Thursday, May 31, 2007
Continuing a theme, the cheerful 60's ditty "Hang on, Sloopy" keeps running through Macro Man's head (though not his Ipod.) It's month end, and Macro Man is set for a very solid month's performance if his portfolio can just hang on another day.
Yesterday's gains were helped, of course, by the Lazarus-like recovery in US equities, which generated a new all-time closing high in the S&P 500. It is quite a testament to how bubblicous the dot-come era was that the Dow and SPX ae now at all time highs, but yesterday's Nasdaq close was at an index level that is only 50% of the all-time high (reached in Marh 2000.)
So with equities recovering sharply, the dreaded carry trade has once more come back with a vengeance, providing Macro Man's beta portfolio with yet another boost. Of course, any mention of currencies these days is apparently forced by law to discuss China. The Strategic Economic Dialogue has come and gone, and it appears that the protectionist element in Congress was less than convinced by Madam Wu. Today's FT carries a rather droll article suggesting that the Senate is close to finalizing a bill that would compel the Treasury to intervene in markets that are 'misaligned'. Quite how the Treasury would intervene to buy a nondeliverable currency (such as that of, oh.....China) doesn't appear to have crossed anyone's mind, but then again economic and market literacy has never been a particular hallmark of protectionists.
Meanwhile, Brad Setser has another post addressing the impact of exchange rates on global (im)balances. The problem with much of the punditry addressing the impact of exchange rates is that it uses too small a sample size. Quartely current account releases do not provide a lot of datapoints, particularly for series as autocorrelated as external balances. Moreover, Macro Man would argue that improved hedging techniques has extended the lag with which FX moves are passed through and thus impact the real economy.
To gauge whether FX rates appear to drive external balances over longer, more statistically significant perods of time, Macro Man performed a simple study using the G10 currencies. He simply looked at the deviation of the Q4 2006 OECD real effective exchange rate from its 20 year average, and compared it with the deviation of the Q4 2006 current account balance as a percentage of GDP from its 20 year average. If there were an impact, we would expect to see weaker-than-normal exchange rates producing better-than-normal curent accounts, and stronger-than-normal currencies producing worse-than-normal current accounts.
By and large, that's exactly what we get. Of the ten countries in the study, eight produce the "right" relationship (including the US, whose FX rate is very slightly stronger than its long term average.) The two outliers were Canada and Norway, whose current accounts and currencies are both higher than average. Of course, these countries are both large producers of energy in the midst of a rampant bull market.
It would appear, therefore, that exchange rates do matter, if one waits sufficiently long for the impact to materialize. Macro Man would be very surprised indeed if The Economist is still whistling the same tune in a few years' time.
Wednesday, May 30, 2007
Who knew that the Sundays, an English indie band that broke up in 1997, were so popular in China? On the same day that Macro Man quoted one of their songs in reference to the end of the Chinese stock market bubble, darned if the authorities didn’t raise the stamp duty on transactions from 0.1% to 0.3%, prompting a 6.5% decline in Shanghai A shares and 9% drop in B shares.
Of course, this pullback took the year-to-date gains in A and B shares to 51% and 133%, respectively- still pretty heady stuff. And when you’re playing for those kind of serious returns, does it really matter if the cost of trading rises from a fraction of a percent to a slightly larger fraction of a percent?
Macro Man would not have thought so, but history suggests otherwise. Two previous stamp duty hikes have provoked bone-crunching declines in Chinese equities. In 1992, the imposition of a 0.3% stamp duty was followed by a 70% decline. In 1997, a rise in the duty from 0.3% to 0.5% was followed by a 75% decline (as well as the Asian currency crisis, coincidentally.)
Ultimately, with Chinese equity volatility this high, and participation so widespread, the rise in the duty should have little impact. Macro Man saw one estimate based on turnover data that the rise in the stamp duty would cost punters 2.8% per year: fairly small beer for indices that move as much as China’s. Yet it is often the last straw that breaks the camel’s back, especially when risk premia are as low as they are at present. Ironically, the US market could be a (relative) star performer if the China malaise were to last for more than a day, given the large short interest on the NYSE and the market’s reported affinity for long Europe/short US spread trades.
(UPDATE: As an aside, isn't this a lot like February? China meltdown on the penultimate day of the month...all we need now is ADP to print 200k and send bond yields screaming higher....)
Elsewhere, the ongoing squeeze in funding currencies (the yen excepted) certainly suggests that markets are cruising for a bruising. Fortunately for Macro Man, even the squeezes are getting squeezed, and the SGD 1 year payer position is now comfortably in profit.
As has been the case for much of the past few weeks, Macro Man is torn between tactical concerns on risky assets and more structural bullishness. News that Russia is formally drafting legislation to allow the state pension fund to purchase domestic equities, erstwhile rock stars that have fallen on hard times recently, is emblematic of the underlying demand for risky assets from sovereigns as well as private sector investors. And lest anyone doubt whether emerging markets are providers of liquidity and/or running overly loose monetary policies, have a look at Russia’s year-on-year M2 growth:
Tuesday, May 29, 2007
Another bank holiday, another hatful of rain. It's quite a tradition here in the UK. As he travelled to, from, and around the Isle of Wight, Macro Man was left to rue the persistently strong correlation between days off from work and precipitation. Still, all was not lost. Putting the Ipod on 'shuffle all songs' took Macro Man (and, to their evident chagrin, Mrs. Macro and the Macro kids) on a musical journey to his past.
As he listened to songs last heard when Margaret Thatcher was the prime minister resigning from office, his mind started wandering. Lyrics he heard reminded him of situations he was observing in the market. (Macro Man is clearly not alone in this propensity.) This morning, he even saw a market story that reminded him of a line from one of his favourite films. So without further ado, here are five random cultural allusions that have grabbed his attention over the last few days:
* Why can't I free your doubtful mind and free your cold, cold heart
- Hank Williams
Probably because your beloved is living in the UK, Hank. Yesterday's bank holiday saw some parts of the UK colder than Alaska and Siberia. If the shops in Ventnor were anything to judge by, May should see a stonking retail sales result in the UK. Macro Man is relieved to be out of the short sterling long.
* Here's where the story ends. It's that little souvenir of a terrible year...
- The Sundays
OK, this one's cheating a bit. Macro Man isn't clever enough to know where the bubble in Chinese shares will end, but he has a pretty good idea of how it will end. Eventually, the authorities will feel compelled to tighten policy more aggressively (that is to say, they'll feel compelled to actually tighten policy.) This may well not occur until after the Olympics ; when it does, however, the future will probably look an awful lot like the past (note the chart below, depicting Shanghai B shares, is in log scale.)
- Tom Petty
This one's also a bit of an exaggeration. But the Taiwan dollar is perhaps another reason to be worried about risky assets. A whipping boy and favoured funding currency all year, the TWD is now flexing its muscles courtesy of CBC intervention and stop lossing. USD/TWD has corrected quite sharply over the last few sessions; further weakness could suggest that perhaps USD/JPY might shake out a few late longs, a development that could grab the attention of the broader market.* Gale: Where'd all the tellers go?
Evelle: They're on the floor as you commanded, Gale
Gale: Didn't I tell you not to use my name?
Evelle: Not even your code name, Gale?
Gale: Yeah, that's right. Y'all hear that? We using code names!
- Raising Arizona
Unlike, for example, the ECB, which has finally decided to end the ridiculous farce of signalling future rate hikes using code words. This may well increase the volatility around ECB meetings and speeches, given that the market will not have received a memo about the timing of rate hikes two months in advance. Could this mean that the ECB tightening cycle is coming to an end? Potentially, though Weber tried to dismiss the notion in the linked article. Still, you'd have to think that the change in communication strategy was prompted by a change in circumstance, e.g. diminshing visibility of the future rate trajectory.
* Crazy...I'm crazy for feelin' so lonely
Hugo Chavez may not be crazy, and he may not be lonely, but he is certainly increasing the volatility of the Latam region. His weekend decision to close the opposition TV network prompted large and violent demonstrations in Caracas. His ongoing flirtation with exiting the IMF and World Bank would also appear to suggest a less than firm commitment to service Venezuela's external debt. While he retains extraordinary popularity amongst the country's economically disadvantaged, Chavez is succeeding in driving out the nation's intellectuals and middle class. While a Venny default would not be the biggest shock in the world (CDS spreads are considerably wider than for similar regional credits) , it is a popular destination for coupon clippers and sellers of risk premium. While a Venny default would not necessarily carry the impact of, say, a Russia 1998 situation, it would be considerably more important than a similar action from Ecuador. As such, the situation bears watching.
If you haven't already, please respond to Friday's poll!
Friday, May 25, 2007
No need for Sergeant Friday yesterday, as US equities started their swoon fairly quickly after the new home sales data nudged ten year bonds towards the year's high yield at 4.90%. On balance, Macro Man viewed yesterday's data as fairly constructive for the US economy; the orders data was solid, and it can ultimately only be a good thing if homebuilders are finally taking the hit to clear inventory. (As an aside, the market seems to have ignored the 'taking a hit' part and focused mostly on the 'clearing inventory' angle.)
Perhaps the sergeant was in Asia today, where Chinese equities once again defied gravity (and other markets) to post a solid gain, while a blatant misprint of Japanese CPI on Reuters screens caused quite a bit of short term volatility. Either way, most major markets are where they were when Macro Man went to bed last night.
Today, Macro Man would like to switch gears a bit and become a bit self-referential (actually, a bit more self-referential, given his proclivity for referring to himself in the third person.) He has been writing this blog for more than eight months now, and has been pleased and gratified to see how interest (or at least readership) has grown.
He's had the pleasure of corresponding with a number of readers in the comment section, offline, and on other forums; he's even met a few readers in person. However, that hasn't really told him much about the nature of his readership.
He can glean an idea of where you come from (the chart below shows the geographical location of the last 100 visitors as of 9.15 this morning):
...and when you like to visit (this chart shows the visits by hour as on 10.30 London time last night- observe the peak around the US market opening):
..but that still doesn't tell him who you are. And by extension, what you find interesting. Discussions on Chinese reserve management? Technical analysis of the US equity market? The blog portfolio? Bad poetry? Macro Man is curious. He started writing the blog as a way of clarifying his own thoughts about markets, and he's been pleased with the results. But his native curiosity makes him wonder who is actually reading him.
He therefore begs you to indulge him and respond to the attached poll. Note that this is NOT a market research exercise. Macro Man isn't planning to sell ads or launch a market newletter or any similar commercial enterprise. You know (to some extent) who he is; now tell him who you are.
Thursday, May 24, 2007
The signature tune of the old television series “Dragnet” will be familiar to most people, even those that have never even heard of the show. It is the ultimate musical conveyance of suspense: DUN da-dun dun.....Dun da-dun dun DUNNNNNNN. Macro Man wishes he could call on the services of the show’s detective, Sergeant Joe Friday, because a financial market mystery has got the Dragnet tune running through his head.
Specifically, what the heck is going on with US equities late in the day? In each of this week’s trading sessions, the S&P 500 has been poised to close at a record high (1527.46 if you care.) Yet sellers have emerged late in the session to push the index sharply lower back towards unchanged on Monday.....
Just as opening session price action is often thought to reflect retail “dumb money”, price moves towards the close are thought to represent the activity of institutional “smart money”. Indeed, the late session swoons remind Macro Man of the hedge fund margin call hell last May and June, where the index repeatedly imploded late in the session. Margin calls wouldn’t appear to be an issue this time around (other than from some of the record number of shorts on the NYSE), but someone is clearly lightening up.
Combined with the familiar litany of reasons to be worried, a sudden emergence of EM profit-taking (even the lowly Taiwan dollar, one of the world’s most populated funding currencies, rallied sharply today courtesy of CBC intervention), and policy concerns (Capital controls announced by Colombia), it’s all the more reason to be worried and nimble.
Wednesday, May 23, 2007
Ever so slightly, things are starting to look a bit more interesting. As Macro Man wavers, the US and China chat, and global rates continue to edge higher, signs are emerging that markets may start to jiggle around a bit more. Consider the following:
* The euro has failed for the time being and looks set to trace out a deeper correction. As of last Tuesday, CTAs had record long positions on the IMM. While the positions are likely smaller now, we are starting to approach levels where some of the more medium term sell signals are likely to be triggered.
* At the same time, very long term EUR/USD implied vol seems to have found a bottom. Macro Man didn’t quite bottom tick 10 year vol, but he wasn’t far off (knock on wood.) When his one touches are revalued at month end, they should provide a nice boost to his FX alpha.
* Intriguingly, there has been a surge in the US equity put/call ratio. Macro Man (and a couple of posters) has opined that the SPX/VIX divergence suggests that introducing optionality into the portfolio makes a lot of sense. Apparently, the market agrees with him. What makes this development so curious is that the prior spike in the P/C ratio resembling this one occurred immediately before the February 27 China scare and subsequent risky asset correction.
* Both the ECB and BOE continue to sound hawkish despite the recent rise in official and market rates. Unrelenting Fed hawkishness this time last year kicked risk assets in the head with an iron boot. Could Europe deliver a similar punishment this year?
Macro Man has decided to clean up the alpha portfolio by closing the short end positions in euribor and short sterling. While there may be some upside to holding onto both positions, any significant increase in market volatility could encourage him to do something stupid. Far better, therefore, to clear the decks and watch the market with a clear head. He hangs onto the long TYM7 as a synthetic equity market put but will probably be forced to exit on a break below the year’s lows.
Tuesday, May 22, 2007
Which of these things is not like the others:
a) Uber-bid oil and gasoline prices at record highs
b) Rising global interest rates
c) A VIX that won’t go down
d) Equities across the globe at or near their highs
OK, now let’s play again. Which of the following just doesn’t belong:
a) Double-digit broad money growth in many economies
b) Defensive positioning
c) Central banks just now starting to buy stocks
d) Near-record global growth
e) An historically favourable environment for corporate profits
f) Upside profit surprises
g) Macro Man’s bearish equity tilt in his alpha portfolio
This is the conundrum that Macro Man, and he suspects more than a few others, currently faces. He feels that equities are currently overdone and due for a correction, particularly when faced with the triple whammy of rising energy prices, rising interest rates, and unfavourable seasonality.
By the same token, he currently feels woefully underinvested, courtesy of the short SPM7 call position in the alpha portfolio. IMM specs are leaning the same way; a diffusion index of all non-commercial positions in the big and e-mini S&P futures reveals a net short position.
Moreover, we are currently living in a tremendous environment for stocks. Globalization has meant that multinational companies are able to reduce (labour) costs like never before, albeit with a concomitant rise in commodity prices. Tax regimes in both West and East are generally favourable, at least for the time being. Global growth is not only extraordinarily strong, it’s also extraordinarily broad-based.
And perhaps most importantly, the hegemonic actors in financial markets these days, FX reserve managers, are only now starting to have a bite at the stock market cherry. As Bretton Woods II starts fraying at the edges, it’s becoming clear that the returns on low-duration fixed income reserve portfolios ain’t gonna cut it.
China’s decision to create a separate investment vehicle and take a stake in Blackstone is by now well-known. But consider also that Taiwan, with a not-insubstantial $266 billion in reserves, is also setting up a sovereign wealth fund. Eventually, even Japan may follow suit. And look out for Russia as well. Vlad Putin said yesterday that oil revenues should go into the domestic equity market (presumably at the expense of FX reserves or the Stabilization Fund, which is tantamount to the same thing.) Even Norway, which has been doing the sovereign wealth thing longer than most, is feeling pressure to perform. Q1 returns for the oil fund were 1.5%- not exactly eye-popping. It surely isn’t a coincidence that the decision to raise the equity allocation of the fund was taken at the same time that returns from more traditional ‘reserve assets’ has been flagging.
Add it all up, and Macro Man is left between a rock and a hard place. He expects a correction to ensue (another Chinese export, perhaps?), but wants to use it to take off his alpha shorts and increase equity length. Positioning indicators suggest he is not alone. Could it be that the real ‘pain trade’ in equities is a continued grind higher? It may well be.
At the same time, he remains of the belief that the tactical headwinds for equity performance have strengthened considerably in recent weeks. He’s though long and hard about this, and arrived at the decision that buying volatility is the way to go. Again, the divergence of the VIX from the SPX suggests that he isn’t alone here. Macro Man needs upside deltas in the event of a continued grind higher, but wants to make hay if the much anticipated correction does finally ensue.
He will therefore buy 100 SPM7 1495 puts at the opening, and buys 500 July DAX 8000 calls at 55. Today’s ZEW confirms the German economy remains resilient against the VAT effect, higher rates, higher energy prices, and a strong euro.
Monday, May 21, 2007
With apologies to Guy Wetmore Carryl....
The lira from the Bosphorus
Makes carry traders prosperous
As long as vol keeps falling
The ongoing liquidity
Feeds risk asset cupidity
And central banks buy dollars
And a frown
Protectionists in Washington
Are getting very angry, son
And threaten legislation
For the nation
Will Madame Wu negotiate
Or could it be that it’s too late
And widening the band
Will out of hand
Though if CBs change their M.O.
(Could Kuwait serve as a demo?)
Then liquidity could tighten
Stocks may frighten,
Take a hit
For if bond yields keep on rising
Stocks will look unappetizing
Unless PE keeps on buying
And they’re trying
So for now stocks keep on soaring
Overweights and longs keep scoring
As the rest wait for correction
Of the highs
And thus feel underinvested
And appear disinterested
For it all just feels too sleazy
So it’s easy
But I want to take some profits
Take some risk exposure off, it’s
Best to lock in a good May
And live to play
Again in June
So I’ll close my whole Turkey long
And the EUR/USD feels wrong
Keep my FX alpha steady
So I’m ready
For the swoon!
Friday, May 18, 2007
To a whole 0.5% per day! When the existing 0.3% band was reached only twice since the reval! And all of this just before the SED! It's the start of a new era in foreign exchange and fixed income! Macro Man is unbelievably excited by this news!
Or, China could just be throwing Paulson a bone to head off the protectionists in Congress, and will change nothing about its behaviour.
With the Strategic Economic Dialogue between the US and China rapidly approaching, the newswires are heavy with stories on all things Chinese. US lawmakers file a petition with the Administration to get China to reval (uh, fellas, what do you think Paulson [and Snow before him] has been doing?) PBOC governor Zhou says the RMB exchange rate will increasingly reflect market forces (a statement as reliable as "the cheque is in the mail.")
Meanwhile, SAFE has slipped Blackstone a cheeky $3 billion for private equity investment- could there be any clearer statement of China's intent on moving up the risk curve (and why it is so tough to be structurally bearish of risky assets?)
Anyhow, it seems reasonable to expect more plaintive requests from the US for the Chinese authorities to "speed up the pace of the currency reform process", aka let USD/RMB plunge. The Chinese willingness to do so, of course, ultimately depends on how resilient the export sector is. Now, with the trade surplus rising at exponential speed, it would seem pretty obvious that Chinese exporters are uber-competitive at current FX levels.
But are they? Mingchun Sun of Lehman Brothers has written an article suggesting that Chinese exporters may not be as competitive as you think, simply because they enjoy a number of artificial advantages:
* Subsidized energy prices
* Subsidized prices for other resources, such as land, water, and minerals
* Low environmental standards and enforcement
* Lax labour legislation and enforcement
* Lax protection of intellectual property rights: why spend on R&D when you can just steal someone else's idea?
* Large tax exemptions and rebates for exporters (a subsidy by any other name would smell as sour...)
Now, there's not much that the US can or should do about some of these, while others represent legitimate points of contention- particularly the latter two. Stephen Roach thinks that enforcing IP would be an "easy win" for China, or at least a legitimate source of complaint for the US.
Others perhaps aren't so sure.
Regardless, Sun's point is that China is focusing on all of the above, as well as the level of the RMB. And that could mean that those of us waiting for a cessation of intervention and a legitimately market-driven exchange rate will be waiting a long time.
Thursday, May 17, 2007
Spring is here! The sky is blue (OK, well not here in the UK), equities are on fire (most major indices are at or near multi-year highs), and EM is a no-lose proposition (just look at Brazil.) Now’s the time to sit back and reap the rewards of globalization, ample liquidity, and the worldwide shortage of risky assets, isn’t it?
Perhaps. Then again, perhaps not. Regular readers will know that Macro Man, while broadly constructive of risk assets medium-term (as demonstrated by the stellar returns of the beta portfolio), has been tormented on and off all year by concerns over complacency and a desire to market-time a correction in the alpha portfolio. The devil of worry is perched on his shoulder once again, whispering into his ear about all the reasons to expect risky assets to dump. After pointing to the calendar and murmuring well-known investment clichés, the devil whispers the following ten things that grab Macro Man’s attention:
1) The divergence of the SPX and VIX: a warning sign or proof that longs are already hedged? Only time will tell.
2) Gasoline prices have surged recently, now topping three bucks a gallon. The inverse correlation between gas prices and stock market return has been pretty strong over the past few years; the recent run-up in petrol suggests equities are due for a (potentially steep) correction.
3) The US housing market isn’t getting any better. Sure, starts beat expectations yesterday, but permits fell sharply. The high levels of inventory and lack of labour force reduction also suggest that homebuilders haven’t taken the full hit from the market slowdown yet. Consumption, meanwhile, is likely to face a slow-burn headwind for the next several years as ARMs get reset and finances get squeezed.
4) Bill Gross and PIMCO have stopped worrying and learned to love the bomb (or at least the carry trade.) It may be cruel to suggest that the capitulation of a high profile bear can be used as a market timing device, but Stephen Roach’s temporary climbdown from his mountain of angst last May provided a clarion call to de-risk portfolios entirely.
5) Bonds, somewhat to Macro Man’s chagrin, are trading poorly and look to be breaking down out of a long term triangle. A push to 4.90% or 5% US ten year yields would likely squeeze the goolies of risky assets, at least temporarily.
6) Gold has already broken down through a fairly obvious support line. Macro Man does not subscribe to the view that gold strength has represented concerns over the world’s welfare; rather, he believes it has been symptomatic of the excess liquidity sloshing around the global financial system, as well as an alternative play on dollar weakness. Gold’s failure, therefore, may be a warning signal that the ocean of liquidity is experiencing a little turbulence.
7) Perhaps monetary policy may actually get tight elsewhere in the world. Yesterday’s BOE inflation report intimated that 5.75% is a done deal, and obviously one rates go there the risk exists that they could rise further. The ECB, meanwhile, still looks on course to put up rates to at least 4.25%, while Germany can evidently take it, other countries in the Eurozone may struggle.
10) Macro Man’s equity p.a. has started to lag the broad market after eighteen months of solid outperformance. He tends to overweight things that he (thinks he) understands, such as financials and energy. Over the last couple of weeks, however, his portfolio has gone down when the broad indices have gone down but failed to rebound with the broad market. Is he the victim of noise and/or sector rotation, or is something more sinister afoot?
All these factors are weighing on Macro Man’s mind. He is not quite prepared to layer fresh risky asset shorts or hedges in the alpha portfolio, but he is not far from doing so. The first order of business, however, is to jettison the pesky oil position; commodity alpha has cost Macro Man more than a million bucks this month, turning his May from spectacular to mediocre. UPDATE: Macro Man is tired of waiting with fingers crossed, so he scales out of the balance of the CLZ7 long at 68.30. The WTI - Brent spread is therefore closed at a $1.30 discount.
Wednesday, May 16, 2007
It is sometimes claimed that a picture says a thousand words. If so, then today's post (delivered late thanks to a Blogger power outage) will be the size of a small novella....
Chart 1: UK wages, deflated by the retail price index. Real wage growth is negative for the first time in a dozen years...will the economy eventually hit a brick wall?
Chart 2: Components of UK inflation. Services inflaton has turned sharply lower, thanks in part to a reduction in utility bills. Yet goods price inflation is not only no longer negative, at 2% it's the highest in nearly a decade. And this is with sterling at close to all time highs! This may suggest the disinflationary "free ride" that global central banks have enjoyed from globalization is indeed coming to an end.
Chart 3: US CPI, with a forward projection. One recent poster noted that the US, and indeed the world, is entering 'base effect Nirvana.' The chart below shows how headline and core CPI will print y/y with steady monthly increases of 0.3 and 0.2, respectively. Note the slight sting in the tail at the end, however; for headline CPI, base effect Nirvana wil morph into Hades come September.
Chart 5: Cross border capital flow from the TIC report. Brad Setser has more time, energy, and inclination to dissect the report fully than Macro Man, so visit his site for a more in depth view. However, the chart below amply demonstrates the degree to which US home bias has eroded in recent years. In the twelve months ending in March, US investors bought a net $270 billion worth of foreign securities. Small wonder, then, that the buck has come under pressure!
Chart 6: The P/L. The bounce in oil has taken the monthly figure back into the black , though Macro Man is still long 500 Dec 07 WTI contracts. He remains 68.50 offer for these, and will be glad to see the back of the energy market for a while.
Tuesday, May 15, 2007
When you stay up at night worrying about positions, you know they are too big. Macro Man has slept pretty well over the last few weeks, but concerns over oil (now that he has a big delta risk) threaten to make him toss and turn this evening. He therefore trims the net long in CLZ7, selling 500 at $68.10. He retains the $68.50 offer for the other monkey.
It's been a while since the last bullet point post, so without further ado...
* It seems quite clear now that China has replaced the US as the global economy's Typhoid Mary. While the rest of the world has famously decoupled from the US slowdown and the March SPX hiccup, the slightest hint of a little trouble in big China seems to send risk trades off the boil. That today's 3.6% decline in Shanghai, a move which literally fails to register on any chart of more than a year, has been used as an excuse for the retreat of risky asset favourites this morning is an ample demonstration of how Sinocentric markets have become.
* That having been said, there is an interesting dynamic developing in US markets. The VIX is famously negatively correlated with stock prices, as equity indices tend to ride the escalator up but take the lift (that's the elevator to you in the US) down. Although the SPX has stalled over the last week or so, the 2 month rate of change remains near its strongest level in at least two and a half years (note the right hand scale of the chart below is inverted.) Yet the VIX is nowhere near recent lows, opening up quite a substantial gap on the overlay. This divergence may suggest that the SPX is about to roll over more aggressively. Alternatively, it could mean that longs are scrambling for hedges, which would then mitigate the extent of any subsequent losses, the dynamic that seemed to play out in March. Either way, it's worth keeping an eye on.
* Yesterday, Macro Man alluded to the poor performance of a notional SAFE reserve basket that would include yen, but didn't include a graphical representation. The chart below demonstrates just how much a reasonably sized yen position would have cost SAFE, which is presumably why they haven't had one.
Monday, May 14, 2007
Financial markets are getting almost as China-obsessed as Macro Man (and Brad Setser.) Macro Man's email box is chock full of acronym-stuffed research reports, as economists and strategists debate the impact of QDII (which now allows retail investors to buy paltry amounts of foreign equities), PIC/SIC/JFEC (the yet-unamed sovererign wealth fund, which presumably will buy more serious amounts of foreign equity), and the CAS (the ginormous current account surplus in China) ahead of next week's SED (the strategic economic dialogue between the US and China.)
Whew. It's almost enough to make one wish to forget finance and take up poetry. In his periodic discourse on the FX carry trade, Macro Man has occasionally referred to SAFE as the world's biggest carry trader, given the size of their reserves and their evident aversion to low yielding currencies like the yen and swissie. Given the current focus on the RMB (which has just started to appreciate a bit more quickly against the $), Chinese equities, PBOC reserve growth, and the forthcoming sovereign wealth fund, Macro Man thought it would be an interesting exercise to figure out how SAFE's FX reserves have actually performed for them.
The rules of engagement naturally entailed some simplification and guesstimating. Macro Man assumed that SAFE holds a constant reserve basket of 70% USD, 25% EUR, and 5% GBP, and that these reserves are kept in 2 year government securities. He then assumed that all FX intervention is sterilized (which we know it is not) through the issuance of 2 year bills (another simplification.) Essentially, what we are trying to calculate is how the return on a stylized reserve basket compares with PBOC liabilities and/or domestic alternatives- short dated RMB paper. The calculation starts on the day after the RMB reval in July 2005.
Macro Man wasn't really sure what to expect from the calculation. The RMB has outperformed the onshore forwards against the dollar, but it has fallen against the euro and sterling. In any event, he knew that carry would be a substantial positive contributor to overall returns.
In point of fact, carry is the only thing that has kept reserve returns positive. In nominal terms, the RMB has appreciated 2% against the USD/EUR/GBP basket since July 22, 2005. However, the average yield on 2 year RMB paper has been 2.25% lower than that of the weighted reserve basket over the period of the study. This has taken the cumulative return from -2% to +2% over the period of the study. So it's true, then: SAFE is the world's biggest carry trader!
The numbers may also explain why China has, to date, demonstrated an aversion to the yen. Switching even 10% of the dollar exposure into yen would have a substantially negative impact upon returns, both nominal and carry adjusted. The yen's weakness against the dollar would take the nominal return from -2% to -2.85%, while the reduced carry of the reserve basket would bring the all-in return from +2% to less than +0.50%. And that, you'll agree, is uncomfortably close to a money-losing proposition.
What is particularly interesting is the trajectory of the returns. SAFE made plenty of money in the first year after the revaluation, but hasn't made a dime since. In actual RMB terms, the returns from the FX reserve holdings has actually been negative since June 2006. This, perhaps, is the real motivation behind the sovereign wealth fund. The powers that be may have recognized that returns from the business-as-usual reserve basket have dwindled to zero even as reserve growth has turned parabolic. It's difficult to justify adding so many reserves when you're not getting an economic return for it. So perhaps the PIC/SIC/JFEC has been created to ensure that the return curve swings back onto a positive trajectory. Regardless, it's hard to escape the conclusion that FX carry has been a haven for SAFE.
A couple of portfolio clean up notes. Commodities are killing Macro Man. If the Goldcorp position were any more of a dog, he'd have to put a flea collar on it. Meanwhile, the crude spread trade has run him over like a cartoon steamroller. The time has come for remedial action. Macro Man will sell out the Goldcorp on today's open and bid it good riddance. The oil spread requires a bit more delicacy. The first order of business is to trim the COZ7 short- Macro Man will bid 69.50 to cover that. Once done, he will offer the CLZ7 at 68.50. Market noise will hopefully provide him with an opportunity to leg out of the position at a one buck discount, though sod's law says the Brent leg will get filled just before the discovery of Osama bin Laden in Afghanistan and a massive deposit of crude in Nebraska.
Saturday, May 12, 2007
In yesterday's post, Macro Man described the rationale for static pricing of his one touches in terms of his in house option pricer giving values below his purchase price. This was a mistype; in fact, the pricer gave prices above the purchase price, hence the reference to low-ticking the ten year implied vol market.
Paying a price above mid-market is par for the course in illiquid securities, and should be reflected as such in P/Ls. Paying a price substantially below mid-market looks like P/L fiddling, hence the decision to mark the one touches at cost.
Friday, May 11, 2007
Well, well, well. The stories are flying this morning, with the following featuring prominently in morning spiels:
* PBOC will raise rates (again) to contain the rampant equity market. Recent surveys of Chinese consumer expectations of stock market returns make the US public during the dot com boom seem like Eeyore in comparison. Either way, it wouldn’t appear to have much of an impact- administrative controls are more likely to dampen enthusiasm
* Thailand will abolish capital controls. This one’s already been denied by the central bank
* Warren Buffett is getting stuck into FX again, and this time he’s buying yen. An interesting story, as the yen would fit Warren’s classic preference for a value, a trait that cannot reasonably be applied to most other developed market currencies against the buck. If those other long term investors, CBs, decide to abandon carry in favour of value, then we finally might have a story that would justify structural yen longs
* BOJ governor Fukui is getting an itchy trigger finger. Perhaps, though any tightening would almost certainly be deferred until after the election. While BOJ policy has certainly come in for some stick in some quarters, Macro Man finds it amazing that real government bond yields in Japan (2% nominal GDP growth) are among the highest in the developed world, while those in China (15% nominal GDP growth) are zero. Can there really be any doubt where the font of global liquidity is located?
Yesterday, Macro Man alluded to another new trade. His timing in deferring it was fortunate, as yesterday’s chain store sales-inspired dip in stocks will make the entry point more attractive. The trade is predicated on the notion that monetary policy in Brazil is switching gears substantially, away from focusing purely on inflation fighting (with a concomitant acceptance of high real interest rates, a strong exchange rate, and low real GDP growth) and more towards growth, which will imply lower interest rates, an even more aggressive fight against exchange rate appreciation (the finance minister declared that “the sky is the limit” for reserve growth), and higher economic growth.
A looser monetary policy and somewhat more stable exchange rate look to be a classic recipe for equity outperformance, perhaps even above and beyond that observed over the past few years. Higher economic growth should entail higher earnings growth, and lower rates could generate a multiple expansion from the current 12.75 trailing/ 10 estimated ratio.
At the same time, the BRL is crowded (foreigners are now short $18 billion on the BM&F), should enjoy a lower interest rate premium in the future, and has an aggressive CB on the other side. This looks like an excellent RV trade in the making. Certainly the correlation between the Bovespa and the BRL has been strikingly high over the past several years. What is interesting to observe is the relative volatility, however. Current three month historical vol on the Bovespa is currently 28, having reached a high of 34 last spring during the unwind. Three month historical vol in USD/BRL, meanwhile, is 5, down from 38 (!) last spring.
So...we have a case where conditions are likely to shift more favourably to the Bovespa and less to the real, the two retain a high degree of correlation, and vol is exceptionally low in BRL with record positioning. This looks like a great opportunity to buy Brazilian equities and hedge with USD/BRL options.
Macro Man will therefore buy 200,000 EWZ (ishares Brazil ETF) and hedge by buying $25 million 3 month AMF USD/BRL calls. These positions will be managed dynamically as time passes.
As a housekeeping note, Macro Man’s in-house option pricer gives values for yesterday’s one touch purchases that are above the purchase price. Tempting as it is to believe that he has low-ticked the 10 year vol market, he has to concede that it more likely reflects the sensitivity of these structures to the inputs and the model used. He will therefore value them at cost in the P/L and update the market price periodically.
Thursday, May 10, 2007
Well, the central bank hoe-down went pretty much as expected. The BOE took the middle ground, hiking by 25 bps, while the ECB announced a June rate hike through Trichet’s linguistic semaphore. Of slightly more interest was the US trade deficit, which registered its widest reading since September, largely as a function of higher petroleum imports. This was wider than either the market or the Commerce department anticipated, and could lead to Q1 GDP being revised down to an o-handle.
So of course, the dollar’s rallied.
In fairness, the jobless claims were strong, confirming the recent trend and perhaps suggesting that the labour market isn’t as bad as last Friday’s data might suggest. Nevertheless, the FX market appears to be in full on pain mode, hunting stops (USD/JPY shorts have now left the building), with more lurking in EUR/USD below 1.35. Macro Man’s EUR/USD stop is at 1.3450 for €15 million. Only the Russian central bank appears to stand in the way of further euro weakness.
This calls to mind something that Macro Man addressed yesterday, the collapse in long term implied volatility in the currency market. Structured product supply of implied vol has taken the entire EUR/USD curve onto a 5 handle from 1 week to 20 year, with lots of trading in the 10-20 year sector around 5.5% in recent weeks. While it may make economic sense to sell the in the context of a multicurrency structured product, it just looks like the wrong price from a purely FX perspective.
US corporate treasuries should really sit up and take note. Unlike most speculators or funds, they can be virtually guaranteed of knowing they’ll still be in business and having currency exposure in a decade’s time. At current levels of implied vol, US exporters can lock in EUR/USD breakevens in excess of 1.30 for each of the next twenty years through the purchase of a strip of at the money forward EUR/USD put options. Simply put, these guys can lock in an uber-competitive rate from here until far beyond the forecastable horizon.
For the speculator, the valuations are equally compelling, though of course there is no guarantee that one will be around to reap the benefits of a 10 year, 1.46 straddle for 12.2 big figures at expiry. For this reason, one touches with payout at touch look a lot more compelling. Consider that a 10 year 1.20 one touch can be had for 26% of the payout....and we were at that level little more than a year ago! Macro Man reckons that fair value for EUR/USD is 1.10. The 10 year one touch at that level costs 13%. In other words, the options market is giving you slightly less than 8-1 odds that EUR/USD will trade at fair value at any point in the next decade. Try getting odds like that in Vegas!
Now it is of course the case that volatility has been trending steadily lower over the past few years. While 5.5% might look a bit cheap today, might it not represent a credible estimate of future volatility over the next decade? Let’s have a look.
10 year historical vol in the post-Bretton Woods era has averaged 10.5% for USD/DEM and EUR/USD. If the next decade looks anything like that average, ultra long term vol is the steal of the century at current levels. The current historical 10 year vol is lower, of course- it’s 9.0%, having trended steadily lower since late 1993. If the next 10 years resembles the previous ten, the current 10yr vol remains a steal. Ah, I can hear you say, but what are the chances of that? Over the past 10 years we’ve had the Asian crisis, Russia/LTCM, the tech boom and subsequent bust, September 11, Enron, and Iraq. What chances that we see such a sorry collection of mishaps over the next decade, especially now that we’re all so clever?
Probably better than you think, given the human bias towards overconfidence when forecasting the future. However, even if recent trends continue, 5.5% 10 year vol looks at worst fairly priced. Extrapolating the trend in EUR/USD 10 year historical volatility since 1994 over the next 10 years, we arrive at a regression forecast of 6% 10 year historical vol in May 2017. So unless you think that vol will decline even more, buying now looks to be of some value, with a nice cheap call on future volatility.
Today is V-E day in financial markets. What's that, you say? You thought V-E day was on Tuesday? For those older than 63, it was. To those in the coalface of modern finance, however, today is V-E day. That is to say, vigilance in Europe day, as ECB governor Trichet is widely expected to use the V-word in his press conference today, thereby signalling a rise to a 4.00% refi rate in June.
The Bank of England at noon London time may prove to be more interesting, however. The dilemma facd by the Bank was in many ways encapsulated by today's data releases in the UK:
* Halifax house prices rose 1.1% in April, more than expected
* Industrial production was weaker than expected and has turned negative y/y
* The trade deficit was much wider than expected, reflecting strong domestic demand and the absurd overvaluation of sterling
What to do? A rate hike seems like a done deal, but further aggressive tightening risks a further appreciation of sterling, which would amplify macroeconomic volatility in the future. Doing nothing would send the wrong message to lenders. Macro Man has spoken to some people who expect 50 bps and some who think they could do nothing. The UK press appears to be rooting for a one and done (clearly, financial journos all have mortgages!) The BOE's course of action really depends on which economic outcome they are most concerned with- inflation (high, but forecast to fall sharply), asset markets (robust, but not fully reflecting prior rate rises), the real economy (fairly robust but with some pockets of concern) or the external balance (deteriorating rapidly.) Base case is for 25 today and leaving the door open for further tightening, though the Bank is unlikely to leak too many details of next week's inflation report. Macro Man will use any relief rally in short sterling to exit his long, as his conviction that 5.75% will be the absolute top (and indeed, that the trade will still make a small profit with rates at 5.75%) is wavering.
The Fed and the currency manipulation hearings were largely non events. More later, including some thoughts on interesting trades, after the CB hoedown.
Wednesday, May 09, 2007
Things just might start getting interesting today. Tonight we have the FOMC statement- the equivalent release last May kick-started the late spring black swan event, though in fairness it was more of a black cygnet. No one is looking for much change in the text, and perhaps they’ll be right. When expectations are low, however, this clearly raises the risk of surprise. In this case, the recent downtick in inflation combined with mixed-at-best activity could argue for a softening of the tightening bias. Whether Big Ben feels sufficiently confident in his inflation-fighting manhood is another question, however.
Before that, today sees testimony before the US House Ways and Means Committee on currency manipulation. No doubt China will feature prominently on the list of topics. Witnesses include assorted worthies from the erstwhile industrial heartland, perennial dollar bear Fast Freddie Bergsten, and, as the token Sinophile, Stephen Roach from Morgan Stanley. It doesn’t take a lot of imagination to anticipate how this will play out:
Rep. Sander Levin, (D) Mich: Hear, hear, come to order. Welcome to Defence Against the Dark Arts. I am your new teacher, professor Levin. OK, who can tell me who is the biggest perpetrator of Dark Arts in the world today?
Mr. Smith, president of Acme Amalgamated Products Corp: China! I mean Voldemort!
Rep. Levin: Very good, Mr. Smith. And who can tell me what spell is most effective against Voldemort?
Mr. Roach: Consumerus savemorus!
Rep. Levin: Hmm, nice try Mr. Roach. But experience has shown that the preparation required to perform that spell makes it difficult to perform another vital incantation, Gettus Electus
F.F. Bergsten: Dollari Fallmorus!
Mr. Roach: Spendlesstus!
Rep. Levin: Very good, Mr. Bergsten, very good. However, we’ve found that that spell has become less effective since Voldemort began using Reservus Accumulato. Mr. Roach, you should know that your suggestion has the same faults as Savemorus. You’ll have to do better than that.
Mr. Williams, Deputy Treasury Secretary for Congressional Testimony: Negociatus Maximus?
Rep. Levin (shaking head): Mr. Williams, you should know by now that that spell is both ineffective and slow-working. Come on, people, think! What is the single most effective spell against Voldemort’s Dark Arts?
Mr. Roach: Budgitdeficito Reductus!
Mr. Smith, Mr. Williams, and Mr. Jones, chief economist of the National Association of Uncompetitive Manufacturers: Tariffus Maximus!
Rep. Levin: Messrs. Smith, Williams, and Jones, you receive an A+. Mr. Bergsten, you get a B+. Mr. Roach, you should know by now that we ran that spell a while ago and it hasn't really worked. You fail- I really have to question your devotion to fighting against Voldemort’s domination.
Harry Potter: (Shakes head.)
Tuesday, May 08, 2007
You can always tell when financial market volumes start to dry up because brokers start organizing a seemingly endless sequence of ancillary ways to add value. Economist meetings, golf outings, and dinners tend to feature prominently on this list. As such, Macro Man has spent a fair few evenings over the past several weeks at roundtable discussion meetings, wherein traders and investors gather together to exchange views and grumble about the market.
And grumble we have. It has become rather evident at these discussions that Macro Man is not the only person in the market to be frustrated by the triumph of beta over alpha. Indeed, a common theme has been frustration over the low level of risk premia, the failure of market timing, and the continued success of what most consider to be relatively naïve, beta like strategies across markets. Far from being the greedy coupon-clippers that are often portrayed in the popular press, the people with whom Macro Man has spoken have felt underinvested and unhappy for much of the past few months, if not longer.
One of the most commonly cited factors causing dissatisfaction has been the relatively short-term time horizon of many investors. Now, fund-of-funds investors have always had an itchy trigger finger, and that will probably never change. In that industry, “what have you done for me lately” isn’t just an investment strategy, it’s a way of life. However other investors, both in hedge funds and in long-only products, are also increasingly demanding a steady stream of positive performance with shallow and infrequent drawdowns.
Now, there are of course exceptions to every rule, and it would be foolhardy to suggest that no one out there has the wherewithal to look beyond a couple of weeks when taking an investment decision. Yet surely where there is smoke there’s fire, and traders and fund managers are being pushed by natural selection towards strategies delivering steady positive returns. This, of course, is the virtual definition of a volatility selling or carry strategy, which clips coupons every day until the black swan event wipes out the bulk of accumulated profits in one fell swoop. To date, the black swan hasn’t really made an appearance, so these strategies continue to fare well and attract new assets. Investors, it would appear, want all of the upside of taking risk, with none of the downside.
Now if a strategy could generate the return distribution above in perpetuity, it would of course be worth pursuing whole-hog. The problem, of course, is that strategies that generate such returns at any point in time usually have an extremely fat tail lurking on the left side of the distribution somewhere in their future. Macro Man thought it would be worthwhile to review basic principles of statistics to review just how often even skilled managers can generate negative returns when not pursuing a strategy designed to maximize the probability of positive return at any particular point in time.
Imagine we have an investor whose true skill is known to deliver a Sharpe ratio of 1- say an annualized excess return of 10% per year, with a volatility of returns of 10%. What are the chances in any given time period that this investor makes money with his trading activities (ignoring, for the purposes of this exercise, any cash component of return, as well as any management or performance fees charged)? While Nassim Nicholas Taleb, among others, have pointed out that high-frequency returns are mostly the result of noise, it is worth looking at graphic representations of return distributions to illustrate just how powerful this effect is.
How likely is it that a Sharpe ratio 1 strategy will lose money on any given day? 47.5%, as it turns out- a little less that you’d get from flipping a coin.
By way of disclosure, Macro Man does not have any particular axe to grind here. He has not suffered any sort of redemption in his real job, and his performance this year is positive- though as with the blog portfolio, perhaps not as positive as it could be had he focused exclusively on beta strategies. However, observing the degree of frustration amongst fellow professional investors has been eye-opening. When he sees things like structured product selling of 15 year S&P 500 vol and 10 year EUR/USD vol, when these implied volatilities are at all time lows, he begins to wonder if the apotheosis of vol-selling, carry driven strategies has finally run its course, and that the time is finally ripe for buying value and/or tail risk. When the 10 year straddle in EUR/USD is given at less than 12.5 big figures, the risk/reward of taking the other side of vol selling begins to look awfully attractive.