Contrarian: Short EUR to hedge Grexit! Are You Sure?

Sounds rhetorical indeed. But does it? 

Two charts below on EUR/USD vs Italy benchmark 10y yield below. The first one shows YTD move, the second shows the relationship back in 2011-12, during the height of European debt crisis. 

It is true the general yield compression and euro sell off is driven by the same force, i.e. QE. However that does not explain the sustained correlation on the other side as well, i.e. periphery sell off along with euro rally. 

This puts a question-mark to the theory that a Grexit will result in a large euro sell off. It depends what safe assets you buy when you panic. But whatever it is, we will see a large move for sure.

Trade Idea: The Short Story of the Long End (USD/GBP/EUR)

Post FOMC minutes, here is a quick look at the current levels of the yield curves across USD, GBP and EUR. Below table gives a snap of how the market currently prices the start of the rate hike cycles (lift-off), the pace of hiking, and the terminal equilibrium policy rates.

As we can see the terminal rate, as well as the pace of hike is highest in case of the US, followed by the UK and the Euro area. This is interesting, esp the change in these since start of 2014. The repricing of lift-off has been large for Euro, by 11 quarters (which is mostly explained by ECB commitment of 2 years worth of QE). For others the lift-off re-pricing has been rather small (almost none for the US and 3 quarters for GBP). What has been remarkably massive is the re-pricing of the terminal rate. Around 190bps for Euro, 145bps for the US and 120bps for the UK. Also note the large re-pricing of the UK pace of hikes, Which is evident in the large push-out of the peak rate timing for (this may be influenced by mismatching supply demand of long end gilts).

I further took these current curves and applied some scenarios on the base case. The scenarios are 1) a 50bps sell-off in terminal rates with faster than expected rate path (the optimistic scenario) 2) a 50bps sell-off in terminal rates with slower pace of hikes (growth with subdued inflation) 3) a 25bps downward revision of terminal rates (a recession scenario) and 4) global convergence - the large global economies converge to a common overall long term rate based on GDP weighted long term nominal trend growth (which turns out to be around 2%).

Overall, the market seems to agree with the secular stagnation theorists more than ever. It also prices in a convergence of global inflation. We indeed have a core inflation convergence (somewhat) for UK and US already. And given UK imports a lot more from Euro area than exports, the case of imported disinflation is strong. The US is more likely to have a higher potential growth than the UK, and is less burdened with Euro area disinflation. Add these up and we may have more that 50bps that is currently priced in, room for long end divergence.

On a relative basis, I think the pricing of terminal rates are okay, except may be a bit too pessimistic. The pace looks balanced too, with an upside risks to faster hike if inflation picks up unexpectedly. Individually, the lift-off for UK is perhaps too early and the pace is too low. I would rather imagine BoE avoiding hiking unless they must. There has been much less talk about bubbles in the UK. And even the London house prices seems to be on course correction. For the US, the lift off seems more or less fine, and the pace possibly as well. But the terminal rates a bit too pessimistic. Given post crisis average nominal GDP in excess of 3.7%, a terminal rates around 2.5% denotes upside around 100bps. On Euro area, well we have QE. It is still not clear the long end has found a support at the current levels. Not to mention Greece and other distraction. And if we have QE extended beyond what is currently promised then everything looks pretty much fair there. Except we have very little downside to go short rates at these levels.

Trade #1: USD 10s30s steepener vs GBP - rationale: see the point on imported disinflation. Also the tight supply and natural long end gilt demand, and a historically tight spread all support this trade. Also historical market rates over the policy rates has been higher for USD than GBP. I prefer 10s30s than other points for this steepener trade. 

Trade #2: Buy USD 1y30y payers vs GBP - rationale: Similar as above, structured through 30y rates, selling the GBP 30y payers. The USD vs. GBP 1y30y vol spread is historically near the tightest levels seen. The election perhaps does not justify all of it.

Trade #3: Long end upside in EUR - rationale: Well we can't go much lower than this and NOT have a prolonged recession. On the brighter side, we can go up quite a bit. The best way to express is outright on the long end. As this has the most asymmetric upside. Can be structured as positive carry trade through bottom right payer spreads. Else through mid-curves at zero cost to carry through 2y in to bottom right forward payer spreads. The vols are relatively cheaper beyond 2y expiries.

Trade #4: Pay UK 2s5s vs US 2s5s - rationale: in case the lift-off date and the pace gets corrected in the UK after the election. And by that time US gets nearer to the lift-off date, leading to relative under-performance of 2y to 5y.

Trade #5: Pay EUR 5s30s vs US - rationale: Euro normalization, vs. downside protection in US for a recession. It is more efficient to express this view via spread options than outright swaps, with chances of large adverse surprise

Finally a brief history of significant sell off in US rates since the 90s. Table below shows change in rates and spreads in bps (Equity is change in S&P in percentage points) over the period of the sell off. The rows highlighted shows cases where long end rates sold off while the policy rate was actually lowered.

All data from Bloomberg.

Economy: India Builds Up SPR after China

This was in news. And I like this trade.

Although the size is rather small compared to China, both in absolute and relative terms. 13 days of consumption (vs. estimated 90 days for China). India's daily consumption is around 3.3 million bbl/day. The world productions is around 85 million.

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?