Time to act?

Holmes and Watson would no doubt have been pleased by yesterday's price action, as the caning of the S&P 500 injected yet more risk premium into financial markets. The news flow released before and during yesterday's trading- HSBC taking $45 billion of SIVs on-balance sheet, Goldman downgrading HSBC, Chuck Schumer taking a break from bashing China to bash Countrywide, Citi to shed loads of jobs- did not exactly engender a feeling of warmth and stability in the marketplace, and it showed.

The price action in bonds was stunning, with Treasuries rallying hard across the curve. It smelled of capitulation and/or convexity-type activity (and for Macro Man it was, as he was stopped out of the short TUZ7 position), given the extent of the rally. However, since the US market close it's been sweetness and light, courtesy of the news of ADIA's $7.5 billion capital injection into Citigroup.

The deal is strongly reminiscent to two other deals in Citi's history: Prince Al-aweed's famous share purchase in 1991, and before that Warren Buffett's purchase of Saloman preferred stock in 1987. In each of those prior deals, the terms were pretty advantageous to the buyer, and this time around is no exception; an 11% yield and conversion strikes starting near the current price look like a home run for ADIA. Memo to John Thain: if you want any more cash, Macro Man will be happy to invest on those terms p.a.

However, it's almost certainly premature to hail this as any sort of turning point. The Buffett deal with Solly's, for example, was consummated in September 1987, just a few weeks before the crash. Moreover, if Citi needs to shore up its capital base on those terms, it begs the question of just how bad financial market conditions must be.

Over the past few months, Macro Man has been fairly critical of the Fed's relatively aggressive easing of the funds rate. He stands by that view, believing that the funds rate should be used to address macroeconomic issues. The current situation, by contrast, is a microeconomic problem- the non-functioning of certain credit channels in the economy- that threatens to become macroeconomic if not properly addressed.

Consider, if you will, the ratio of 3 month LIBOR to 2 year not yields (looking at the spread between the two yields similar conclusions.) Under normal circumstances, the ratio of the two will be around 1 or so; higher if the Fed is restrictive, lower if the Fed is accomodative. Since 1986 the average ratio has been 0.94, reflecting that the Fed has, in aggregate, eased policy over the last 22 years. The ratio is currently 1.63, higher than in August and much higher than any other period since the BBA began publishing LIBOR fixings.
This is a direct reflection of the non-functioning money markets and reveals the degree to which market liquidity conditions have tightened. It is unsurprising, therefore, that equities and other risk assets (including erstwhile bulletproof EM darlings like Brazil) have come under the cosh recently.

Now perhaps the Fed wants this kind of tightening of conditions, but given the lip service that they've paid to "the proper functioning of the financial system", it would appear not. So these conditions, based on what the Fed has told us, merit a response. Per the above, Macro Man believe the solution should be microeconomic rather than macroeconomic, via aggressive open market operations from the New York Fed, providing the system with as much cheap funding as it needs to restore confidence and normalcy.

And while the NY Fed did announce a term repo yesterday that will extend over the turn of the year, it was almost worse than nothing. An $8 billion repo is a drop in the bucket compared to the demand for funds, and perhaps suggests that the Fed does not understand the true scale of the problem. And if that's the case, things will likely get worse before they get better. For starters, the Fed may want to add another zero to their term repo volumes should they wish to assuage market fears of an implosion of the banking system.

What seems clear is that Treasuries have rallied to the degree that even non-profit maximizers cannot be persuaded to buy them if they have a choice. The Fed's custody holdings of Treasuries for foreign CBs have begun to fall, mcuh as they did in August, even as Agency holdings continue to build up. August's trend was ultimately reversed by the discount rate cut and subsequent follow through; will the Fed act this time around?
If they do, then equities could be in for a nice bounce. Last week Macro Man observed that VIX had failed to make a new high even as the S&P 500 made a new low, and mused whether that was a buying signal. Ex-post, the answer was pretty clearly "no." But Macro Man went a bit further and conducted a simple study to measure the efficacy of a VIX divergence strategy. If, on a given trading day, the SPX closes at its lowest level of the past 25 days but VIX does not close at its high of the past 25 days, the system flashes a buy signal. The market is then bought at the following day's open and sold at the close 5 days after the signal is generated.
Over time, this simple 'divergence play' model does seem to produce profits. The return curve of the strategy is laid out in the chart below, going back to 1990. The hit ratio of the strategy is 59%, with an average winner of 2.2% and an average loser of 1.9%

The strategy is far from perfect, and there have been periods of significant drawdown. Nevertheless, it's not bad for a couple hours' work...and suggests that if the Fed does realize that it's time to act, then equities could fly, if only temporarily.
If, on the other hand, the Fed remains focused on the macro at the expense of the micro...then Macro Man will need to lay even more hedges on his long equity beta plus portfolio.


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Anonymous
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November 27, 2007 at 10:49 AM ×

MM, I may be oversimplifying a bit, but isn't the VIX NOT hitting new highs when SPX hits new lows, an indicator that the major panic button has not been hit yet, and consequently, the SPX needs to go down further to induce those last brave souls who sold puts/vol/ to throw in the towel? You are assuming that someone out there is smart enough to be selling vol ahead of a potential rebound, when that someone may just be getting out of a long vol position, as opposed to a going naked short vol... Not saying you are wrong, but there are 2 ways you can look at the data.

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Macro Man
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November 27, 2007 at 11:00 AM ×

My (perhaps simplistic) take is that when the market (i.e. sophisticated players) is long/not hedged, they pay up for options and VIX goes up. When the market has already hedged or is short, there is less aggregate demand for options so VIX does not track the SPX as closely.

The implication is that if market is short or hedged, a rally becomes more of a 'pain trade' and thus becomes more likely.

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Anonymous
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November 27, 2007 at 11:52 AM ×

your theory could be right, or it could just be that the strategy was lucky enough to be biased to the side of the trend(bull market of equities), how can you be sure it wasnt that

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Macro Man
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November 27, 2007 at 12:49 PM ×

The short answer is that I can't...though the fact that the strategy returns have comfortably exceeded the late 90's highs, whereas the underlying index has not, does suggest that there is some embedded alpha in the idea. Of course, if I did discovre a failsafe trading strategy out of this....I'd hardly give it away for free, would I?

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Anonymous
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November 27, 2007 at 1:09 PM ×

mm,the CAD,gold,GBP,TRY are all getting pounded lately, yet the euro is the only one holding on to its all-time highes, im thinking it might be a slam dunk to short the euro at this levels betting the divergence wont hold

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Anonymous
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November 27, 2007 at 1:31 PM ×

MM - what tool did you use to backtest your vix divergence strategy? Thanks!

ti

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Macro Man
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November 27, 2007 at 1:47 PM ×

Anonymous, the only problem with selling euro is that FX reserve managers keep buying it!

Ti, Excel and mr brain are what I used.....so judge the results accordingly. It was a relatively simple study.

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Anonymous
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November 27, 2007 at 2:26 PM ×

macro -- care to offer any details on which fx reserve managers are buying? and how does the current market differ from say last april/ may, when the reserve managers had -- judging from the data -- even more cash than they have now (though tis a bit harder to track the flows from the central bank data when so much is in the hands of slow reporting petro-states)? I am trying to differentiate between euro buying linked to fast reserve growth and the need to sell to meet portfolio targets, and active diversification (i.e. an effort to lower the $ share of reserves).

bsetser

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Macro Man
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November 27, 2007 at 2:31 PM ×

Brad, I think participation has been fairly broad- Asia, Eastern, Europe, and Middle East.

Some is no doubt down to recycling new reserve assets (from oil, trade, capital inflows), but I think more is probably down to getting to benchmark...it's the Q4 seasonality that seems to support EUR/USD at the end of every year.

From what I hear, the reserve managers themselves are less than enthralled at adding to the euro weight of reserve baskets at these levels: it seems to be a common view that EUR/USD is well above its long term equilibirum level.

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Anonymous
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November 27, 2007 at 3:48 PM ×

re: watson, i think the dog that isn't barking is voldemort because he's being fellated by bernanke & co. (paulson); an unpleasant picture to be sure, but hard to keep out of mind... if fed/treasury ever stop their ministrations and china/saudi simultaneously revalue, 2010 is a lot closer than it appears -- the emperor has no clothes, the US is no longer master of its domain (a vassal, if not slave, to its creditors)

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November 27, 2007 at 8:24 PM × This comment has been removed by the author.
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November 27, 2007 at 8:26 PM ×

http://www.mrbrain.com.br/

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Macro Man
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November 27, 2007 at 8:56 PM ×

Ha, amusing (if surreal) spot there, CB. I'd originally intended to write "my brain", but after I posted I spotted the error...and figured "mr. brain" conveyed the message just as well if not better.

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Anonymous
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November 28, 2007 at 2:59 AM ×

I tend to agree with the reserve managers, and I think most would agree that I am more than a bit of a dollar bear -- this isn't really the time to buy euros. 2005 or even 2006 was.

that said, are are reserve managers willing to make the opposite bet and add to their dollar allocation? I.e. dollar is cheap, and while over the long-term it may make sense to hold a balanced portfolio, in the near term it makes sense to bet on the $ (and then to rebalance at a better rate)?

bsetser

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November 28, 2007 at 6:36 AM ×

I just assumed "Mr. Brain" was some kind of uber-specialized hedgie number-crunching software.

I was a little surprised to see that it hailed from Brazil. But so what? They have numbers in Brazil, don't they?

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Macro Man
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November 28, 2007 at 7:24 AM ×

Brad, from what I gather some of these guys are increasing- wait for it- the yen allocation in their portfolios. What's interesting is that there's been relatively noise about reserve managers in sterling recently.

Moldbug- teh only disappointment, really, is that Mr. Brain seemed to have lost the ability to speak Portuguese by the time he got to me!

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