Tuesday, July 17, 2007
When the weather's getting you down, there's nothing like bolting town to escape....unless you happen to go to Scotland on business, where it gets even colder (and, if possible, wetter.) Golf fans 'round the world need only tune into this week's Open at Carnoustie to get a flavour for what Macro Man and other denizens of the appropriately-named Blighty have put up with this "summer."
A day out of the office also affords one the opportunity to reflect on markets without the pressure of a screen and brokers providing, during environments like these, plenty of noise but lamentably little signal. Macro Man has been giving plenty of thought to volatility and risk premia after the latest victory of DOTW (Dipbuyers Of The World). And upon further review, he still expects both realized volatility and risk premia to rise, even if the absolute return of risky assets remains quite strong. Consider the following:
1) The credit issue isn't going away. Not only is the turd-calibre BBB- ABX index plumbing new depths (left hand chart below), but ominously even the AAA rated tranche is starting to roll over (right hand chart.) And you heard it here first: the US is indeed asking China to buy more mortgage backed debt!
2) The quality of economic data remains poor, to say the least. It now appears that that some of the missing construction job losses in the US may not be missing after all. Per the usual, we'll probably have to wait for the benchmark revisions in Q1 2008 to tell us how horrible the construction job market was in Q1 2007.
3) Will the strength of the euro fracture Europe? The strength of the euro exchange rate is probably close to the level where it will start to impact ECB monetary decisions, if we're not there already. Of course, attempted intervention by Nicolas Sarkozy could well encourage the ECB to stay the tightening course when they otherwise might be tempted to stand pat. Such suboptimal policymaking should ultimately deliver suboptimal economic outcomes, which should drive financial market volatility.
The UK press is already cackling at the prospect; yesterday saw columns in both the Telegraph and the Times discussing Europe's currency problems. Neither mentioned the role of FX reserve managers in driving euro strength, which is one of the reasons why Macro Man chooses to highlight the subject so often. Those unfortunate enough to trade foreign exchange know, by and large, that SAFE, CBR, the Gulf monetary/investment authorities, et. al. are hegemonic participants in the EUR/USD and GBP/USD rates; the mainstream media remains blissfully ignorant, for some reason.
4) Don't look now, but energy prices could/should become a concern again. Goldman's excellent oil analyst Jeff Currie recently suggested that crude prices could reach $90/bbl without OPEC production increases; tellingly, oil curves have moved from steady contago into backwardation recently. The chart below shows the first minus the fifth Brent contract, for example.
This should both increase the attraction of oil longs (despite the recent rise in spec length) and increase the inflationary impulse from energy should the prices be sustained beyond September (due to base effects.) Macro Man has tangential exposure through his TIPS position (which recently paid its coupon) , but may consider adding some calls on a dip.