Monday, January 15, 2007
This week is shaping us as judgement week for the carry trade. Consider the following events risks, any and all of which could derail the market’s love affair with at least one aspect of the G10 FX carry trade:
* Tuesday sees the release of UK CPI. After last Thursday’s shocking rate hike, the pound has roared as many carry traders have substituted sterling for dollars in their FX carry baskets. However, Macro Man continues to believe that there is a 3% print already in the price for both short sterling and the GBP. Any inflation print on a 2 handle could prompt a nasty unwinding
* Tuesday evening sees the release of New Zealand CPI. The RBNZ has come down on the hawkish side over the past few months, and many in the market expect that trend to continue. This CPI figure will provide a substantial hint as to whether the RBNZ will be as hawkish on January 25 as many seem to expect. Moreover, the bank will be releasing its own estimate of core CPI for the first time, which will provide the market with a sense of underlying inflation pressures. In the past, DR. Bollard, governor of the RBNZ, has alluded to the recovery in housing as a key inflation risk for the country. However, the latest building consents data actually suggests a relapse (see below).
* Thursday sees the BOJ meet, and with it a chance of a rate hike in Japan. Recent press leaks suggest that there is a good chance of a tightening, although the market evidently remains 50/50 on the issue. Although Macro Man continues to believe that moving rates from 0.25% to 0.50% will do little to alter the attractiveness of the yen as a funding currency (three month interbank rates are already 0.60%), he concedes that the market may see otherwise for a short period of time. Thus, a rate hike could prompt a temporary unwinding of yen-funded carry trades.
* Finally, Thursday also sees the release of US CPI. It’s been several months since the market has worried about US inflation, and a sense of complacency appears to have crept in. However, with the tone of the growth data having improved over the last month, a 0.3% monthly reading on the core data could begin to prompt concerns that the Fed may actually (gasp!) have to tighten rates this year. Such an outcome would likely disturb the carry trade quite a bit.
In a sense, Macro Man is hoping for a bit of disruption. Although he is long TRY, the ultimate carry currency, he is short NZD and has yet to implement the beta plus G10 carry basket in the portfolio. So in actuality he feels short of FX carry, which is not a nice feeling when the yield hogs strap on the feed bag.
Similarly, he has yet to implement the US equity component of the beta plus strategy. After a few early year jitters, equities are looking more constructive as early earnings reports have yielded encouraging news. And at the end of the day, 3% real GDP growth (which consensus is swiftly moving towards for the upcoming Q4 release) and relatively low inflation is a great macro environment for equities.
Macro Man will therefore layer orders to go long US equities. He has decided to do so through the SPY, the S&P 500 ETF. This instrument provides intraday liquidity, pays a dividend, and has a lower fee structure than even the Vanguard 500 index. As such, the total returns of the SPY have been even higher than the Vanguard fund. On the occasions in which Macro Man wishes to hedge equity exposure, he will probably do so through futures.
Macro Man will allocate $60 million to the equity beta-plus strategy, 60% of his nominal AUM. Given the stochastic nature of price action and the upcoming data event risks, he will attempt to do so on the cheap, by scaling bids below the market. He therefore leaves the following orders:
* Buy 139,860 SPY at 143
* Buy 140,845 SPY at 142
* Buy 141,844 SPY at 141
At the same time, he bids 125 to close out his short DIA position. He retains the long SPH7 exposure at least until he has purchased the first slug of SPY.
Strap on your crash helmets, ladies and gentlemen: it promises to be an interesting week.