Wednesday, October 31, 2007

Bravo, Thomas Hoenig

It's nice to see that at least one FOMC voter isn't afraid to tell Jim Cramer where to stick his Ferrari.

The relatively hawkish statement (i.e., aggregate risks now balanced = no more mechanistic rate cuts) should be bearish equities and, by extension, other risky assets. After all, the only thing that should prompt a further dose of liquidity is a deterioration in the growth outlook and, by extension, earnings/credit conditions.

If equities come back to finish strongly on the day....well, that tells you that we're already swimming in an endless see of investable borrow in turds ($, Yen, Swissie) to the hilt and buy the riskiest rubbish you can find....

Very superstitious....

Well, the big day is here. Today's Fed announcement carries more uncertainty and drama than any event since....err...the last Fed announcement. With just a few hours to go, the "trick or treat" research counter is currently at two. (Shame, shame JP Morgan and Wells Fargo!) Unless another couple of US researchers succumb to the temptation, Macro Man will have missed his guess of four.

As for the outcome of today's meeting, Macro Man has close to the same attitude as last time. He thinks the Fed should do nothing but will do 0.25%. Perhaps even more so than last month, a 50 basis point easing would be a grave, grave policy error. Yesterday's Greg Ip article probably means that 0.25% cut won't generate a massive "sell the fact" knee-jerk reaction, as yesterday's US equity dip must have a taken a few hopeful 0.50%'s out of the euqation.

The dollar, meanwhile, continues to plumb new depths, and Macro Man's early-month forecast of potential all-time lows in USD/Europe by today in with a shout of being realized. While it's easy to fixate on the dollar and the Fed, let's not forget that developments in Europe are of interest as well. The ECB meets tomorrow, and given the potential for headlines of the "dollar at all time low" ilk, might M. Trichet register a sign of distress at the ongoing strength of the uber-euro?

Perhaps, but the the chances are probably lower than they were this time last week, despite the ongoing weakness of the buck. For the flash estimate of Eurzone CPI registered a rather bone-jarring 2.6% y/y reading today, well above the expected 2.3% and a sharp rise over September's 2.1%.

While it's true that survey data released simultaneously was disappointing, unlike the Fed the ECB has the mandate to focus solely on inflation. And the largest inflation miss in more than five years will not be particularly comforting for the governing council. What's remarkable is that the high inflation readings have come in the context of muted energy price inflation, which itself is remarkable given the surge in crude prices over the last few months. Were the authorities to engineer a weaker euro, the inflationary consequences would be rather unpleasant. So while the euro is obviously overvalued and damaging the profitability of certain (ahem, Airbus, ahem) European exporters, it would appear that for the time being, the ECB's hands are tied.

Today's Times carries a rather interesting study on the foibles and superstitions of the British public. For example, in what surely must be a triumph of hope over experience, substantially more Britons believe in Heaven than Hell. More than half of Britons "touch wood"; moreover, 42% of Britons who claim that they are not superstitious still knock on wood when convention would dictate.

Now, Macro Man has gone on record as a firm believer of using the scientific method in financial market analysis and is generally rather dismissive of "cargo cult" methodologies. So at the risk of losing what few shreds of credibility he may retain amongst readers, he, too, must confess to succumbing to the occasional superstition in his trading. Nothing methodological, mind; this is more Pascal's wager-type stuff, wherein exercising his superstitions is ultimately pretty harmless.

Among the superstitions that he has succumbed to over the years include the following:

* The aforementioned knocking on wood

* He grew a beard over his August holidays and made so much money that he's kept it ever since

* When on a good P/L run he drinks the same kind of smoothie every morning for breakfast

* When on a good P/L run he drinks water out of the same kind of glass every day

* He once wore the same jacket to work every day for a month during his greatest trading period ever

* He tries to avoid owning portraits of American revolutionary leaders

Is Macro Man the only freak out there? Any readers who also indulge in superstitions, by all means share 'em in the comments section, lest Macro Man book himself into Bedlam...

Tuesday, October 30, 2007

How weak is the dollar?

So former Treasury Secretary and Harvard president Larry Summers has put his two penneth into the debate about the dollar, and how the US should address the greenback's weakness. Unsurprisingly, this has prompted a good deal of debate about the subject, some of it thoughtful and some of it hysterical.

Most commentators seem to take it as read that the dollar is weak, and that that weakness is becoming a problem. As an American residing in Europe, Macro Man can confirm that the dollar is cheap when compared to European currencies. Of course, Europe is not all that matters. While the buck clearly appears undervalued against the "big dollar" to its immediate north, the dollar is less clearly cheap against the currency of another close trading partner, Mexico. And of course, the elephant in the valuation room, the RMB, is pretty clearly undervalued against the dollar even at its current "lofty" levels.

But beyond the valuation question, it's far from clear that dollar weakness is a problem. Sure, the private sector has less appetite for US assets than in the past. But if public sector financing were to step away, the subsequent readjustment in US asset prices would produce bond/earnings yields that the foreign private sector would eventually find enticing.

In the bigger picture, the exchange rate should also send important signals to economic actors. The chronically weak RMB, for example, has directed Chinese growth towards investment at the expense of consumption. Current domestic demand in China is growing at a 9% GDP run rate; there's simply no real need to add another 2.5% to growth via the export channel. Moreover, investment contributes substantially more to growth than consumption, to a degree that is difficult to find elsewhere. A stronger RMB exchange rate should not impact aggregate domestic demand, but shift the balance towards consumption and away from investment. This is the sort of rebalancing that the regime claims to desire, and their reluctance to pursue the obvious strategy to accomplish it is puzzling, to say the least.

The US, meanwhile, has the opposite problem. Too much consumption and not enough savings/investment. Personal consumption as a % of GDP has always been high in the US, but the bursting of the tech bubble in 2000 has produced a sharp increase in the consumption share of activity. The chart below explains external imbalances in a nutshell.
So what message should the exchange rate be sending to actors in the US? SPEND LESS! While many commenters, including Macro Man, have fixated on the inflationary consequences of Fed policy and the weak dollar, perhaps we're losing sight of the big picture. Maybe what is required to solve the world's ills is a dollar that is so weak that Americans lose international purchasing power, and thus spend less.

How close are we to such an outcome? It's impossible to say, but Macro Man undertook a little project to get a sense of how much purchasing power Americans really have compared to elsewhere in the world. He took a basket of five discretionary consumer goods and compared prices from a uniform source ( in five different currency regions. The basket is comprised of:

*Harry Potter and the Deathly Hallows
* The 5-CD set of the complete Beethoven symphonies, as recorded by Herbert von Karajan in 1963
* An 80 mb iPod
* Windows Vista Home Premium Edition
* A Playstation 3 (60 mb version)

Macro Man checked the prices of these items in the USA, Canada, UK, France, and Japan. The Chinese site did not have an English option, and, strangely, there is no Amazon available in Brazil. Readers in those countries can feel free to contribute their own price data in the comments section. For some reason the iPod is not sold via Amazon in Canada, so Macro Man got his Canadian iPod price from the Apple website.

In any event, the local currency prices for his basket was as follows:

Of course, such data is meaningless as a basis of comparison for those without an extremely able facility for mental arithmetic, so the table below sets out the basket prices in USD terms using current exchange rates. It seems quite clear that far from suffering from a weak buck, American consumers continue to enjoy the benefits of cheap consumer goods relative to the rest of the world. No wonder they spend so much!

Ah, but there's a catch. Amazon in the US does not include sales tax in its price, whereas other countries impose a VAT at source. Surely these disparities are explained by different tax regimes? Not entirely. Macro Man recalculated the basket, stripping out VAT (6% in Canada, 17.5% in the UK, 19.6% in France, 5% in Japan) from his USD prices. The resulting at-source cost of the discretionary consumer basket is set out in the table below:

Remarkably, for someone who was raised on stories of $100 watermelons in Tokyo in the mid-1980's, the Japanese consumer basket is almost as competitively priced as the American one. That the Canadian basket was the most expensive was a shock, and certainly bodes well for US retailers along the border with Canada this holiday season. It came as no surprise that European goods were dear: that UK Playstation price is "rip-off Britain" in a nutshell.
Of course, some of this disparity can still be explained by the fact that prices have not had time to adjust and that the weak dollar makes the American basket appear cheaper than it really is. However, the US has a substantially higher nominal per capita GDP than the other countries in the study, even accounting for this year's dollar weakness. So this basket of goods represents a smaller proportion of per capita income in the US than it does in any other country in the study.

The dollar may be weak, but it's not yet weak enough to hit consumers in the pocketbook. Until it does, it's hard to see US savings rates rise and a more substantial correction in external imbalances.

Monday, October 29, 2007

Hedge when you don't need it.... one of Macro Man's favourite maxims. The constructive risk asset view has paid dividends, despite some rather gut-wrenching price action last week. Now that the portfolio seems safely out of the water and into the black, hedging against adverse developments in what should be an eventful week would appear wise.

Macro Man therefore does 450 lots of a November 1560/1515 SPX risk reversal, trading away a bit of upside for the ability to insulate the portfolio from a Fed-, payroll-, or credit-induced meltdown over the next few weeks. The strategy is done at zero cost and should dampen portfolio volatility over what is sure to be a noisy period.

Why the long face?

A horse walks into a bar. The barman looks up at him and asks "Why the long face?"

Another day, another record low in the dollar against the euro and the loony. Indeed, EUR/USD now isn't far off from the all time USD/DEM-equivalent extreme; a repeat of Thursday and Friday's price action would carry the buck into record territory.

Fresh highs in oil (courtesy of a production outage in Mexico) and news that OPEC may consider switching to a currency basket for pricing have helped depress dollar sentiment this morning, and shorts are no doubt high-fiving each other and kicking up their heels in glee.

Or are they? For a look at the currency options market reveals few signs of euphoria, or indeed crisis, that one might ordinarily expect to see at dollar extremes. For one thing, the level of implied volatility is still quite low: one month vol is currently quoted around 7.6%, which is the high of the last couple of months but still well below the levels observed in August.

More telling is the skew in the market- the vol premium or discount that participants are willing to buy euro calls over euro puts of an equivalent delta. Normally, with EUR/USD at its highs, one might expect calls to command a handsome premium over puts as players look to profit from/hedge against further gains. And over time, there generally is a good correlation between spot moves and risk reversal skew. The chart below shows 12 week changes in EUR/USD with the 1m 25 delta risk reversal skew, with positive readings showing a premium being placed on euro calls, and negative readings showing a premium on euro puts. Whats remarkable is that despite the strong rally in EUR/USD to record levels, options skew has remained firmly bid for puts. Far from crisis or euphoria conditions, it looks like most currency punters are worried about a corrective rally in the dollar. What's worrying from the dollar bear's perspective is that the last such obvious dissonance, in Q4 2004, heralded a blow-off top in EUR/USD and ushered in 12 months of dollar strength. Should dollar bears be quaking in their boots even more?

Macro Man constructed a simple study to find out. He regressed the data above, 12 week EUR/USD spot moves against the level of the 1 month risk reversal. He then checked the residual against EUR/USD spot moves in the subsequent 8 weeks. The resuts are depicted in the chart below. In summary, sometimes the disconnect is a useful leading indicator......and sometimes it isn't. As you can see in the chart, in late 2004 the residual perfectly called the trend reversal in EUR/USD. However, there have been plenty of other times when the residual completely missed the boat. Over the last four years, the correlation between the risk reversal residual and the subsequent eight week spot move has been 0.14; postive, but not significantly so. So while this is clearly a situation that's worth keeping an eye on, the continued bid for EUR/USD downside does not in and of itself provide conclusive evidence that the end is nigh for dollar weakness. Macro Man continues to wait for The Economist to signal that.

Of course, currency punters hardly have a monopoly on pessemism. Results from Macro Man's recent poll were not as lopsided as August's result, but it's still telling that both market pros and retail punters viewed S&P upside through year end as the least likely outcome. Moreover, futures positions remain heavily skewed to the short side. Macro Man's preferred measure is a diffusion index which looks at the net positioning of the S&P and e-mini futures as a percentage of the open interest. As can be seen in the chart below, net index futures shorts as a percentage of the O.I. are near their extremes of the past several years.

Of course, hedging by long/short and market neutral funds, as well as by macro men, is a possible explanation. By the same token, that still begs the question of how net futures length has fallen so precipitously over the course of 2007. The wall of worry would appear to be fully intact, and the potential for short squeezes, especially in light of what the market takes to be favourable developments, would seem to remain high.
That having been said, given the recent rally and this week's event risks, it would appear churlish not to hedge, and Macro Man may look to do so later today.

Friday, October 26, 2007

The end of the line for the buck?

Are the Rosicrucians at it again? For the second straight session, a ropy-looking US equity market was buoyed at roughly 2 pm NY time to rally strongly and close within a few S&P 500 points of unchanged. The tin foil hat brigade is no doubt having a field day. Strong Microsoft earnings (man, when was the last time they were relevant?) after the close could set the stage for upside today.

The real story, however, is the continued shellacking of the US dollar. Enthusiasm for any positive action in US equities or other American assets has got to be tempered by the knowledge that the dollar appears to be falling in value against virtually everything in the known universe. Well, everything except a large number of coastal houses, that is.

Oil, for example, has ascended on wings of eagles and is now up more than $30 on the year. Remember when $30 was thought of as the long-term equilibirum price for crude? Now it's just 10 months' worth of price action. Of course, product prices have yet to follow suit; if they do, then Macro Man's constructive US equity outlook will require a rapid re-assessment. In any event, the superspike to $100 isn't looking so slow-motion any more.
Gold is following a similar pattern, as is of of course the euro. One of Macro Man's preferred indicators has reached a critical threshold this week. The interest rate differential between the US and Europe, as priced by the third (i.e., June 2008) eurodollar/euribor contract has swung to a premium for Europe for the first time in several years.
A truly daunting prospect is that if strip pricing is realized, the dollar will have the third-lowest interest rate in the G10 by the middle of next year. And that will mean that the greenback will end up as a funding currency in the tens of billions of dollars worth of passive carry strategies that have had such an influence on currency markets. A situation wherein investors do not receive interest rate compensation for financing the US current account deficit should spell doom for the dollar.

And yet....the dollar isn't the whole side of the story. True, in the scenario described above, the US will rely on foreign central banks as the primary conduit of deficit financing. Yet Macro Man remains troubled by this analysis, as it implies a definite knowledge that the deficit comes first, and thus requires financing.

But the Eurozone, for example, with only a modest current account deficit, is still the recipient of €150 billion or more a year in central bank financing inflows. For Europe, it seems quite clear that the financing has come before the deficit (which is now widening, particularly if we look at the EU as a whole.) Macro Man continues to believe that the US deficit/financing issue is more complex than most currently assume, and that sans unwanted financing, the deficit would be lower (and market rates higher) than is currently the case.

In any event, the current market dynamic is clearly being driven by factors described above: US reflation and declining rate premia. And from that perspective, dollar weakness is justified. Yet in conversations with other market risk-takers, Macro Man has detected a distinct lack of enthusiasm to buy euros. Valuation is apparently finally taking its toll on private-sector demand for euros, so traders and fund managers are less enthused about betting the mortgage on EUR/USD than they were in, say, Q4 2004.

It is the case that the euro's trade-weighted index is at its highest level in more than a decade- and the chart below (the Bank of England TWI) doesn't even include China, so it almost certainly understates the true degree of euro strength. Ultimately, this is likely to have a material impact on European growth, though currency hedging will likely mitigate the impact compared with 15 years ago. Nevertheless, it is unlikely that the EUR/USD rate will go up forever, and at 1.50 we should probably all be prepared for Europe to start digging its heels in more forcefully.
Results from the S&P poll are mixed so far...if you haven't voted yet, by all means please do so.

Thursday, October 25, 2007

Up, down, or shake it all around?

Wall Street chiropractors must be loving the current market, as the whiplash of the last few days is surely providing them with a steady stream of customers. Yesterday's late-day rocketship, ostensibly on the back of emergency discount rate rumours, was in reality just the upside analogue of Friday's late-session meltdown. Lots of noise, wide ranges, but relatively little net change. Having been stopped into a Treasury short near the lows, Macro Man has now been stopped out near the highs. Ugh.

What's remarkable is that despite the turmoil and volatility of the last six months, the S&P 500 has, on aggregate, netiher gained nor lost ground. Indeed, it's spent most of its time since mid-April in a relatively tight 1450-1550 range, with a couple of peeks to the topside and August's bum-clenching downside test.
That the 200 day moving average continues to contain losses is an encouraging sign; less positive is the lack of breadth in the market. Earnings expectations surely have further markdowns to come; by the same token, bonds offer little competition at current yields. Soveriegn wealth funds will be switching out of fixed income and into equity; however, the buyback and private equity bid seems likely to be less potent in the future. October seasonality is horrible; seasonality in November and December, meanwhile, is usually quite supportive of the market.

So there are plenty of reasons to be bearish, but valid reasons to be bullish as well. On balance Macro Man feels like the market is bearish, but it's hard to be sure. So he is curious about your view. Punch in your view in the poll below; apologies to the couple of you who voted in the sidebar poll, but Macro Man prefers this format- feel free to vote again!

Wednesday, October 24, 2007

A bit of risk management

Well, the Merrill write-offs weren't as bad as feared ("only" $7.9 billion), but earnings were a shocker at -$2.85. Fortunately, Merrills credit rating was downgraded a few hours later, giving investos vital insight in ML's health.

In any event, the merrill news, combined with some truly awful existing home sales data (there's now 10.5 months of inventory in the pipeline) has left risk assets plumbing recent depths. In other words, this doesn't look like any kind of time to be short duration of any description. Macro Man will therefore place a stop on his short TYZ7 position at 111 to stop the bleeding. Any future shorts may well be taken in Bunds, given the hawkish ECB and containment of housing difficulties to Spain and Ireland.

What's your edge?

The three-ring circus that is global finance continues to astound and amaze, with noise levels approaching jet-engine thresholds. Mean reversion has been the order of the week to date, with whippy price action and WTF? headscratching as standard operating procedure.

At least one source of uncertainty should be resolved-to a degree- today, as Merrill Lynch finally reports Q3 earnings at 7.30 EDT this morning. Press reports suggest that another $2 - $2.5 billion will be written off, though as noted yesterday speculation is rampant that the all-in write-down could be as high as $15 billion or so. Meanwhile, a high-profile market-maker on Eurex has gone bust, further increasing market jitters. Oh, and the the situation in southern Turkey remains perched on a knife-edge. Are we having fun yet?

In stressful markets like these it is often useful to look inwards and remind yourself of what your edge is. One of the most commonly-asked questions of traders and fund managers is "How do you make your money? Why should you be expected to generate consistent returns?" Unsurprisingly, saying "I buy 'em if I like 'em and I sell 'em if I don't" is rarely deemed to be a satisfactory response.

When Macro Man looks in the mirror and engages in a bit of Delphic introspection, here's where he sees his investment advantages:

* Combining beta-plus and alpha strategies is an excellent way to maintain market participation during favourable conditions while retaining the flexibility to either add or dial-down risk as circumstances warrant. Pure quant strategies tend to get caught out by fat-tailed risk events, as in August. Pure discretionary traders, meanwhile, can on occasion get caught up in noise and lose sight of the bigger picture.

* Of course, a process is only as good as its inputs. Macro Man's relatively simple models are meant to get him out of the market when conditions deteriorate; while there is no guarantee that they will always work, they nevertheless kept him out of the FX carry debacle in August, for example. As such, his "beta plus" foundation would appear to enjoy a comparative advantage over passive exposure strategies.

* At the same time, models clearly don't capture the whole story. Profiting from temporary or non-quantifiable factors can be an important soure of alpha. Managing risk on the basis of things that models cannot "see" is, in Macro Man's view, a vital element to chopping off the nasty tails lurking at the left side of the return distribution. Of course, there is no guarantee that he will always manage to do so; however, having the ability and, vitally, the intent is more than half the battle.

* Macro Man is able to develop, backtest, and implement simple models. He is not a "quant" who creates "black boxes", but he is nevertheless able to develop a hypothesis, create an 'experiment', and act on the results. By doing the numerical work himself, he hopefully has a clearer sense of a model's strengths and weaknesses than if he were implementing someone else's work.

* Macro Man has a pretty good grasp of macroeconomics and has closely followed the data in key markets for a number of years. He is comfortable with his own sense of what matters and what does not, and the key drivers of the economic cycle. He doesn't always get it right- nobody ever does- but he at least has the ability to critically assess the forecasts that are "in the market" and look for mispricings or incipient swings in sentiment.

* While not a "mine-yours, shag" trader, Macro Man nevertheless has a reasonable grasp of charts, positioning, and the psychology of high-frequency or market-making traders. He relies on these skills not only to identify when price action is noise, e.g. the last couple of days, but also when there is actionable signal. Again, it doesn't always work, but it's a useful arrow to have in one's quiver.

* While Macro Man is confident in his ability, Macro Man knows that he is not bigger than the market and is never afraid to admit that he is wrong. He is willing to take losses when "the facts change" and has learned to scale his position sizes in line with his conviction levels. He tries very hard indeed to avoid the error of confirmation bias that seems to plague so many financial market particpants; maintaining an objective outlook should confer an investment advantage.

* Separating noise and signal. When Macro Man is trading well, he tends to fixate on a few key themes and filters out the noise from just about everything else. This (hopefully) allows him to avoid the sin of over-trading or headline-chasing; his analytical expertise is not in the short-term, so he should not get caught up when decibel levels rise. His current thematic focus is on the continued abundance of global liquidity, the looming threat of global inflation (which should eventually cause the removal of liquidity), and a secular rise in financial market volatility.

* Knowing what you're good at. Macro Man is a reasonably dab hand at currencies, knows US equity indices pretty well, and isn't bad at government bonds and swaps. He lacks expertise in single-name stocks, credit, and commodities, which is why his risk allocation to those sectors is relatively low. There's nothing worse than being blind-sided and losing lots money in a market that you don't really know, something that happened to a few of his commodity punts early in the year and in 2006.

A final comparative advantage that Macro Man enjoys is this very space. For better or for worse, his brain is hard-wired to develop and refine thoughts through expression; put another way, his ideas are better when he writes them down. Maintaining a paper P/L has also enabled him to try out new strategies without taking a real hit; the aforementioned commodity losses, for example, were only on paper, and taught Macro Man that commodities aren't as easy as they look.

A final advantage of this blog is the ability it confers to exchange views with largely anonymous but nevetherless widespread and thoughtful segments of the investment universe, both professional and retail. This occurs in the comment section, offline, and via the occasional poll: was there a better equity buy-signal than the lack of "V" responses in August?

So there you go. That's how, where and why Macro Man thinks he can be successful. While he generally refrains from offering advice directly to readers, in this case he'll make an exception: Know thyself, and your P/L will thank you for it.

Tuesday, October 23, 2007

20 Questions

Yesterday, the offices of Dr. Market, DDS, did a roaring trade as a good many people got their teeth kicked in. EUR/USD went up, then it went a hurry. Bonds went down, then they went up, then they went down. Stocks went down, then they went up, then they went down, then they went up. Fun for the whole family! Markets are currently feeling a bit bettter after the strong close and the stellar results from Apple. However, would you really be surprised if things turn round again? With this much noise in the market, Macro Man finds it useful to step back and play another round of 20 Questions:

1) How bad will tomorrow's announcement from Merrill Lynch be? So far Macro Man has heard rumours of an $8 billion write-down and a $14 billion write-down.

2) The HKMA is intervening at 7.75. Does anyone really think the HKD peg will go?

3) Is Macro Man the only one who feels like the expected value of any trade in markets like yesterday's is negative?

4) What, exactly, is the US Congress attempting to achieve with this Armenian genocide bill? The alienation of one of America's few Islamic allies?

5) What's next, a bill calling on the EU to apologize for the sack of Constantinople in the Fourth Crusade?

6) Is Macro Man the only guy in London wondering how he is going to reconcile the Fed announcement next Wednesday (and the attention that it merits) with taking his kids trick or treating?

7) What is the SNB trying to achieve by injecting 1 week repos into the market at 2.05% when their policy target is ostensibly 2.75%?

8) Does Macro Man's unpopular constructive risky asset view mean that he has unwillingly joined the ranks of the DOTW?

9) Is the Japanese branch of the Dipbuyers of the World starting to run into trouble?

10) Why is it that no matter how carefully one stows an iPod in one's pocket, the earphones become entangled in a Gordian knot by the time you next want to use them?

11) Is the ECB talking tough so that they don't have to put up rates, or would they really hike with EUR/USD on a 1.40 handle and leading indicators rolling over?

12) How many research pieces will be written next week that have some sort of "trick or treat" theme in the title (referring to the outcome of the October 31 Fed meeting)? Macro Man reckons the over/under for pieces that he personally receives is 4.

13) Now that the Communist Party Congress is over, isn't it about time for China to let the RMB get jiggy?

14) It seems like US curve steepeners are a pretty consensus trade...and yet the pullbacks have been very shallow indeed. Is the rest of the market waiting along side Macro Man for a dip to slap on the steepener?

15) Will the London Olympic committee get taken to a UN human rights tribunal for forcing all visitors to experience the hell on earth that is London public transport?

16) Is there a more depressing moment of the year than when you walk out of the office for the first time after daylight savings "falls back" and see that it's pitch black outside?

17) Why does the "Iris scan booth" at Heathrow airport NEVER EVER WORK?

18) Is oil actually in the midst of a "slow motion" superspike up to $100?

19) Will the New England Patriots lose a game this year? Will the Miami Dolphins win a game this year?

20) How bad would you feel if your boss at Merrill Lynch told you: "We've dropped a load of money this year and there's no bonus pool because we've spent the reserve on muppets." Kids, the wort of the day is 'redundancy.' (Note that Macro Man has kids and is generally supportive of socially munificent corporate behaviour....but his friends at ML are bordering on suicidal.)

Bonus question 21: What's the real story behind the super-SIV?

Bonus question 22: What does Ben Bernanke think of Alan Greenspan? Godfather, sage, or serial reflationist who won't shut the f*&^ up?

Monday, October 22, 2007

Two things that provide comfort...and one thing that causes worry

There's a faint whiff of panic in the air this morning, as equities look horrible, bonds remain bid, and FX carry is getting carted out. The weekend G7 meeting was predictably lame, and the call for China to allow faster RMB appreciation has fallen on deaf ears. Indeed, over the past month USD/RMB is actually a bit higher....and that's before you add in the horribly negative carry available to foreign investors.

Macro Man's weekend post, wherein he articulated a broadly constructive medium-term outlook for equities, generated a fair amount of pushback. True, last week's earnings reports out of the US were rubbish, with the bulk of the weakness coming from domestic earnings. But Macro Man's large cap/small cap trade should help capture that dynamic.

It's also the case that oil is at stratosphereic levels. Yet the hit to consumers may be less than you think. Here in the UK (where, incidentally, Macro Man this morning had to scrape his windshield for the first time this autumn), petrol prices have yet to reach last year's highs....and that's with the Government's fuel duty escalators. In the US, meanwhile, a very notable divergence has occurred between the price of crude and the price of gasoline. The steady moves in gas prices offer some comfort that the world is not, in fact, coming to an end. Readers with an expertise in crack spreads should feel free to chime in with any insights they may have on the issue.
Another bedrock of the constructive risk-asset view is the ongoing glut of liquidity in financial markets. While last week's TIC data received mammoth amounts of attention, a less remarked-on development is that Fed custody holdings of Treasuries and Agencies have made a new all-time high. The CB buyers' strike in August is looking like a temporary phenomenon, and a continued CB demand-inspired decline in risk-free rates should enourage equity multiple expansions.
On the flip side, fundamentals do at the end of the day matter, and so does sentiment. And what seems clear is that the credit environment is deteriorating once again. The latest tranche of BBB- asset-backed turds, as shown below in the Markit chart, has plumbed new depths. As July and August showed, a significant weakening of credit conditions can lead to babies being chucked out with bathwater as people sell first and ask questions later.

So the market merits attention. In this environment it may be a delicate thing to filter out the noise and still capture signal. Short term pain is and may remain a reality. Macro Man's judgement is that it is too late to buy equity puts or yen calls-he has some of both already- but he could of course be wrong. The holy grail is a cheap hedge on something that has yet to perform.

An obvious candidate is gold, where Macro Man will sell his Dec 750 calls and replace them with 200 740 puts when the maket opens.

Sunday, October 21, 2007

Weekend Special: Paging Mr. Billy Shears

It was twenty years ago today
Sgt. Pepper taught the band to play

- The Beatles, "Sgt. Pepper's Loney Hearts Club Band"

Macro Man was out of the office on Friday, missing not only the decimation of equities and the dollar, and the concomitant uber-bull in bonds, but also the inevitable bevy of retrospectives on what was a defining moment of modern finance, the Black Monday crash of 1987.

In many ways, the situation today does resemble that of 1987. Stocks have had an excellent run over the past few years but begun to roll over. M&A/LBOs/Henry Kravis are front page news. The dollar has had a shellacking the past few years, and there's even a weekend announcement on currencies (the tepid G7 communique this weekend, the announcement of a derisory 0.25% rate cut from the Bundesbank in 1987).

So should we expect a once in a generation decimation of equities tomorrow? Somehow Macro Man thinks not. The primary difference between now and then is valuation. In October 1987, stocks were bum-clenchingly expensive by just about any measure; tod♠ay, they continue to look cheap when compared to Treasuries. Macro Man looked at this issue nearly a year ago, and circumstances haven't really changed since.

The dollar, meanwhile, is also not a good parallel. In 1987, Treasury Secretary James Baker was actively trying to resuscitate the dollar after two years of post-Plaza Accord bollocking. The primary policy prescription of this weekend's G7 meeting was "the dollar needs to go down against the Chinese renminbi". Sure, Hank Paulson said that he sure does love a strong dollar...but also noted that he's not really prepared to do anything about it.

The real issue for stocks is one of earnings. Since the money market ruptures of early August, consensus 12 month forward earnings estimates for the S&P 500 have fallen by roughly $1.50 per share. All else being equal, this should produce modestly lower stock prices. Of course, all else is not equal. The Fed has cut 0.50% and looks set to do more, while Treasury yields are now at or towards their lows and the curve has steepened.
This latter factor should generate a multiple expansion, which could perversely propel stock prices higher even as earnings expectations are marked significantly lower. Given that the magnitude of the change in discount factor has been substantially greater than the actual change in earnings expectations, Macro Man continues to view the medium-term outlook for stock prices as relatively good. The current 1500 level is a reasonable technical support, though self-fulfilling "Black Monday, mark II" fears may well propel share prices lower tomorrow. Unfortunately, Macro Man never got around to adding fresh index hedges, and at this point he's not sure if the cost of doing so justifies the potential rewards.

In any event, Friday was just another piece of evidence that the low-volatility world of the past few years is receding into the rearview mirror.

Thursday, October 18, 2007

Housing: is this cycle different?

Well that was fun. Old habits die hard, and Macro Man tends to be so fixated on inflation as a medium-term macro theme that he sometimes focuses too much on price data and not enough on other stuff. So proved to be the case yesterday, when the focus was not on CPI but on yet another piece of horrible housing data.

Fed rate cut hopes, which as recently as yesterday morning appeared dormant, received a fillip from both the housing data and the Beige Book, which indicated a marked deceleration in activity in late September/early October. Somewhat surprisingly, stocks appeared to take relatively little comfort from these relatively dovish developments. Could this perhaps be a sign that a deeper correction is looming? That early session eurphoria in equities, emerging markets, and FX carry gave way to renewed weakness and a widening of credit (to the degree that someone actually mentioned the euro crossover index!) lends credence to the notion.

Going back to housing, it has struck Macro Man that perhaps a sense of perspective might be useful. The financial press and blogosphere is awash with doom-and-gloom stories facing homebuilders, house prices, and any structure on U.S. soil with four walls and a roof. While housing starts certainly do not tell the whole story, they do represent the most mechanistic impact of housing on economic growth, via residential construction.The chart above shows monthly housing starts data going back to 1959. And what's immediately clear is that the anomaly is not the swift and steep decline in starts, which appears pretty standard for housing down-cycles, but rather the prolonged fifteen-year period of steady increases in hosuing starts. For that, of course, we have Easy Al to thank. His swift and deep rate cuts in 2001 propped up housing when the impact of the equity bubble bursting and the concomitant investment recession seemed likely to produce a downturn in housing. At least it seemed that way to Macro Man, who in late 2000 sold a property in Hilton Head- just as the party was getting started, as it turned out. In any case, this time (at least in terms of the deceleration in housing activity) doesn't appear to be different, after all. Will the same hold true for US household wealth?

Wednesday, October 17, 2007

An ancillary benefit of blogging

Regular readers of the comments section of this blog may have observed that for the past few weeks, Macro Man has been engaged in a debate with friend-of-the-blog Cassandra over the nature of certain capital flows. To wit, how much of the recent capital exportation from the US and Japan represents a reduction in home bias (e.g., the preference of investors to remain overweight domestic assets relative to the optimal allocation per modern portfolio theory), and how much of it represents the herd mentality of momentum investors who buy what goes up and sell what goes down?

It seems clear that both of these effects are at work; where Macro Man and Cassandra differ is the relative importance of the two factors. And there's nothing necessarily wrong with that; it is eminently possible for two people of reasonable intelligence and goodwill to observe the same set of data and reach different conclusions. Moreover, there seems litle near-term prospect of either of us being "proved" right; indeed, one could probably argue that we won't know the truth for another decade.

But what hasn't been clear is whether anyone else, other than the Brad Setsers of the world, really care too much about the issue of international capital flows. This is where the benefit of blogging rears its head. An ancillary feature of writing a blog is that one can gauge interest in a market environment or a subject by the amount of traffic the site generates. The more interesting a market environment, post, or discussion, the more visitors and/or links will flow to the site.

And what is remarkable about yesterday's TIC data, and the off-the-cuff post that Macro Man wrote about it, is the amount of traffic it generated. To be clear, this site is small potatoes compared to many of the financial blogs out there, but then again Macro Man is just some random anonymous guy spouting off. He is frankly surprised and flattered that anyone chooses to visit. But he can still distill interest in a particular subject by looking at relative changes in traffic patterns. And somewhat to his surprise, yesterday saw far and away the highest ste traffic since the week of the last Fed meeting, which itself was a record for the site's traffic.

Now, that the issue of the TIC data generated loads of interest doesn't provide any support for either Macro Man's or Cassandra's point of view. But what it does suggest is that this is an issue that is interesting to both market professionals and retail investors; and that, Macro Man believes, is useful information to know. He'd suggest that the level of interest in the subject indicates that, all else being equal, the trends of capital exportation from the US and Japan are likely to remain in place for some time, whether they are based on momentum or a more secular asset allocation. In the event of a benign US CPI figure, that could start half an hour from the publication of this post.

For some reason, Blogger didn't like the P/L sheet today.

Tuesday, October 16, 2007

Bloody Hell!

That's what Macro Man said when he saw the August TIC data, released today. The figures were always going to be freaky, given that they captured the height of the recent market crisis, but whoa Nellie!

* The monthly long-term flow was -$69 billion

*The montly total flow was -$163 billion

*The monthly private sector flow was -$141 billion

All of these are comfortably in record territory- and not in the direction that the US would want.

Private sector flows are running at roughly 40% of their 2006 run-rate. That, ladies and gentlemen, is a big reason why the buck has fallen this year.

The only sector to see a US inflow was Agencies. This is curious, bcause it puts paid to the notion, that Macro Man himself has subscribed to, that US investors would repatriate assets wholeheartedly in tims of crisis.


I-Bank profits: Leaking like a SIV?

All of a sudden, the world doesn't appear quite so rosy, does it? The recent floating-on-air performance of risk trades, which as recently as yesterday morning had Macro Man's blog portfolio knocking on the door of 3% month-to-date profits, has swiftly descended to Earth. The heady days of last week seem like a long, long time ago....

The decline in US equities yesterday was telling. Whereas markets had previously been willing to shrug off bad news (e.g. Merrill and UBS), yesterday's earnings announcement from the Prince of Darkness appeared to dent morale from the get go. And what we're left with is an S&P 500 teetering nervously on a highly visible and obvious trendline. A close below would, in all likelihood, generate further position liquidation. Although Asian equity trade was mixed, price action in S&P futures this morning does not bode well.
Of course, there was more news than just Citigroup earnings (which, as far as Macro Man could make out, were actually a tad higher than the consensus expectation.) The announcement that Citi, B of A, and JP Morgan were jointly creating a "super SIV" also generated quite a buzz.

Now, Macro Man does not purport to be an expert on structured crdit and the inner workings of SIV-type vehicles. But as far as he can make out, the premise of this vehicle's creation, which was orchestrated by the US Treasury, is as follows: SIVs are currently unable to issue sufficient quantities of short-term debt to avoid the sale of illiquid assets, with the concomitant unpleasant voyage of price discovery that follows. As a result, banks are forced to take these unwanted assets onto their balance sheets, which is impairing their capital ratios and potentially their willingness or ability to lend. As a result, it is better to create a new SIV...which will then attempt to issue short-term debt to finance its illiquid asset base.

Errr....if there were sufficient demand for asset-backed CP, wouldn't that obviate the need for this super-vehicle in the first place? And if banks are forced to extend credit to this super-SIV if it's unable to issue short-term debt, won't that compromise their ability to lend to other borrowers?

A cynic might observe that this vehicle is a handy way to stripping turdholdings off these banks' balance sheets, and replacing them with even more-difficult-to-value loans to the super-SIV. Moreover, it also appears to concentrate a very substantial amount of asset-backed risk into a single entity. All the easier, perhaps, to conduct the inevitable government bailout?

Meanwhile, a Fortune magazine story is now doing the rounds, highlighting the degree to which Goldman's stellar 3rd quarter earnings were the result of so-called Level 3 "mark-to-myth" valuations. Macro Man recalls that GS was relatively opaque when it came to disclosing the impact of Level 3 earnings when they announced profits last month; evidently more colour was provided in a recent filing. Macro Man hasn't read the filing, and even if he did, he isn't sufficiently conversant in these issues to make an informed judgement as to their severity. In a sense, though, he doesn't need to; when markets turn, participants tend to shoot first and ask questions later.

It's perhaps worth putting the last few weeks in perspective. NZD/JPY is a useful barometer for global risk appetite, as it is the highest-yielding cross in the G10 FX complex and captures Japanese risk appetite in a way that many standard measures do not. The chart below is really remarkable, as it shows that the NZD/JPY cross delivered two rallies of 20% plus-not including carry-in a little more than seven months. Quite amazing, really. That second rally, of 23%, took less than two months, and is now putting in quite a clear top. What odds on a further position liquidation? One would think it must be reasonably high.

Finally, Big Ben's speech yesterday had someone for everyone. Depending on the prior viewpoint of the analyst, one could read that it was dovish, hawkish, or something in between. All you really need to know is that the Fed could cut, hike, or remain on hold as circumstances warrant.

In this environment, a long volatility position is looking good. Macro Man will sell out his long USD/JPY option hedge at 116.95 on a spot basis and €30 million of his EUR/USD long at 1.4170 spot basis. Time to batten down the hatches, folks: all of a sudden it's looking like the no-brainer risk trade has come to an end.


It's looking like one of those horrible days where everything goes wrong at once. Certainly Macro Man's getting filled at 108-08 on a TYZ7 short yesterday was ill-starred, and FX carry is getting "carried out" on the proverbial P/L stretcher.

Macro Man therefore buys back his JGB short at 134.71.


Monday, October 15, 2007

Apparently, all it takes...

Apparently, all it takes to get central banks out of the foreign exchange market is a good old-fashioned financial crisis. Sure, China still added more than $100 billion in Q3-and we don't know exactly how CIC is treated in this data- but the reserve growth from the emerging world, as proxied by the BRICs, clearly decelerated last quarter. Indeed, reserve growth in August plummeted by more than 50%, taking it all the way to its lowest level since....last October. Somehow, that lsit bit makes the decline seem not-so-impressive, doesn't it?
Of course, the data tell us more than just how many dollars Voldemort and pals bought last quarter. It also contains information about what the value of the constituent currencies did over the quarter. And as we know that the non-dollar currencies ended up appreciating against the buck, despite the sharp appreciation of the dollar versus European and carry currencies in August. From this, we can back out, with a few assumptions, how many euros the BRIC central banks had to purchase in the open market to maintain portfolio benchmarks.
As it turns out, Macro Man estimates that the BRICs banks only had to buy around €12 billion EUR/USD in Q3, the lowest level since Q4 2004. So it it seems as if he's complained less about Voldemort and chums over the past few weeks, it's not just because he now benefits from their nefarious market activities. They just haven't been as involved as they were in the recent past.

Q4 is shaping up a a differnt kettle of fish altogether, however; Russia has already bought in excess of $8 billion, reportedly, and Asian CBs, notably India and Singapore, have also been active. Plus ca change, plus c'est la meme chose...

Friday, October 12, 2007

Just one of those days

Yesterday was just one of those days, one of those glorious days that comes around only once or twice a year, when everything comes together. Just about every single position that Macro Man has in his real-job portfolio was making money yesterday, and he had the rare and pleasant sensation of being positively surprised whenever he looked at his P/L. It's once of those days that you wish you could bottle because you feel invincible.

Of course, you're not invincible, and it's important to remember that fact. When Macro Man mentioned to a colleague that he was having "one of those days", the colleague asked him how long he reckoned it could last. "Until I walk out the door," Macro Man replied, "then I'll start losing money."

Little did he know how right he was. For once Macro Man left the office, yesterday's "one of those days" turned into another type of "one of those days", a type that, alas, occurs with much greater frequency than the first kind. The sharp intraday reversal in US equities put a dent in the risk asset lovefest (Macro Man's risk appetite indicator took a tasty plunge away from euphoria levels), but that's not what turned today into "one of those days." Sharp intraday turns are to be expected in high volatility environments, and regular readers will recall that one of Macro Man's core views is that secular volatility is on the rise.

No, what makes today another "one of those days" is the rumour and innuendo surrrounding yesterday's share price swoon and the hysterical overraction across asset markets to tick-by-tick moves in equities.

So far, Macro Man has heard the following explanations, presented in all seriousness, for yesterday's reversal:

1) JP Morgan downgrades, the overvalued Chinese inernet company that has partied like it's 1999

2) JP Morgan itself has a Merrill- or UBS-like turd about to be unveiled

3) Turkey recalls its ambassador to the US as Congress contemplates legislation to call a 90-year-old campaign against Armenians as genocide.

4) Hank Paulson reiterated that America likes a strong dollar. (He also asked Santa for a PlayStation 3 for Christmas.)

5) Belated realization that oil is trading at $80, not $20

Macro Man is almost surprised that there wasn't some mention of the Plunge Protection Team taking profits on the stocks they bought at SPX 1375...

In any case, Macro Man was inundated with tick-by-tick reports on Shanghai shares this morning. Amusingly, they closed more or less unchanged, and on a six-month chart the day's action is pretty indistinguishable:

Despite today's PPI and retail sales data in the US, therefore, Macro Man is fearful that today will be one of those horrible "infinite noise-to-signal" days. Perhaps he'd be better off by closing his Bloomberg terminal and doing research...

Elsewhere, yesterday saw the release of US trade data, as well as Macro Man's new favourite datapoint, import/export prices. Trade was better than expected, and will likely force the Street to mark up its Q3 growth forecasts. Folks, the Fed spends several paragraphs in the minutes talking about foreign growth for a reason: they are expecting the rest of the world to help support the US economy. So far, this is one thing they have got right.

But US import prices from China rose yet again, the eighth straight month that such prices have been flat or higher on the month. Year-on-year import price growth from China is now 1.6%, while the annualized quarterly rise is in excess of 4%! Those claiming that food prices don't matter (a posse that includes the Fed, it must be said) are missing the boat, in Macro Man's view.
One central bank not missing the boat is that of South Africa, which hiked rates another 0.50% yesterday to 10.5%. While the rand is at levels that has previously made the SARB uncomfortable, they hiked rates yestrday and observed that a strong ZAR mitigates the impact of higher food and energy prices.

Contrast that behaviour with the Central Bank of Russia, which this week has stated that a) they don't plan to allow any more rouble appreciation, and b) that they are giving up hope of meeting their inflation target. you think those two facts might be connected? In what is surely an unrelated development, some Russian banks are reportedly running into a spot of bother.

So, too, are banks in erstwhile petro-darling Kazakhstan, where the central bank has spent a quarter of its FX reserves on supporting the tenge and purchased all sorts of turd-like assets. Now the government appears to be set to embark on a prgram that is tantamount to re-nationalizing some Kazakh companies.

Could we finally be on the cusp of sub-optimal policy choices coming home to roost? If so, the world could be set to get a bit more interesting...

Thursday, October 11, 2007

RMB speculation, and what hath Ben wrought?

Another day, another dollar (to be sold.) Macro Man's comment that EUR/USD could conceivably trade towards 1.4575 by month-end is looking slighty less outlandish. Indeed, the buck has already plumbed new depths against the AUD, BRL, and PLN, amongst others, while gold is once again looking perky. After an irritating few days of profit-taking, it's beginning to look as if the dollar-down bubble is inflating once again.

There are exceptions to the rule, of course. While the last two weeks have seen the greenback weaken markedly against most Asian currencies, it's been remarkably stable against the RMB. Part of that was down to last week's Chinese holidays, but there's been virtually no catch-up in the spot rate this week. As discussed on Tuesday, this may be a result of the imminent Party Congress. But having given the matter some thought, Macro Man has devised a couple of alternative theories.

The Bloomberg terminal has a function, WCRS, which allows one to see the performance of a currency against a universe of other currencies over a given time period. Macro Man thought it would be interesting to see how the RMB stacks up against every currency in the known universe year-to-date. He was stunned by the result. Out of 180 (!) currencies in the Bloomberg universe, the RMB ranks 93rd in terms of spot performance this year- and it's basically tied with numbers 91 and 92, the Georgian lari and the Tunisian dinar. So despite a massive current account surplus and huge capital inflows, the RMB is essentially the median performer of all the world's currencies. Could it be that the authorities are targeting a median return? Macro Man asks that only partially with tongue in cheek, as the RMB's lack of appreciation on a global basis is difficult to explain any other way. (In case you're interested, the best performer this year has been the Gambian dalasi, and the worst the Zimbabwe dollar.)

An alternative explanation rests with one of Macro Man's primary beefs with the Chinese currency regime; namely, while they are happy to punt around in other nations' currencies, they damn sure don't want foreigners speculating on their own. The chart below shows the annualized USD/RMB decline priced into 3 month NDFs and the one month change in the actual spot rate. Observe that when the market prices in a faster rate of RMB appreciation (low points on the blue line), the actual pace "magically" appears to decelerate (spikes higher in the red line.) The correlation of the two series in 2007 is -0.18. So it seems that the authorities have maintained the mindset that they'll only permit currency appreciation when the market is not positioned for it. Meanwhile, SAFE happily contributes to the seemingly inexorable rise in the euro. This is why Macro Man favours international mediation from the IMF, or someone else, lest the world economy fall into a broad-based protectionist trap.
Turning back to the Federal Reserve, Macro Man cannot help fixating on that passage from the recently-published minutes of the September 18 FOMC meeting:

"Such a measure should not interfere with an adjustment to more realistic pricing of risk or with the gains and losses that implied for participants in financial markets."

Now, it's certainly Macro Man's impression that the larger-than-expected rate cut has interfered with the re-pricing of risk, but he decided to delve further. Macro Man tracks a financial conditions index similar to that calculated by Goldman Sachs. He recalibrated the index so that it was at 100 the day that the Fed first started tighening rates in June 2004. As the chart below indicates, financial conditions are only a couple of beeps away from 100- in other words, US financial conditions are more or less identical to where they were when the Fed funds rate was at 1.25%!!!! Note how the index has fallen sharply since the last Fed meeting, indicated by the arrow. Over the past month or so, US financial conditions have unwound half of the entire tightening. Is it any wonder that equities are at all-time highs and the dollar is plumbing close to all-time lows against some currencies?

Macro Man also looked at the risk index he tracks...and the story is the same. The index is a normalized scale, with 0 equating to risk neutrality, 1 equating to risk appetite 1 SD above neutral, -1 equating to risk aversion 1 SD above neutral, etc. Note how, despite the rally in equities, Macro Man's index was still hovering comfortably in risk aversion the day before the rate cut (as indicated by the arrow.) As you can see, risk appetite has now climbed to its highest level since the Fed started tightening policy (though nowhere near the heady heights of the equity bubble at its apex.)
What conclusions are we to draw from this? That the Fed don't know what they are doing...or that they don't care? Macro Man isn't sure if it matters; neither one makes him want to hold dollars...or Treasuries either, for that matter. If Mr. Bernanke wants to know why people still call him Helicopter Ben, a glance at these charts will tell the tale. In the meantime, the risk trade remains on, baby, until Ben decides to land his chopper.

Wednesday, October 10, 2007

Time to Relocate Macro Man Towers?

There have been two interesting pieces of financial market news over the past twenty-four hours. The first of these was last night's release of the minutes of the Fed meeting on September 18, which resulted in the 0.50% easing that has subsequently produced the risk-asset lovefest of the past several weeks.

Macro Man's alpha portfolio is positioned short dollars and long US fixed income, via TIPs. His beta portfolio is positioned long equity and long FX carry. So he had every reason to hope for a dovish set of minutes that would propel his profitability to further heights. And while his portfolio has appreciated handsomely over the past twenty-four hours, his interpretation of the minutes was that they showed little sense of urgency to ease policy further.

True, the committee noted that housing was an ongoing concern while inflation was less of a worry. Near-term forecasts were marked down acccordingly, and the decision was taken to cut rates to address this change in circumstance.

Yet the minutes also noted that the FOMC's underlying concern was credit conditions. Since the day before the announcement, conditions have eased noticably, as both spreads and absolute borrowing rates have come lower. Yes, there has not been a complete normalization of conditions in certain markets, notably that for jumbo mortgages. But it seems safe to assume that some of the Fed's concerns have been mitigated by the slow improvement in conditions.

Most other aspects of the minutes, meanwhile, suggested that the rationale for further easing has evaporated.

"household wealth likely was providing a diminishing impetus to the pace of spending, reflecting recent declines in stock market wealth and an apparent further deceleration in house prices." With US equities making all time highs, it seems safe to assume that stock market wealth is now providing a renewed tailwind.

"Such a measure should not interfere with an adjustment to more realistic pricing of risk or with the gains and losses that implied for participants in financial markets." As one of Macro Man's favourite analysts wrote yesterday, "the risk ignored return is back." Indeed, Macro Man's immediate intepretation of the 0.50% rate cut was "damn the torpedoes, full speed ahead" with the risk-asset trade. As anyone short stocks, credit, or carry would tell Ben, the 0.50% easing has interfered with a normalization of risk premia, in a very substantial way. Hell, look at the equity reaction to the minutes themselves!

"Inflation risks could be heightened if the dollar were to continue to depreciate significantly." Evidently Mr. Bernanke needs to eat breakfast at the office more often.

All in, the FOMC exhibited more confidence in the US consumer than Macro Man expected. At the same time, financial conditions have eased further since the FOMC's September announcement. The justifiable market conclusion was to reduce the priced-in likelihood of Fed easing, and that's pretty much exactly what happened.

What's remarkable, though, is how many analyses of the minutes appeared to be coloured by the positions (either literal or intellectual) of the person conducting the analysis. Goldman's US daily, for example, was titled "The hawkish read seems misguided." In a remarkable coincidence, Goldman has been among the most economy-bearish houses on the street, and has looked for the deepest rate cuts. A bond market long of Macro Man's acquaintance was also dismissive of the market interpretation, noting that the Fed marked down its near-term forecasts and stated that they remained worried about the credit environment.

When Macro Man observed that the staff also forecast above-trend growth for 2009, he dismissed this fact as utterly irrelevant. Equally "irrelevant" was the fact that financial market conditions had eased noticably since the meeting.

Perhaps. But this willing dismissal of apparently contrary evidence is a dangeous thing, and suggests to Macro Man that there is the potential for an adverse market reaction should the Fed dampen further hopes of rate cuts. The Treasury market is at an interesting juncture; TYZ7 has broken one uptrend line and is hovering just above a former resistance, now support, line around 108-12. Macro Man will look to sell 100 contracts on a break of 108-10 as a way to play the Fed no-go that might undermine some of his other positions.

The second interesting piece of news was a statement from the Monetary Authority of Singapore, who announced a modest tightening of policy. Singapore's monetary policy is conducted through the exchange rate, with the SGD managed against a nominal FX basket. For the past seveal years, the MAS has pursued a policy of allowing the SGD to appreciate modestly against the NEER basket parity. This has produced a pretty sharp SGD appreciation against one of the major basket consitutents, the USD:

In any case, the MAS announced that they will allow the pace of SGD appreciation against the basket to accelerate. As neither the basket nor the appreciation target are published, the to-the-pip implications are difficult to assess. But with y/y GDP growth of 9.4%, the rationale for the move is pretty obvious. And the general implications are also pretty obvious: the SGD should continue to appreciate steadily against the USD. (As an aside, the desire for tighter policy has also provided a welcome boost to Macro Man's SGD swap position.) If only Singapore could export monetary policy makers to...oh....China?!?!?!
Finally, it's worth noting the potentially colossal mistake that Alistair Darling may be making with the UK budget. While the details and interpretation are still sketchy, Mr. Darling apparently wants to screw non-domiciled foreigners residing in Britain by imposing a £30,000 annual tax on them. For someone like Macro Man, the upshot is that he evidently has the following choices:
a) Becoming 'domiciled', and allowing the UK government to tax his worldwide income- those bits that Uncle Sam doesn't already tax him for, that is
b) Paying an extra £30,000 per year for the privilege of having no vote, waiting in absurdly long passport queues, and getting rained on for eleven and a half months a year
c) buggering off, and telling Mr. Darling where he can stick his tax.
I wonder which one he will choose? The ironic thing is that the tax is being portrayed as a means to raise revenue from "super rich" foreigners, a caste of which Macro Man is sadly not a member. £30,000 is about 5 seconds' worth of income to someone like Roman Abramovich, but is enough to encourage many productive members of UK society to leave for good, taking their income taxes with them.
Macro Man can only hope that the final policy does not conform to his interpretation, else it might be time to think about relocating Macro Man Towers to a more favourable milieu....

Tuesday, October 09, 2007

Welcome to the Jungle

Welcome to the jungle
We got fun 'n' games
We got everything you want
Honey we know the names
We are the people that can find
Whatever you may need
If you got the money honey
We got your disease

-Guns N' Roses, "Welcome To The Jungle"

Macro Man has no idea if Hank Paulson is a Guns N' Roses fan or not. Still, he cannot help but think that the US Treasury Secretary should enter the forthcoming G7 meeting, WWE-style, with lights flashing and "Welcome To The Jungle" blaring out of strategically-placed loudspeakers. Hell, Macro Man would be willing to grow a mullet and fork out $50 to see it happen.

And why, you may ask, should the US Treasury Secretary make such a histrionic entrance to what is normally a fairly staid summit meeting? Because European policymakers have belatedly realized that China is, for lack of a better phrase, taking the piss with their currency policy, and have at last begun to complain about it. "Welcome to the jungle," Mr. Paulson may feel justified in saying, "and welcome to my world."

To be sure, Europe would also like the US to flesh out the "strong dollar" policy which has been the Treasury's mantra for a dozen years, but such hopes are pretty clearly misplaced. The strong dollar policy has been little more than a zombie for the past few years, exhumed from its grave on occasion but with no real sparkle in its eye. Not that that is necessarily a bad thing; with large external deficits and a slowing economy, it 's not terribly difficult to see how a weaker buck might be a boon to both the US economy and the party currently occupying the White House. Of course, if there ends up being an inflation problem (as seen through the lens of the bond market, rather than Joe Sixpack), then a strong dollar might have some utility- as it did in 1995. For now, though, Macro Man interprets the strong dollar policy as favouring a "strong dollar, as long as it doesn't mean that the dollar goes up."

So why has Europe arrived at the "China, quit screwing around" party? Other than the obvious surge in EUR/USD, which has applied pressure to some (though not all) exporters, the trends in trade with China are rather telling. Updating charts that Macro Man first posted a couple of months ago reveals that a milestone was reached in August. Although China's trade surplus with the US continues to grow, the incremental change is pretty small. Both import and, more importantly, export growth have decelerated.

Compare the picture above with China's trade with Europe. Note how the monthly balance continues to rise sharply, and observe the scale on yearly export growth. China's export growth to Europe has grown nearly three times as fast as its export growth to the US! To be sure, European domestic demand has been a bit higher than in the US over the past year (1.9% versus 1.4%, by Macro Man's calculations), but that clearly doesn't explain such a pronounced gap in China's export growth. Regardless, China's surplus with Europe ($15.3 bio) exceeded its surplus with the US ($15.0 bio) for the first time in August. Maybe, just maybe, currencies actually do matter, as Macro Man and Brad Setser have been arguing.Given trends in trade, capital flows, and good-old-fashioned valuation, EUR/RMB should be dropping. While it is not at the all-time highs observed in late 2004, it has been rising steadily for the past two years-even as China's trade surplus with Europe has exploded. At the same time, Voldemort has been buying euros every month as part of its FX reserve strategy. This year, Macro Man figures they've needed to buy €10-15 billion a month just to maintain portfolio benchmarks. Can there really be much doubt that PBOC is the agent responsible for preventing EUR/RMB from falling?

And so Europe has now entered the same jungle occupied by the United States for a number of years now: saddled with an overvalued exchange rate and seeing external deficits with a strategic trading partner ballooning fast. At the same time, the monetary authorities of that partner fully exercise (and, many would argue, abuse) their right of participation in global markets while restricting participation in their domestic currency, bond, and equity markets to a priviliged few. Is it any wonder that Europe is irritated?
Of course, living in the jungle and thriving in the jungle are two different things. And while G7 may call upon China to quit playing around, they possess neither the carrot nor the stick to force China to do so- at least, not a carrot or stick that they are prepared to use. Indeed, it's not difficult to argue that the most important meeting of the month will be the Party Congress of the Chinese Communist Party.
Macro Man isn't sufficiently conversant with the people involved to comment intelligently on likely outcomes and long-term policy ramifications. What he does know, however, is that the run-up to the Congress has seen something of a policy vacuum, with no one really willing to stick their neck out, lest their head get removed in the process. As such, the prospect for meaningful change in the FX regime would appear be higher after the Plenum than has been the case for the past few months.
That having been said, the base case should probably be for no change, or change at the margin. Gradualism has been the hallmark of the CCP's management of the economy, and it would seem reasonable to expect that to continue. The upshot is that FX reserve accumulation is likely to continue, RMB appreciation versus the dollar is likely to remain frustratingly slow, and the RMB very well might continue to decline against the euro.
Welcome to the jungle, Europe. Grab a seat. You might be here awhile.