Trade Ideas: The Curious Case of Down Under

See the left hand side chart below for all large developed economies in interest rates swaps space, 2 year rates differential to US vs the 5s30s slope. Returns of FX carry trades have strong correlation to curve slope. Researches (see this and this, open PDFs) show buying currencies with flatter curve slope against steeper slope pair produces returns which are often better than the traditional carry trades based on short end rates differentials.

My general conjecture is that in this connected global economies, the long end of the yield curve is driven by the state of the global economy (flow of goods, services, money and inflation drives nominal rates). Where as the short end is up to the central bankers. Now to the extent that US drives the global, or at least the developed, economies, the relationship between this differential to slope is a straight line. Higher the differential, lower the slope, driven by the shorter end. And all points should lie on the trend line.

And to the extent they are off from it, that signifies the presence of other possible drivers. In this case, the Aussie and the Loonie are the obvious picks, possibly China driven. But AUD is simply way off. Assuming China does not influence, the AUD curve needs to flatten a lot. Assuming China does influence, and is forcing Australia to a possible recession, then there is a good chance it will keep rallying pressure on the long end further, which will lead to flattening if US rates hikes drive the carry trades out. 

The only case against it is a sharp central bank response. Australia has not seen much recessions in recent years and it is not clear how the response will be. On the flow side, we have seen recent international outflows (dominated by equities, but also in bonds), while stepped up bonds allocation from domestic investors. The assumption is internal flows will be concentrated more in the shorter end of the curve than domestic

Wait out for the possible rate cut next meeting and then go for a significant AUD flattening in the medium to long term. A good cross market version is against EUR, the spread is near historical lows

O Captain, My Captain!

What’s wrong with death sir? What are we so mortally afraid of? Why can’t we treat death with a certain amount of humanity and dignity, and decency, and God forbid, maybe even humor. Death is not the enemy gentlemen. If we’re going to fight a disease, let’s fight one of the most terrible diseases of all, indifference.

- Patch Adams(1998)

This is NOT Nuts, Where is the Crash?

The secret of making money in the market is to bet against it and then be right as well. As a far-fetched corollary, we can also say when everyone is worried about a market crash, that is perhaps not the best time to actually position for a crash. Even if they are central bankers warning of over-valuation of certain stocks or warning of outright market crash. Central bankers have not shown particular excellence and consistency in timing the markets. Keywords charts for "asset bubbles" and especially "market crash" bursting through the roofs here!

So here we take a look at the global market valuation. We have all range of valuations, from downright moribund Russian stocks to upbeat Mexico. And these excludes much of emerging and frontier markets. As good as a time to stay invested for long term, as any other time. And look for value.

And the markets seem to understand. We have hardly seen any great shift in momentum in equity flow. We have seen recent outflows in emerging market debt, high yield and developed markets equities. And also some increased flows in to US and core Europe bond funds. But before you listen to financial analysts and talking heads, there are very little evidence of flight to safety here. On longer term, what we are seeing is NOT rotation, rather a reflation, i.e. money continues to flow in to both bonds and equities. This is corroborated by central banks flows of funds accounts, as well as other higher frequency flow data. The amount of recent outflows from US equities is dwarfed by the amount pumped in since the financial crisis.

There are reason to believe these latest rounds flows in to bonds has little to do with safe heaven demand. The unforeseen consequences of changes in regulatory landscape (BASEL 3, SOLVENCY 2, all leading to higher bonds demands) and austerity and stress on balanced budget (leading to lower supply) may be the major driver. Clearly yield chasing has been significant as well, but there is some amount of caution out there - see the recent outflows of high yields. The real dangers are the developed economies getting in to the next recession following a natural business cycles from a much lower peak than past recoveries, and a China problem. But none of these present an extreme tail scenario to me. And if your expectation is a total Chinese melt-down, then heaven save us! So unless we see a central bank induced shock therapy gone wrong, a crash may never come anytime soon. At least not when everyone is looking for it! 

And even if it does arrive, probably it will be safer to stay in equities than in fixed income

And, oh, if someone tells you the evidence of irrational exuberance in the equity market is the insane levels of margin debt on NYSE and/or the cheapening of put skew, just sigh and shake your heads.

Trade Ideas: USD vs GBP Short End/ Belly Convergence

Following up on my last post where I promised a closer look at the convergence trade of USD and GBP short term rates

Based on the latest data on both (We have the latest June prints for UK consumer prices, US prints are till May, the next US prints are due this Tuesday). The US CPI has recovered from last year's lows firing on all major component - food, housing and transportation (partly driven by energy prices). For UK, CPI prints have softened. The energy component seem yet to pass through and food has been weak as well. The stronger components have been housing, education and restaurant + hotel expenses. On pure price terms, if the trends remain, US will soon catch up a lot with the UK inflation, and inflation expectations should be priced upward accordingly as well.

Crucially, the one of the core drivers of forward looking inflation, the wage growth and personal income growth, have been much robust in the US (part of the productivity puzzle in UK employment, where presumably a large part of the employment gain has been at the expense of productivity and wage growth). Neither of them particularly impressive, nonetheless the US is doing better in forward looking terms. The counterpart of the productivity puzzle of the UK employment has been the dropping participation rate for the US. However, a large part of that has been attributed to changing demographics (retiring baby boomers) and the latest such study (opens PDF) is from the President's Council of Economic Advisers. If that is the cause, the overhang on the inflation should be less.

Also, the credit side of the story is much better for the US as well. The household credit growth and credit demand picture also support a stronger come back of inflation in the US compared to the UK.

Ignoring jitters about the compression of the term premiums and the asset price bubbles, or the recent round of Risk Offs, US inflation is poised for an outperforming compared to UK. And this means trades for short end convergence in USD and GBP. The price momentum was against this trade even a few weeks ago, and now the weekly moving average of the spread (on 5y swap rate) has cross the 50 day MA. 

Time is ripe for this trade!

UPDATE: Another study on the participation rate concludes similar

Macro Views Series: 2014 H1 Quick Look-back

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

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

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

NIFTY: Technicals - Choose Your Divination!

Now with the budget out of the line, we will be trading relatively event-less in near term more or less. So focus is less macro and more micro, stock-picking and timing the markets etc. In case you rely on technical indicators, here is a quick summary of what works and what does not among the weapons in the technical traders' arsenal for NIFTY. All data from Bloomberg.

The first chart shows the total performance of different strategies based on technical indicators, against simple buy and hold. The whiskers show the maximum and minimum annual returns, while the thicker bar s show the average annual returns in a trending market and in a range-bound markets (it is white if trending return < range bound return and black otherwise). The data spans 2004 to YTD 2014. The trending years are identified as 2004 to 2007 and then 2010 and 2014.

The second chart shows the relative rankings of strategies in a given year (1 is the best, 23 the worst). Again the whiskers show the best and worst ranks over the years and the thick bars show the average annual ranks in trending as well as range bound markets (again, it is white if the average trending rank is lower than, i.e. better than, average range bound rank)

So based on this if you believe we are in a trending market, NOTHING beats the simple strategy of buy and holds. And if you think we are in a range bound market, the best performing strategy is a variation of moving average (Triangular moving average - a three-point double-smoothed variation of the moving average method, with majority of weights in the middle point).

In general, you are better off following Ichimoku or different variations of moving average methods in a trending markets (if buy and hold is too simple for your taste!). And in range bound market also, the moving averages perform relatively better than other complicated indicators. But even then, they do not beat the simple buy and hold strategy by a large margin.

Of course, as we all know, past performance is not indicative of future returns.

Macro View Series: Cross Country Market Cap To GDP

Out of sheer lack of actions in the market (which I hope will change with the NFP and ECB tomorrow, the ADP came in great today), we take a look at cross country relative equity valuation. That is basically a vague sounding smartspeak for checking out the market capitalization of listed companies (as a % of GDP). Market cap to GDP is a quick and dirty way to compare fundamental valuations across countries, assuming fundamentals matters in your trade horizon (so we are talking long term here). Of course, this ratio will be influenced by, among others, share of unorganized sectors (inversely proportional) and proportions of productive companies listed (directly proportional), and claim on other countries' GDP (like Switzerland - a home of many multinationals, directly proportional)

We look at two aspects. First, the market cap to GDP vs real GDP growth rate - this kind of gives how the market prices in the expected growth in earning vs price. 

Also we look at the ratios with comparison to investment share of GDP. Note the countries are presented using internal country code (ISO 3166) here.

From the above we see a certain patterns. Most economies lie with reasonably narrow band no the 2nd chart. Look at the outliers - like on richer side Switzerland and Singapore. Both are financial hubs and home of many multinationals. So we naturally expect the market cap to GDP ratio to be higher. However, the South African and Malaysian markets are suspect of overvaluation. On the cheaper side you have Venezuela, Argentina and China. Venezuela and Argentina have their own pressing problems. And China is, well, China. So hop over them, and you see the suspects for cheap valuation: Kazakhstan and Czech Republic

Now the fun is to look in to more details of the specific economy and convince yourself. Happy hunting!

And here for the tail piece: the market cap to GDP ratio for India and US over the years (approximated from BSE 500 and S&P 500 market cap respectively)