ECB QE: Too Early to Declare Victory

Some misguided report in the media.

They are already declaring ECB QE a winner and more potent than the Fed, or the BoJ, citing yield compression (as opposed to an actual sell-off in case of US, and no move in case of Japan). Of course this is a completely wrong way to look at QE!

A QE is a monetary tool used to influence real rate when the nominal rates are stuck at zero lower bounds. Central bankers promises inflation targeting (mostly) and if markets believe them, a rate cut is basically lowering of real rates (as inflation expectation does not change much). However since at ZLB, you cannot cut nominal rates much further, the way to influence real rates is asset purchase. This is supposed to influence the inflation expectation upwards. So even if the nominal rates do not move, you have effectively achieved a rate cut.

And this is exactly what happens! For Fed, or BoJ and also for ECB. And yes, as expected Fed has been far more effective. In the policy moves after the initial crisis settled in (QE2/ Twist/ QE3) we have the 5y inflation break-even move 125bps/ 70bps/ 60 bps respectively. If we take relative move (i.e. the difference in break-even moves between the US and Eurozone, in order to filter global effect, if any), the figures are 35bps/ 30bps/ 25bps respectively. 

For ECB, the rates it has been around only 55bps so far absolute. And only 20bps relative (over and above the US). So it is rather small. Of course the change in yields are much more and in the reverse direction. This is because the portfolio impact of QE is much stronger in the Eurozone than the US (given the outstanding amount/ composition and holders. See here). But yield compression is hardly the primary target.

In fact if we look at the real rate (instead of inflation expectation, as above), it is even worse for the ECB. Since Jan it has barely recovered the real rate tightening seen last half of 2014 in the Euro area. In the right direction, but nothing to celebrate.

Far too early to declare victory in for ECB. What we have seen is just front running by the markets with a very positive reaction. It was a real determined and confident policy move, and in Europe, such moves are rare, and are always appreciated by markets. Real economy still to catch up.

Nifty: Small Caps vs Large Caps

Focusing back to Indian Equity markets!

The interplay between small cap and large cap has been very interesting back home, compared to global benchmarks. For last couple of years, S&P 500 and Russell 2000 more or less matched each others performance. In late 2013/ Early 2014 the small cap index outperformed, which is now reversed by a relative under-performance. Compare this to India. Ever since the financial crisis, the market recovery has been led by the large caps. Small caps (or mid caps) consistently under-performed, except since last June. The election saw a large out-performance by the small caps, but otherwise it has been pretty much dull. Small caps premiums has been in fact negative.

We take a look at the financials to see if there is any clue there. Below the aggregated balance sheet for Nifty 50 stocks, vs. Nifty Mid cap 50*

And here are the corresponding PnL figures*

* All data from Bloomberg as they report. I think more or less the trend is captured here.

As we can see, one large issue with the small cap balance sheet is in general total indebtedness. Since 2007, both the large caps and small caps companies increased their sales 2.3x, with an increase in balance sheet in the 3.44x/3.42x range. However while for Nifty companies it has been funded 70% by non-current liabilities, for Nifty Mid cap 50, the figure is at 80%. Both not great, but mid cap definitely worse. On top, the figures for small caps were worse to begin with. So the current levels look far from comforting from investors' point of view.

On the other hand, as far as the standard valuation parameters are concerned, on both revenue and balance sheet related metrics (like price-to-sales or P/E pr P/B) large caps are slightly overvalued (relative to historical spreads).

So overall it is not a straight forward call. Small caps are undervalued, but not by much as they were before mid 2014. At the same time, the overall sector balance sheet looks vulnerable to any interest rates shock. The question is if that valuation compensates for the leverage risks. Given the current outlook, probably this will tilt in the favor of small caps and mid caps over all. But not without a constant watch. I will definitely avoid any adventure in this space.

Trade Ideas: Opportunities in USD and GBP Rates Post Fed & BoE

After the recent Fed and BoE, here is my take on current opportunities in USD and GBP for longer term positioning in rates.

For USD curves, the slopes and curvature are more or less near there historical mean values, with some limited scope for flattening. However, what is interesting is that this normalization has been primarily been driven by compression of term premiums (one of the reasons is that the term premiums in magnitudes are now much larger compared the rates levels than before) . The risk neutral slopes remain much steeper compared to history. I think the term premia will remain depressed, esp for long end, and the flattening positions still makes sense. However, on the short end, the term premium (which is in fact negative) can pick up. This would suggest a 2s5s or similar steepening position. I prefer to express same view more conservatively through 2s5s10s fly. Note all term premia based on NY Fed regression based model available here.

Also in USD, the 5y has for a long time traded range bound (since the Taper actually), and has been testing either side to break-out. Right now it is roughly in the middle of the range. I think chance of a strong breakout in either side is limited given the level of rates and the state of the economy (unless we have a surprise in inflation). I think this gives us a good opportunity for long vol (vs long end in the gamma maturities) or for long vol vs. short vol of vol positioning in 5y. The range has been - ignoring some extreme points - within 50bps. So the trade is to sell 50bps wide strangle vs straddle (zero cost, which carries great as well). The vol of vol has been marked up recently, and thus makes a good entry point.

For GBP, the slopes and the curvature can follow similar comments as in USD. However, I see the opportunities more in Euro area convergence than outright (at the moment). The long end normalization of Euro can be structured against GBP. Given the trade relationships (most of GBP imports from euro area, so a direct import of disinflation), and the ECB QE driven yield chasing, it is hard to imagine a high GBP long end sustaining with euro area long end under 1 percent handle. The best way to position for this is to sell receiver 10y10y in EUR vs GBP, which will carry fantastic. An alternative way is in swaps directly.

Also watch out for ECB's update on PSPP (expected today). In the week of 13th it ended with Eur 9.75 b purchase of sovereign bonds. That is not a lot to start with (EDIT: target is 42 b per month or 10.5 b per week; EDIT 2: The figure came in 16.55 b, so total Eur 26.3 b).

UK Budget Market Reaction

Large rally  in European rates, which is led by UK rates. For a change! 

"Gilts Rise as Osborne Budget Leaves Sales Lower Than Estimated"

Or so says the headline. Really? UK DMO estimates a GBP 133 billion issuance against analysts expectation of GBP 147 billion. That causes the long end to rally 8bps at pixel time although it is GBP 126 billion more than last year? There is something seriously missing from the narrative.

Rather it is mostly seems BoE minutes pricing out rate hikes any time soon, as well as repricing of terminal rates. The UK PMI has been weak, wage growth not encouraging, the ECB QE driven outflows from Eurozone sure to hit UK gilts and BoE is nowhere as willing to consider rate hikes as the Fed. Also is there any housing correction in London? As a result the 2s5s flattens 4bps, 5y spread between US and UK widens 7bps, and the overall move is bullish led by the belly.

UK long end has further room to go. So stay bullish. 

What is more interesting is the catch up of the GBP long end gamma vol, relative to US. In terms of realized vols, I think US performed better. Too much priced in for the Election?

Trade Idea: My favorite Grexit Hedges

Things are getting quite edgy in Brussels and today we enter another round of showdown talks, backstairs deal attempts and hard-nosed negotiations. The reason the market has not given the due attention to this latest round of Greek tragedy can be mostly explained by the phrase "been there, done that". If you were bleeding profusely in carry and protection cost back in 2010 or 2011 or 2012, you may very well remember how it all ends. Usually. After a lot of words and diplomacy drama, they finally shake hands and make up. Sometimes the ECB chips in - either with no ELA threat, or "whatever it takes" pledge - and both turned out to be very effective. So far.

So there is, perhaps, no reason to believe this time it is any different. And there lies the rub. The chance of any tail event is probably even smaller than the word "tail" implies. At the same time, no one seems to be prepared for it. So here is my favorite list for hedge that will work in case risks flare up. But won't bleed you to death to carry.

1) In FX, it is the simplest. Short euro (or as Goldman points out, even Eastern European currencies as well). There is a chance euro will come back if talks go successful. But given the low rates and the large ECB QE looming, any comeback will hardly be a trendsetter. 

2) For equities (and for others who prefer RV) buy USD quantoed puts on Euro Stoxx Banks index (SX7E) vs vanilla. This is the trade above, plus a good RV in correlation of EUR/USD vs European stocks, which is at pre-crisis historical low levels with hardly much justification.

3) For rates, Buy 5y or 10y break-evens in Germany vs Italy. That is buy the Germany linker vs nominal and do the reverse in Italy. In bad times during the crisis, the inherent larger credit risks in linker vs nominal blows out, and this spread effectively tracked the Italy CDS during height of the European debt crisis.

All of them cost little to carry, and have huge upside. In brief quite close to a good asymmetric bet. You won't go broke carrying them for a while (and it may need a while. The end game, if there is any, is not happening possibly today, or this week or even end of March). And will pay off handsomely if the Europeans do indeed go for the nuclear option.

Good luck.

France, Germany (and Greece): A Long and Winding Road (of History)

A brilliant entry from Michael Pettis in his blog. A must-read for the weekend!

Trade Idea: 2015 Top Trade Ideas To Start (Rates only)

This is exclusively rates only piece. Others may follow soon.

Trade Idea #1: Buy EUR 10y30y 2% payer vs 10y5y 4% payer (Macro)

Rational: The Euro long end is ridiculously low. Lower than even Japan. Even the long-dated real rates are trading negative. This is a great trade to position for any correction whenever that happens. The extreme bottom right of the vol surface has developed fantastic vol carry vs. other points on the surface. The forwards are near-about the same (and historically they have been same). The spread has moved in negative correlation to 10y swap rates in post-Lehman era. Now it is near historical average. Given current level of rates, we will see a break-down of this correlation in a rally (i.e. the spread does not move much, the trade benefits from carry). In a sell-off the trade benefits from delta. The trade also benefits in a steepening scenario if Euro area moves further close to Japan. The adverse scenario is a bull flattening. Given the current levels, a large move in that direction is unlikely except a) another euro crisis b) strong yield chasing flows in to the longer part pushing 10s30s down. The trade will be net long gamma in any case. So a strong convex pay-out which costs nothing to carry.

Trade Idea #2: GBP 5s10s steepeners against  USD 5s10s (Cross market)

Rational: The convergence and the relative rally of GBP rates compared to USD last year was mostly a correction of the over-optimistic inflation pricing in GBP. However the underlying growth numbers for the UK has remain quite solid in terms of private consumption and capital formation, apart from a few misses in PMIs. This year, notwithstanding the election, this should continue or even pick up in speed. However, given the influence of the Euro area economies (largest trade partner for UK) , the pressure on inflation will remain on the lower side. Also the sensitivity of UK inflation to oil prices are comparatively low. This will keep front end rate hike pricings in check and may lead to a steepening in 5s10s on the back of solid economic growth. On the other leg, the US is more closer to a hike and the Fed may indeed go ahead with policy rate hike mid this year. This will lead a solid performance of this trade.

Trade Idea #3: 20y1y vs 4y1y steepener in swaps (Carry)

Rational: Unless we have something really surprising, Europe is potentially in the area of low-for-long for a while. That makes having a carry trade in the portfolio an absolute necessity. This combination is one of the sweetest spot, in terms of the carry generated per unit of risk taken. This spread in particular has also seen a sharp flattening from around 150+ bps to 85 bps area. This brings it back to about the same levels of the pre-crisis average. This presents an opportune timing to enter this trade.

Trade Idea #4: EUR Long-end ASW (Macro)

Rational: The long end ASW in Euro (swaps vs. Germany) has recently shown excellent correlation to vols, not only in rates, with equity and FX vols as well. Given the massive QE from ECB compared to Germany supply, and given the positioning in the market, the long end ASW should widen from here. In a rally, Germany long bonds have still room for yield compression and flows should work for the trade. In a sell-off, given the strong long positioning in rates, the hedging pressure will force ASW widening across maturities. Therefore the long-end offers a convex bet. Plus the correlation to vol, if continues, gives excellent way to position for long vol, as the trade will carry positive.

Trade Idea #5: Pay EUR in 10s30s (steepeners) vs USD (Cross-market)

Rational: The EUR 5s10s30s fly is too cheap, primarily driven by the too flat 10s30s leg. With the Japanification of Europe, the front-end of EUR and JPY swap curves have settled in to similar patterns. The anomaly lies in the long end. Any normalization from here will support this steepener on the EUR leg. On the USD leg, a possible re-pricing of rates (terminal rate) will keep the flattening pressure. Over the latter half of the past year, the major changes in the rate hikes pricing has been a front-loaded timing along with a lowered terminal rate. Any surprise in wage will impact the terminal rate upwards and will help the trade. On top, any long end carry related flows in to treasuries, buoyed by liquidity from ECB, BOJ and other central banks, will add to further flattening pressure even in a rally. The package can be done either through payer swaptions or through swaps. The swaps version carries better. A more efficient version will be expressing the views through the 5s10s30s fly (instead of 10s30s), which is almost flat to carry. However, the better carry comes at an increased risk of a 5y led sell-off in the US.

Trade Idea #6: Buy USD 2y1y 2%/ 2.5% payer spread (Macro)

Rational: The current ATMF is 50 bps cheaper than the minimum policy rate from the FOMC committee projection for 2017 as of Dec 14 (last available projection). This trade attempts to capture the good chance that the market is behind the curve from the FOMC. The structure takes advantage of the high payer skews to make a 4:1 pay-out ratio (max) if the view realizes. The carry is negative but tolerable.

Trade Idea #7: Buy 6m30y straddle in EUR vs 6m5y5y midcurve (Tactical)

Rational: The recent uptick in vols in most asset classes can extend its scope and bring back the missing vols in rates. Given the rates level, most of the action will be in the long end, in either direction. This trade presents an efficient structure to get long gamma on the long end while selling the expensive midcurve vol on 5y5y. The ratio of 10y to 5y vol is near historic high, making the midcurve attractive to sell. A premium neutral trade will be net flat vega, carries flat initially, and long gamma on the slope (and significantly long gamma on rates levels on the rally side). In recent time the 10s30s slope has been dominated by 30y (than 10y) and this presents an effective long gamma trade with little cost to carry. The downside is of course flipping correlation and 10y whipping around instead of 30y. The main scenario under which this can happen is an exogenous (led by the US perhaps) general sell-off in rates.

Trade Idea #8: Global Commodity Slump trade - Buy AUD receivers Vs USD (Macro)

Rational: The global commodity slump will stay here for a while. This is not helped by a Chinese slow-down, which may grow even lower than 7% depending on how the policy makers steer ahead with liquidity. The result is a global glut of liquidity and rally pressure on all commodity currency economies. The ones affected most will be ones with starting higher level of rates and large and relatively free economies. Australia is in the preferred choice. The sweetest spot in terms of carry should be in intermediate left. However even 10y or belly receivers should work. Outright, or against the USD rates (or GBP rates, i.e. economies in general poised to gain from lower commodity prices and higher liquidity).

Trade Idea #9: Currency Peg Trade - Buy DKK belly receivers against EUR (Macro)

Rational: The massive QE will put pressure on all currencies pegged to EUR. Unlike SNB, the Danish central bank has been maintaining peg since the Deutsche mark era. So it is indeed a tail event to remove the peg. However, the more plausible way to fight pressure from Euro is even more depressed rates. We have not yet seen the pressure on DKK in scale, evident in the FX reserve change in Nationalbank balance sheet vs SNB. When that does build up we will see further rate cuts, possibly into deep negative territory.

Trade Idea #10: Sell forward Euro HICP floor spread, strike 0% and -1% (Tactical)

Rational: The recent deflation fear made the Euro HICP 0% floor to blow out with a large spike in inflation vol. Given the ECB action and the still positive core inflation (and the downward price + wage rigidity), this is an opportunity to cash in on the panic dislocation. The risk is that we get stuck in policy inaction in case of further deterioration of the situation. The spread makes positive PnL till about -0.5% (note: ball-park pricing here). Even for Japan the average inflation prints between 2000 till before the 2008 financial crisis was -0.5% (and much better post crisis). The upside also includes a sharp correction in energy prices. Alternatively, the trade can be structured as a real rate trade, by buying matching floors on the Euribors.