Thursday, November 26, 2015

Ten Things I'm Thankful For

The last couple of weeks have really refocused attention on how fortunate most of us are to live in relative peace and harmony in our daily lives.  With that in mind, this seems an apt time for Macro Man to give thanks that:

1) The Macro family is in fine fettle.  Mrs. Macro is healthy, as lovely as ever, and still willing to put up with Macro Man.  Macro Boy the Elder has grown from a boy into a fine young man in the space of about six months, while Macro Boy the Younger is smart as a whip with a wicked sense of humour.

2) Macro Man himself is in the proverbial "best shape of his life."  Of course, cycling an average of nearly ninety minutes a day, every single day of the year, will do that for you.

3) Mrs. Macro backed off from her midyear insistence that Macro Man cycle less!

4) In a tough environment for just about everyone, Macro Man still has friends in the market who are looking out for him and willing to lend a hand wherever possible.

5) He was able to finagle another Bloomberg trial over the last couple of months.  It's really been re-invigorating to be properly plugged back in to the data.  Sadly, barring quasi-divine intervention, it's coming to an end in a few days, so it will be back to relying on mates for data and some charts.

6) He's not levered long high yield and distressed debt.   Those guys have had a rough go of it recently, and with more and more issues trading distressed, next year isn't looking any easier.   Then again, those guys don't have to give back the ludicrous money they "earned" for winning the Turdbuyer of the Year Award from 2010-13.

7)  2016 is finally shaping up as a year of divergence, macro imbalances, and, dare we hope, a return of the thinking man's investment style.

8) Having caught up on two decades of sleep deprivation this year, Macro Man doesn't have to worry about losing any wondering if he'll spend his bonus on the Maserati or the Aston.

9) Despite the occasional moan in this space,  his mind still feels fit and sharp and creative.   Having the time to read a shedload of books hasn't hurt.

10) This space continues to roll along, with a solid cadre of dedicated readers and a community of commenters that generally keep it lively and interesting without going too far overboard.

Thanks for reading, happy Thanksgiving, and good luck for the rest of the year!

Wednesday, November 25, 2015

The Answers

Economies and markets

While the situation between Turkey and Syria certainly appears to be serious, it does provide a useful laboratory experiment to test Macro Man's longstanding thesis that geopolitical events generally do not matter for financial markets beyond those fleeting moments of time after the red headline has hit.  To be sure, there are local exceptions- witness the performance of Turkish stocks since the incident- but broadly speaking there was a decided lack of contagion evident by the end of the day.

That's not to say that such events have no impact whatsoever on economic life.  One might reasonably posit that the Paris atrocities put a dent in US consumer confidence, and the absence of Russian tourists from Turkish beaches next summer could give another kick to Turkey's ever-present external balance concerns.

However, it's an old saw that economies are not markets, and vice versa.  Here's a fun game to see how well that's playing out at the moment.  Macro Man downloaded y/y GDP, CPI, and equity return index data for ten countries.    See if you can match each country to its GDP, CPI, and equity returns...without cheating!   Answer will be posted separately later today.

Tuesday, November 24, 2015

Knowing where to look

Macro Man's already come to grips with his basketball defeat and rationalized it away.   A little bit of measuring last night revealed that the Macro Boy, while still an inch and a half (3.5 cm) shorter than his old man, already has a longer wingspan.  No wonder Macro Man had so much trouble rebounding!  In any event, he can still whip the kid where it matters, i.e. on a bicycle.

He still has a few tricks up his sleeve when it comes to Mr. Market, as well.   Sure,  the quants can data mine a model to their hearts' content, and it will work great, too....until it doesn't.   One of the benefits of a bit of age and experience is knowing where to look to see if the wheels are going to fall off.

Take an old standby from recent years: Spooz and Blues.  This strategy, coined by David Zervos at Jefferies,  simply involves buying a given amount of Spooz and an equivalent risk-weighted amount of blue (i.e., 4th year) eurodollar futures.   Macro Man actually ran a bit of this strategy at his old fund, and no doubt the quant legends and risk parity heroes are doing something similar, if a little more sophisticated.   It's not hard to see why; even given the ruptures of August and September, the returns of the strategy have remained strong; much stronger, it must be said, than the pre-fee return profile of most macro funds out there.

Of course, the model doesn't necessarily have the same path dependency that most macro punters operate under; if it has a bad day or week, there's no threat of a tap on the shoulder and a cut in the risk allocation.   Like the honey badger (also popular at the time of the Spooz and Blues heydey), it just doesn't care.

The six years comprising this return history would seem like a pretty decent sample period, justifying a good amount of faith in the strategy.  In reality, the entirety of the period doesn't even resemble a sniff of a full market cycle; indeed, the sample covered in the chart above has been dominated by a policy regime more or less explicitly geared to make Spooz and Blues work (i.e., by pushing down yields and interest rate expectations to benefit risky assets.)

If we look at a longer sample of the strategy covering actual market cycles, we find a return profile that is somewhat less impressive.   Macro Man ran the performance of Spooz and Blues since 1992, and while the performance is still positive the information ratio goes from 1.16 to 0.61.

Now, it seems pretty obvious that different policy regimes are going to deliver different type of results for this strategy...and guess what?  It's true!   Macro Man ran a simple filter of model performance based on Fed policy regimes, and whaddya know: Spooz and Blues does best when  the Fed is easing and worst when it is tightening!

Now, Macro Man doesn't expect anyone to be particularly blown away by this insight, because frankly it's not that insightful.  Heck, even some of the clever models might pre-emptively filter for this sort of thing and reduce risk....then again, given the propensity to focus on ex post rather than ex ante returns these days, perhaps not.

The point is, however, that having a certain degree of experience to understand the existence of different regimes and to forecast their arrival can be incredibly useful in dodging the odd bullet.   This is clearly a simple example; not only did Macro Man know where to look immediately, but he suspects that most model designers would, too.  However, in more complex systems and models, it's not always so easy or obvious to know where to look...or when to turn the machines off.

It's hard to believe that the great "Quantmageddon" of 2007 was more than eight years ago, and clearly a new breed has sprung up in place of those that have faded away.  One of the benefits of youth is having a short memory, and not being scarred by the traumatic experiences of earlier years.  Then again, one of the dangers of youth is not being scarred by the traumatic experiences of earlier years and possessing a false sense of infallibility.

It's a fine line between wearing blinders on the one hand and seeing monsters behind every door on the other.  Quants and kids can mine data...but give me a macro guy any day to understand the data....preferably one with gray hair!  Readers are invited to judge for themselves whether the investment regime of the last six years is going to continue, a world of JBTFD and Spooz and Blues and Unicorns.  History suggests that it won't, and while history doesn't repeat, it usually rhymes.... 

Monday, November 23, 2015

Feeling old

Yesterday witnessed a watershed event chez Macro Man.  Much to your author's chagrin and despite his best efforts, Macro Boy the Elder (aged 13) bested him for the first time ever in a game of 1-on-1 basketball.  As recently as the spring Macro Man would have put the over/under for his demise at 2017 or 2018; somehow his son closed the gap and surpassed him with bewildering speed.

Is this somehow an analogue for his professional life?  In many ways, it's tempting to say yes.  During the financial crisis and its immediate aftermath, he was a successful part of a small team of macro punters that made 10% per year with low vol and almost no drawdowns.   For reasons largely beyond our control, the fund was wound down in 2010.  Fast forward a few years....and no one other than the fund's founder is in any kind of seat, trading or otherwise.

Has the world changed so much that the skills that translated into superior performance a few years ago are now obsolete to the point of irrelevance?  To be sure, macro is not exactly the flavor of the month amongst investors and allocators, and a shrinking pie naturally leads to fewer risk taking opportunities.     Moreover, the emphasis on risk/compliance/legal functionalities after Madoff has squeezed the ability of small funds to survive and prosper, so AUM has tended to congregate in a handful of mega-funds rather than be dispersed across a broad range of hedge fund investment vehicles.  It's ironic, regulators have embraced the mission to obliterate "too big to fail" across regulated banking institutions, you may be seeing the same issue arise in the much more loosely regulated world of leveraged fund management.

Moreover, even where there is appetite to take risk, it seems as if much of it is centered in quantitative models, be it HFT or quant asset allocation.  Macro Man touched on this issue in March, and things unsurprisingly haven't changed much.    The quest for the Holy Grail of a consistently profitable model is a tempting one, and it's frankly unsurprising to see the demand where it is.  However, we've learned the hard way over the years that models generally fail when exposed to shocks or other unforeseen circumstances that a more discretionary investment approach can pick up on, so the apparent lack of interest in discretionary investment professionals is curious.

It's a little hard not to sound like a grumpy old man, even though mid-40's isn't- or shouldn't be- "old".   But in a world dominated by coders on the one hand and box-tickers on the other (no MBA/no CFA/no dice), it feels like the experience of analyzing and trading part market cycles is an active detriment.  Either that, or the quality of Macro Man's analytical skills, like his basketball skills, has eroded badly since his younger days.  However his mind, unlike his jump shot, still feels fresh and sharp. 

But it doesn't matter how many jumpers you make if you can't get in the game.

Friday, November 20, 2015

Sense checking the EUR/USD trade

Hi ho silver!   Well, not really; after a nice break higher in the US morning, price action was actually pretty flaccid.  So despite silver finally breaking its record losing streak, it felt notable that commodities seemed to lag the dollar weakness that materialized in FX markets.  Even there, the strength of the euro has actually been quite modest; however, given the increase in positioning and the lack of evident catalyst, the correction somehow felt a bit bigger than it actually was.

Given that increasing focus is being paid to positioning risks on the dollar trade, particularly versus the euro, Macro Man thought it was worth re-visiting the trade through the prism of a number of fundamental factors that typically drive exchange rates.  None of these will provide much real-time comfort if and as a positioning squeeze materializes, but recalling where we are in the bigger picture can provide an intellectual anchor to knowing how to trade the noise.

Let's look at 5 factors that impact the supply and demand for currency over time:

* Short rates
* Long rates
* Other monetary policy considerations
* Valuation
* External balances

Obviously there are other factors that come into play, such as central bank diversification flow and international equity investment; at the moment, however, the former is reacting to developments in the first 3 factors while the latter is generally not large enough to make a substantial impact.

Short rates

Developments here are pretty unambiguously negative for EUR/USD; since the "policy divergence" theme came to the fore a few weeks ago, EUR/USD has followed the evolution of the 3 month forward points more or less to a T.

Putting the FX forwards into historical context, we can arrive at a couple of different signals.   The current level of the 3m forwards (in red in the chart below), while the highest since the crisis, are nevertheless pretty paltry in the grand historical context.  This would argue for a relatively meager bear signal for EUR/USD that one could argue is more than in the price.   However, the level of the implied interest rate differential (0.90% in the 3 month tenor) is massive considering the low (or in the case of Europe, negative) level of interest rates.   Indeed, if we express that implied rate differential as a percentage of the US interest rate, we find that this is the largest difference in the history of the euro!  This would certainly argue in favor of further weakness in EUR/USD if that implied differential remains steady or widens further.

Long rates

The Treasury/Bund spread is widening back out towards the multi-decade highs of the spring.  One could argue that until it gets there, the justification for further euro weakness may be weak.  Moreover, the historical link between this spread and the exchange rate is poor on a contemporaneous basis.   On the other hand, these are the sort of market developments that impact central bank asset allocation decisions (as well as spreads at the short end of the curve.)  Indeed, there has been plenty of anecdotal evidence of reserve managers shifting out of European government securities because of the low yield on offer.  For your guide, they're not sticking that money on deposit to earn zero; they're getting the hell out of dodge.

In reality, it may be unrealistic to expect to much more of a widening from here, given how stretched we are from an historical perspective; barring an abrupt narrowing, however, the yield advantage of Treasuries across the curve should keep attracting central bank flows.

Other monetary policy considerations.

In other words, QE.   The ECB is expanding its balance sheet and looks set to accelerate and/or extend that trend in a few weeks' time.   The Fed, meanwhile, has been there and done that; while they haven't got the cojones to shrink the balance sheet just yet, even through ending the portfolio reinvestment policy, the tide of relative balance sheet expansion has tilted unquestionably against the euro.   This factor has borne a solid resemblance to the trend in the EUR/USD exchange rate after the crisis, and looks set to point towards more euro weakness.


Macro Man is old school (quite literally); he uses a PPP model that he first developed a dozen years ago to generate his estimate for EUR/USD fair value.   This is not a dynamic model, and there is little expectation that deviations can or should be corrected quickly.   His current PPP estimate is 1.17, with European deflation pushing it higher since its 1.08 valuation before the crisis.

It's interesting to note that the model shows the euro to be undervalued for the first time in a dozen years; coincidentally (or not), that was the last time that FX reserve managers didn't feature heavily as regular buyers of the single currency.  The current misalignment is exceptionally modest by historical standards; it's worth observing that most cycles have taken the euro to be misvalued by at least 20%.  As such, valuation is not much of a concern...yet.   Below parity, on the other hand, and the magnitude of undervaluation will be sufficiently large as to prompt greater inquiry as to how and when the rubber band might snap back.

External balances

Here's the thing about current account balances: they don't matter until they matter.   In the ordinary course of business of open financial systems, capital account flows tend to dominate supply and demand demand for currencies.  Ordinarily, countries running C/A deficits compensate investors for financing the deficit; investors generally like to be compensated, and so the C/A gets financed.   Obviously, you occasionally find situations like Brazil over the last couple of years, where the compensation is deemed inadequate for the financial/political/economic risks, and then current accounts matter very much indeed.

As such, they are worth observing, not as a signal for what will happen today, tomorrow, or this time next year, but rather as a signal for what will happen if everything resets to zero.   In the case of EUR/USD, you will probably not be surprised to see that the current account factor is not at all supportive of the dollar; indeed, over the last year the relative current account and the EUR/US exchange rate have moved in opposite directions.

 Now, given everything written above, it would be absurd to buy euros based on this current account dynamic.   There is almost always a narrative that accompanies periods where current accounts are useful as factor of exchange rate determination; you know, G7/G20 statements, that sort of thing.  We're clearly pretty far away from that at the moment.  Nevertheless, it is worth noting that if the compensation offered by the US to fund its C/A were deemed insufficient (such as negative interest rates, god forbid), then external balances would likely matter again, and the US would look very ropy indeed.

How are we left?  The short term fundamental drivers of the EUR/USD exchange rate continue to point towards further weakness.  Longer term risk factors both argue that the EUR should be stronger; frankly, over a full market cycle (if such a thing even exists any more), it almost certainly will be.  Macro Man is left much wear he started; thinking that we'll dip below parity, and that the ex ante returns from the trade won't look so good once we do.  In the meantime, any slings and arrows thrown his way from positioning unwinds are best viewed as an opportunity rather than a threat.

Thursday, November 19, 2015

3 points on the Fed minutes

*  It was interesting (and kind of disappointing) that the Fed didn't provide any discussion of the implementation of lifting rates off of zero.  As has been discussed here and elsewhere, thanks to the Everest of excess reserves, the mechanism for raising rates is a little more complicated than simply specifying a target range for Fed funds and adding/draining liquidity.   It seems pretty clear that IOER will be used to ensure a ceiling for the target range that banks will use to park excess reserves; the trouble comes from the GSEs, who have access to the Fed funds market but not IOER.   The Fed will likely use a reverse repo facility that the GSEs and money market funds can access, but as of yet, we still have no idea a) if it will be a "your amount" facility, or b) what the spread will be to IOER and the FF target.  It's kind of crazy when you think about it, but if the RRP spread is wide enough, the Fed could conceivably raise rates without actually raising rates.  A little clarity on their intent would not have gone amiss.

* The dovish wing of the committee is talking themselves into a bit of a catch-22 when it comes to normalizing policy.  "They also noted uncertainty about whether economic growth was robust enough to withstand potential adverse shocks, given the limited ability of monetary policy to offset such shocks when the federal funds rate is near its effective lower bound, and concern that the beginning of policy normalization might be associated with an unwarranted tightening of financial conditions."  In other words, with rates at zero, you cannot move the policy rate any higher because if something goes wrong, rates are too close to zero to generate an effective easing.   In addition to casting a subtle aspersion on the efficacy of QE, this line of thinking also suggests that ZIRP is like the event horizon of some sort of monetary black hole; once you enter, you can never leave.  Actually, the empirical evidence to date would appear to back that up....

* The initial part of the minutes summarized a discussion on a staff presentation on the equilibrium real interest rate, a subject Macro Man touched on a few weeks ago.  While the conclusion was understandably that the equilibrium rate was lower than it used to be, Macro Man was struck by this:

In their comments on the briefings and in their discussion of the potential use of r* in monetary policy deliberations, policymakers made a number of observations. The unemployment rate has declined gradually in recent years, indicating that real gross domestic product (GDP) growth has, on average, exceeded growth of potential GDP, but not by a substantial margin. This outcome, in turn, suggested that the actual level of short-term real interest rates has been below but not substantially below the equilibrium real rate, consistent with estimates that r* currently is close to zero...

So the edifice of the argument that the equilibrium real rate is zero is that unemployment has only declined "gradually" over the past few years?   Sure, unemployment has declined more slowly than it increased, but that's the case in almost all recessions and recoveries.   Let's put the recent decline in unemployment into context.   Here's a chart of the rolling 5 year change in unemployment since the 1950's:

As you can see, the 5 year decline in the unemployment rate is unmatched in history, except for the go-go 1980's.  The current percentile is just 1.2%.  OK, you say, but that's coming from an unnaturally high base thanks to the Great Recession; what if we look at a more recent time frame?   Here's the same indicator, but with a rolling 2 year change:

That's much less impressive; we're all the way up to the 2.4% percentile, and only the joint second fastest 2 year decline since the 1950's.  Gradual indeed.   If we look at the 1 year change in unemployment, what do we find?

From that perspective, it's a more middle-of-the-road decline in unemployment....but we've still seen the fastest decline in 30 years, though things have decelerated a bit since then.  Even so, we're still in the 21% percentile, which is pretty solid when we're so close to NAIRU.

By just about any definition, the decline in unemployment during the recovery has been faster than normal, even accounting for the high starting point.   Sorry, Fed.   You're entitled to your own opinions.   You're entitled to your own models.   You're not entitled to your own facts.

Finally, Macro Man doesn't really do "hot tips" for short term trades, but if he did, today's would probably be to buy silver.   Argent declined for fourteen consecutive days including yesterday, smashing the previous record of ten set during the financial crisis.  The loss of downside impetus over the last several days was notable, and yesterday's doji candle could represent something of a turning point.  It's notable that the RSI has already hooked higher at the first sniff of a rally, and it really wouldn't be surprising to see a 50c -75c pop from here just to kick a few of the latecomers to the selling party squarely in the groin.

Wednesday, November 18, 2015

Minutes and buybacks

Today we get one of the Fed's last chances to slam on the brakes before next month's FOMC decision, where the market is currently pricing a 2/3 chance of lift-off.  Although Fed governors and regional presidents would never say so explicitly, much of the rhetoric since last month's surprisingly "hawkish" statement has seemed to take the stance of putting their collective hand in the air and saying, "Yeah, we over-reacted to the whole equity sell-off thing."

How much of that tone is retained in today's minutes will help shape implied market probabilities; it's difficult to expect pricing to exceed more than a 75% chance of tightening until you see the red headline saying "Fed hikes rates for first time in nine and a half years"; after all, the Pavlovian impulse is a strong one.

Other markets, of course, continue to adjust in expectation of imminent Fed lift-off.   Gold is the latest one to cross an important threshold, breaking and closing below the 1080 level that marked the lows over the summer.   There's nothing but fresh air between here and 1000, and below there....who knows?  One of Macro Man's mates suggested that the UK stick a bid in to "take profit" on Gordon Brown's ill-timed golds sales of nearly two decades ago.

Elsewhere, Reuters ran a nice story on buybacks yesterday that was linked in the comments section yesterday.  It's certainly an interesting topic of debate;  while companies should generally be allowed to make decisions as they see fit, it's hard to escape the notion that issuing debt to buy back stock on the scale that corporate America has done achieves little in terms of improving the overall well-being of society while potentially posing financial stability risks.  As the financial sector has found to its sorrow, the umbrella of "financial stability" permits regulators to exercise fairly autocratic powers to rein in behaviour of which they don't approve.

And what has it all achieved?  Obviously there are always sob stories of individual buybacks that don't work out, but the slow and steady success stories usually don't merit a mention.  Macro Man does not possess an exhaustive database of share buybacks and subsequent performance, so he used a little shortcut to perform a small analysis.

He looked at the total return of the Powershares Buyback Achievers ETF (PKW) and compared it with that of the SPY.  For those not in the know, PKW tracks a basket of companies that have repurchased 5% or more of their outstanding shares over the past year.   Although it's not a perfect vehicle, it's close enough that it's useful to judge the relative performance trend of heavy buyers of stock.

On the surface, the return profile looks decent  with an aggregate 15% outperformance versus the SPY since the inauguration of the PKW ETF in late 2006.  Maybe corporate America is doing the right thing after all!

When you run the numbers, however, it's not so impressive.  It's easy to overlook the fact in the first year of the ETF, late in the last credit cycle, buyback firms underperformed by 10%.   Taking the full sample, the PKW outperformance has averaged 1.78% per year.   Not bad, perhaps, but is that really worth taking out record amounts of corporate debt for?  It seems dubious.  Moreover, a strategy of capturing the alpha of buybacks by going long PKW and short SPY offers pretty paltry reward for the amount of risk being taken; to earn that 1.77%, the spread incurs 5.11% annualized volatility, for an information ratio of 0.34.

Moreover, the penny hasn't even really dropped yet on the debt side of the equation.  If it does....well, let's just say that the Little Lebowski Urban Achievers might be a better investment.