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 | Positioning For The UK Election

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

 

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

 

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

 

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

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

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

 

 

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

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 | Quick Take on Presidential Inauguration

Next week's Presidential Inauguration is a much awaited phenomenon - for general public as well as for the financial markets across the globe. Dow 20K is mostly an arbitrary mark for a market index designed for pre-computer era (and some equally arbitrary Theoretical Dow has already crossed the benchmark). But it appears the entire market is somewhat directionless at present. Since the election, it has made certain assumptions on the policies of the upcoming government and has shown some very strong move across asset classes (see here, here and here). However, we still have very little in terms of concrete policy direction to rely upon. The latest press conference did not quite live up to the expectation of details on policies. A strong guidelines on future policy in the inauguration can provide a new direction to the market one way or the other. And this can kick start the next phase in the market.

The charts below show the market impact of Presidential inauguration since the post-war era (excluding first term of Barack Obama, which was in many ways an outlier). The X-axis is the number of business days from the inauguration day. The chart on the right shows normalized moves of the S&P 500 Index from 3 month before to 3 month after for each inauguration. The chart on the left shows the median line and the uncertainty around it. It appears more often than not, the markets usually rallies in to the inauguration, experiences a slight correction going in to the exact date, and tops out  around 1 or 2 weeks after the actual date before picking up its own course. (Note we have not corrected for the usually positive trends for the markets in general and hence we should not focus much on the trends here but change in the direction of the trends instead.) However we have quite an amount of uncertainties around this. Looking closely at the right hand side chart we see this pattern was more or less followed by around 10 or 11 times out of last 17 cases. (The legends on the right chart are initials of the presidents followed by a digit signifying the term, if required)

Overall positioning-wise, we have nothing extreme in either way. Post elections the leveraged funds (CTAs and hedge funds) and asset managers have increased their long (from CFTC reports). The dealers have become slightly short the markets - but all well within range. On VIX, however the dealers and asset managers remain long against the leveraged players.

This, and trend analysis of the recent intraday movement of S&P 500 suggests the street (i.e. the players who hedge) is mostly long gamma at this point. See the chart below (and see here for interpretation). This means a large sell-off is quite unlikely in the short term. On top of this, we have the asymmetric scenario on the policy clarity. If President-elect Trump does announce clear guidelines on his policies, this will likely confirm the market assumptions (very low chance of a major negative surprise) and market can have the next leg of rally. On the other hands, impact of rhetorics and vagueness will most likely be muted as there is always the next time. This suggests a long positioning for the equities. However the case of dollar is quite different. We have a very strong long dollar positioning from the leveraged players and any disappointment can be felt quite hard in the dollars.

Finally, while you can't miss the obvious market reaction to Trump's win, it is fairly easy to miss - what I think the most dramatic - real economy reaction. The NFIB small business optimism and outlook went over the top following the election, much more than the overall business outlook and optimism measures. The charts shows the standardized measure and the spread. 

I think in itself, this is quite significant. Historically, we have only two similar situations when the business indicators were significantly positive and small business optimism outperformed overall measures. Once was during the recovery of early 90s and secondly during the recovery of early 2000s. While we have too few data points to draw any statistical conclusion, in both cases we had sustained economic improvement and overall positive market performance. Of course small business optimism does not necessarily mean it will be realized, nor what is good for small businesses is also necessarily good for overall markets. But perhaps we have too many people bracing for a crash now?

Macro: The Quiet Riot - Continental Version

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

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

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

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

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

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

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

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

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

Macro | Oil Rally - Not A Dead Cat Bounce

The recent rally in oil, which started with general risk asset rally in early February this year has been a solid one. This blog discussed about the bottoming out in oil and a potential come back in the past. It played out quite well (although it apparently surprised a few). Along with equities, it has initially benefited from the softening of Fed hike expectation. And then went on braving an increased Fed hawkishness. I discussed the policy expectation re-pricing, and also noted the potential decoupling in correlation. Nonetheless, the strength of the oil rally in the face of more than doubling of a June hike probability is remarkable. 

In some measure it has been a bit different than the earlier dead-cat-bounce rally we have seen last year around this time. Here is a chart tracking who made what from the oil price gyration for last couple of years in the (zero-sum) futures market (from CFTC reports).

As you see, apart from producers (who are supposed to be hedgers), the biggest gain in the oil sell-off in 2015 was captured by the swap dealers (large trading houses like BP and Shell and a few Financial Institutions still left in the business of commodities). Most of the pain went to presumably the CTA community and non-reportables (individual investors and smaller hedge funds). You would expect that - as most large trading houses have considerable advantages of information and physical stocks (even over large banks, many trading houses are trading arms of large producers), they are the people who should be in the know.

During the false rally last summer, those big players were still short and did not mind taking losses (which of course paid off in the second leg of the sell-off). This time around while most of the money seem to have gone to the CTA/ non-reportable communities, the big players are flat.

In this light, the recent interesting piece in WSJ is true on facts but perhaps paints a wrong picture of a rally fueled by dumb money. It is an expected bounce of an overly sold market, where smart money just stayed out, not actively betting against. This will last beyond the driving season with all probabilities.

I would not expect another leg of sell-off, nor a continued upward movement from here. While this rally cheered the economy-is-all-good signal from Fed, it is hard to keep it going. The still significant inventory, a possibly weakening OPEC, and the cost and operation structures of shale producers make it a long shot to take us back to 100 or even 70 oil. Over the past years, as the oil price tumbled, so did the breakeven for Shale. 

I think the real implications from this cycle in oil price are mostly two - firstly the conventional high-cost producers got a raw deal. The thing is, unlike shale, for traditional high-cost producers, it is easy to turn off the tap, but not so much to turn it on back again. That involves time and cost. The distribution of the gain and ruins from this price gyration will be uneven and shale producers may not be the most damaged lot when the dust settles.

Secondly, while few producers reduced output significantly, the most obvious victim of the sell-off and associated cost reduction was exploration. And this meager rally so far has done little to change that significantly. Most producers and service companies are now shifting from a strategy of hope to a strategy of low for long. But this also means an increased sensitivity of prices to the inventory levels (as future inventories are compromised). Unless we have settled down in to another recession by then, I expect another leg of this rally in medium term, in 2017 or 2018. When we feel the pinch.

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.

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

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.

 

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!

2014 H1: Top 5 Pain Trade

#1. Short Rates: USD, GBP (USD shown below)

#2. Short JPY vs USD: (and Long NKY)

#3. Flattener: in USD and in GBP (USD shown below, see short ED + notes vs long in long bonds)

#4: Long CNY Carry

#5 Short EM

And now after the ECB, we are back to carry trades

Markets: Speculative Positioning Update

Below some selected charts for global speculative positioning (compiled from CFTC CME, CFTC CBOT, CFTC CMX and CFTC NYMEX data). The red line is the asset price levels (on RHS axis) and the blue lines is the outstanding net speculative interest

The theme is, as usual, momentum chasing, with most asset positioning closely tracking the performance. The exception to the rule is VIX. Of the notable changes, the wheat and the corn have seen a strong turn around in the short interests as is the case for Aussie dollars. The opposite was seen for gold, which has a serious reduction in long interest after peaking in March. Equities remain marginally net short, except Nikkei 225 where the long interests strengthened in recent times. Commodities mostly strengthened. And rates remain mixed, with strong short interest in the belly and otherwise for the short end as well as long end.