not mean we have an increased supply, nor it means depo is reflationary. All it does it to save the QE program by making more bonds eligible. I have not checked for euro area, but based on Germany distribution of yields and amount outstanding, roughly a move from -20 to -35bps makes 84b more available. With a capital key of 18% that is ball-park 470b more papers to buy for ECB, approx. 8 months worth of QE. This is significant. But we also have to count in the feed-back response, as the market may potentially push the curve further down, and thus neutralizing a part of the impact the ECB hoped to create. So if this depo rate comes with any significant expansion of QE in terms of time or size, the long end should be biased for rally. And if the depo rate cut does not match market expectation, the short end will sell off back to previous levels.

And while we have all these, another point to note is the levels of vols. The implieds are way to high compared to delivered. But if we adjust for the Fed hike expectation (by computing implied/realized premiums in EUR over USD), the front ends are still cheaper compared to long end on a realized basis, with 5y around fair.

I believe whatever ECB does, it will hardly be a lasting change. Europe needs fiscal stimulus now. Monetary policy is just a tool to avoid falling behind, but can hardly give a large push ahead. Whatever the move follow the momentum, and then position for a fall back. ECB claims the QE has "clearly" worked, but the real rates in euro area were back at the 2014 levels at end of August, before the new QE expectation kicked in.

The trade here: A convex flattening position in 5s30s or 5s10s. If not through spread options, given the vol richness and underlying directionality, buying the belly payer vs. long end looks better than the alternative in a risk-reward consideration.  Otherwise a Nothing. Wait till the announcement and no point trying to fade the market from here.

EDIT (3-Dec-2015:08:55 UTC): The hidden risk to this view is the ECB doing away with the yield-floor limit for QE eligibility. That may lead to a large upward correction in long term yield and a significant steepening.

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.

US Asset Flows + The Thing That is Chinese Stock Market

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

 

 

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

 

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

 

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

 

 

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

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

 

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

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