Reality bites

You know markets are feeling the squeeze when volatility is maintained in the week before Christmas. Usually this is a week to nip out shopping, enjoy long boozy lunches, and engage in quizzes with colleagues and counterparties. This year, however, there seems to be a fair amount of portfolio cleansing, with risk across a number of popular strategies getting cut. The upshot is that most directional players who made money last month are probably losing in December...as are many of those who lost money last month as well.

It's also the time for banks, strategists, and even bloggers to begin sending out their list of "Favourite trades for 2008" or "Things to watch for Next Year." Friend Cassandra had a go yesterday, wherein one of next year's expected trends was forecast as "disinvestment beats investment by a wide margin." In other words, everything's overvalued and cash is king.

While such a theory is easy for many observers to embrace in equities and credit, to date it has had little resonance for government bonds. Sure, govvys have backed up over the last few weeks, but in many developed countries yields are still perched very much to the low end of the 2007 range. The rationale, of course, is a "safe haven" bid amongst the sturm und drang of money market ruptures and equity volatility.

Yesterday Macro Man proffered the suggestion that nominal duration is an unttractive proposition; today he offers a bit of viiual evidence. The chart below shows real 10 year yields in the G4, deflated by the broadest measure of consumer prices, lagged one month. This means that that Gilts, for example, are deflated by the Retail Price Index (current reading 4.3% y/y) rather than the harmonized CPI (current reading 2.1%.) While the latter is the target used by the Bank of England, the former more accurately reflects the cost of living. Try, for example, to avoid paying your mortgage or your council tax bill by claiming that you "only consume the harmonized CPI basket", and see how far that gets you!
In any event, the chart shows that real yields have fallen across the G4, particularly in the US and Europe. Part of that is down to a base effect quirk in the CPI data, of course, but a good deal is down to the decline in nominal yields as well. In any event, real 10 year yields in the US are now not only negative, but at their lowest levels of the millennium. And all markets look much more expensively priced than at the beginning of the last global downturn. Judged from a real yield perspective, therefore, the investment prosepct for nominal government bonds bites.

What's particularly interesting is that the real yield gap between the US and Europe is now 1.37% in favour of the latter. This is the highest reading in favour of the EUR since March of 2001, a month in which EUR/USD traded through 0.90. While The Economist cover curse has done its work, generating a sharp correction lower in EUR/USD, Macro Man gets the sense that the market wants to make something more of the dollar. Could it be that people are actually turning....bullish?

On one measure, at least, so it would seem. The DB/Rusell Mellon position survey suggests a sharp increase in dollar longs at both the median and extreme levels. Such a move is difficult to reconcile with the trend in place until a couple of weeks ago, but might suggest that some deep-pocketed currency punters are beginning to use valuation as a more prominent investment metric.
Of course, that begs of the question of relative asset market valuation...which brings us back to the real yield measure noted above. Of the G4 currencies, US 10 year valuation is pretty clearly the least attractive. And since the US is still a "fixed income" currency, that should bode ill for the dollar in the medium term, barring either a bum-clenching recession (which shakes out long-term dollar shorts) or a sharp acceleration in growth (leading to higher nominal yields.) While each of these is certainly possible in 2008, neither is likely to emerge with certainty in the first quarter. Strangely enough, therefore, a bullish EUR/USD strategy into new year may have the twin attraction of being both fundamentally justified and contrarian!

One possible roadblock would be an unorthodox policy choice from the Middle East. What if, instead of allowing their currencies to appreciate against the dollar, they instead force the dollar to appreciate against other currencies? Forget the arguments on sovereignty and the appropriateness of foreign agents setting monetary conditions in the US; PBOC has been doing so for four years already.

But from the GCC's perspective, what would be easier? Breaking long-held pegs and switiching to a "complicated" basket....or just saying "200 billion EUR/USD yours"? It's not like they don't have the money to do so! And it would ease at least part of the problem, namely the decline in the trade-weighted foreign exchange value of the riyal, dirham, et al. It wouldn't of course, solve the issue of farcically low interest rates and the money creation resulting from partially sterlilized intervention...but then again these guys don't seem to care about that stuff anyway. Hell, they don't even seem to really care about the foreign exchange value of their currencies....why else would USD/SAR be at a multi-year in a week when millions of Muslims are convening on Mecca?


Finally, a bit of portfolio clean up. Macro Man will roll his short ESZ7 exposure to March this afternoon and will close the SGD swap overnight. Over the next week or so he'll look to roll out his put exposure on the Hang Seng as well. If Cassie and others are right and valuation is starting to matter, this is no time to be jettisoning short exposure to quasi-Chinese equities!