Friday, October 31, 2014

Boom goes the dynamite

No Fed LSAPs?  No problem!  Team Japan delivered a double-barreled assault on the nattering nabobs of negativity last night, with an aggressive expansion of the BOJ's QQE program and the long-awaited announced of the new GPIF model portfolio.

Unsurprisingly, the Nikkei went doo-lolly last night, with futures now at new cyclical highs.  So too did the yen, with USD/JPY at its highest level in nearly seven years.

Naturally, Japan's domestic financial asset developments have resonated throughout the globe, dragging global equities higher and EUR/USD very slightly lower.  Curiously, given the generally close ties between fixed income and the yen (as well as portfolio shifts vis-a-vis equities), Treasuries are only slightly down today (and German bonds are flat.)

Clearly the moves from Team Abe were coordinated to achieve the maximum possible market impact, so kudos to them.  As for punters....if you wanted to add length and were cautious....unluggy.   Spooz are back above 2k.

If you're short....ugh.   Boom goes the dynamite.   It must feel as comfortable as the chap in the video.

With seasonals turning sharply favourable for risky assets, it's hard to see how JBTFD won't remain in vogue for another few months at least.

Wednesday, October 29, 2014

Get in there

"Although inflation in the near term will likely be held down by lower energy prices and other factors, the Committee judges that the likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year."

If the put fly mentioned in today's earlier piece is ever gonna work, this should do it.  Other than Kocherlakota's preference for ZIRP on a Buzz Lightyear timescale, the statement was about as un-dovish as could reasonably have been expected.

Get in there! 

It's all about inflation

So.  Today's the day when markets will, presumably, be freed from the yoke of Fed QE for the first time in two years.  After the judders of a couple of weeks ago, equities now seem relatively sanguine about the prospect; could you have envisaged 10 trading days ago that the VIX would be below 15?

What's interesting to note is that while Spooz have roared back nearly to their highs, US fixed income has trod a decidedly more careful path.  Indeed, overlaying a chart of SPX futures with EDZ5 illustrates how resilient rates have been; simply eyeballing the chart suggests that EDZ5 "should" be 30 ticks lower.

Of course, a few things have changed in the interim.   James "5 Minute Macro" Bullard suggested during the equity sell-off that the Fed could defer ending QE.   In the realm of adult analysis, the ongoing weakness in commodity prices could certainly be taken as a deflationary signal.   Well, it could if the Fed were ever prepared to take rising commodity prices as an inflationary signal, which they seemingly aren't.   But hey, what's a little hypocrisy between friends?

As such, the market will pretty clearly focus on the inflationary language in the statement for clues as to where the Fed stands.  The September statement that "the likelihood of inflation running persistently below 2 percent has diminished somewhat since early this year" may well be altered in the wake of the commodity downdraft and the slightly below expectations September CPI.

The magnitude of any change will set the tone for trading over the next couple of days- the larger the magnitude of the change, the more dovish it is likely to be taken.   Of course, given current pricing, one could argue that a dovish outcome is already priced- in certain segments of the market, at least.   Looking at Macro Man's usual-suspect EDZ5, a purchase of the 99.25/12/00 put fly at 2.5 does not look like a terrible way to bet on an outcome that's not quite as dovish as hoped.

Of course,  the phrases "not quite as dovish as hoped", "Yellen", and "profit" are rarely spotted in the same room together.  Given that punters seem to have abandoned all interest in bearish rates plays, however, if fading a dovish consensus were ever going to work, a day like today could well be the time.

Tuesday, October 28, 2014

Automated Lift (song for QE)

With apologies to Elton John.....

Goodbye, then, QE
Though I never liked you at all
You ensured financial markets
Answered the Fed's each beck and call
You'd show your hand each morning
And you'd get into our brains
While you raised the stock of reserves
They gave you a fancy name

And it seems to me that you lived your life
Like an automated lift
You took financial assets
To the sky
And I would have liked to known how
The economy had done
If you were kept in the Fed's pocket
After QE #1

The early years were tough
The toughest rally you ever made
Eurozone created catastrophe
And pain was the price we paid
And even when you died
Oh the press still hounded you
All the papers had to say
Is "We need QE 2!"

And it seems to me that you lived your life
Like an automated lift
You took financial assets
To the sky
And I would have liked to known how
The economy had done
If you were kept in the Fed's pocket
After QE #1

Goodbye, then, QE
Though I never liked you at all
You ensured financial markets
Answered the Fed's each beck and call
Goodbye, then, QE
From the man you drove off of the street
Who sees you as the enemy of anyone
Who thinks while in a seat

Monday, October 27, 2014


Well, the Sunday reaction to the European bank stress test results seems to have been one of relief.   Like Rocky Balboa to Clubber Lang, analysts seem to be saying "You ain't so bad."

Although there were officially 24  failures, upon further review capital raising activities since the end of last year have enabled another 10-11 banks to meet the stress test criteria ex-post; what we're left with is a dog's breakfast of usual-suspect banks, largely from usual-suspect countries.   Indeed, looking at a list of these institutions, Macro Man almost feels like listening to (insert wretched pop song of your choice from 3 years ago here), it feels so very 2011.

Regardless, if markets want to be relieved, they will start by taking the SX7E higher this morning.   After the harrowing decline in the six weeks starting the beginning of September, it should make for relatively stress-free trading for longs in European financials and the periphery.

Or will it?

After all, Macro Man cannot help but recollect that the EBA published "good news" in prior stress test results.   To be sure, this version is a bit more credible, coming with the imprimatur of the ECB's asset quality review; nevertheless, one might credibly question how and why institutions in, say, Germany did "surprisingly well."

Lest we forget, the stress tests in 2011 showed "good" results, with 8 banks failing.   In 2010, only 7 banks failed.

Perhaps Macro Man's memory is failing him in his middle age, but he cannot recall those episodes ending particularly well.   To be sure, there's a different sheriff in town now, and a lot of water has passed under the bridge.  The ECB is revving up a QE program rather than hiking Europe back to the Stone Age.

Nevertheless, and bearing in mind that your author does not possess an intimate familiarity with the balance sheets of every constituent of the Eurostoxx banks index, history suggests that relief rallies on news like this are meant to be sold- particularly if you're long.

After all, the only truly stress-free position in European banks is to be flat!

Thursday, October 23, 2014

If I Could Turn Back Time

So is this A-B-C or 1-2-3?   Inquiring minds want to know.  While the recent SPX rally provided quite a bit of overlap with waypoints from the downdraft, suggesting that recent weakness was indeed corrective, other indices have not.   The jury, therefore, is still out, as yesterday's price action indicated.

The slightly-below-expectation CPI print was presumably enough to raise the hackles of at least a few deflationistas, but really, in the grand scheme of things, it's merely trading water in the range of the past couple of years.

In fact, Macro Man was rather interested to observe that in the latest edition of the Financial Crisis Observatory's quarterly Cockpit publication, they identified several negative bubbles in commodity markets, as well as signs of a strong USD bubble.  Signs that the deflation scare is approaching "tabloid" status, perhaps?

Unsurprisingly, they also identified more signs of government bond bubbles than six months previously- and bear in mind that the document was released on the 1st of this month, before 10y Treasuries ripped 35 bps in one morning!  Intriguingly, the analysis found less risk in equity markets than they had at the beginning of April.   One can only presume that the bubble risks in stocks have receded further.


None of this is to be taken as gospel of course; nevertheless, it is still interesting to observe what the maths say in terms of the sustainability of price action.

Switching gears slightly, the other day while cycling Macro Man had the grave misfortune of having that wretched Cher song "If I Could Turn Back Time" stuck in his head.   How it got there, he has no idea (Cher isn't exactly in the rotation on the MM family Sonos system), and it was only by climbing a few arduous hills that he was able to extricate himself from its grip.

However, the experience got him thinking.  As many readers are no doubt aware, prior to the formation of the Federal Reserve there were more than a few instances of low inflation/outright deflation in the US economy.   This was naturally a function of the metallic monetary standards that were prevalent for much of that time, as well as the periodic financial shocks that hit the economy.  (The last of these, the Panic of 1907, was one of the raisons d'etre for the Fed's creation.)

In any event, Macro Man thought it would be fun to look at stock and bond performance during the pre-Fed era to see if there was any linkage to inflation/deflation.  He sourced data from the excellent Irrational Exuberance website, which purports to have scrubbed data going back to 1871.

He divided the data into 10 deciles sorted by annual CPI inflation, and calculated the mean equity market annual total return for each decile, as well as the standard deviations of those total returns.  He also calculated the average 10 year government bond yield, again using data provided by Professor Shiller.  The results are set out in the table below.

As you can see, deflation was much more prevalent pre-Fed than since the birth of the central bank.  Indeed, in the 43 years preceding the birth of the Fed, the average annual inflation rate was slightly negative- note that the first 5 deciles are all in negative territory.  Put another way, in the 43 years prior to the foundation of the Fed, there were 243 months of negative annual CPI inflation; in the 100 years since, there have been only 166.  There are a number of factors which explain this, not all of which are maleficent. Indeed, one could argue that transatlantic cables and the invention of the telephone and radio were the equivalents during this time frame to the latter day internet and globalization.

Regardless, the moral of the story from the table above is that equities really only showed a sensitivity to inflation at the extremes, performing poorly in times of sharply negative deflation and performing best when inflation was at its highest.   This is clearly not an experience that has been replicated in its entirety during the Federal Reserve era, when peak inflation coincided with execrable stock market performance. (The only properly nasty deflationary episode of the Fed era did, however, coincide with wretched stock performance.)

One wonders, meanwhile, whether bond investors before the Fed were primarily from Wales or New Zealand- the historical record certainly suggests that they were sheep, with yields displaying zero long-term sensitivity to the level of inflation.   Some of this may of course be a data quality issue, but man- it must have been nice to get 4% on a bond investment with inflation of -10%!

What does all of this mean for today's investor?   Quite possibly nothing.   Much as some might wish it were not so, the continued existence of the Fed is indeed a fact of life, and it is very hard indeed to see the modern financial system returning to a framework as rigid as a metallic currency standard.

Moreover, the explosion of debt across vast swathes of the world economy over the past several decades has made deflation a less savory outcome than perhaps it once was, particularly given the predilection for "zombiefication" instead of Schumpeterian creative destruction.

In any event, basing high-frequency investment decisions in the 21st century based on financial pricing in the 19th will almost certainly end in tears.  Nevertheless, it is comforting to know that a dose of disinflation, particularly one that stems from global capacity issues, does not automatically consign risk assets to a watery grave.

That still leaves the tactical issues of how to navigate the end of QE and the possible onset of rate hikes.   Old Diamond Jim Brady, Jay Cooke, and Cornelius Vanderbilt never had to deal with these sorts of issues.    If only we could turn back time....

Tuesday, October 21, 2014

A Hobbesian correction?

So now that the dust has settled (if only for the time being), what are we to make of it all?  Is there another sting in the tail for equities, or was this merely a Hobbesian correction (e.g., nasty, brutish, and short)?

We may find out soon enough.  A few short days after the market was in abject panic, and we're already at the tell-tale 1900-1905 region on Spooz.  As a refresher, this is not only the region of the 200 day moving average (a break of which saw the downtrade accelerate), but also a level that has prompted a reaction on previous visits as well.

Gun to the head, Macro Man would take the side of the market resolving higher over the next month or so.   While it's true that VIX has already fallen very sharply since it touched 30 (an "old school" turning point level, as Macro Man opined in one of his rare Twitter forays last week), over the past couple of years gap reversals from a VIX high have tended to hold and extend.  And this was quite a gap reversal.....

One might also credibly project that buybacks will accelerate after this earnings season and into the end of the year.   Not only is Q4 a seasonally strong time for buyback activity, but many companies might find their stock prices "on sale" given the recent volatility, an added incentive to engage in that sort of activity.

Ultimately, Macro Man's equity market "conscience" resides with a model that he has run with some success since before the crisis.  This simple model, which he has occasionally referenced over the past 8 years, is a simple projection of 12 month forward SPX returns.   Although the forecast is not to be taken as gospel, he has found that both the shape of the line and the magnitude of the forecast relative to volatility to be useful guides for future performance.

In this case, the 12 month projection is still well above the historical norm, and has even improved slightly after a small hiccup over the summer.  As long as the model is this bullish, Macro Man struggles to adopt a secularly bearish stance.

That having been said, there are further insights to be gleaned than simply looking at the 12m projection.   As noted periodically in this space over the last several months, volatility should be higher in the future than it was in the pre-October recent past, and the last few weeks' juddering is actually a normalization of the volatility profile.  That ex ante reduces the projected Sharpe ratio of holding equities moving forwards.

Moreover, it seems quite clear that abundant liquidity is a (the?) primary driver of expected equity returns.  No, not market liquidity, which the past couple of weeks have shown is not abundant at all (again, not a great shock.)   Rather, it's financial liquidity, courtesy of ZIRP-world, QE, and the reluctance of any central bank to rock the boat.

Macro Man can disaggregate the forecast above into what he terms 'liquidity' and 'growth' vectors.  Plotting a Z-score of these factors relative to the historical norms, we see that the vast, vast majority of the large expected returns are a function of financial liquidity factors. 

It's interesting to note both the astounding degree to which liquidity factors have driven expected equity performance, and also that they seems to have tailed off recently.  Should this trend continue, then it would be up to growth factors to pick up the slack or else see the forecast return decline- perhaps sharply.  When that happens, of course, Macro Man reserves the right to change his mind and raid his closet for his bear suit.

Until then, he plans on continuing to tread warily, adding risk selectively when market have a tantrum, and cutting back on risk when the SPX looks like the festival of San Fermin.

Thursday, October 16, 2014

A Fed poll

Well, that was...exciting.  The long-awaited return of volatility has arrived with quite a fanfare (or is that a requiem?), with yesterday's whip-saw price action unlike anything observed since the US downgrade furore in 2011.

How crazy was it?  Macro Man got one of those "eurodollars screaming higher, no offers in sight" texts from one of his brokers yesterday morning, even though neither of us are currently in a seat.   One can only presume that plenty of punters who are in seats got similar messages, if not shoulder taps from risk managers.

Indeed, the late-session selling that has characterized so much of this "meltdown" in stocks is highly symptomatic of both margin call-related selling and rebalancing from the uber-leveraged-ETF-that-separates-the-public-from-their-money crowd.

Macro Man was intrigued to see the VIX print 30 yesterday as Spooz shanked 3%; in the good old days before the GFC, 30 was usually a good bellwether for at least a short term bottom.  Sure enough, stocks did rally sharply thereafter, though the above-noted factors knocked them off of their intraday high.

A key question for many investors, macro or otherwise, is how or if the Fed will react to recent developments.  On the face of it, it's frankly absurd to even raise the question.   A 10% sell-off in equities is hardly outside of the realm of normality, and most forecasters still expect US growth of something close to 3% in the second half of this year, with ongoing improvement in the labor market.  The downdraft in energy prices is bad for those involved in its extraction and distribution but good for everyone else; as Polemic has noted in the comments recently, the magnitude of the recent sell-off is more consistent with a purging of financial excess than a reassessment of the fundamentals.

And yet......this is the same central bank that pushed through an intra-meeting cut because of a French rogue trader in early 2008.  The same CB that likes to reference 5y5y breakevens when they tank (even though a prime driver of the pricing of inflation bonds is energy, which the Fed strips out of its own inflation targets.)  The CB that has reminded us ad nauseum  that asset purchases are not on a pre-set path, and that the pace of QE can go up as well as down.

Macro Man isn't naive enough to suggest that yesterday's fixed income melt-up was the result of a sober re-assessment of the likely trajectory of Fed policy.  It wasn't.   And yet, for yields to stay here for any meaningful period of time, it will likely require just such a re-assessment.  An obvious catalyst would be for the Fed to shake up the market's (erstwhile) perception that monetary policy is entering a quiet period on auto-pilot while the FOMC girds its courage to actually start tightening.   What better way to shake up that lazy view (and to show the equity guys that Janet's got your back) than by not ending the taper in a couple of weeks, but extending it through then end of the year?

What do you think?   The blog traffic-o-meter has gone shooting higher over the last couple of days, which is usually a great sign that something has gone horribly wrong somewhere.  Please respond to the poll below to help us gauge whether the expectations for the Fed have shifted....or just the price of fixed income.

EDIT:  Responses here.