Wednesday, February 28, 2007

Of cats

So the SPX has opened higher, albeit never reaching the levels implied by the futures for most of the trading day so far. So does this cat have another eight lives, or is it deceased? Inquiring minds want to know.

Macro Man reckons it is a sucker's bounce, reflecting the assumption that 'nothing's changed.' Quite remarkable, really. Many of the same people who have been sweating the subprime market and fear a US recession now want to throw risk at the market after a one day downdraft. Remarkable! (As he types this, new home sales print a truly awful number.)

While Macro Man does expect this dip to eventuate into a nice buying opportunity, experience dictates that 'volatility events' like we had yesterday do not dissipate in 12 hours.

He therefore sells some risk assets- and what can be riskier than Turkish equities? He sells 2000 A51 futures at 52.825, risking 54.

Busy morning

Macro Man has unsurprisingly been busy this morning doing his real job. He offers the following thoughts and notes, and will hopefully have time to post more later:

* Pursuant to yesterday's query, he definitely votes 'b' in terms of what we are observing. Yesterday's price action in equities and the VIX was clearly a market dislocation and/or a volatility event. These are rarely "one and done" affairs. Indeed, Macro Man is somewhat perturbed by the degree of complacence that he observes out there. It seem a lot of people want to buy EM, buy credit, etc. He believes this will prove unprofitable in the near term.

* The risk aversion model that Macro Man follows has turned risk averse today, so he exited the FX carry basket at the morning opening. Rates are in the P/L below.

* An old order in SPY was filled, buying the last of the beta position. Naturally, he wishes he had moved it, but such is life.

* He does NOT believe that we are moving towards option (c), full blown recession. The durables data was horrible, worse than he was expecting, but nevertheless consistent with a substantial inventory unwind. Indeed, the durables data and the Feb ISM inventory reading were, in effect, the same data. What was striking was that the consumer confidence figures registered new highs in a number of areas....hardly consistent with a consumer pinned against the wall by falling house prices and burgeoning debt. He retains the view that Q1 will be the low water mark in US growth for the year.

* For now, Macro Man will likely look to establish risky asset shorts on bounces.

* Macro Man observed a rather large degree of schadenfreude in his trawls around the blogosphere yesterday. This provides a degree of comfort that this episode of risk aversion is simply that, rather than the end of the world

Tuesday, February 27, 2007

OK, I vote 'B'

Macro Man feels safe in assuming that most measures of risk appetite will slide into risk aversion as of c.o.b. today. This will necessitate some trading tomorrow; Macro Man will provide a post mortem when he has some time away from the real job.

Taking stock

OK, let's take stock of what we know:

* The worst-of-the-worst subprime index in the US has gotten killed
* This week's economic data is likely to be weak in an absolute sense
* The dollar has sold off across the board against G10 currencies, but
* Funding currencies have rallied harder than carry currncies, and
*The dollar has rallied against high yielding EM
* Chinese equities got smoked overnight for no obvious apparent reason
* The same thing happened in India last week
* Treasuries have rallied across the board, with no obvious out/underperformance from TIPS
* Commodity prices have remained firm until a couple of hours ago
* Developed market equities are off their highs but have not broken uptrends; VIX is off its lows but remains low in an absolute sense

So what are we seeing here? Three possibilities include:

a) A slight wobble, not dissimilar to the one observed in January of this year. These can last a few hours to a couple of days, and then normal service is resumed. A lot of the people Macro Man has spoken to today seem to think this is what we are experiencing. Macro Man finds that troubling, as it smacks of complacency. Indeed, believing that this is no big deal is more like to result in it being a big deal.

b) A full blown risk aversion event. It is too early to say with certainty that this is the case; we'd probably need the SPX to fulfill the current futures move (-9.5 points at the time of writing) and a concomitant move in VIX to spur more broad-based risk aversion. EM and credit spreads are wider than the lows, but still well narrower than at the turn of the year. Risky currencies like TRY, AUD, and NZD remain near their strongest levels of the year against the dollar. We need mroe proof.

c) Pricing in a second downleg in US growth and the possibility of recession. Certainly that would fit with the likely outcome of this week's data and the rally in Treasuries. However, Macro Man would have expected inflation breakevens to narrow more than they have done, and for the belly of the eurodollar strip to rally more (EDZ7 is still below its 2006 closing price.) Moreover, a US recessionary outcome should ultimately be negative for commodity type currencies, and indeed overvalued stuff like the Europeans. Perhaps that will be the sting in the tail later this week; it's hard to say.

For now, Macro Man remains cautious and somewhat defensive. While the beta plus portfolio is carrying plenty of risk, the alpha portfolio is more defensive, carrying short deltas in equities, NZD and ZAR, and gold. Given Macro Man's view that gold has rallied on the basis of financial liquidity and leverage, a risk aversion event should in his view lead the yellow metal lower; hence the presence of the puts in the portfolio.

Uh oh

China stocks down 8% at the time of writing, yen and CHF mysteriously bid. Looks like a (mini) bout of risk aversion is upon us. Macro Man is likely to be busy today with meetings, so he wanted to get in a quickie this morning.

At this point he is uncertain of the extent of the risk aversion event, only that large (negative) moves in uber-speculative assets are generally consistent with broad trimming of risk. That these moves are occuring in spite of the recent Treasury rally is particularly interesting; perhaps fears are mounting of a growth scare as the subprime mess hits the front page of main street, rather than just the Wall Street, journals?

Regardless, some further hedging/trimming would appear appropriate.

He therefore sells 15 million NZD/CHF at 0.8683 (0.86815 to 02 March) and buys $10 million USD/ZAR at 7.1220 (7.1229 to 02 March.)

Hopefully, more to come later.

Monday, February 26, 2007

(Sub) Prime Time

Has the day of reckoning arrived? Macro Man’s email box and Bloomberg message cache is chock full of missives on the subprime market and the serious deterioration in the price of the lowest-rated credits in the sector. And indeed, it does look grim...the ABX BBB- chart reminds Macro Man of the price action in GKOs in the summer of 1998.

So has Macro Man changed his stripes? Has he come to his senses and realized that his domino game is about to be played out in real life? That the yen carry trade is the root of all evil, that US equities are farcically overvalued, and that gold holds the key to financial salvation?

Not really. While Macro Man concedes that the subprime market does indeed look fugly, he retains his belief that contagion is probably unlikely. Overall mortgage delinquency rates in Q3 were just 1.72%, according to the Fed; while this is admittedly off its lows of a couple of years ago, it remains well, well below the average of the past 15 years.

So does this mean that risky assets are bulletproof? Far from it. Indeed, Macro Man has had a growing sense of unease for some time, hence the alpha portfolio hedges in TIPS, the SPH7 seagull, and gold puts. Macro Man sold some Treasury futures last week to turn his TIPS position into a partial, purer inflation hedge. In retrospect, this was a mistake, as Treasuries will catch a safe haven bid on a risky asset unwind. Moreover, on balance the data to be released this week is likely to underscore the popular (and, in Macro Man’s view, misguided) notion that housing is finally killing the US economy.

Macro Man therefore covers his TYH7 short at 107-27.

Elsewhere, Macro Man notes that central banks have expressed an interest in buying equities in a recent survey. Indeed, this is one of the reasons why many, including Voldemort, are establishing separate investment vehicles. However, consider the impact if even 10% of global FX reserve assets are deployed into equity markets: $500 billion into a market where global net issuance is a fraction of the size. Yowsah!

If this theme ever gains broad currency (pardon the pun), then equities are going to be a screaming buy.

In the meantime, however, Macro Man continues to worry, but is pleased that the subprime story is at last playing out. It’s much better to take the risky-asset hit now when everyone’s worrying already...

Friday, February 23, 2007

Worry, Be Happy

Bobby McFerrin was a sucker. Or at the very least, we know he wasn’t a trader. The title of his wretched 80’s ditty, Don’t Worry Be Happy, is the worst advice a trader could ever receive. Indeed, Macro Man is rarely happy unless he is worrying, and he rarely worries more than when he is in the midst of a purple patch.

So what worries Macro Man at the moment? The inevitable collapse of the subprime lending market? The next leg down in US housing, and the concomitant hit to consumer spending? Global imbalances (chuckle, chuckle)? A potential downgrade of (insert insanely crowded, crappy-fundamental emerging market or corporate credit here)? War with Iran?

Nah. All of those things are issues, but they are widely known and, in Macro Man’s view, widely discounted. Macro Man spends his weekends with Macro Boy setting up elaborate domino patterns, with each domino bearing the name of a different subprime lender, major bank, or emerging market country. They then tip the first domino over and watch the global financial system implode. Metaphorically speaking, of course.

No, what worries Macro Man is the stuff that either isn’t known or cannot be controlled. And as he has alluded in the past, he views inflation at the top of the list of potential roadblocks to continued risky-asset prosperity. And despite the presence of TIPS in the portfolio, recent signs are starting to trouble him.

Consider the price of gold. Since cratering in the first couple days of the year, it has rallied nearly $80 in more or less a straight line. It tried to sell off on Tuesday but came back uber-bid on Wednesday. Now, in the grand scheme of things, the rate of change has been fairly modest in comparison with the pace of the moves of the past couple of years (see below.) But in a sense, that is what’s troubling Macro Man. Last spring, gold shot through the roof and the Fed reacted fairly quickly (and painfully). This time around, the move has been more stealthy...which, in a sense, makes it more difficult to determine when exactly it becomes an issue.

To be sure, financial assets that have traditionally followed gold have lagged the move of the past couple of months. Macro Man’s Goldcorp position, for example, should be at $35, according to a relatively naïve overlay. Similarly, inflation breakevens appear 5-10 bps too low on the basis of where gold and oil (which appears to be breaking higher) currently reside.

What will it take to close the gap? Another 0.3% on core CPI? Signs of complacence from the Fed? Who knows. But if and when the gap closes, things will get interesting for risky assets, particularly if/when the Fed sits up and takes notice. A sure sign of the financial apocalypse (or at least the risky asset hiccup) will be when gold starts to melt down. The key is to be prepared, so that one can keep worrying but avoid panicking.

As such, Macro Man will apply a couple more hedges to his portfolio. He sells 100 TYH7 at 107-11, turning 40% of his TIPS position into a quasi-breakeven strategy. He also spends ~$150k premium on gold puts, buying 275 GCJ7 660 puts at $5.5 per. If the shakeout’s gonna come, he can only hope it comes before expiry.

Thursday, February 22, 2007

Housekeeping notes

2 things:

1) USD/SEK alpha short stopped at 7.1170 spot, 7.1154 to 2 March

2) There was an error with the P/L spreadsheet; unusually, it was understating P/L (the NZD beta plus trade was not included in the beta totals despite being listed amongst the trades.) A revised P/L is posted below

Return of serve

“We’re caught in a trap. We can’t walk out. Because I love you too much, baby.”

- Elvis Presley, Suspicious Minds

I hear ya, King.

Just when Macro Man thought he could write about fun stuff like Argentinean farmland or US railroad shares, Brad Setser over at RGE served up another piece on the global carry trade that (literally) invited a response.

Unfortunately, Macro Man has quite a busy day lined up today, so he cannot respond in as elegant a fashion as he might like. Instead, he offers a series of bullet point thoughts on the matter, alluding to points in Brad’s piece in italics.

Right now, I see lots of indirect evidence of the popularity of carry trades. Large Glacier bond issues and large -- perhaps record large -- foreign positions in the Icelandic Krona. A strong kiwi. Strong reserve growth (implying rapid capital inflows) in high carry emerging economies like Brazil, India and Turkey. The FT's concerns about slow Brazilian growth don't seem to be shared by the markets: Brazil could add close to $10b to its reserves in February alone trying to fight carry trade inflows. A weak yen and Swiss franc.

Macro Man does not dispute that there are some economic agents putting on carry trades. Hell, it would be churlish to do so, given that he has the carry trade on both in the blog and in real life. However, it is a probably a mistake to assume a 1:1 correlation with official reserve growth and ‘carry trades.’ After all, Chinese reserves are growing at a pretty healthy clip, and implied CNY rates in the NDF market are zero!

A significant (and, in Macro Man’s view, growing) source of capital inflows is in equity markets rather than fixed income. In Turkey, for example, many fixed income investors continue to buy T-bills, but at least partially currency hedge. Equity investors, on the other hand, almost always invest ‘naked.’ While an investment in Turkish equities can certainly be called a ‘risky’ trade, can it really be called a ‘carry’ trade? After all, the dividend yield of the ISE 100 is only 0.08% higher than that of the S&P 500 (and 0.23% lower than the S&P 100)!

The Vietnam Opportunity Fund provides an interesting glimpse into the rising interest in EM equities. Observe the massive uptick in volume over the past few months, which not coincidentally has accompanied both a strong rise in the underlying equities, but also in the dong (relatively speaking, of course.)

And of course, US investors have been enthusiastic about foreign equities like never before. Insert link to tic Again, these investments are certainly risky trades, but are they truly carry trades? (Whether the distinction matters economically is another question, given the correlations in global asset markets.)

* Are Japanese retail investors who buy – without borrowing any money – New Zealand bonds engaged in a carry trade? What of Japanese pension funds who buy US agency bonds for the yield pickup?

Yes, these are carry trades. But what about if Mrs. Kobayashi invests in a foreign equity investment trust, as she is doing with increasing volume? As above, Macro Man would characterize this as a risky trade, not a carry trade.

A more important question is whether Mrs. Kobayashi is establishing/adding to overweight risk positions, or covering underweight risk positions. The evidence is pretty firmly in favour of the latter. Even with the recent capital outflow from Japan, something like 50% of household financial assets are on deposit, a residue of the dark years when return of capital took precedence over return on capital. As has been widely discussed, those dark years appear to be behind us.

In Macro Man’s view, what we are seeing from the Japanese household sector is akin to what was observed among the institutional sector in the mid 1980’s: a one-off stock adjustment in the level of risky assets, including foreign assets, in investment portfolios. Given the large cash position of Japanese investors, Macro Man believes that we remain fairly early in this process.

* Personally, I suspect both the “real” money carry trade and the leveraged carry trade matter.

Agreed. But it is important to bear in mind that “real” people have a drastically different time horizon from investment professionals. But this includes not only people like Mrs. Kobayashi, who have a carry trade investment, but real money borrowers as well.

In Macro Man’s opening salvo on the carry trade a few weeks ago, he printed a chart of Japanese yen lending to foreigners. It is reprinted below. Even if we accept that none of the ‘investment’ carry trade is captured in this data, it still must ultimately represent lending to borrowers in the real economy: Koreans taking out yen mortgages, etc. And those who claim that the carry trade is much bigger than ever before must explain why the level of yen lending to foreigners has yet to approach, let alone exceed, levels observed 4-5 years ago.

Now, Macro Man will concede that CHF mortgages are a booming business, particularly in Eastern Europe. Yet despite the volatility of last spring, HUF has come back, and demand for Swiss mortgages is stronger than ever. Why? Because mortgage holders look at their statement once a month. It will take a sustained period of substantial HUF weakness/CHF strength to alter behaviour. Could it happen? Absolutely. Will it be a catalyst? Highly unlikely.

Brad then quotes Tim Lee of Pi Economics on a number of issues.

* The $1 trillion estimate comes originally from a piece of work I did, and I thought it only fair to contribute my explanation for anyone interested.

In the work I accept that guesstimates for the size of the carry trade that can be derived from balance of payments and banking statistics fall in the range US$100-350 billion...The one trillion number is less a genuine 'estimate' than an indication of what I believe to be the order of magnitude. My guess is that the outstanding carry trade is probably even larger than this.

To paraphrase a more colourful analogy: opinions are like tonsils. Lots of people have them, but that doesn’t mean they are of any use.

BOP data suggest a carry trade of 100-350 billion. Survey data of discretionary managers suggest very modest yen shorts (Russell Mellon, which shows a much larger dollar short) or yen neutrality (Merrill Lynch.) Macro Man doesn’t see sufficient evidence to balloon the carry trade estimate fivefold on the basis of a hunch.

* The big adverse development in the Japanese balance of payments data (IMF data) that occurred subsequent to the massive intervention up to March 2004 was the deterioration in 'monetary capital' (i.e. increase in Japanese banks' net foreign assets). This suggests that it is carry trades that have weakened the yen, not Japanese institutional or retail funds going into foreign securities, and it suggests that the moral hazard created by the intervention was the original cause.

The massive inflow into Japan in late 2003 /early 2004 was a partially a result of speculative inflows, but more substantially a product of the daiko henjo, by which Japanese pension funds returned money to the government for management, selling foreign securities and returning the cash to the government. Part of the Japanese demand for foreign assets of the past few years has been the redeployment of that investment capital abroad.

* Indications of the carry trade such as Japanese banks' gross foreign assets, cumulative short-term net foreign lending from the Japanese bop, the spec net short position on the Chicago IMM correlate quite well with each other and also with the yen rate. I think these indicators do not tell us the size of the carry trade but they do tell us the direction. Again, these suggest that it is the carry trade that has been responsible for yen weakness.

The IMM is almost exclusively used by trend followers. They don’t care what the BOJ does, what the Fed does, or what phase of the moon we are in. They amplify price action; they do not create it. If the IMM yen position does represent a yen carry trade, it begs the question of why IMM traders are short yen against a basket of EUR and GBP, rather than simply against the dollar.

* Carry trade currency relationships are now enormously out of line with fair values. I have the yen about 30% undervalued against the dollar. The Turkish lira I have 130% overvalued against the yen, which is extraordinary. Turkish inflation is 10%, but the lira simply will not go down (bar the episode last spring).

Mr Lee has the yen 30% undervalued against the dollar. Macro Man has the yen 7.5% undervalued against the dollar. In a world driven by capital account rather than current account flows, it is not immediately apparent how or why either estimate matters. And if Mr. Lee is correct, why isn’t the US bilateral deficit with Japan substantially larger? Since 1985, US exports to Japan have grown 268%, while imports have grown 217%. This hardly suggests a drastically overvalued exchange rate, particularly when one considers that US nominal GDP has tripled in size over the period, while Japan’s is just 50% larger.

* The Japanese MOF/BOJ had to acquire roughly US$500 billion to prevent the yen appreciating up to March 2004. The yen is now much lower in real terms. Logically the amount of intervention next time round is going to have to be much greater - my estimate is roughly US$2 trillion. The idea that the carry trade is, say, only US$200 billion is inconsistent with this in my view

Macro Man does not understand the logic here at all.

* When you add all this together, it is simply not plausible, in my view, that the carry trade could be as small as most observers are saying. The observed impact that the carry trade is having on the currency and other markets is too great. As to why hedge funds, investment banks and others have not been frightened out of it, I think they have 'learned' that it 'always works' in the end, much as technology growth stock investors 'learned' in the second half of the 1990s. They do not see how it could possibly go badly wrong until Japanese rates have been raised significantly, and they see no prospect of that.

Macro Man believes the real issue is that many analysts have not realized that the universe is expanding. The home bias in Japan and, to a lesser degree, the US, has come down, meaning that what was a large holding of foreign assets in 1997 might be considered woefully tiny in 2007. This is a trend that is both well entrenched and in its early stages. There is of course no guarantee that money will not be repatriated from time to time; if and when this occurs, EM equities and bonds are likely to be the biggest losers.

In a sense, Macro Man feels like Edwin Hubble in realizing the extent of the expanding universe. There were plenty of smart guys, including Albert Einstein, who were slow to recognize that the universe is expanding. Similarly, there are plenty of smart people, both analysts and fund managers, who have yet to recognize the significance of the expanding investment universe.

Macro Man will close with an interesting anecdote: Over the past few days he has spoken with a number of sell-side institutions. A common theme is the degree of surprise is how many long yen positions are out there from discretionary managers; these positions are revealed when the fund managers roll their forwards.

There seems to be a common misconception that currency traders and macro managers are either blind, stupid, or naïve. While most of us are all of these things on occasion, natural selection ensures that we can’t be that way all the time. We can see as clearly as the economists that things like EUR/JPY are farcically overvalued. That’s why many discretionary traders have attempted to play the yen from the long side.

But Mrs. Kobayashi is a force of nature, and she is still gathering strength. The only agency capable of stopping her is Voldemort, but for the time being he seems content to be the biggest carry trader of them all.

Wednesday, February 21, 2007

Much ado about nothing

OK, well that went according to plan. The BOJ hiked but intimated further tightening would be modest in scale and slow in execution. As anticipated, JGB yields and the yen both rallied on the news (or, more specifically, a pre-meeting leak from the NHK TV station) but sold off swiftly thereafter. From here, the base case is probably a slow grind lower in the yen for another couple of weeks before risky-asset threatening data comes to the fore again.

Five Things I Think I Think (apologies to Peter King of Sports Illustrated)

* Macro Man wants to be short sterling, but cannot bring himself to pull the trigger at current levels. While price action following the BOE minutes (7-2 vote in favour of steady policy) suggests that the market remains long sterling, it is unclear how long the pound can underperform in a broadly pro-carry environment. The Lazarus-like recoveries of the Aussie and Kiwi dollars are instructive here. The moral of the story: sell sterling on strength, not weakness, unless risk appetite falters.

Surely a sign of the apocalypse: London is accepting foreign aid from Venezuela!

Is EM putting in a top? Yesterday’s CPI linker auction in Turkey was instructive. The competitive bids were awarded at a real yield of 9.72%, way below the pre-auction estimate of 10.5%. Bid to cover ratios were extreme. These bonds, as well as the lira, are now lower today. Turkey has a contentious presidential election in less than three months; recall how well Mexican assets and the peso fared last year. Macro Man would like to find a way to be short Turkey without losing his shirt. More thought is required here.

* On a pickup in economic activity (such as that Macro Man expects to emerge in a few months), the Dow Transports should fare well. However, the trannies have already put in a strong performance vis-à-vis broader indices. This trade, then, is one for the future; Macro Man will keep an eye on the Transports and look to implement an RV trade on a broad market pullback

* Markets feel like they are waiting for a catalyst, but don’t know what that catalyst might be. Macro Man is surprised at how slow this week has been, even accounting for Monday’s holiday. Most people that he speaks to have relatively little conviction and want to sell options. Normally this is a warning sign; however, selling options has been the right trade since July, a remarkably long time. Despite the strong performance of the portfolio, Macro Man is more nervous now than he was last year when he hit a rough patch. What does this mean?

Taking stock(y)

The Swedish government is accelerating plans to privatize SEK 150 billion worth of state owned assets (including the makers of Absolut). Given that many longstanding SEK longs have been shaken out by the post-Riksbank caning of the Stocky over the past week, the techincal position of the market is cleaner in SEK than it has been for some time.

Macro Man therefore goes to market on his USD/SEK sell order at 7.05 spot basis, 7.0473 to the March 2 forward date.

More to come later

Tuesday, February 20, 2007

Hodge BOJ

Hang onto your hats, ladies and gentlemen: tonight is the night that the BOJ may or may not switch short term interest rates from virtually zero zero, give or take.

Markets are currently pricing in roughly a 60% chance of a rate hike tomorrow, so on the face of it there may be some upside for JGB yields and the yen should they deliver. By the same token, 3 month TIBOR is 0.55%, so markets have by and large already completely discounted some movement in the near future.

As such, any initial impulse for the yen and JGBs may swiftly fade; a rate hike tomorrow will be as good as it gets for JGB and USD/JPY bears, and they may feel compelled to take profits.
One trade that Macro Man has been tracking for a while but not pulled the trigger on is playing for further tightening in H2. The spread between June and Dec 07 euroyen futures has ranged between 15 and 40 bps over the past year or so. It is currently at 21 bps. Macro Man suspects that after the upper house elections in July, political opposition to higher rates will ebb, thereby raising the risk that 2007 tightening is actually backloaded.

Macro Man will therefore try and buy the spread (10,000 futures) at 19.5 bps, looking for a move to 30. If done, he will stop out at 14.5.

Separately, USD/SEK is at an interesting level. Macro Man will look to sell $20 million at 7.07 for the alpha portfolio, with a stop loss at 7.1150.

Random Shots

Swervin’ Mervyn, all is forgiven. The Bank of England has come out with a couple of pearls over the past few days. In a submission to the Treasury Select Committee, the BOE noted that “some depreciation of the real effective exchange rate will probably be necessary” for the current account deficit to narrow. Amen, brother!

King also made some very interesting comments re: Japan last week. “I have some difficulty trying to understand why the call for Japan to ensure that its economy is growing as rapidly as other economies seem to be growing is consistent with saying that they should take a policy action to raise the exchange rate when that policy action would be likely overall to have the impact of slowing domestic demand growth.” Another gold star for Mervyn. Will tomorrow’s MPC minutes send the pound or short sterling shooting higher? Macro Man hopes for the latter but is slightly concerned that it will be the former.

Is the US dollar overvalued? There appears to be a broad consensus that this is indeed the case. After all, how can you have a $60 billion per month trade deficit without a drastically overvalued currency? Macro Man has no beef with the assertion that the dollar remains overvalued against the CNY, SAR, and other current account surplus countries.

However, on a broad trade weighted basis, the answer is not so clear. The dollar appears to be clearly undervalued against the euro on a PPP basis. Ditto sterling and the Canadian dollar. The Mexican peso is a bit trickier, given the periods of high inflation that the country has sustained in the past; however, Macro Man’s best estimate is that the US dollar is moderately undervalued against the MXN. And what about the yen? Macro Man estimates USD/JPY PPP at 110; a moderate overvaluation, perhaps, but one that would appear justified by interest rate differentials and capital flows.

On a broad basis, Macro Man could construct an argument that the dollar is actually undervalued. What would we expect to see from an undervalued currency? Surely that exports would rise substantially faster than imports. In fact, that is exactly what has happened in the US once oil imports (which are price inelastic in the short run) are stripped out. The effect has been masked because the stock of US imports is so much higher than the stock of exports, so exports have to grow substantially higher than imports just to keep the trade deficit constant. That is exactly what’s happened. As the chart below indicates, export growth has been at its strongest level vis-à-vis imports since the current trade data series began in 1992.

Even if we include oil imports, export growth is outstripping import growth at its fastest rate since 1991 (goods only pre 1992). That trade improvement was the result of a retrenchment in domestic demand. This one? It could well be the exchange rate. This of course begs the question of how much improvement would be required to sate the bloodlust of the professional worriers. Anyone with thoughts on the matter, answers on a postcard please!

Monday, February 19, 2007

Back in the saddle

It is a bit of a cliché that markets are always most interesting when one is away on holidays, but last week lived up to the old saw. Macro Man and the dollar spent most of the week going downhill, while global stocks and bonds keyed off of Ben Bernanke’s relatively neutral testimony to roar higher.

The moves were not terribly difficult to understand. The dollar suffered as US data turned down and Europe and Japan registered stellar growth figures for Q4 of 2006. The combination of trade and TIC data was all it took to put the nail in the dollar’s coffin and bring the perma-bears out of the woodwork. Poor activity data and a relaxed Bernanke, meanwhile, proved sufficient to spur a cheeky 10 bp rally in both 10 year Treasuries and Dec 07 eurodollars. This was all the stock market needed to generate a liquidity fueled rally which took the SPX to another multi-year high.

Macro Man is still digesting everything that happened last week. He does, however, have a few thoughts based on what he heard on the slopes and what he’s read so far this morning:

* Last week was not a carry unwind story. Sure, the yen rallied against both the USD and the EUR. However, some of this was likely related to Treasury coupon payments, while macro discretionary traders have scrambled to go long yen in the hopes that they will be able to earn a couple bps more carry on Wednesday. Color Macro Man unimpressed. In a real carry unwind story, stuff like AUD and NZD and TRY and BRL would get caned, not lifted up on wings of eagles. That’s not to say it cannot happen, but it is highly unlikely with the SPX at its highs.

* The TIC data is like watching a traffic accident in your rear view mirror. It might tell you something about driving conditions in general, but says little about the direction of the road ahead. Lost in the kerfuffle over the TIC data was the fact that the dollar actually rose against the euro, the yen, and the ADXY last December. If this data were of any use in market timing, surely there would be at least some modicum of contemporaneous correlation between capital flows and the performance of the currency market.

* That having been said, there is a clear trend towards the erosion of the home bias amongst US investors. December set a record for net purchases of foreign equities. Given the disproportionately large market cap of the US equity market, as well as return-dampening factors such as Sarbanes-Oxley, a steady flow of equity capital out of the US is likely to continue. Ultimately, this probably means that a given level of interest rates will be less supportive in the future than it has been in the past.
* Macro Man expects Q1 growth in the US to be quite poor, perhaps 1.5% (finger in the air estimate.) However, he also expects that to be the low water mark for US growth in 2007. Much of the weakness should be concentrated in manufacturing, where inventories remain high relative to shipments. December/January has seen the onset of inventory liquidation; Macro Man reckons it should be over by March. This should set up some interesting trading opportunities over the next few months.

* The portfolio fared OK during last week’s mayhem, despite the premature profit take on the short sterling position and the unsuccessful option hedges on SPH7 and EUR/JPY. The short NZD/USD position in the alpha portfolio was stopped at 0.6922 (two pips slippage off of the 0.6920 level). Macro Man will start to think about selling US bonds around the 109 area in TYHY, and may think about buying JGBs around 1.80 on the benchmark yield.

Saturday, February 10, 2007

Please disperse, there's nothing to see here

We reaffirm that exchange rates should reflect economic fundamentals. Excess volatility and disorderly movements in exchange rates are undesirable for economic growth. We continue to
monitor exchange markets closely, and cooperate as appropriate. In emerging economies with large and growing current account surpluses, especially China, it is desirable that their effective
exchange rates move so that necessary adjustments will occur.
Essen G7 communique

So much for the weak yen as cause celebre. Of course, there was some side chatter on carry trades and the necessity for markets to understand that they are not a one way ticket to Paradise. Fellas, given that real money investors ain't short yen and that even the gross (as opposed to net) spec yen longs on the IMM are above their 1,3, and 5 year averages, consider the message delivered.

We also met with Ministers of Finance from a number of key emerging market economies to discuss the role of local bond markets in fostering growth and financial stability. In this
context developing local currency bond markets deserves higher priority to reduce emerging countries' vulnerability to external shocks and financial crises and to promote growth.

Uh, guys? You do realize that the only reason that developed market investors generally buy these local currency bonds is to earn carry, right?

Macro Man expects the yen to weaken and high yielders to trade fairly well on Monday morning at the very least. However, he would be wary of chasing these moves, given the high volume of data and other events risks on the week.

Macro Man will return on February 19. Good luck!

Friday, February 09, 2007

Hedge ledge

OK, we all know the G7 is meeting this week. Most of us expect relatively little, which means that the yen gets creamed next week by greedy carry traders, right?

Not so fast, my friend.

There's also the little matter of Big Ben testifying before Congress and Japanese Q4 GDP. Either of these could temporarily upset the yen weakness apple cart, and indeed the risky asset apple cart more generally.

Macro Man has his equity market hedge on; now it's time for the currency market hedge. The time to buy yen calls is when the yen is weakening, not strengthening. It's hard to believe after all the Euro finance minister yakking, but EUR/JPY is all the way back to 158. It's time to hedge.

Macro Man buys EUR 25 million 155 yen calls and sells EUR 25 million 159.90 yen puts, both expiring February 21, for zero cost.

Hopefully he gets assigned on the 159.90's- he can always buy EUR/JPY back, and it would almost certainly mean that the rest of the portfolio is kickin' ass and takin' names. And if nothing much happens, well, nothing's been spent so nothing is lost.

Farmyard finance

The always enjoyable Mark Gilbert explains in the world of finance in terms of cows

"You have two cows. China has one trillion cows. Guess who sets the price of milk?"

Seven important charts

A sustained rise in inflation breakevens is the single largest threat to global risk assets. Fortunately, breakevens have turned lower recently.

"Inflation" in funding currency countries needs to go up more (or at all) to seriously threaten the FX carry trade on a permanent basis

Oil is at critical levels. Will a break higher spur the inflation required to upset risky assets?

Monthly resistance for US 10 year yields is at 4.95% - 5.0% . A break could get very, very ugly from a technical perspective

2.00 has been the sale of the century in cable for 20 years

The Bovespa is near critical levels. Will EM melt up or melt down?

And of course, the most important chart for any trader, the P/L....

Thursday, February 08, 2007


Macro Man's decisions to close the Bund straddle and stick with the short sterling positions were both vindicated today, as the Bank of England left rates unchanged and Trichet dropped the V-bomb with his opening salvo in the ECB press conference.

To quote Hannibal from the A-Team: I love it when a plan comes together!

The short sterling position is now (gasp!) in profit since inception. Macro Man is slightly concerned, however, that the market is over-reacting to the unchanged rate decision. After all, very few economists actually forecast a rate rise, and very few risk-takers that Macro Man spoke to looked for anything, either. Next week sees the release of the quarterly inflation report; fan charts showing upside trajectories to growth and/or inflation, a not inconsiderable risk, would likely send the short sterling strip careening lower again.

Given that Macro Man is having a good start to the month and won;t be around to manage the position, a change in tactics would appear wise. Macro Man therefore takes profits on the L M7 position at 94.22. In the event of a crackback in the strip, he will sell 1000 June 94.125 puts at 10 (futures) ticks. Macro Man reckons he could sustain two rate hikes and still make money on the trade at that price.

Elsewhere, Trichet might just as easily have said "we're gonna hike next month." Why he plays these rhetorical games with the word 'vigilant' is anyone's guess, but at least it gives us something to do once a month. For choie, Bunds should be a sale, but they may struggle to come off with the Treausury market looking bid. Perhaps as a spread against's inventory data suggests decent downside revisions to Q4 GDP, and he continues to look for a soft Q1 on de-stocking.

Macro Man will sleep on it and may do the trade tomorrow.

Morning quickie

Macro Man has had to fend off the gut reflext to short all things British this morning after a typically excruciating experience on public transport this morning.

The elephant in the financial market room today is of course the announcements from the BOE and ECB. Macro Man's long short sterling posiition (trying explaining the meaning of that phrase to a layman) is in jeapordy should the BOE hike unexpectedly; by the same token, he could get some relief should they stand pat. Today's decision will be based on next week's inflation report; given comments from Swervin' Mervyn last month, Macro Man holds out hope that the January shocker was pre-emptive rather than the start of something horrible. New of price cuts from utility suppliers should provide some comfort that a primary driver of inflation will ebb. In any event, should the BOE hike, prudence dictates that Macro Man sell out his short sterling position at best. Fingers crossed.

Meanwhile, we get to play our monthly game of 'spot the V-word' with Jean-Claude Trichet today. Markets are discounting that he will express the need for vigilance, thus pening the door for a March rate hike. Should he deliver, bunds should drift lower and perhap the euro will drift a bit higher. Should he fail to drop the V-bomb, however, expect a rally in European fixed income and a sell off in the EUR, perhaps down towards 1.29 against the dollar. It is probably a buy there, given the appetite of Voldemort and co. over recent weeks.

Speaking of which, the Russkies reval'ed the rouble by 10 kopecks today. At this juncture it is unclear how or if this will alter their intervention patterns in EUR/USD.

More later after the elephant performs his party piece....

Wednesday, February 07, 2007

How do you solve a problem like vacation?

Macro Man is stuck with a problem. As problems go, it's a pretty good one to have, but it remains a problem nonethless. He is going on vacation next week.

Sadly, macro traders are not consulted when the UK school system compiles its holiday calendar; otherwise, they might not have scheduled the half-term break the week after G7 (and the week of the Humphrey-Hawkins testimony and a whole slew of key data.)

Nevertheless, Macro Man needs to start thinking about what to do with his positions, as it could be dangerous to leave them sitting for a week. (He will of course be actively managing his real world portfolio, but the blog portfolio will remain untouched all week.)

Step one is to position for risk aversion, which would lill a lot of the alpha and beta positions.

Macro Man therefore puts on an option spread on SPH7.

He buys 200 March 1445/1425 put spreads at 5.7, and sells 200 March 1480 calls at 5.9.

Yen again

"Just when I thought that I was out they pull me back in. "
-Michael Corleone, Godfather Part III

Macro Man was hoping to write about something else today, but cannot seem to escape the yen just yet. Today's FT carried an editorial urging the Bank of Japan to sell some of its foreign xchange reserves and buy yen. To do so, the piece claimed, would "boost the yen and its economy at the same time."

Three points:

1) This is a perfect example of the sort of fluffy argument that Macro Man alluded to on Monday. To claim that Japan has a large trade surplus so the yen must strengthen is lazy thinking, to put it politely. As Macro Man demonstrated on Monday, the trade surplus is actually smaller than the long run average, despite a confluence of surplus-boosting factors. As such, arguing that the yen is too weak on the basis of trade is fairly limp.

2) The author of the article claims that the reserves are "dead money" that the BOJ could better employ elsewhere. Wrong and wrong. The vast, vast majority of the reserves are owned by the MOF, not the BOJ, and the income generated by reserves goes onto the government's budget as receipts.

3) The author makes no attempt to justify how and why buying yen in the foreign exchange market would "boost" Japan's economy. Given that this is probably a necessary condition for the MOF to sanction intervention, the silence in terms of justification for the statement is deafening.

To be clear, Macro Man thinks that EUR/JPY is way, way overvalued. But that is a euro thing, not a yen thing. There are valid arguments to be made that this overvaluation should be corrected, and appropriate mechanisms for doing so. This limp editorial provided neither.

More interestingly, a poster drew Macro Man's attention to a phenomenon of which he was admittedly ignorant. Apparently, there is a semi-widespread belief that last spring's decline in USD/JPY from 118 to 109 represented some sort of massive carry unwind that eventually filtered through into other assets, eventually dragging global equities lower.

Certainly, a glance at the chart of USD/JPY and the SPX, for example, clearly indicates that USD/JPY went down and then some time later, the SPX went down.

It is is factually true that USD/JPY went down, and then so did the stock market. However, one of the first things that Macro Man learned as a callow young trader is that "correlation does not imply causality." That is certainly the case here.

In the few weeks of 2006, macro and currency traders were indeed involved in the carry trade generally and long dollars specifically. However, the downgrade of Iceland in February 2002 and subsequent attention on external imbalances led to more selective position-taking. Contrary to what appears to be the popular image of macro/currency traders as yield-obsessed coupon clippers, there are plenty of times when nominal interest rates are not a particularly strong driver of positioning.

Starting with the Iceland downgrade, currency traders began to focus on external imbalances as a driver of currency moves. Cue sharp declines in most currencies sporting large current account deficits, such as the ISK, TRY, NZD, HUF, and USD.

By mid-April, curreny positions were leaning short USD (and long yen!); these positions were aggressively lengthened in the aftemath of the April 22 G7/IMF communique, which appeared to suggest that the IMF would take a role in co-ordinating currency adjustments to ease external imbalances. (Since then, of course, we've heard nary a peep.)

So the move from 115 to 109 was actually a positive currency traders and a positive for global risk appetite. It was only when the Fed surprised markets on May 11 with the hint of another rate hike that risky assets rolled over. Far from losses incurred as USD/JPY moved from 115 to 109 causing equity selling; macro traders lost money as equities went down and USD/JPY went up!

As proof, Macro Man offers the chart below, which plots USD/JPY and the Barclay currency trader index, a composite of 106 currency funds and CTAs. Note the sharp rise in profits that accompanied the shrp decline in USD/JPY! The resumption of a negative correlation between the two series (on the chart) by late June suggests that that is when the carry trade was re-established.

Elsewhere, Macro Man took profits on his short Bund strangle this morning at 0.35. The market has tilted towards a more dovish viewpoint on the ECB; should Trichet drop the hammer of vigilance tomorrow, we could see Bunds ease back towards a 114 handle.

Morning quickie

Macro Man woke up this morning with a powerful sense that the yen's little recovery has about run its course. The abject failure of the Antipodean currencies to maintain weakness suggests that an underlying demand for cross/yen remains very much in play.

Macro Man therefore:

* Closes the long EUR/AUD discertionary position at 1.6696 spot, 1.6721 to 02 March

* Establishes the NZD/USD beta plus carry position, selling $20 million against kiwi at 0.6830 spot, 0.6822 to 02 March.

Tuesday, February 06, 2007

Eight points about yesterday's post

1) Rudeness sells! In what may be a sad commentary on human nature, yesterday’s deliberately provocative title coincided with a record number of page hits in the short history of the Macro Man blog. The correlation between impoliteness and eyeballs may well explain Dr. Roubini’s, shall we say, combative style.

2) Yes, yesterday's effort was posted on the RGE website soon after it was published, though not by Macro Man.

3) Brad Setser at RGE seems like an open-minded and civil fellow, and addressed the substance rather than the style of yesterday’s post. So please ignore all allusions in yesterday's post to anyone at RGE except its proprietor.

4) Yesterday's post was not written out of any sense of 'sour grapes' vis-à-vis last Friday's (to date underwater) USD/JPY purchase. That trade is on page 1 of its history, and any loss incurred in advance ofG7 is frankly the cost of doing business.

5) In any event, the point of yesterday's piece was to refute that the argument that the yen is a substantial financial risk, not to dispute the right of Roubini or anyone else from arguing to the contrary.

6) Amusingly, Macro Man saw another "enough already with the yen carry trade is the pathway to disaster" piece, written a couple of hours after his piece was published. Interestingly, this second piece was penned by someone long yen.

7) Macro Man has yet to hear any worrying about another pernicious trade- the sterling carry trade! If you think the yen at 20 year REER lows is worrisome, then golly, you must really be beside yourself at sterling, which is at a post-Bretton Woods REER high.

8) The end of yesterday's post indicated two possible scenarios for a substantial and lasting shakeout of yen shorts, including one that would make Macro Man happy to be limit-long yen (or close enough.) At the end of the day, Macro Man is paid to make money. Dogmatism and profitability are companions not often glimpsed in each other's company, and it is foolish to maintain positions when underlying circumstances change. Macro Man certainly has no intention of doing so. By the same token, it is neither foolish nor immoral to position one's portfolio in a manner that one deems most likely to meet one's investment targets, whatever they may be at any particular time. Indeed, it would certainly be foolish and, depending on the circumstances, possibly immoral to do anything else.

RGE’s Brad Setser responded to a few points made in yesterday’s post. Re: Japan’s trade balance, he posted the following:

Re: Why isn't Japan's trade surplus bigger --

a) lags -- yen wasn't so weak not so long ago (04). watch 07

b) oil

c) yen is only weak v. rest of the g-3. it isn't obviously weak v. the yuan

d) don't forget about japan's exploding income surplus

Addressing these in turn:

a) By the same token, USD/JPY was exactly where it is now in July 2003. In any event, the exchange rate and the trade balance have a symbiotic relationship that reflexively act upon each other. One could argue that given the current level of Japan’s trade surplus, USD/JPY should be at 125 if not higher.

b) The US petroleum deficit has stabilized, so it is unclear why the same shouldn’t hold for Japan. In any event, the oil issue is a key one for Japan: the run-up over the past several years has been a clear negative terms of trade shock, which exerts a negative influence on the yen. Indeed, in discussing who is selling all those yen, not enough attention is paid to Japanese importers, many of whom have seen cheap hedges (via barrier options) disappear, thus forcing them to go to market at recent elevated levels. These will be forced to chase USD/JPY through 125, should it trade there.

c) On a broad-based nominal TWI, the yen is at its weakest level since 1998. And while the yen may not be particularly cheap against the CNY, try telling the Koreans that it ain’t cheap against the won! In any event, the real mispricing is not so much the yen, but the euro, sterling, the Aussie dollar, kiwi, etc.

d) The income surplus is obviously captured in the current account rather than the trade account. Roughly 1/3 of the income surplus is earned by the MOF via its FX reserves, which generally are rolled over. Obviously, the private sector’s share of income receipts should rise over time as outward investment continues. However, it is unlikely in the near term that that portion of income which is repatriated will overwhelm the sheer volume of new capital that is leaving the country.

With regards to positioning, Macro Man remains very comfortable with his view that global real money bond and equity managers are, on aggregate, overweight yen relative to benchmarks, which marks a distinct and important change relative to past episodes of yen weakness. While hedge funds are almost certainly short yen, Macro Man’s inquiries continue to suggest that these positions are not extreme relative to 1998.

Monday, February 05, 2007

Nouriel Roubini is a big fat idiot

Please allow Macro Man to apologize for the rather rude and witless title to today’s post. He generally prefers to conduct himself in a (relatively) polite and professional manner. However, the subject of today’s post, Dr. Nouriel Roubini, has developed the charming habit of calling those who disagree with his analysis “fools”. What better way, then, to refute the good doctor than by starting off one’s argument with an epithet taken straight from the schoolyard?

In any event, Dr. Roubini and his merry band of globe-trotting pundits at RGE have decided that the yen carry trade is the latest issue that could undermine the global financial system and potentially send the world careening into recession. Having missed the boat with housing and the economy (yes, the housing market has come off sharply, as accurately forecast by RGE; no, this has not produced a recession, as forecast by RGE), they have decided to invoke the spirit of 1998.

In fairness, Roubini is not the only one. Macro Man has seen and heard an increasing drumbeat (mostly from non-currency specialists) over the past several months about the size and danger posed by the yen carry trade, and how it risks a catastrophic unwind a la 1998. Indeed, the recent World Economic Forum at Davos was full of angst and hand-wringing from assorted worthies about the endgame for the yen.

Michael Lewis did a fair job of dismissing the general doom and gloom of Dr. Roubini and the Davos Doom-Mongers (sounds like a 60’s novelty band, doesn’t it?). The good doctor rewarded Lewis by calling him a “reckless fool”, an especial token of esteem from all and sundry at RGE. Macro Man now proposes to discuss the specific argument of the yen carry trade; the conclusion, as if you couldn’t guess, is that the carry trade ain’t what it used to be.

The “1998 all over again” arguments appear to hinge on two factors. One is that the yen is at “20 year lows” in real terms, which by definition appears to mean that the world is funding out of JPY. The second looks at positioning on the IMM in Chicago, which admittedly is at a record extreme, and presumes that this reflects positioning for the currency market as a whole.


Japan’s Vice-Minister for International Affairs, Hiroshi Watanabe, has disputed that the yen is as cheap as standard models suggest. Although the yen is indeed very cheap on a real effective exchange rate (REER) basis, a substantial degree of this cheapness comes from Japan’s deflation of the past decade. Standard calculations suggest that the yen should strengthen during periods of deflation to maintain a constant REER. Watanabe suggests that this is nonsense, and that the appropriate policy response during deflation should be for the yen to weaken, thus helping to stem deflation. While his comments may not hold academic water, they do resonate from a common sense perspective.

Regardless, if the yen were as cheap as REER analysis suggests, we should expect to see that reflected in Japan’s trade account. With Japanese domestic demand tepid and growth strong in most of its trading partners, surely yen weakness has prompted record trade surpluses in Japan? Uh-uh. In fact, Japan’s trade surplus is currently smaller than the average of the past 20 years. This surely suggests that the underlying premise, that the yen’s REER accurately reflects its “true” valuation, is mis-placed.

The obvious indicator here is the record short position in yen futures contracts on Chicago’s IMM exchange. It is certainly the case that this indicator is at an historical extreme, and has been for some time. And if currencies were only traded on the IMM, it clearly would be cause for concern vis-à-vis the yen carry trade.


However, the IMM represents only a very small sub-set of foreign exchange traders. The people who use the IMM are typically momentum-driven commodity trading advisors, an important yet nonetheless non-hegemonic participant in the currency market. Very few hedge funds or real money investors use the IMM; clearly, their positions, which are generally more reflective of “fundamentals”, can differ dramatically from those of purely price-based CTAs.

In fact, that appears to be the case. While hedge fund positioning is notoriously difficult to get ahold of, there are a number of surveys of real money equity and bond managers that can provide a reading on positioning from more ‘fundamentally’ based managers. And given that many real money shops now operate hedge funds, these surveys perhaps provide a reasonable glimpse of what hedge fund positioning is like as well.

One such survey is the Deutsche Bank/Russell Mellon survey. And the message there couldn’t be clearer: 2007 is nothing like 1998. In 1998, the median fixed income manager was very significantly short of yen; indeed, even the 25th percentile manager had a small yen short on. Fast forward to today. While there is a cohort of the market that clearly has the yen carry trade on (as indicated in the 75th percentile line in the chart below), the median manager’s yen position is only very slightly short, having been long or flat for most of the past several years. The 25th percentile manager, meanwhile, retains a yen long.
Deutsche Bank/Russell Mellon

It seems clear, therefore, that the yen carry trade is neither as large nor as broad as it was in 1998. Anyone who cites the IMM data as “proof” of FX market positioning is almost certainly an academic or an amateur.

Another way to gauge positioning is to look at Japanese banks’ yen lending to foreigners. Currency traders must ultimately borrow yen when they sell it short, and this borrowing generally filters bank into Japanese banks, with whom other banks have their yen nostros. We can therefore get a read on yen borrowing by looking at Japanese banks’ yen lending.

As the chart above illustrates, there has been a substantial increase in Japanese bank lending to foreigners...which has almost taken it back to where it was sixteen years ago. This data suggests that the apex of the yen carry trade was not in fact 1998, but 2002, when USD/JPY traded up 135 before gently declining over the next several years (with no massive repercussions for the global financial system, funnily enough.) While the recent sharp increase in lending does suggest a carry-trade buildup of sorts, the fact that lending has already rolled over a touch is far from indicative of risk appetite gone wild.

Finally, among the most enthusiastic sellers of yen have been the Japanese themselves. While it is true that retail currency trading volumes have exploded, and could perhaps pose a small risk, the overall size of these positions is very small compared with the currency market as a whole. More persistent is the retail appetite for foreign currency investment vehicles. These include foreign currency uridashi bond funds, but also to an increasing degree, foreign equity funds. Japanese households retain more than 50% of their financial assets in yen deposits that pay little more than zero. With the normalization of the economy and concomitant increase in risk appetite, it is small wonder that Japanese retail has lowered its home bias to a measurable degree.

Of course, when Mr. and Mrs. Jones buy foreign equities (as they did in record volumes last year), it is a sign of loss of faith in the American economy and financial system-and therefore a prudent move. When Mr. and Mrs. Kobayashi do the same thing, it is a sign of reckless risk appetite and the carry trade gone mad. Why? Well, because the good Dr. Roubini says so, of course!
Three other issues

Of course, some of the doom-mongers can provide other ‘evidence’ that their vindication is right around the corner. Chief among these factors is the impending rate rise from the BOJ, which in fact has been impending for about eight months now. While it is true that a BOJ rate hike may provide a temporary bout of support for the yen, it is unlikely to produce a large scale wash-out of short yen positions. Even if the BOJ were to hike 0.25% or 1.25%, the yen would be far and away the lowest yielding currency in the world (outside of some NDF currencies that occasionally price in negative rates!) and yield a substantial discount to other major currencies. Just as the CHF has failed to benefit from SNB tightening (since the SNB started raising interest rates from 0.25% to 2.00%, EUR/CHF has rallied from 1.50 to 1.62), Macro Man believes that any BOJ rate below, say, 1.5% will not be sufficient to dissuade carry traders.

Amazingly, USD/JPY is more or less right where it ‘should’ be on the basis of pre-quantitative easing relative monetary base growth!

Moreover, assertions that the fundamental backdrop to the short USD/JPY are ‘just like 1998’ or even 2002 are well wide of the mark. The last two episodes of yen weakness were characterized by a ‘sell Japan’ mentality, which evinced itself not only in currency shorts but also in equity shorts.

In 1998, for example, Japanese banks were in such bad shape that their yen borrowing rates were substantially higher than non-Japanese banks. This ‘Japan premium’, represented by the spread between 3 month TIBOR and 3 month LIBOR, no longer exists.


Finally, it seems likely that international equity investors are positioned differently from previous episodes of yen weakness. The last two episodes of yen weakness (1998 and 2001-02) were accompanied by substantial weakness in Japanese equities. Although firm positioning data for international equity index managers is difficult to come by, Macro Man has a strong anecdotal recollection that both real money and hedge fund managers were short/underweight Japanese equities at the time.
In other words, in addition to yen shorts from the carry trade, there was another layer of yen shorts from underinvested/short equity managers. Today, this is not the case. The Nikkei has been one of the darlings of Macroland for several years now, albeit with disappointing performance in 2006. As such, any signs of improvement in Japan will not necessarily be met with yen buying from short covering equity managers. As such, a key factor that made prior yen squeezes so vicious is notably absent today.

Ultimately, there is one category of ‘investor’ who has the yen carry trade on in enormous size: Macro man’s favourite financial market participant, the FX reserve managers. According to the latest IMF data, which is admittedly un-comprehensive, the yen makes up just 3% of the reserve baskets of those central banks who deign to disclose their reserve weightings. Sterling, on the other hand, has a 4% weighting (and nearly 6% amongst emerging economy central banks.) If that’s not the carry trade, what is?

Ultimately, the yen should and probably will remain weak on a broad basis until one of two things happens.

If Japan careens back into deep recession, Mrs. Kobayashi will likely curtail her purchases of foreign securities, eliminating a substantial headwind for the yen. At that point, risks of a short-covering rally would increase.

On the other hand, Voldemort and his cronies could finally alter their behaviour and start buying yen like they do euros. If and when that happens (and it might not be that far off), the yen will rise very substantially, and it will be a great trade to be long yen against everything.

For the time being, however, neither of these factors is in play. And while the good Dr. Roubini jets around the world (presumably on someone else’s dime) wringing his hands with worry, those of us who have real P/Ls will remain more concerned with finding out the real story than the interesting story. And if that makes us fools, well, then so be it. I’d rather be a fool than a big fat idiot any day.

Friday, February 02, 2007

Descent into farce

Just when you think it cannot get any worse....

The payroll headline was clearly leaked, as the USD got caned in the minute before the number. Karma proved to be a bitch, however, as the dollar actually reversed course after the market digested both the revisions and a dovish ECB rumour.

It wouldn't be a Friday with a descent into utter farce, however, and markets soon started spreading the rumour that California was somehow not included in the payroll data. Surely someone would notice if the largest population in the union and one of the ten largest economies in the world just went missing? It's not quite the same as leaving one's umbrella in a restaurant...

In any event, the data that was released has become worse than useless. The benchmark and other revisions added an average of 40k a month to payrolls over the last two years...rather a lot! Moreover, the durability of the labour market releative to trend appears to have improved as well; rather than 10 of the last 24 months' payroll gains registering above the 6m moving average, 16 of the last 24 months have now registered above the (old) moving average.

If you didn't like the January figure, just wait; it will no doubt be revised to the orignal consensus next month. The bond market's failure to sell off (and it tried) confirmed Macro Man's suspicions that the range remains intact. he therefore went to market and bought $25 million of the 01/17 TIPS bond at 99-17.

When good news is bad news...

The dissonance between economics and markets was amply demonstrated yesterday by the US bond market, which closed the day a few ticks lower despite the release of a substantially lower than expected (and as importantly, sub 50) ISM survey.

In fairness, the market rection was not as perverse as first appeared. Virtually the entire decline in the ISM was prompted by the inventory component, which collapsed from 48.5 to 39.9, its lowest level since tech bust. This, it is thought, will ultimately prove bullish for US growth as production eventually recovers. Indeed, the ISM chief economist was quoted as saying that the US economy is "holding up quite well."

OK, that's fine. But Macro Man is still slightly troubled. If the manufacturing sector were really robust, an inventory unwind would not have been sufficient to drag the ISM below 50. Moreover, while the inventory build (relative to sales) has been concentrated in the manufacturing sector, it nevertheless represents the largest rise in the manufacturing inventory/sales ratio since 2000-2001. And we know how that ended.

Thus, while Macro Man remains comfortable with the resilience of the US economy and expects solid growth for 2007 as a whole, he wonders if Q1 won't relapse into weakness. In addition to the inventory drawdown in manufacturing, rising commodity prices (and the concomitant terms of trade shock) should put upward pressure on imports. As a result, the impact from net exports should be less positive in Q1 than it was last quarter.

Of course, Macro Man needs to be careful and not make the same mistake that the housing market bears have made, i.e. to think that their issue is the ONLY or the DOMINANT issue driving economic activity. The chart below illustrates where and how the housing market doom-mongers have gone awry.

While it is the case that household equity has declined on a year-on-year basis, rising financial assets have more than made up the slack. The latest data (Q3 2006) suggests that household net worth rose 7.7% y/y, despite a 2% decline in household equity.

Of course, this can cut both ways; one could argue that the recent deceleration of the equity rally will take the wind out of financial assets' sails. More perniciously, an outright decline in equity prices would exert a 'double whammy' impact on household balance sheets. Perhaps, but the threat won't keep Macro Man awake at night. After all, income growth on an aggreagte level remains very strong- up 5.9% y/y according to yesterday's data.

The obvious rejoinder to this argument is that the distributions of household and financial assets are radically different. Housing equity (the thing that is going down) is widespread, whereas financial assets are heavily skewed towards the top decile of investors/plutocrats (depending on your politics.)

Macro Man does have some sympathy for this view, and it remains a threat to the soft landing thesis. Nevertheless, the consumer confidence surveys should capture Joe Sixpack's mentality better than any aggregated macro data. And the message there is comforting: both the Conference Board and Michigan numbers are at or near their highs of the past several years.

Therefore, roll on the range trade in fixed income. There perhaps may be some downside risk to USD/Europe but also for risky currencies and equities, though these dips should ultimately be bought for the real re-acceleration in the spring.

Macro Man will therefore look to buy TIPS today after the payroll figure, which is of course a crapshoot. He will bid 99 for $25 million of the on-the-run 10 year TIPS (Jan-17), with a stop entry at 99-28. Should the payroll be inconclusive, he may well go straight to market.