Saturday, June 30, 2007
Lost in the noise and administrative drudgery of quarter end was a remarkable article from Bloomberg that winged its way across the information superhighway yesterday:
S&P, Moody's Mask $200 Billion of Subprime Bond Risk
Among the choice quotes from the article include the following:
``We're taking action as we see it,'' said Brian Clarkson, Moody's global head of the structured products in New York. ``We're not doing knee-jerk responses.'' Hmm. Perhaps they didn't see that subprime foreclosures rose from 3.86% in Q3 of last year to 5.1% in Q1 of 2007.
Fitch is ``deliberate'' in its actions, John Bonfiglio, the firm's head of U.S. structured finance ratings, said in an interview in his New York office. Fitch is a unit of Paris-based Fimalac AS. ``I would not say we were slow.'' Deliberate? You mean deliberately trying to screw investors who rely on your ratings, John? I also wouldn't say that you're slow. "Glacial" is perhaps a more accurate representation of your response time.
S&P abandoned seven-year-old criteria for determining a bond's protection against default in February.
Under the old guidelines, S&P said a bond's ``credit support'' must be twice the rolling 90-day average of the sum of value of mortgages delinquent by three months or in foreclosure plus real estate that has been seized by the lender.
Of the 300 bonds in ABX indexes, the benchmarks for the subprime mortgage debt market, 190 fail to meet the credit support standard, according to data released in May by trustees responsible for funneling interest payments to debt investors.
Most of those, representing about $200 billion, are rated below AAA. Some contain so many defaulted loans that the credit support is outweighed by potential losses. Fifty of the 60 A rated bonds fail the criteria, as do 22 of the 60 AA rated bonds and three of the 60 AAA bonds.
All but five of 120 securities in BBB or BBB- rated portions of the mortgage-backed securities would have failed S&P's criteria, according to data compiled by Bloomberg.
None have been downgraded, though S&P and Moody's have parts of three pools of securities linked to the index under review for a downgrade. Fitch has downgraded parts of three mortgage pools tied to the ABX and put four on watch for downgrade.
``Don't misunderstand me: I'm not saying these others are performing great,'' Robert Pollsen, a director in S&P's residential mortgage surveillance in New York, said in an interview last month. ``And they certainly might warrant our attention several months from now, which obviously we're going to do.''
What can I say? To abandon a credit-standard test just as it starts to bite is the height of irresponsibility. And the comments from Mr. Pollsen are so lame, they need a cane.
It really seems to have come to the point where we need to ask "Who watches the watchers?" It seems relatively clear that the ratings agencies do not have the best interests of investors at heart in their ratings activities.
Macro Man would therefore suggest that we create a new ratings agency to rate the existing ratings agencies. Investors can use the new agency's ratings to gauge the accuracy of the CDO ratings of Fitch, Moody's, and S&P.
After careful consultation with a battery of analysts, Macro Man has derived the following ratings agency ratings via a proprietary quantitative methodology, blah blah blah. To clarify the ratings, they will be assigned in the familiar school-grade format, with a C or better required to pass:Fitch: C- At least they've actually downgraded something.
Moody's: D- Very, very poor.
S&P: F- Abandoning the credit support criterion is just poor. If S&P were a student, it would get left behind to repeat the seventh grade.
As an aside, is anyone else struck by the following coincidence:
The US has $200 billion worth of overvalued CDO junk.
Voldemort has $200 billion to invest in "risky assets".
Are you thinking what I'm thinking?
Friday, June 29, 2007
Well, the initial market reaction has been to conclude that this is, after all, just another dip that we're meant to buy. While the SPX has stabilized, many other risky assets have roared higher, including the dreaded FX carry trade. Macro Man is among those who've been sucked back in, as his carry model filter is now flashing bright green. The P/L has been updated accordingly.
While it's tough from an intellectual point of view to get back in to an overvalued trade at a level above the recent exit point, at the same time it is strangely liberating to do so when instructed by a 'higher authority', e.g. a mechanistic model. As far as Macro Man can make out, those gaijin who do have the yen carry trade on in any meaningful size are those that follow a similar quantitative process. Those managers who engage in qualitative assessments, among whom number the legendary cabal of secretive macro hedge funds who rule the world in conjunction with the Pentavirate, the Illuminati, Opus Dei, the Rosicrucians, and Hermes Trismegistus, are relatively unexposed or even long yen, or so Macro Man believes from his conversations with a number of these types of players.
One topic of discussion and speculation today has been the news that China's yet-unnamed soverign wealth fund will be selling $200 billion worth of RMB bonds to pay for its initial assets from SAFE. Contrary to the general expectation, they will not be able to jam these bonds down PBOC's throat because it's against the rules. Of course, so is industrial espionage and copyright infringement, but that hasn't stopped those sorts of activities in China. Nevertheless, one should probably respect the fact that "no" in this case does appear to mean "no".
In which case, CIC and the authorities will need to find a home for these new bonds. A swift look at China's yield curve will reveal that the market probably isn't priced to receive $200 billion worth of bonds, particularly given the level of nominal GDP growth in China:
Macro Man has read one analyst's note that suggested that a drip feed issuance will ensue that will replicate the impact of a 0.5% hike in the reserve requirement every month for the next year or so. Given the general view that further hikes in the RRR might actually alter banks' behaviour, this is clearly an undesirable outocme. Where, oh where, therefore, to dipose of these bonds?
Macro Man has some ideas. Herewith, and with apologies to Cassandra, is Macro Man's Top 10 ways of disposing of RMB 1.55 trillion worth of debt:
1) Include RMB 1 billion worth of bonds with every DVD player sold in America and the EU.
2) Call the new debt Bond.com, pretend it's a stock, and let Chinese equity punters have at it.
3) Strip out the interest payments from the principal, and back each one with the production output of a different non-existent factory. Securitize each cash flow into an "asset"-backed CDO, and bribe the agencies to provide a favourable rating. Sell it all to Western hedge and pension funds at $10,000 on the dollar. Laugh.
4) Call your new best mate Steve Schwarzman and "suggest" that Blackstone buy a few.
5) Tell Senator Herb Kohl that if he wants to sign Yi Jianlian, he'll need to buy your bonds, too.
6) Pay the Pentavirate, the Illuminati, Opus Dei, the Rosicrucians, and Hermes Trismegistus to dispose of them for you.
7) Use diplomatic contacts to construct an "oil for bonds" transaction with regimes deemed unsavory by the West.
8) Default on the first interest payment, and then issue government-guaranteed debt to buy back the 'reserve issue' at half price.
9) Get Jim Cramer to pimp it for you on CNBC: Boo-yah! Back up the truck, baby!
9a) Trade the bonds to the Duke of Westminster for a small portion of his property portfolio. After all, London property is the fashionable investment of choice for kleptocrats the world over...
and finally, the least likely of the bunch....
10) Open your capital account and allow foreigners to have access to onshore rates and currency risk
Thursday, June 28, 2007
So has this been another short-lived crisis? The S&P 500 tested and rejected a break of the neckline yesterday, while FX carry, which looked so horrible 24 hours ago, has roared back with a vengeance. It appears to be yet another 2007-style mini-crisis, that dip that you're supposed to buy over and over again.
Perhaps. It's true that risk assets shrugged off a poor durable goods report yesterday, which easily could have been used as an excuse for further weakness in equities, EM, credit, and FX carry. By the same token, however, the elements of recent risk asset weakness have not been about the economic cycle per se; they've been, first and foremost, about liquidity. And there was no real news, good or bad, to emerge on that front yesterday.
The greatest threat facing risk assets is a withdrawal (or possible reversal) of the financial market "liquidity multiplier" in the event of a re-pricing, re-rating, and widespread dumping of toxic credit structures. There is some suggestion that the greatest threat will actually come next week, after hedge funds in particular mark their portfolios to market (though there may well be some foot-dragging in the subprime CDO space) and prime brokers adjust margin and credit settings.
Of course, the Fed also has some say about liquidity conditions. Macro Man has been rather interested (and pleasantly surprised) by recent press rumblings that the FOMC may switch focus away from core inflation to headline. It would be somewhat ironic, of course, given that the preferred core measure is finally likely to enter the comfort zone tomorrow. However, if the Fed (justifiably) switches the goal posts, it could finally focus attention on the fact that headline inflation is rising rather sharply indeed. This in turn should raise risk premia and support Macro man's TIPS position.
Macro Man recalls that the Fed closed the book on last spring's financial market turbulence by signaling an end to the tightening cycle at the equivalent to tonight's meeting in 2006. Might the FOMC actually kickstart market turbulence by demonstrating that inflation remains a problem and that any Bernanke put is struck so far away that it doesn't even appear on a screen?
Note: Severe network problems have rendered the P/L inaccessible today.
Wednesday, June 27, 2007
Is this more than your run-of-the-mill six hour bout of risk aversion? It's beginning to look that way. A number of stars appear to be aligning in favour of a more pronounced drawdown in risky assets. Credit looks horrible, for justifiable reasons, and equities are entering interesting technical territory. Meanwhile, official headwinds to the carry trade appear to be emerging for the first time in quite a while; an English translation of a Nikkei article articulating the detrimental impact of yen weakness is now doing the rounds.
What's interesting to note is that much of the 'valuation gap' between the SPX and the VIX appears to have vanished (in favour of the VIX, of course.) Might this mean that the market is no longer overweight downside, and thus more vulnerable to a steep correction? The 1487 double top neckline should provide critical clues. Whether that level breaks or holds, and whether such action is sustained, could well depend on whether the FOMC sends an overtly dovish or hawkish message tomorrow night.
Market focus remains on the swirling subprime issue and the potential for mark-to-market shockers as we end the quarter. What's interesting is that, as one might suspect given market correlations over the past year, most measures of volatility have risen substantially. VIX, MOVE, and credit spread indices are all back at or near their highs of February/March. One exception is USD/JPY vol, which has lagged markedly despite the historically strong correlation. While the chart below compares USD/JPY 3 month implied vol with the VIX, rest assured that MOVE, crossover, and ABX indices all look a lot more like the white line than the green one.
Tuesday, June 26, 2007
Currency markets have been relatively uneventful for the past few months (some would argue the past few years), a fact reflected that the only alpha trades in the portfolio at the moment are very slow-burn, long-term trades. However, things appear to betting more interesting, if only temporarily, today.
For the first time in a couple of months, Macro Man has received a signal to exit the G10 carry basket, which he did this morning. The limp performance of US equities into the close was the primary culprit, as concerns over subprime and a possible impact on the real economy continue to percolate. While yesterday's headline exisiting home sales were pretty much bang in line with expectations, the details beneath the surface were pretty ugly: supply rose from 8.4 months to 8.9 months, a new high. This would appear to bode quite poorly for today's new home sales data and, by extension, the homebuilders.
Another potential source of uncertainty and angst comes from Japan, where Vice-Minister Watanabe, Japan's chief currency spokeman, has decided to stand down in favour of Naoyuki Shinohara. Now, Macro Man is fairly certain of three things regarding this handover:
1) Macro Man does not know exactly where Shinohara stands on the yen and the carry trade
2) Neither do you
3) It is impossible for him to be MORE laissez faire (and by extension, pro-carry trade) than Watanabe; therefore, the risks must be skewed towards a slightly firmer stance from the Japanese.
The word on the street is that international irritation with Japan is rising fairly steadily; perhaps this personnel switch, along with suggestions that the BOJ might turn slightly more aggressive, has been designed to throw a bone at would-be Japan-bashers everywhere.
What's interesting to note is that despite a number of rumours over the past few months, Russia only revalled once FX reserve growth slowed dramatically. UBS put out a note yesterday suggesting that the recent "surge" in the RMB may have come at the same time as a sharp deceleration in the pace of reserve accumulation. It seems quite clear that the newly prominent participants in the "new world order" have a rather strong aversion to anyone profiting from speculating on their currencies. How they square the moral circle with their own speculative activities is a question as-yet left unanswered.
Monday, June 25, 2007
All hail our new ruler! Those of us residing in the UK now live under the leadership of the long-suffering but now-ascendant Chancellor Palpatine.
The UK press is now speculating that Palpatine will call an election next year to cement his place as Emperor. While the grinning Chancellor is all sweetness and light at the moment, one wonders what surprises the wily Sith Lord and his apprenctices may have in store for the UK. 'Stealth taxes' are a fairly reasonable assumption.
Sterling has marked the Chancellor's assumption with another visit above the Deuce this morning, though how durable that proves to be remains to be seen. It's interesting to note, however, that a higher power seems to have voted on the Chancellor's ascendance, and it's not exactly a ringing endorsement:
Friday, June 22, 2007
Three random shots on a Friday morning:
* Perhaps the SNB is finally getting it. This week they've allowed the 1 week repo rate to drift higher by 8bps, which makes an interesting contrast to the last time they raised rates. For the first time in recent memory, the daily SNB repo is being watched by the market with interest. While the modestly stronger CHF has not done the FX carry basket any favours, Macro Man is nevertehless pleased to see that the SNB has decided to put their money where their mouths are.
* Further evidence of renewed CB interest in bonds comes fom the weekly Fed custody holding data. After falling over the prior two weeks (a time in which bonds sold off pretty hard), Fed custody holdings of Treasuries and Agencies rose by a healthy $11.7 billion in the last week. Looks like stories about China coming back to market may have been accurate- though wouldn't alternative purchases of T Bills also have been held in custody by the Fed?
Thursday, June 21, 2007
As the more scientifically aware reader will no doubt already know, today is the summer solstice and the longest day of the year in the Northern Hemisphere. Given the systems problems and other assorted mishaps encountered in the real job so far this morning, it already feels like the longest day of the year and it's only 10 am!
The NFL has a charming tradition of calling the last man selected in the annual new player draft "Mr. Irrelevant." While some Mr. Irrelevants actually stick with a team and go on to have meaningful careers, most live up to the name and quickly fade into obscurity. It's a little-known fact, however, that financial markets also have a Mr. Irrelevant. He currently goes by the name of Rodrigo de Rato, Managing Director of the IMF.
Any doubts as to whether Rato deserves the nickname have been dispelled over the last few days. Many readers will no doubt recall the furore that resulted from the IMF announcing that it intended to take a more prominent role in exchange rate surveillance in April of last year. Global imbalances were all the rage, and there was nary a carry trade to be seen.
Now fast forward to this week. On Monday, Rato made a speech where he announced that the IMF has taken the decision to overhaul its exchange rate surveillance framework for the first time in thirty years, adding the proviso that "a member should avoid exchange rate policies that result in external instability." To say that the market was underwhelmed is an understatement. So irrelevant has the IMF become that none of the currency specialists that Macro Man talks to on a daily basis have even mentioned it at all. One can almost hear coupon clippers everywhere bellowing "Mr. Irrelevant, we who are about to put on the carry trade salute you!"
One byproduct of global imbalances and mercantilist exchange rate policies has of course been the accumulation of FX reserves and a concomitant price-insensitive bid for US Treasury securities. It looks as if that may be changing. One popular explanation for the recent rise in yields is that China, et al had stepped away from the market just as traders and investors were expecting them to step up to the plate in size. The removal of the 'PBOC put' helped catalyze the move through 5% on the 10 year Treasury, after which stop loss and convexity selling tacked on another 30 bps. Macro Man has quite a bit of sympathy for this view.
Brad Setser has an interesting post on T Bills, which more or less suggests that CBs have been piling into the short end and eschewing notes and bonds. It's an interesting idea, so Macro Man decided to have a look at a graph comparing 10 year yields with that of 3 month T Bills. He was stunned by the result. The implication couldn't be clearer; somebody with significant size to shift has been market-timing the yield curve. As Macro Man wrote on Brad's blog, if SAFE et al start treating government bond markets like they do currencies, then expect to see a lot of unhappy bond managers out there over the next few years....
Elsewhere, US equities put in a surpisingly soft performance yesterday as concerns over suprime continue to swirl. The ABX indices continue to head lower, and stories about disposals from badly-underwater Bear Stearns hedge funds are circulating everywhere. The problem is that the market's risks and exposures are fairly opaque, much as they were in the autumn of 1998. Now, Macro Man is not suggesting that the current situation poses as serious a threat to markets as the double whammy of Russian default and LTCM implosion did nine years ago. Still, it's pretty unsettling, as there are a lot of badly underwater structured credit positions out there that have not been marked to market.
A forced disposal from the Bear fund could establish a new market price for some of the more odious instruments; if risk managers elsewhere are on the ball, this could force others to mark their toxic waste to market. At the same time, the SPX looks to be forming a classic double top formation, with the neckline at 1486. A break would target 1430.
The portfolio got bushwacked yesterday as both beta (of course) and alpha (unusally) portfolios have a long equity bias, despite the recent purchase of XHB puts. It's time to remedy this. Macro Man will buy 1000 July E Mini 1520 puts and sell 1000 1555 calls. Net premium outlay will be roughly $462k, a small price to pay for avoiding disaster.
Elsewhere, the CBC (Taiwan's central bank) raised rates by a higher than expected 25 bps and surprised the market by raising the FX reserve requirement. The TWD has strengthened as a result.
Are you listening, SNB?
Wednesday, June 20, 2007
It's pretty rare for Sweden to be the focus of financial markets for more than a few minutes, but such has been the case today. The Riksbank announced its interest rate decision this morning and delivered the expected 0.25% increase. However, the accompanying statement was modestly hawkish, hinting at a future rate path slightly higher than that priced by markets. The SEK, erstwhile market whipping-boy and funding currency extraordinaire, promptly rallied a percent, erasing all of the EUR/SEK of the previous week.
Are you listening, SNB?
Meanwhile, a Finance Ministry Report concluded that Sweden's $25.1 billion in FX reserves were excessive and that "the need for currency interventions is limited for the foreseeable future." The report recommended that the Riksbank cut its exposure to foreign currencies over a period of a few years.
Are you listening, PBOC?
Elsewhere, the June BOE vote on rates was surprisingly close at 5-4. Swervin' Mervyn King was on the losing side of the ledger for the second time in his career. This makes a July hike more likely, obviously, and perhaps could sightly raise the terminal rate that's priced into the strip. Macro Man continues to believe that the higher rates go, the harder they (and the economy) will eventually fall, but concedes that that theme is on the backburner for the time being.
A few days ago Macro Man opined that bonds could catch a bid at the expense of stocks as pension funds rebalanced their portfolios into quarter end. He decided to perform a quick and dirty study to see if he could capture this in past performance data.
He took total return performance fitures for the S&P 500 and 7-10 year Treasuries for the past thirteen years and compared the retuns of equities and bonds. Arbitrarily selecting the last two weeks of a calendar quarter as a period most likely to see rebalancing flows, he compared the quarter-to-date outperformance of stocks versus bonds with 10 trading days remaining in the quarter with the relative performance in the last 10 days of the quarter.
The results were mixed. The average quarter-to-date equity outperformance of equities with 10 days left was 1.6%; the average outperformance over the last 10 days was -0.53%. In other words, on average, bonds have outperformed stocks over the last ten trading sessions of the quarter since 1994. This would appear to confirm Macro Man's prior hypothesis.
However, digging deeper suggests that there may not be much in it. Despite the figures cited above, the correlation of QTD equity outperformance with ten days left with outperformance over the final ten days is positive. A glance at the scatter chart above suggests that any evidence for a firm relationship is tenuous at best. Moreover, of the 53 quarters in the study, only 27 have the "right" sign if Macro Man's hypothesis is correct. In other words, equity out (under) performance through the first 2 1/2 months of the quarter is met with equity under (out) performance in the final ten trading days just about half the time. It doesn't get more inconclusive than that.
Perhaps there's data to be had at the extremes? After all, equities have outperformed bonds by 10.5% so far this quarter, the seventh best showing since 1994. Again, performance data from the other six is inconclusive. While equities did indeed underperform bonds during the final ten days of the quarter in four of our prior datapoints, the two in which they did not were doozies, as stocks bested bonds by at least 4% in the span of two weeks.
As a result, Macro Man is forced to admit that after a cursory inspection, he cannot reject the null hypothesis that the final ten days of a quarter will not reverse the pattern of the prior two and a half months. The usual disclaimer, of course, applies: this study was not exhaustive, was not meant to be exhaustive, and if anyone knows of a more rigorous study on the same subject, by all means pass it along!
Tuesday, June 19, 2007
Market lethargy remains well-entrenched across a number as asset classes. That US equity indices closed within 15 bps of flat and EUR/USD had a peak-to-trough range of 45 pips yesterday is a pretty good indication that summer markets have arrived; perhaps it's time to crack on with that reading list!
However, as noted yesterday, Macro Man finds the current benign and, dare he say, complacent, environment unsettling. "Investors" have apparently decided to throw risk at EM assets of virtually every stripe; after all, in a period of low inflation, and with bond yields seemingly having put in a top last week, what else could go wrong?
The answer is plenty.
Macro Man is beginning to wonder if 2007 isn't shaping up as some sort of Bizarro version of 2006. Consider what we saw in 2006:
* A market driven by concerns over exteral imbalances in late winter/early spring, with carry trades performing horribly
* Stocks take a pummeling in the spring as liqudity is withdrawn on inflation concerns
* Stocks put in a stunning reversal in late June and rally strongly through the end of the year
In 2007, what have we seen?
* A market obsessed with carry and contemptuously dismissive of current acccount considerations in late winter and the spring
* Stocks rally strongly in the spring even as interest rates rise on rising growth prospects
The final leg of the Bizarro juxtaposition in 2007 would be a surprising reversal in equities some time around now. Will it happen? To be honest, Macro Man does not know. Could it happen ? Absolutely. And the catalyst could (finally) be that well-mined source of angst and worry, the US housing market.
Many (though not all) commentators have concluded that the worst is past for residential construction, with some even forecasting a positive growth contribution from the sector by the end of the year. Frankly, this seems absurd. Homebuilders have yet to even shed reported labour payrolls after a sharp rise in the previous few years; surely some rationalization of the workforce is a prerequisite for a bottom?
Consider also that the NAHB index continues to plumb new depths, registering a sixteen year low last night at 28. The weakness in the index suggests that res construction as a percentage of GDP could/should dip below 4% from the curent 4.5%. Today's housing starts data will provide a clue as to whether this may be taking place.
And let's not forget our old friend called "structured credit." Unless Macro Man has been asleep at the wheel, he hasn't exactly noticed that the wave of long-overdue ratings downgrades has hit the wires recently. Somewhat ominously, the most toxic of the on-the-run ABX indices is now plumbing new lows (though admittedly the higher grade indices haven't moved.) Should this continue, or if the ratings agencies ever (gasp) downgrade already-underperforming CDOs, then perhaps the risk trade will finally come under pressure.
So there we go. Macro Man has found a defensive trade that he can buy into with gusto. He'll look to add to his short XHB exposure by spending $100k or so of option premium on puts. He'll look to buy 1200 August 31 puts this morning before the housing data; last night's closing price was $0.75.
Monday, June 18, 2007
The world seems like such a happy place this morning that Macro Man is suffering from a severe lack of inspiration. Friday's data was, in the context of the way in which markets choose to view the world these days, about as Goldilocks as it gets. Core CPI and capacity utilization data where lower than expected, thus reducing the perceived threat of inflation, while the Empire manufacturing and TIC data were strong. What's not to like?
Certainly asset markets could find very little, as everything from the Turkish lira to JGBs have put in a nice rally since 8:30.01 EDT on Friday. Even more RBNZ intervention, a potential risk to the FX carry trade, was viewed as offering the kiwi dollar on sale, rather than a threat to the profitability of existing positions. A test of the RBNZ's will, via a market attempt to push the NZD higher, seems likely.
So, Macro Man finds himself in an unusal spot. His P/L is up very nicely indeed this month; even the table below understates it, as the SPY and XHB positions went ex-div on Friday. The combined future dividend flow represents another $300k or so of profit, which would take his YTD P/L up above 10%. The vast bulk of his short equity exposure rolled off on Friday, so his long exposure to equities has gone up substantially. He can find little reason to worry at the moment, and doesn't feel particularly inclined to re-establish equity shorts in the alpha portfolio. In other words, he feels fat, contented, and complacent.
And that's bad.
While there's not much utility in worrying for the sake of worrying, it's still important to be prepared for any negative developments in the pipeline. While there's no obvious catalyst that could take bond yields up and through the highs, there wasn't much of a catalyst that got them there in the first place.
So while Macro Man lacks the inspiration to dissect Friday's data (those interested in the TIC and current account data, both of which suggest a reduced imminent threat from external imbalances, should visit Brad Setser's blog), and fails to see any speedbumps on the horizon, he's less happy than he ought to be. It's harder to deal with a "crisis" that you cannot foresee.
For a natural worrier like Macro Man, this market is now so good that it's bad.
Friday, June 15, 2007
'Summer reading lists' are a staple feature of many commentators, both financial and otherwise. Macro Man always enjoys perusing these lists for interesting material that he may not have previously encountered. Of course, financial literary recommendations are often
populated by similar types of books, with several titles appearing on most of them. Who, for instance, has not been directed towards the Edwin Lefevre's classic Reminiscences of a Stock Operator at some point? Or Jack Schwager's Market Wizards and New Market Wizards?
While these books are certainly worth reading (though Macro Man can't help but observe that much of the wisdom contained therein does not seem to work terribly well these days), there is of course insight and pleasure to be derived from works that stray a bit further afield.
Without further ado, therefore, Macro Man is pleased to unveil his first list of recommended non-fiction, non-financial reading. The following are all books that Macro Man has read and enjoyed (in most cases, multiple times.) Many of them have, in one way or another, helped shape the way he thinks about markets:
1) The Closing of the Western Mind: The Rise of Faith and the Fall of Reason, by Charles Freeman.
An impressively erudite exploration of the rise of Christianity and the increasing emphasis on faith, as opposed to logic, in late antiquity. Dismissed by some critics as one-sided polemic, the book hits home when Macro Man reads some financial market research. Currently on Macro Man's bedside table.
2) Surely You're Joking, Mr. Feynman!, by Richard P. Feynman and Ralph Leighton.
Amusing yet insightful anecdotes from the Nobel-winning creator of cargo cult science. Good for airplane journeys with small children, as it's easy to pick up and put down. Recommended by Macro Man's high school physics teacher; the teacher was right.
3) The Elegant Universe, by Brian Greene.
While the second half of the book discusses the incredibly bizarre and utterly unproven superstring theory, the first half provides a clear explanation of both Einsteinian general relativity and the weird world of quantum physics. If you've ever wondered what the theory of relativity actually says (other than e = mc ^ 2) , or what Heisenberg's Uncertainty Principle is, you'll find out here.
4) Science: A History, by John Gribbin.
Keeping with a theme, this book takes the reader through the evolution of scientific thought and technique. Not as homespun as Bill Bryson's A Short History of Nearly Everything, but written by a much more knowledgeable author.
5) The Devil in the White City, by Erik Larson.
50% crime thriller, 50% history lesson on the workings and architecture of 1890's Chicago, 100% true. There's not much in this one to shape your thought process, but it's a cracking good read.
6) Moneyball, by Michael Lewis.
Yes, the book is a bit of a panegyric to Oakland A's general manager Billy Beane. But the story of how one financially-challenged baseball team has used scientific analysis to challenge the game's orthodoxy and remain consistently good provides another lesson in the importance of tailoring your strategy to the facts, rather than deriving your facts from a pre-decided strategy.
7) Byzantium: The Early Centuries; Byzantium: the Apogee; Byzantium: The Decline and Fall, by John Julius Norwich.
Lord Norwich's narrative history of Byzantium in three volumes takes the reader through the twists and turns of the Eastern Empire from its foundation by Constantine the Great through the fall of Constaninople in 1453. The history of the empire has more twists and turns than a lifetime's worth of soap operas, and offers a few object lessons in how nothing really changes in geopolitics.
8) Fermat's Last Theorem, by Simon Singh.
The story of the solution of one of the most famous problems in mathematics, it is equally a history of mathematics (and its practioners) itself. Singh is a talented enough writer to make a complex subject matter accessible and enjoyable to the layman.
It promises to be a bit of a turbulent day today. Not only is there a raft of vital and not-so-vital data out in the US- CPI, Empire State survey, TIC, industrial production, and Michigan consumer sentiment- but it is also triple witching in the equity market, which is sure to create even more volatility. Macro Man is receiving plenty of advice that "if CPI is x , then do y" from his professional counterparties, but wonders if that isn't a tad simplistic.
It's not hard to imagine a scenario wherein core CPI prints a market-friendly 0.1 or 0.2, albeit with another nasty headline reading, and risk assets soar. What to do, then, if industrial production and especially capacity utilization are much higher than expected, and if Michigan survey inflation expectations take a decidedly upward tilt? The people who buy bonds at 5.17 could easily end up selling them back at 5.25.
So while the temptation is there to trade on CPI, regardless of the outcome, prudence probably dictates waiting for the remainder of the data before pulling any execution triggers. Macro Man, for one, would rather incur some degree of opportunity cost than take another ride on the Whipsaw Express.
Thursday, June 14, 2007
Macro Man finds himself in a rather unusual spot these days. Despite the recent bout of market volatility, and despite a horribly timed foray into a long duration bet, he finds himself making more money than expected so far in June. It's a welcome change, in his experience, from the usual situation; this in turn is perhaps down to the human tendency to remember one's winners with crystal clarity (thereby forming expectations of profitability) while compartmentalizing the losers in the dim recesses of the psyche, subject to recall only with an effort.
Yesterday featured more ups and downs than Space Mountain, with an early-session bond market rout reversing sharply after bond-unfriendly data. A market-friendly Beige Book simply added fuel to the fire, propelling US equities to their largest point gain of the year. Fortunately for Macro Man, his short SPM7 call position looks set to settle within shouting distance of strike (so he is collecting decay this week), while his equity sector bets are also paying off. Meanwhile, EUR/USD vega continues to tick higher, generating more value for the FX powerball tickets. And of course, the G10 carry trade remains alive and well.
That having been said, the week is only 2/3 over, with the most difficult period (US PPI today, CPI, IP, TIC, and Michigan tomorrow) to come. Macro Man remains of the view that inflation is an issue, and was frankly somewhat surprised at how little attention was paid to the import price data yesterday, which showed a larger-than-expected 0.9% rise in May. Perhaps most remarkably, the US is now importing inflation from China for the first time in the (admittedly short) history of the price series. While the y/y change is barely positive, the year-to-date change is running at a 1% annualized pace. If and as this trend intensifies, expect more discussion about the potential end of the Great Goods Price Disninflation trend.
However, that's a theme that will play out over quarters, if not years. It won't necessarily impact financial market prices in the near term, however much Macro Man might wish it to be so.
Taking a step back, it's probablyalso useful to put the recent bout of volatility in context. Macro Man looked at the 3 month moving average of VIX, MOVE (a measure of fixed income vol), and a rolling average 3m historical vol of USD/JPY and EUR/USD.
Wednesday, June 13, 2007
Tomorrow morning, at 9.30 am local time, the Swiss National Bank will announce its second quarter interest rate decision. A 25 bp rise in the LIBOR target is widely discounted; today's 3M LIBOR fix was 2.48%, a hair shy of the expected new target rate of 2.50%.
The SNB has also been the most vocal central bank in the world on the subject of the carry trade. For much of the past year, SNB officials have complained with increasing intensity about the weakness of the CHF and the prevalence of the Swissie as a funding currency.
Simply put, the time has come for the SNB to put up or shut up. Messrs. Roth, Gehrig, et al can really have no basis for complaint about CHF weakness if they are unwilling to do anything about it. It's more than three years since the SNB started raising rates; to date, they have hiked by a "whopping" 2.00%.
Gentlemen, if you don't want the CHF to weaken any more, then hike 50 bps. Appoint Rod Tidwell to the SNB board, if you have to. But if you want to complain about the weakness of your currency and expect the market to listen, you have to do one thing first.
The (higher yielding).
UPDATE: They blew it. Despite raising their current year GDP forecast from 2% to 2.5%, and even taking up their 2008 inflation forecast a smidge, the SNB did 25 bps. Please, messieurs, no more moaning about the CHF now!
Well, the price action in bonds now officially qualifies as a rout. Contrary to popular expectations that things would settle down ahead of the US data dump starting today, 10 year bonds shed more than a point yesterday, taking yields through everyone’s obvious target of 5.25% (last year’s high.) Meanwhile, price action in short sterling is if possible even uglier. Implied rates on the Dec 08 contract have gone up 20 bps since Monday’s close- and that’s with lower than expected inflation and wage date released during that period. Ouch!
Global email boxes and Bloomberg message caches are now filled with missives purporting to explain the rationale for the rout. Mortgage convexity selling? The lack of indirect bidders at yesterday’s 10 year auction? Forced selling of unprofitable positions that have reached their ‘business risk’ stop loss? All of these have been offered as a possible explanation for the wretched price action in fixed income over the past few days.
And therein lies the problem. These analyses are long on explanation, but short on forecasts. Of course, this is nothing new in the realm of economics and strategy. If Macro Man had an email spam filter that rejected any variant of “here’s why this apparently bullish/bearish datapoint actually supports our bearish/bullish case”, then his Delete key wouldn’t be nearly as worn as is actually the case.
Richard Feynman once described science as saying “If I do this, what will happen?” and then finding out. Alas, much financial market analysis seems to focus on post hoc descriptions of what was done. As Macro Man’s Cockney friends would say, it’s all written by Harry Hindsight. Research from Frankie Foresight, meanwhile, appears to be in short supply.
Now, regular readers will know that Macro Man is of the view that FX reserve managers exert an enormous influence on global financial markets. Although never articulated here, a month ago Macro Man opined that the withdrawal of Voldemort, et al from allocating fresh funds to the US bond market would tack on 50-100 bps to ten year yields. Now, one can dispute this analysis, or one can believe it, but at least it yields a forecast of future events, and thus passes the bare minimum requirement for science (as opposed to reporting or creating myths.)
Of course, Macro Man then proceeded to ignore his own ‘forecast’ and buy bonds ahead of 5%. Why is that? Simply put, he felt (and indeed still feels to a degree) that there is insufficient evidence that the bond buyers of last resort (within current ranges) have departed the market, never to return. While CBs were clearly absent from yesterday’s auction, they are still accruing $ reserves at an extremely strong pace, and those funds need to be parked somewhere.
One hypothesis that Macro Man is toying with is that Voldemort and other CBs who are morphing into sovereign wealth funds will substantially and systematically shorten the duration of their fixed income investments so as to have a steady supply of funds in which to invest in risky assets. If this hypothesis is correct, it would represent a significant shift from past behaviour, in which these guys would simply buy the highest yielding part of the curve (thus exerting a significant flattening influence on global yield curves, exacerbating a trend already in place due to pension fund asset-liability management.)
It is the forecast that results from this analysis that is the most important part. If the hypothesis is correct (and Macro Man doesn’t know if it is or not), then we should see at least a partial unwinding, over an extended period of time, of the flattening of global yield curves. In other words, for a given level of rates, inflation, and economic activity, we should see yield curves steeper over the next two years than they have been over the last two years.
At this juncture, Macro Man doesn’t have sufficient data to make such a trade with the requisite degree of confidence. But the point he is trying to make is not that curves should steepen, or golly gee isn’t he clever for suggesting bond yields would rise. Quite the contrary- he is distinctly unclever for losing money while trying to step in front of the bear market train. No, the purpose of today’s post is to encourage readers to demand (or, if they are analysts, to write) research that is as scientific as possible- in other words, to contain not only a hypothesis/explanation, but also a forecast of what should or will occur if the hypothesis is correct. Research that merely explains what’s going on, or twists every data point to fit a preexisting forecast?
To quote Richard Feynman again, that’s nothing more than cargo cult science.
Tuesday, June 12, 2007
Readers of a certain vintage and nationality may recall the “Mr. Robinson’s Neighborhood” sketch that a young Eddie Murphy used to perform on Saturday Night Live in the early 1980’s. The sketch, a takeoff on a popular children’s television program, used to feature a “word” of the day, which normally landed Mr. Robinson in trouble. In the spirit of those old SNL sketches, today’s word is “inflation.”
Today say the release of May CPI in China, which registered a higher-than-expected rise of 3.4%. This was the highest reading in two years. Most economists immediately shrugged it off, noting that the bulk of the rise is attributable to food prices, which rose 8.3% y/y. In contrast, non-food CPI was only up 1% y/y. The question that Macro Man cannot get out of his head, however, is the following: don’t Chinese workers need to eat? And as they become more affluent, won’t they eat more expensive, protein-based foods? Won’t this ultimately play a factor in raising wages in China and, ultimately, unit labour costs, which will raise the cost of export prices?
In Japan, meanwhile, McDonald’s has announced the intention to raise prices in a thousand urban stores to meet rising rent and labour costs. While they are also adjusting prices downwards in some rural locations, the aggregate impact will very much be one of higher prices. All this comes on the heels of a rise in the price of a bottle of plonk. Perhaps 10 year JGBs won’t stop at 2%, as is commonly supposed. (Note that Macro Man rolled his JGB futures short yesterday.)
In Europe, ECB President Trichet gave a speech wherein he noted that the Bank takes asset prices into account in making policy. The rationale, he explained, is that the ECB believes that asset-price inflation impacts consumer prices. Paging Alan Greenspan....
Friday sees the announcement of May CPI in the US, and the Fed will probably pat itself on the back if and when core prints another 0.2% m/m and 2.3% y/y. Who knows, maybe the owner’s equivalent rent, a measure that reflects the consumption basket of nobody, will push it even lower. Ignored in all this will be another tasty rise in the headline CPI, which is forecast to rise 0.6%. This would represent the fourth monthly rise in the unadjusted index of 0.5% or more this year, and take the year-to-date rise in CPI inflation (that is, the rise since December) to 3%. This is the inflation rate being faced by Mr. and Mrs. Joe Sixpack, not the core measured favoured by the Fed.
In fairness, the core measure should provide an anchor for headline inflation during periods when volatile commodity prices are mean-reverting. However, this is not currently the case, as a cursory glance at any commodity index chart covering the past five years will attest. As a result, there has been a persistent gap between the trend of headline and core inflation this decade. The last time such a gap opened up with such persistence was in the 1970’s. The driver of the gap, unsurprisingly, has been commodity prices: trend changes in the CRB have a remarkable correlation with the trend in the gap between headline and core CPI.
As long as the Fed continues to focus on core prices, which strip out the rising trend in food and energy, the actual cost of living in the United States is likely to remain uncomfortably high, and inflation expectations (which are formed by real-world cost of living rather that constructs such as owner’s equivalent rent) will remain firm. Therein lies the trade (which Macro Man admittedly already owns.) TIPS appear to be priced on the basis that the Fed will be broadly successful in reining in core inflation, and that headline will follow suit. As long as the commodity bull remains in place, however, that is unlikely to occur on a trend basis.
Monday, June 11, 2007
Well, well, well. Say what you like about this market, but at least it appears to be getting more interesting. Apparently Macro Man wasn’t the only one asking “what the %^&?” about the stunning rally in the New Zealand dollar on Friday evening, as the RBNZ intervened in the currency market, selling kiwi, for the first time in history this morning. Bonds, meanwhile, are now moving as much in a day as they used to in a month. And the US economy, virtually pronounced dead a few short weeks ago, is now expected to grow more than 4% in the current quarter by a few Wall Street economists.
All of this perhaps could (and definitely should) be a recipe for higher volatility. The situation in New Zealand is particularly interesting, as the Matterhorn chart pattern of the past couple of days is certainly suggestive of a blow off top. While it’s easy dismiss the potential impact of the RBNZ, who reportedly sold only a few hundred kiwi, Macro Man is wary that it is always easier to weaken your currency than to strengthen it. He also recalls an episode a year and a half ago when Messrs. Bollard and Cullen visited Japan to warn Japanese investors off of buying more NZD uridashi bonds. Over the next five months, NZD/JPY fell from 87 to 68.
The Malaysian ringgit is another interesting development. Long a darling of macro, currency, and bond funds, the MYR delivered stellar returns for most of this year. There was nothing not to like: a huge current account surplus, not-terribly-onerous funding costs, and a central bank that publicly favoured domestic currency strength. The last few days, however, have delivered a swift kick to the posterior of MYR longs, erasing all of the carry-adjusted gains since February. If a no-brainer like the MYR can cause pain, what might that say about the risks embedded in less attractive propositions?
The environment certainly looks ripe for a rise in volatility. While equity and bond implieds have risen sharply over the past few sessions, the movement in currency vol has been much more modest. Given the intervention from the RBNZ (might other noted whingers the SNB perform a similar action this week?), long currency vol looks like a good bet. If so, then Macro Man’s EUR/USD powerball tickets should continue to perform nicely.
Friday, June 08, 2007
So equities stabilize, and NZDJPY decides that that merits a 2% rally on the day!?!?!? While there has evidently been demand from the Land of the Falling Currency, this price action is really, truly, stunning. Clearly there is more about the current climate than bonds that Macro Man doesn't fully get...
No time for chit-chat (or writing), but this is all you need to know about markets. The pain and ugliness is real. 5y5y inflation breakevens don't widen 40 bps in a week during normal conditions; per Monday's post, this a definitively bearish development for risky assets. Be warned.
update: It was ugly for a reason. The 10y TIPS screens were frozen. Reality is much less hideous, though still not pleasant.
To say that the clarion call to buy bonds was "poorly timed" does a disservice to poorly timed calls everywhere. Just horrible. Macro Man was stopped at 104-31 yesterday, and more carnage has ensued since. Macro Man is understandably tied up this morning; more later.
Thursday, June 07, 2007
Macro Man’s bond purchase has not worked so far, despite yesterday’s equity sell-off. One obvious explanation why is that most developed market central banks (other than the Fed and the funding currency CBs) are being dragged into taking a hawkish stance. Perhaps decoupling really is a myth; rather than the rest of the world getting dragged down with the US, however, perhaps the US is simply being dragged up by the rest of the world!
The ECB delivered the expected tightening yesterday, and Jean-Claude Trichet signaled more to come by describing monetary conditions as ‘accommodative’ (clearly he didn’t get the memo about not using code words). While the ECB actually downgraded its 2008 growth forecast and characterized risk to the forecast as being to the downside, any potential dovish implications were blown out of the water by the Bundesbank’s Axel Weber, who characterized policy as being “far, far away” from restrictive. Clearly there’s one monetarist who’s alive and well!
In the Antipodes, meanwhile, the news was equally bad for bonds. The RBNZ delivered a surprise 25 bp hike, taking kiwi rates to a decidedly EM-like 8%. While RBNZ governor Bollard expressed some dismay at the level of the currency, he’s shown little inclination to do anything about it. (Perhaps the RBNZ and SNB should combine to sell NZD/CHF?) In Australia, meanwhile, unemployment reached a record low 4.2% a day after the stonking GDP report. A further rise in RBA rates would appear to be close to a dead cert.
True, the COPOM in Brazil actually cut by 50 bps, but it’s quite clear that growth, rather than inflation, if the primary concern there. In any event, the cut proved beneficial to the BRL, which clawed back most of the day’s losses late in the session.
Today sees policy announcements from the BOE and SARB. The market ascribes little chance of a UK hike today, though a further tightening is virtually written in stone. The SARB, meanwhile, is confronted with an interesting dilemma; inflation is above the target threshold, but largely driven by food and energy prices, something which domestic monetary policy can do little about. Does Mboweni hike 50 and take a hawkish stand to drive down domestic inflation expectations? If so, he risks an undesired currency appreciation. Or does he play softly, softly, thereby risking a perception that he’s fallen behind the curve (and leading to higher bond yields?) ‘Twill be curious to see.
In a world increasingly convinced that growth will persist and that inflation may become a problem, a long bond position may seem perverse. But Macro Man sees the risk/reward opportunity of being long at current levels as representing a cheap put on risky assets; certainly cheaper than one could get on the CME, Eurex, etc.
Wednesday, June 06, 2007
On the face of it, all remains bright and beautiful with the world. Australia registered super-strong (1.6% non-annualized) Q1 GDP growth, and the Oz (and kiwi, too, naturally) registered new 17 year highs against the US dollar. Chinese equities, so wobbly of late, appear to have stabilized. Growth remains good and liquidity remains ample. All aboard the market lift; next stop: financial Nirvana! Right?
Perhaps, but Macro Man was perturbed to see in his email box today not one but two clarion calls to buy bonds. It may be a bit trite to suggest that the ultimate buying opportunity occurs when the last bull pulls in his horns, but that appears to be more or less what's happened to US bonds (or, to put it another way, the bears on the economy have had their claws clipped off.)
Goldman Sachs and Merrill Lynch have both abandoned their long-standing calls for substantial US rate cuts in the second half of this year. Now, Macro Man actually agrees with this view, and has never really had much conviction that rate cuts are/were in the offing. Yet when he finds himself suddenly in the company of Merrill's David Rosenberg (whose forecast spreadsheet for the past five years has run off the simple alogorithm that if the day ends in 'y', deep rate cuts are forecast), he finds it an uncomfotable proposition.
When one considers some of the tactical factors that are driving the market, a cheeky purchase of bonds looks even more attractive. Yesterday appears to have been the day that rising real rates started to matter for equities, as a US 10 year at 5% proved sufficient to send the S&P 500 heading lower. While 5% need not be an insurmountable hurdle forever, it does seem likely that further near-term weakness in bonds will be met with a sell-off in equities, which should in turn put a floor under bonds.
Consider also that the recent run-up in energy prices should eventually become an issue sooner or later, whether as a hit to consumer confidence or via a more real impact on disposable income (and therefore, discretionary spending.) Moreover, ancillary market indicators that have been highly correlated bonds appear to be turning. Short bonds and short USD/BRL have been the same trade (at least directionally) for the last few months; the BRL appears to have turned, at least temporarily, and the little overlay below would suggest that TYU7 should be in the mid 106's rather than the high 105's.
Technically, meanwhile, Treasuries are as oversold (on a daily chart) as they've been in nearly four years. Not since the mid-2003 deflation scare/convexity squeeze was unwound has the RSI been this low. A guarantee of a reversal? Of course not. But it certainly raises the probability that a (at least temporary) rally occurs.