Friday, May 11, 2007


Well, well, well. The stories are flying this morning, with the following featuring prominently in morning spiels:

* PBOC will raise rates (again) to contain the rampant equity market. Recent surveys of Chinese consumer expectations of stock market returns make the US public during the dot com boom seem like Eeyore in comparison. Either way, it wouldn’t appear to have much of an impact- administrative controls are more likely to dampen enthusiasm

* Thailand will abolish capital controls. This one’s already been denied by the central bank

* Warren Buffett is getting stuck into FX again, and this time he’s buying yen. An interesting story, as the yen would fit Warren’s classic preference for a value, a trait that cannot reasonably be applied to most other developed market currencies against the buck. If those other long term investors, CBs, decide to abandon carry in favour of value, then we finally might have a story that would justify structural yen longs

* BOJ governor Fukui is getting an itchy trigger finger. Perhaps, though any tightening would almost certainly be deferred until after the election. While BOJ policy has certainly come in for some stick in some quarters, Macro Man finds it amazing that real government bond yields in Japan (2% nominal GDP growth) are among the highest in the developed world, while those in China (15% nominal GDP growth) are zero. Can there really be any doubt where the font of global liquidity is located?

Yesterday, Macro Man alluded to another new trade. His timing in deferring it was fortunate, as yesterday’s chain store sales-inspired dip in stocks will make the entry point more attractive. The trade is predicated on the notion that monetary policy in Brazil is switching gears substantially, away from focusing purely on inflation fighting (with a concomitant acceptance of high real interest rates, a strong exchange rate, and low real GDP growth) and more towards growth, which will imply lower interest rates, an even more aggressive fight against exchange rate appreciation (the finance minister declared that “the sky is the limit” for reserve growth), and higher economic growth.

A looser monetary policy and somewhat more stable exchange rate look to be a classic recipe for equity outperformance, perhaps even above and beyond that observed over the past few years. Higher economic growth should entail higher earnings growth, and lower rates could generate a multiple expansion from the current 12.75 trailing/ 10 estimated ratio.

At the same time, the BRL is crowded (foreigners are now short $18 billion on the BM&F), should enjoy a lower interest rate premium in the future, and has an aggressive CB on the other side. This looks like an excellent RV trade in the making. Certainly the correlation between the Bovespa and the BRL has been strikingly high over the past several years. What is interesting to observe is the relative volatility, however. Current three month historical vol on the Bovespa is currently 28, having reached a high of 34 last spring during the unwind. Three month historical vol in USD/BRL, meanwhile, is 5, down from 38 (!) last spring.
So...we have a case where conditions are likely to shift more favourably to the Bovespa and less to the real, the two retain a high degree of correlation, and vol is exceptionally low in BRL with record positioning. This looks like a great opportunity to buy Brazilian equities and hedge with USD/BRL options.

Macro Man will therefore buy 200,000 EWZ (ishares Brazil ETF) and hedge by buying $25 million 3 month AMF USD/BRL calls. These positions will be managed dynamically as time passes.

As a housekeeping note, Macro Man’s in-house option pricer gives values for yesterday’s one touch purchases that are above the purchase price. Tempting as it is to believe that he has low-ticked the 10 year vol market, he has to concede that it more likely reflects the sensitivity of these structures to the inputs and the model used. He will therefore value them at cost in the P/L and update the market price periodically.


Anonymous said...

interesting trade. personally, i like longer maturity BRL debt, but that is a very very crowded trade and it reflects the fact that i feel more comfortable with int. rate and fx exposure than equity exposure ... in part b/c of what i know, and in part b/c it seems more insulated against "china investment/ equity boom" collapses risk.


Macro Man said...

Yes, there is clearly a risk with a generalized equity meltdown...but that's why I referenced the relative collapse in USD/BRL vol. The trade buys $11 million in equity and $25 million in if there is a normaliztion in currency vol, the larger position size should mitigate some of the losses.

Debt probably does OK to, but as you note there is good news priced (curve is inverted), and ultimately the upside is capped by the very nature of fixed income.

In any event, a set of circumstances that are good for BRL fixed income should also be good for equities, as EM fixed income trades more like equity in the short run than it does developed market fixed income- i.e. it sells off during risk aversion.