Tuesday, July 17, 2007

Upon further review...

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.

5) Currency complaints aren't just the province of Europe. New Zealand finance minister Cullen suggested that the government could change the RBNZ's mandate to prevent further rate increases , which in turn strengthen the kiwi dollar. Killing the inflation-targetting goose that laid the golden economic egg would probably be a case of the cure being worse than the disease, but it once again suggests that policymakers the world over are being tempted by suboptimal policy options.
And that, at the end of the day, should help promote a secular rise in financial market volatility once one cuts through the day to day noise. Even if the DOTW remain profitable moving forwards, Macro Man cannot help but expect that their Sharpe ratios will decline. He has to admit, however, that such a development doesn't appear imminent; then again, it never does.


Anonymous said...

'ominously' is the right word. For the AAA tranches to be impaired would require a truly awe-inspiring collapse in the subprime market - which certainly is being implied by the ABX market but not at all by actual performance data of underlying deals (which while bad, just isn't going to hit the AAAs, or AAs for that matter). A sign of the massive dysfunctionality of that market.

Macro Man said...

It is perhaps a cliche, but I nevertheless believe that bad things generally happen when people (be it traders, portfolio managers, real world business people, or policymakers) act because they HAVE to, rather than because they WANT to.

Shoulder tap margin calls of the kind that would throw the baby out with the bathwater are just such an occasion.

Anonymous said...

now if only i can convince someone like CIC to load up the boat on some feisty paper.

and no i'm not long the ABX, seriously....

Anonymous said...

yep, subprime is a buying opportunity for the CIC -- i suspect there are lots of folks making the case directly to them.

Macroman -- any idea why the hegemonic forces in the fx market, who usually are hegemonic forces in the bond market too, didn't show up at all in the TIC data? The gap between my measure of global reserve growth and recorded inflows to the US has never been bigger ...


Macro Man said...

Brad, my guess is that they probably did step back from the market a bit- after all, it's quite telling that yields rose pretty sharply in May, which is what you'd expect in the absence of a price insensitive buyer.

It could be that CBs, China in particular, kept their dollars on deposit- in anticipation of some diversification flow (which we've subsequently seen in June/July) but also in anticipation of handing the money over to CIC.

So while some CB buying may well be hidden via third party transactions, it's not clear to me why CBs would have abandoned buying UST at auction in favour of paying bid/ask spreads from banks.

My guess is that there was something of a disengagement from the market, which helps explain why yields rose so sharply in the face of decent but not stunning economic data.

The size of the inflows also reinforce my belief that the US can finance its current account deficit without CBs, albeit at a greater cost (higher yield.) That having been said, I am surprised at the size of the bond inflow at the yield levels prevailing in May, though some of that could easily have been private-sector short covering.

Dataman said...

I recently discovered your blog along with bsetser's and now read them both on a daily basis. Thanks for writing down your insights.

loren said...

Curious that you see oil going higher. Another blog I follow sees it declining. http://zmansenergybrain.com/?p=459

Anonymous said...

We have lost money on the two BSC hedge funds. they have issued a cryptic statement today.

What is really going on MM ? $ USD fell very nicely as well.

Macro Man said...

Without wishing to be flippant, in the event you suffered a deleterious loss, but I'm not sure what is cryptic about "all the money's gone." I think most people probably expected that the more highly levered fund had lost everything, and that proved to be the case.

On the margin, returning 10 cents on the dollar for the original fund may be a bit worse than expected...hence the dollar decline.