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.

Wednesday, October 15, 2014

Fixed income gets medieval

Although the equity guys get the headlines, given that that this month's Spooz Swoon has taken the index back to "barely up on the year" territory (oh, the humanity!), spare a thought for those poor souls toiling in the classic macro crucible of short-end fixed income.

For today that market has well and truly gone medieval, sending EDZ5 shorts (including your correspondent) to the rack:

Note, gentle readers, that today EDZ5 has made an all time contract high.    Consider the panic button pushed, the stop losses executed, and the market's tail tucked firmly between its legs.  That 10 year yields printed on a 1.80 handle raises the question of what the Fed might hope to accomplish by re-introducing QE (as hinted by Williams the other day- that didn't take long!); they can hardly complain that the level of back end yields is stifling growth!

Not that the pain is exclusive to the US, mind you; the rally in some of the longer-term short sterling contracts has been truly breathtaking.  It's been said that there are two kinds of short sterling traders- those that have blown up and those that are going to.  We can probably add a few more names to the later list, it would appear.

(Thanks to FC for the chart)

Now, one of the wonderful things about trading short ends is that you can apply some sort of policy rate path 'valuation anchor' that doesn't really exist in equities, FX, or even long end government bonds.

Of course, a re-setting of the expected policy rate path is one of the costs of doing business in this market.   By the same token, it is also possible to mistake stop-loss pain-trade price action for just such a re-setting.   Macro Man suspects that that represents a lot of what we are seeing today.  He is therefore sticking to his valuation guns, albeit with the proviso that he'd like to see some semblance of normality before adding anything to a position.   Far better to sell 99.25 on the way down than 99.35 on the way up- at least if one plans on sleeping well at night.

In the meantime, he's going to take his time on the rack and try to manage it as comfortably as he can.

Tuesday, October 14, 2014

What now?

It's times like these that Macro Man really misses his Bloomberg account.  Not so much for the news- life without the "red headline" is just fine, thank you very much- but more so for the charts (in terms of the breadth of chartable instruments) and especially the downloadable data.  Unfortunately, the kinds of ad hoc studies and indicators that have generally made this place so much fun to write (and hopefully to read) are just not possible without having reams of data close at hand.

Nevertheless, it is still possible to comment upon the doings of the financial world, even if it's from a more detached perspective than your author would prefer.  Indeed, a somewhat detached perspective allows one to maintain a sense of equilibrium when it seems others may be losing theirs.  The current environment may be just such a case, if some of the missives that Macro Man's received are any indication.

What do we know?

* The SPX has broken a 2 year uptrend line and breached the 200 day moving average for the first time in a couple of years.

By an amazing coincidence, the Federal Reserve is about to stop purchasing assets for the first time in a couple of years.  In the QE era, there has been a very strong inverse relationship between the degree of policy accommodation and the level of equity vol.  As such, from Macro Man's perspective, the current "collapse" merely represents a normalization in the Sharpe ratio for holding equities, credit, other risky assets etc.

* The Fed reacts asymmetrically when the newsflow turns somewhat negative.  Dodgy growth in Europe, Ebola, a strong dollar....pick a card, any card why hikes need to be priced out.   This is hardly a new development, however, and recall that a couple of the notable hawks will feature on the committee next year.

One of the reasons that the last few years have been challenging for global macro investors is that key assets haven't really gone anywhere, oscillating within ranges that sometimes are broad and sometimes aren't.   One of the key features of this environment has been that central banks have tended to "push things to the middle."   CBs have tended to lean against price extremes in markets, most notably against overtly hawkish developments in monetary pricing and "undue" weakness in risky assets.

EDZ5 is now at (actually, slightly though) the top of its yearly range.   Macro Man's call to fade strength late last week was clearly premature.  That being said, key Federales have kept singing from the "mid-2015" hymn sheet; even if that's proven incorrect and rates don't move til September of next year (Macro Man's base case), pricing LIBOR at just 80 bps for the end of next year looks low.

* FX corrections are painful.   Industry performance reports suggest that macro is fully engaged with the long dollar trade (as forecast here!), and the research-sphere was awash with "OMG Record $ length on CME" emails over the weekend.  Let's leave aside the fact that the CME captures CTAs, not "macro"; they may overlap in the Venn  diagram, but they aren't the same thing.  CTAs don't care that their Twitter feeds are going haywire with panic or that the Ebola headlines are pretty scary.   They push the button and do what the model tells them.

Now, an uptick in market or portfolio level volatility may encourage some position reduction to  maintain a constant level of portfolio level VaR.  But the meat of the $40 someodd billion dollar long won't be cut until the main signal turns.   By Macro Man's read, we're still a ways away from that.

Which leaves discretionary macro.   USD/JPY has fallen 3% from its peak and looks more offered than glossy photos of Roseanne Barr in a leopardskin bikini.  The euro has corrected by about 2%, but somehow feels like it's less than that.  This probably tells you where the positioning was (and still is?)  Early returns for the industry this month have not been encouraging; one can only assume that they have deteriorated further over the last couple of days as a flock of flamingos takes flight.

Having crossed the proverbial P/L Sahara for much of this year before finding an oasis in August/September, it seems unlikely that punters will wish to venture forth once more with only a thimbleful of water.   In other words, the impulse to protect what gains remain in the tank will be very strong indeed.

From Macro Man's perch, this is not 2000, 2007, or any similar market-topping analogue.   While there has been some financial excess, there is nothing like the kind of real economy excess to produce a proper meltdown/recession.  As noted above, what we are observing is the start of a normalized volatility regime, at least in certain segments of financial markets.  If anything, the proper historical analogue for next year will be 1994 or 2004- two years when stocks kind of scuffled as monetary policy was tightened for the first time in several years.  (For fun, look what happened to USD/JPY on Valentine's Day 1994.)

While your author is not yet dipping his toe into equities to re-engage, nor is he selling any more at these levels.  Standing pat might be a luxury that professional longs don't enjoy...but it's one that he's going to exploit while he can.

Friday, October 10, 2014


Nasty price action all around recently, but particularly in the riskier spectrum- Europe and the Nasdaq.

The flight of the flamingo rumbles on......

Thursday, October 09, 2014

The Fed notices the dollar

Well, that was an interesting set of Fed minutes, in much the same way that colon exams are interesting to their unhappy recipients.  For many market participants, Macro Man would venture to guess, the outcome was a series of intense if not not pleasant sensations.

Your author doesn't intend to engage in a thorough exegesis of the minutes, but there were a number of points which struck him.  The shot which hit the market's bow was, of course, the explicit reference to the dollar, and how it might impact both America's external accounts (X-M in GDP accounting) and, of course, the all-important 2% target for the core PCE deflator.  We can leave aside comments that the inflation target is really nonsensical- the average for the decade before the crisis was 1.75%, for example- and instead focus on why the Fed chose to raise the issue.

The Fed cited the euro, yen and sterling as weakening against the dollar.  Hmmm...let's see....the ECB had just announced an asset purchase program, speculation was mounting that the BOJ would add to its own QQE program, and the Fed meeting took place the day before the Scottish referendum, thus putting a significant risk premium on sterling.  More broadly, even in the absence of idiosyncratic factors elsewhere (the same sort of idiosyncratic factors, it need not be said, that provided a US tailwind via a weakening dollar for much of the Fed's QE adventures), does it really come as a surprise that the dollar might strengthen as the Fed starts to contemplate its first tightening in nearly a decade?  Really?

Perhaps Macro Man's reading too much into this, but it looks like one of those cases where those PhD models that assume "all else being equal" might have allowed its range of adjustable factors to be a little too narrow.  Either that or, as Yellen herself suggested, the Fed might be able to learn something from markets.   Sadly, if the recent dollar rally came as any sort of surprise, the FOMC might have to start with the basics- defining "mine", "yours", etc., because it would appear they have a LOT to learn.

Moreover, thanks to the shale revolution and the generally well-behaved consumer, it's not exactly like the US trade deficit is at all threatening.   Indeed, the current deficit is narrower in nominal dollars than it was a decade ago, and doesn't appear to be going anywhere.  (Admittedly, it's much too early for the recent dollar strength to impact the data.)  In any case, it's not like a stronger dollar is full of unalloyed negatives.   Lower commodity prices deliver a tasty positive income shock to households, which could spur a bit of  the spending that has thus far been fairly tepid in the expansion.

As for the DXY, it does look like the biggest flamingo in macro space currently.  It's easy to forget how neat the euro down-trade was; it could easily retrace back towards 1.30 while keeping the trend very much intact.

Another interesting feature of the minutes is that while they one again played the "stretched stock valuation" card, on balance the financial stability issue was pooh-poohed while the beneficent impact upon household balance sheets was pimped.  (OK, maybe not pimped, but at least mentioned.)  The Fed of course cannot say that they are targeting Spooz,  but it seems safe to assume that Yellen doesn't complain when they rip.

As for Macro Man, he still sees them in something of a no-man's land and frankly uninteresting at this juncture.  This is particularly the case given the forthcoming earnings season.

Finally, Macro Man was interested to read a couple of points which were roundly ignored by the market.  The first is that the minutes again noted that market pricing was quite a bit different from the dots (even more so now!) , ascribing this to pricing a element of a downside tail risk premium from a normal baseline.   This is probably somewhat accurate, though market pricing also likely reflects a "can Yellen actually look at herself in the mirror and hike" risk premium, given the extent to which she accentuates the negative.

What was also interesting is that several participants also suggested that current forward guidance gave the market a false sense of (dovish) security vis-a-vis the timing and magnitude of eventual rate hikes.   Just the other day, Dudley reiterated that a mid-2015 liftoff point seemed sensible...and yet EDM5 has rallied more than 10 ticks in two days!  Macro Man's favourite contract, Z5, rallied nearly 20 ticks peak-to-trough over the same period.

Yes, the minutes raised the USD and weak domestic demand elsewhere as "new" (ahem) potential negatives, and as such were correctly interpreted as dovish.  But they weren't unambiguously so- certainly not, in your author's opinion, to push Z5 from close to the bottom of its range to close to its top in two days.

Macro Man's had good success this summer playing the range in this contract, and it looks like it might be time to start contemplating another portfolio adjustment.

In the meantime, if the Fed really wants to "learn from markets" about arcane things like why hawkishly divergent monetary policy vis-a-vis the rest of the world might support the dollar, they should drop your author a line.  He's got some free time and could use a nice fat consulting contract.  And would put a dent in the unemployment gap......