Macro Man

It's been another nice day for equities, and the S&P 500 is rapidly approaching the critical zone at 1490 - 1500. Amazing as it seems, the S&P has already retraced half of its peak-to-valley trough, which took the better part of six weeks, in a matter of four days.

That, my friends, is a market due for a rest, and the looming resistance area offers an obvious stopping point. Macro Man therefore sells 460 ESZ7 contracts at 1485, which hedges half of his beta plus exposure to equities. A quick dip back down to 1440-1450 is eminently possible, particularly ahead of next week's payroll data, and it would be churlish to pass up the opportunity to hedge.

Q. What is stonger than The Economist cover curse for dollar bears?

A. An Economist dollar cover that they've ripped off from someone else.

Yes, ladies and gents, we have a double whammy potential dollar cover curse this week, as both Der Spiegel and The Economist put the falling dollar on the cover. Amusingly, they both use the same metaphor, that of a plane going down in flames. Note that Der Speigel came out earlier in the week, so the next time an Englishman tells you about the great English wit, ask him why they need to steal ideas from the Germans!
In any case, the dollar on the cover of The Economist traditionally spells the end, if only temporarily, of rallies in EUR/USD. For those who are relatively new to this space, take a walk with Macro Man down memory lane, back to December 2006.....

....December 2004.....

....and February 2004.

At this point, Macro Man is not prepared to say that the buck is going to quit going down, especially given yesterday's open letter calling for a maxi-reval of GCC currencies. By the same token, after a nice run it's not terribly difficult to bank profits on longstanding short dollar exposure.

Macro Man therefore closes EUR/USD at 1.4750 spot, and will bid 109.80 for $15 mio USD/JPY to partially hedge his straddles.

Elsewhere, the risk aversion trade may be slowly morphing, however temporarily, back to a liquidity trade. Yesterday's price action in equities was broadly encouraging....and yet bonds rallied like a banshee. Emerging markets have come roaring back as well. And all of this has happened in a context of broadly poor US macro data!

If it continues, the portfolio should benefit, as Macro Man is long both equities and fixed income. Another day like the last couple, however, and he will probably look to set some hedges and lock down profits. For the meantime, though, he is humming AC/DC under his breath, as the blog portfolio is "back in (the) black" with just the London and New York sessions until month end.

Finally, a milestone of sorts was reached while Macro Man was nursing a modest hangover on the train this morning; fourteen and a half months after he started scribbling his thoughts down in cyber-space, the 100,000th visitor passed through his electronic door. Thanks to all and sundry for reading, and especially to those who thoughtfully pointed out the Economist cover via email or the comments section last night!

Greetings

I wish you all a safe and enjoyable journey to your forthcoming summit meeting next week, and to those residents of the United Arab Emirates I wish you a happy national day this weekend.

Though I would not presume to dictate to you how to run economic policy, I would like to offer a friendly piece of advice on your currency pegs. I write to you from the perspective of a participant in the currency markets, and indeed as someone who has some of the assets that I manage invested in Gulf currencies.

It is quite clear that your peg regime is now suboptimal. I needn't tell you that conditions are completely different now to when your basket pegs were instituted, and that as a result policies which were appropriate in the 1980's and 1990's are now completely wrong for many of your countries.

Simply put, your major export commodity and source of wealth has appreciated to such a tremendous degree that your currencies must appreciate. This can happen in two ways: either the value of your currency must go up against the dollar, or your inflation levels must rise substantially.

While the latter option may seem preferable in the near term, over somewhat longer periods it is much more damaging to your economy and indeed, society. History is replete with angry protests from peasants and workers who cannot afford to feed their families; as far as I am aware, there are no recorded incidents of hotel owners taking to the streets because they've lost a marginal tourist.

All this is probably known to you. What I really wish to bring to your attention is the mechanism of how to adjust your peg regimes. Just about every recent example of a change in currency regime has emphasized gradualism. In recent years, China, Russia, and indeed Kuwait within your own region have changed regimes to what is tantamount to a crawling peg with a slow nominal appreciation against the reference basket.

While it is too soon to judge the efficacy of the strategy for Kuwait, I would suggest to you that the policies have proven to be ineffective in China and Russia. Simply put, the actions required to maintain a slow crawling peg introduce as many if not more distortions to the financial system than not moving the peg at all.

Adjusting a peg, however slowly, is a tacit admission that a currency will move towards its equilibrium value. For the currencies referenced above, as well as the remainder of the GCC, the equilibrium value against the US dollar is far, far away from current levels. By adjusting the peg, however slowly, one encourages a tremendous amount of capital inflow which must be purchased by the monetary authorities to maintain the crawling peg regime. This intervention proves very difficult to sterilize completely, which introduces an even greater inflation threat to the economies in question.

If we consider a simple measure of "excess reserve growth" as the monthly growth in FX reserves in excess of the trade surplus, we observe an interesting phenomenon. In China, after the peg regime was adjusted in July 2005, excess reserve growth slowed for a year or so. However, it has subsequently risen very sharply and indeed, and with it so has inflation.
In Russia, a similar phenomenon has emerged. The rouble was pegged to a USD+EUR basket in February 2005. This initially generated a lower (in Russia's case, more negative) excess reserve growth. However, subsequently excess reserve growth has risen sharply, turning strongly positive this year. At the same time, an eight-year trend of lower inflation has been reversed.

Given that inflation is already a significant problem for some of your countries, I would urge you to look beyond the short term. Yes, a small re-pegging may ease your problems for a few months. In the longer term, however, it will only exacerbate them.

It's been a hard year to reside in quant-land. The ignominy of being the smartest guy in the room and yet underperforming day-traders must gall those financial market participants with more degrees than the Sahara in the summer. Even Macro Man, whose "degree count" is closer to absolute zero than the desert, has seen his relatively simple quant strategies get absolutely butchered this month.

The problem, it appears, is that everyone who is using a model looks at the same things. Goldman Sachs, whose Global Alpha fund is reportedly suffering even more than Macro Man's beta plus portfolio this month, said in August that they'll need to include some more "unique factors" in their model construction. This strikes Macro Man as an eminently sensible suggestion. To help his quant-y friends, and to ensure that Aston Martins stay in the proper hands, he offers herewith some suggestions for unique factors to include in future-generation models. Astute readers should feel free to contribute their own suggestions below.


1) Neptune's moons. Has your 2007 performance left your investors out in the cold? Enlist the aid of the coldest thing in the solar system, Neptune's moon Triton! If the number of Neptune's moons visible from an earthbound telescope is even, go long stocks. If the number is odd, go short stocks. If your telescope is broken, go flat.



2) What book are you reading? If it is non-fiction, that suggests that you are interested in facts and analysis. Construct a bottom-up model that trades primarily from the long side. Are you reading fiction? You are creative and imaginative. Sell a basket of stocks short, contact a friendly journalist, and make up salacious rumours about each. Cover your shorts when you finish the book. If you don't or can't read, trade foreign exchange instead.


3) Flip a coin. An oldie, but a goody.









4) What colour shirt are you wearing today? If it is a primary colour (red, blue, yellow), go short equities. If not a primary colour (everything else), go long.




5) Football. Everyone's kids plays football (i.e. soccer) these days, even in America. If your kids score two or more goals combined this week, go long equities next week. If they score one goal, go flat. If they don't score, go short. If you don't have kids, become a broker- you'll be up all night entertaining clients , but at least you can sleep in at the weekends.




6) Use a dartboard. For those who manage Asian equities, where stocks are typically listed by numbers rather than mnemonics, construct a long/short basket by throwing darts at a dartboard. Not only will this give you an uncorrelated strategy, but the practice you get should enable you take take money off your friends at the pub on Friday night.


7) Use sunspot activity as a variable. Actually, maybe this isn't so unique after all.

8) Use your social network! Find the largest person you know. Ask him what his favourite food is. Go long the commodity used to make that food. Then find the most petite person you know. Go short the commodity used to make their favourite food. Rebalance once a month.





9) Use Mr. Brain! In yesterday's comments section, Macro Man inadvertently noted that he used "mr. brain" to develop the simple VIX model that he had written about. Friend-of-the-blog Charles Butler helpfully found the link above. Macro Man isn't sure what Mr. Brain actually does, but is confident that it can only be of use in constructing financial market trading models.

10) Use realistic transaction cost/correlation assumptions. Yes, it may be more mundane than the previous nine, but on current evidence it might be the most unique of the bunch.

Holmes and Watson would no doubt have been pleased by yesterday's price action, as the caning of the S&P 500 injected yet more risk premium into financial markets. The news flow released before and during yesterday's trading- HSBC taking $45 billion of SIVs on-balance sheet, Goldman downgrading HSBC, Chuck Schumer taking a break from bashing China to bash Countrywide, Citi to shed loads of jobs- did not exactly engender a feeling of warmth and stability in the marketplace, and it showed.

The price action in bonds was stunning, with Treasuries rallying hard across the curve. It smelled of capitulation and/or convexity-type activity (and for Macro Man it was, as he was stopped out of the short TUZ7 position), given the extent of the rally. However, since the US market close it's been sweetness and light, courtesy of the news of ADIA's $7.5 billion capital injection into Citigroup.

The deal is strongly reminiscent to two other deals in Citi's history: Prince Al-aweed's famous share purchase in 1991, and before that Warren Buffett's purchase of Saloman preferred stock in 1987. In each of those prior deals, the terms were pretty advantageous to the buyer, and this time around is no exception; an 11% yield and conversion strikes starting near the current price look like a home run for ADIA. Memo to John Thain: if you want any more cash, Macro Man will be happy to invest on those terms p.a.

However, it's almost certainly premature to hail this as any sort of turning point. The Buffett deal with Solly's, for example, was consummated in September 1987, just a few weeks before the crash. Moreover, if Citi needs to shore up its capital base on those terms, it begs the question of just how bad financial market conditions must be.

Over the past few months, Macro Man has been fairly critical of the Fed's relatively aggressive easing of the funds rate. He stands by that view, believing that the funds rate should be used to address macroeconomic issues. The current situation, by contrast, is a microeconomic problem- the non-functioning of certain credit channels in the economy- that threatens to become macroeconomic if not properly addressed.

Consider, if you will, the ratio of 3 month LIBOR to 2 year not yields (looking at the spread between the two yields similar conclusions.) Under normal circumstances, the ratio of the two will be around 1 or so; higher if the Fed is restrictive, lower if the Fed is accomodative. Since 1986 the average ratio has been 0.94, reflecting that the Fed has, in aggregate, eased policy over the last 22 years. The ratio is currently 1.63, higher than in August and much higher than any other period since the BBA began publishing LIBOR fixings.
This is a direct reflection of the non-functioning money markets and reveals the degree to which market liquidity conditions have tightened. It is unsurprising, therefore, that equities and other risk assets (including erstwhile bulletproof EM darlings like Brazil) have come under the cosh recently.

Now perhaps the Fed wants this kind of tightening of conditions, but given the lip service that they've paid to "the proper functioning of the financial system", it would appear not. So these conditions, based on what the Fed has told us, merit a response. Per the above, Macro Man believe the solution should be microeconomic rather than macroeconomic, via aggressive open market operations from the New York Fed, providing the system with as much cheap funding as it needs to restore confidence and normalcy.

And while the NY Fed did announce a term repo yesterday that will extend over the turn of the year, it was almost worse than nothing. An $8 billion repo is a drop in the bucket compared to the demand for funds, and perhaps suggests that the Fed does not understand the true scale of the problem. And if that's the case, things will likely get worse before they get better. For starters, the Fed may want to add another zero to their term repo volumes should they wish to assuage market fears of an implosion of the banking system.

What seems clear is that Treasuries have rallied to the degree that even non-profit maximizers cannot be persuaded to buy them if they have a choice. The Fed's custody holdings of Treasuries for foreign CBs have begun to fall, mcuh as they did in August, even as Agency holdings continue to build up. August's trend was ultimately reversed by the discount rate cut and subsequent follow through; will the Fed act this time around?

If they do, then equities could be in for a nice bounce. Last week Macro Man observed that VIX had failed to make a new high even as the S&P 500 made a new low, and mused whether that was a buying signal. Ex-post, the answer was pretty clearly "no." But Macro Man went a bit further and conducted a simple study to measure the efficacy of a VIX divergence strategy. If, on a given trading day, the SPX closes at its lowest level of the past 25 days but VIX does not close at its high of the past 25 days, the system flashes a buy signal. The market is then bought at the following day's open and sold at the close 5 days after the signal is generated.

Over time, this simple 'divergence play' model does seem to produce profits. The return curve of the strategy is laid out in the chart below, going back to 1990. The hit ratio of the strategy is 59%, with an average winner of 2.2% and an average loser of 1.9%

The strategy is far from perfect, and there have been periods of significant drawdown. Nevertheless, it's not bad for a couple hours' work...and suggests that if the Fed does realize that it's time to act, then equities could fly, if only temporarily.

If, on the other hand, the Fed remains focused on the macro at the expense of the micro...then Macro Man will need to lay even more hedges on his long equity beta plus portfolio.

We left Holmes on Friday contemplating the curious case of the vanishing bid for risky assets. We pick up the story the following morning....

The next day dawned gray and cold, but at least the storm had passed. I was surprised to see Sherlock Holmes, normally a late riser, at the breakfast table before me. He was clad in an outlandish uniform that resembled nothing so much as the outfit worn by a professional golfer, except for the blazer worn over the shirt and V-necked sweater.

“Good lord, Holmes!” I exclaimed. “I didn’t expect to see you up at this time of day, and still less dressed like Charles Danforth Ogden!”

“Now, now, Watson,” replied Holmes, “how am I to find out what is ailing Ogden’s hedge fund if I don’t look the part myself? I’m off to a series of bank-sponsored investor roundtables. Perhaps I’ll discover what’s happened to the bid there. Here,” he added, passing a card to me over the table, “brother Mycroft knocked these up for me last night after you went to bed. What do you think?”

The business card, which featured the small likeness of a deerstalker in the upper left-hand corner, read:
“Moriarty Capital Management?” I inquired, raising an eyebrow at Holmes.

“Ah, now, Watson, just a little jest at the expense of an old adversary. Right, I must be off now. It wouldn’t do to be late for my first meeting.” And with that he strapped an unfeasibly large watch onto his wrist and strode out the door purposefully.

I was busy with my medical practice all day and didn’t see Holmes again until it was nearly time for dinner. At a quarter past seven he strode in the door with a weary mien. At my inquiring look he raised a solitary finger, murmured “All in good time,” and disappeared into a back room.

For the next few hours a fug of tobacco smoke and the sound of Saint-Saens on the violin were all that escaped from Holmes’ room. At last, Holmes emerged, a satisfied half-smile upon his face. When I attempted to question him on the case, he demurred with a wave of his hand. “Tomorrow, Watson, tomorrow. It’s been a rather long day and I haven’t the energy to discuss the particulars this evening. However, with a good night’s sleep and one of Mrs. Hudson’s breakfasts in my belly, I’ll feel ready to share the fruits of my enquiries with you and friend Ogden.

The next morning, Holmes awoke at his usual hour and clad himself in more fitting attire. However, he was no more forthcoming on the subject of Ogden’s case than he’d been the previous evening, squirreling himself away for most of the day to work on his latest monograph, which identified the seventy-six separate circumstances in which one might successfully challenge a citation from a City of Westminster parking warden.

As dinnertime approached, the front bell once again announced the presence of a visitor. At this, Holmes sprang from his room with surprising alacrity. “And now, Watson,” he cried, “your patience shall be rewarded!” When Charles Danforth Ogden entered the room, my friend gestured eagerly towards a chair. “Sit, sit, Mr. Ogden! I must thank you, sir, for a presenting me with a most stimulating case!”

“So have you cracked it then?” asked Ogden, a hopeful look upon his face. “Have you found the vanished bid? When will it return?”

“Not so fast, my friend. Allow me to explain my methods before sharing my conclusions.”

“Very well.”

“It was clear to me from the outset, Mr. Ogden, that the research piece upon which you had pinned your hopes was merely a red herring. That it worked for as long as a month is, quite frankly, a surprise."

“But...”

“While I am not a professional investor, this nevertheless allows me a welcome degree of detachment when observing the behaviours of yourself and people like you. Any clear-thinking person of reasonable intelligence could see that ‘buy stocks no matter what’ is a recipe for disaster, the triumph of hope over reason.”

“But...”

“Allow me to finish, I beg you. Yes, it’s true that, broadly speaking, the world remains awash with liquidity, and that all else being equal this should underpin risky assets. However, it seems quite clear that all else is not equal at the moment. Developed economies are slowing while food and energy prices are rising all over the world. The implication is that conditions which may have produced a stellar rally in risky assets six months ago will not necessarily do so now.

“I sat in on a number of investor roundtables today, including one, Mr. Ogden, that you were at, hosted by BigI-Bank.”

“What?” gasped Ogden. “But..but...I didn’t see you there!”

“Ah, Mr. Ogden, you were not meant to. I was travelling incognito, as it were. But shall I tell you what I discovered at my roundtables?”

“By all means, Mr. Holmes.”

“Very well. At a credit roundtable this morning, I found a very grave concern that the securitization process, as it has been conducted over the past few years, is very significantly impaired- perhaps permanently. The implication, Mr. Ogden, is that the supply of credit is likely to be more restricted in the future than it has been in the past. And what this means, sir, is that the credit cycle has decisively turned for the decade, and that spreads should trend wider moving forwards.

“Here,” he said, handing a piece of paper to Charles Danforth Ogden. “You see here a simplistic representation of what I refer to. Ten year swap spreads in the US have begun to widen...but history suggests that we are fairly early in the process, both in terms of magnitude and time.”

“But does this mean that the US economy is moving to recession?” asked Ogden.

“Eventually....yes,” replied Holmes. “And Inspector Lestrade of the Yard would probably tell you that we’re already there. But look closely, Mr. Ogden. The last two recessions didn’t begin until after swap spreads had already peaked- it takes time for tighter credit to arrest the economy’s growth. So I’d suggest to you, sir, that recession is more likely for 2009 or 2010 than it is for 2008.

“I then went to a government bond roundtable, which generated a rather interesting discussion about equilibrium rates, inflation, and what is priced into markets. Particular attention was paid to what a 2.5% trend rate of growth in the US might mean. Some participants argued that this downward revision to trend growth has lowered equilibrium nominal interest rates; however, I found much more persuasive the argument that it has actually raised equilibrium real interest rates, given the lower threshold for a growth/inflation trade-off.

“The question was then raised as to why the bond market is ignoring inflation. In my guise as a hedge fund manager, I suggested that the market is not ignoring inflation, but balancing inflation concerns with both recession worries and, in the context of the disappearing equity bid, capital preservation considerations. Unlike prior bond market rallies this year, TIPS are actually outperforming nominal Treasuries; 10 year breakevens are about 10 bps wider since the recent peak in nominal yields. Moreover, the curve has steepened sharply in this move; a wider term premium is exactly what you’d expect from a market concerned about inflation.”

“But Mr. Holmes,” said Ogden, staring intently at the second chart that Holmes had given him, “it looks to me that the last two times the curve has started to meaningfully steepen, the economy was pretty much already in recession.”

“Well spotted, Mr. Ogden, bravo! That’s one reason why I suggest that a recession is more likely for 2009-10 than next year; nothing is certain in this particular line of enquiry and I could of course be mistaken. But I suggest to you, sir, that the inflationary dynamic across the globe is considerably different now than it was in 1990 or 2000, which is why the curve is steepening earlier in the cycle: not only because of growth, but because of a secular change in the direction of inflation pressure.

“Next I went to a currency roundtable. There were a few interesting things to emerge there. The first was a general feeling that, from a medium term perspective, investors are not adequately compensated to finance the US current account deficit, shrinking though it may be; therefore, the dollar is falling. That, at least, must be known to you already. What was curious, though, was the sense that currency markets may be reaching in important inflection point. The carry trade, for example, which I believe you mentioned is in your portfolio, Mr. Ogden...?

“Yes, it is, Mr. Holmes.”

“Yes, well, the carry trade can be expected to work very well indeed during ‘Goldilocks’ periods, wherein growth is reasonably strong and inflation reasonably low. However, both points on the Goldilocks axis are moving in the wrong direction: growth is slowing and inflation is rising. This naturally begets volatility, which makes the carry trade inherently less attractive. If one takes a yen trade-weighted index as a sort of inverse measure of currency market risk appetite, one can see that after falling in more or less a straight line for the past several years, the yen has started to rise recently. As pure carry considerations become de-emphasized, perhaps markets may choose to focus on antiquated metrics such as ‘value’ and the like.

“And of course, sir, the very liquidity which has supported risky assets can ultimately sow the seeds of its own destruction. Consider that a major supplier of liquidity to global markets has been the currency policies of FX reserve accumulators. But look about you now, sir. China has its highest inflation rate since 1996. Taiwan has its highest since 1994. Singapore has its highest since 1991! And of course, the Persian Gulf countries are all experiencing uncomfortably high levels of inflation. All of these countries need tighter policy, which suggests, Mr. Ogden, that global liquidity conditions are likely to be less accommodative in the future than in the past. This should naturally beget a more selective attitude towards risky assets and increase volatility.

“And finally, sir, this afternoon I came from an equity roundtable, where I sat next to you in my guise as a portfolio manager at Moriarty Capital Management.”

Charles Danforth Ogden’s jaw dropped and he gazed at Holmes in amazement. “That was you?”

“It was indeed, sir. In my line of work the ability to appear as what you are not proves useful on occasion. And as you no doubt recall, we discussed a range of topics. Earnings expectations for next year are being marked down; however, the increased uncertainty over those forecasts has meant that, for the time being, index multiples have not expanded at the same time. More fundamentally, a greater degree of macroeconomic volatility may well beget lower multiples on a trend basis in the future than we’ve observed in the past.

“Of course, while credit market disruptions remain significant, the near-term prospect for buybacks has also waned, taking a large, relatively price-insensitive buyer out of the equation as well. The combination of weakening fundamentals, less visibility, and greater macroeconomic volatility are all a recipe for higher equity volatility...which as you know is what we have seen recently.”
“Oh no!” cried Ogden. “From what you say, Mr. Holmes, it sounds like the bid has gone forever! But still....you haven’t told me who is responsible for this catastrophe?”

“Now, now Mr. Ogden,” Holmes replied, a gentle smile on his face, “it’s not quite so bad as that. I don’t think it’s fair to say that ‘the bid has vanished forever’ or draw the conclusion that it is impossible to make money in risk assets. However,” he continued, leaning forward and looking earnestly at Ogden, “it may be the case that for this market cycle, the price-insensitive bid has indeed gone missing. What it means, Mr. Ogden, is that you will have to be more selective in your investments: do your homework, so to speak, be aware of what it is you are buying, who has bought with you, and how large the exit door might be should you all wish to sell at once.”

“But Mr. Holmes...you still haven’t told me who or what is causing all of this!”

“Ah, Mr. Ogden, you’ve still not figured out what’s happened? I’m sorry to tell you, sir, that there is no Moriarty at work, no individual or cabal whose apprehension can restore things to their 2003-2006 norms. Lestrade might tell you it’s the US housing market...but he’d be mistaken. How about you, Watson?” Holmes turned to me for the first time since he began his explanation. “Have you deduced the identity of the culprit?”

“It’s tempting to blame Voldemort or another distorter of market prices, Holmes...” I could detect the slightest trace of a grimace on my friend’s features. “...but somehow I think not. It looks to me like it’s the ineluctable return of...of...a financial market risk premium. The bid is still there, but for the time being it’s buying options, not assets.”

“BRAVO, WATSON!” cried Holmes, leaping to his feet and slapping me heartily on the back. “Spot on! We’ll make a detective of you yet!” This was perhaps the warmest compliment that my friend had ever paid me, and I confess to feeling a bit choked up at finally having fulfilled his expectations for me.

“The answer, Mr. Ogden, is simply that the free lunch is no longer free...at least for this market cycle. Buying the dip across risk assets mechanistically is likely to prove unsuccessful, sir, because undoubtedly some of them are dipping for a reason. Consider that wider credit spreads, steeper yield curves, a lower dollar, higher yen, and higher implied volatility are all symptomatic of rising risk premia. It would seem reasonable, sir, for each of these trends to continue, in one way or another, throughout the next year or so.

“I would suggest to you that the high, almost mindless correlations between risk assets will ultimately break down. We are moving into an environment where the cream will rise to the top, an environment where relative value trades may offer a higher risk adjusted-return than simple directional strategies, an environment where option volatility, rather than risk assets, is the ‘mindless’ buy on dips. In other words, Mr. Ogden, you’ll be required to buy that which is good and sell or avoid that which is bad, rather than merely buying everything.”

“But Mr. Holmes!” cried Charles Danforth Ogden, a tear in his eye, “we’re not a relative value shop! We are equipped to make money in a low-vol world, not a high-volatility world!”

“Then, Mr. Ogden,” replied Holmes as kindly as he could, “I suggest that you shutter your doors and pursue another line of work. I’d be happy to write you a reference to any of the banks I visited today. Perhaps once they’ve finally written off all of their subprime exposure, they’ll be in the market for a sales guy or an analyst. I can easily put your name forward.

“In the meantime, should you need of a bit of cash, I’m sure you and Watson here could come to some arrangement on that Ferrari F430 that I saw you drive up in.”

Charles Danforth Ogden shook his head mutely, and slouched out of our Baker Street rooms. We heard a few months later that his fund had closed, unable to meet a wave of redemptions at the end of the calendar year.

“Well, Watson,” said Holmes after the door had closed behind Ogden, “we can only hope that our pensions are being managed by people more astute than friend Ogden. And now,” he added, reaching for pipe and violin, “how about some Mendelssohn?”

A late November tempest howled outside in the London night, and the gale rattled the room’s ancient windows, disturbing what had heretofore been a pleasant evening’s reading. Still, the chamber was warm and snug, and a comforting safe haven against the late autumn storm.

“You’re right, Watson,” said the voice of Mr. Sherlock Holmes, disturbing me from my reverie, “it’s a good thing we took out that price guarantee from British Energy.”

“My word, Holmes!” I exclaimed, leaping from my chair. “How the deuce did you know I was contemplating that very thing?”

“Tut, tut, Watson,” came the gently mocking reply from my friend. “Nothing could be easier. I observe that you’ve been perusing the markets section of the Financial Times, doubtless to check on the progress of that South African issue you purchased a few months back. I can see from here that you had turned to the commodity section, where you’ve no doubt read that energy prices are, yet again, threatening to breach all time highs.

“The requirement for adequate heating is painfully obvious on an evening such as this,” he added, glancing ruefully out the window, “as the ferocity of the storm outside cannot elude even your powers of observation. Indeed, I saw you stare outside this very window not five minutes ago, and the disgusted shake of your head told me that you were not pleased with what you saw. When you then glanced at the thermostat immediately thereafter, I surmised that you must be ruminating on the likely rise in heating bills over the next few months, and the serendipity of our having chosen to lock in what I’m sure you’ll agree is a competitive rate. I merely agreed with your rather excellent deduction.”

“Extraordinary, Holmes! When you describe it like that, it all seems so simple. And yet no one but you manages to see what, when you explain it afterwards, would appear to be the most obvious thing in the world.”

“Most of my observations are obvious, Watson, for those who are prepared to see rather than merely look. Unfortunately, many of my colleagues, such as the well-meaning but hopelessly bumbling Lestrade, are only prepared to look for those facts which appear to support their prior beliefs. I, on the other hand, keep an open mind and thus am able to see what others often miss."

It was a measure of the esteem in which I held my friend Sherlock Holmes that I didn’t raise an eyebrow at his description of the Chief Inspector of Scotland Yard as “hopelessly bumbling.”

“And what I see this evening,” he continued, “is a night best-suited to a comfortable chair, a good book, a pipe full of tobacco, and perhaps a passage or two of Mendelssohn upon the violin.”

As if to prove that even the ablest of sleuths can miss his mark on occasion, the bell at the door of 221B Baker Street rang vigorously just as Holmes reached for his violin, announcing the presence of a visitor who no doubt required the services of my illustrious friend.

“Ah, Watson,” remarked Holmes, shaking his head with a wry grin, “I was mistaken. For unless my powers of observation have departed me altogether, we shall have a more stimulating pursuit this evening, courtesy of this gentleman here, Mr....?”

Our visitor strode into the room through the door opened by Mrs. Hudson, but was taken aback to see us both looking at him expectantly. After gathering himself for a moment, he then resumed his forward progress and seized Holmes by the hand. “Charles Danforth Ogden, Mr. Holmes, Charles Danforth Ogden. It’s a pleasure to meet you, sir, but you must help me!”

Mr. Charles Danforth Ogden was a youngish man in his mid-thirties, dressed in crisply pressed chinos, a dark blue jumper over a collared white shirt, and dark blue raincoat, from which he shook the water unconsciously as he stood before us. Although his visage retained a certain boyish aspect, he nevertheless carried himself in the manner of a man who is accustomed to having his orders carried out by others.

“Well, Mr. Ogden, what can I do for you? Is there a problem with your fund that you wish me to help you with?”

“Yes, Mr. Holmes, yes, it’s all gone horribly wrong and I can’t figure out why!” our guest exclaimed, before gaping at Holmes. “But...but...how did you know I was a hedge fund manager?”

“Please, Mr. Ogden, you insult me. If I couldn’t spot a hedge fund manager (what with your business casual attire, Rolex, and expensive jacket) from a mile away, I wouldn’t be much of a detective, would I?”

“Ah ah, Mr. Holmes, I see you’re right. Very clever!” Charles Danforth Ogden then straightened up and assumed an air of authority. “Yes, well, I am the founding principal and Chief Investment Officer of the C/D/O Enhanced Multi-Strategy Fund, a diversified hedge fund that seeks to generate stable returns for our investors with moderate volatility and low drawdowns.”

“Yes, yes,” said Holmes, “I’m not a fund-of-funds manager so you can spare us the marketing spiel. Please proceed to describing your problem; the sooner tell us your story, the sooner we can be of service to you.”

Ogden glanced at me uneasily. “Perhaps it would be best if we got you and your friend to sign a non-disclosure agreement. If investors found out....”

“Now really, sir,” burst out Holmes, angrily. “Dr. Watson is my friend and colleague, and you can trust him as you trust me. And if you do not trust me to keep my lip buttoned, then I’ll wish you goodnight and ask you to leave, for I had rather planned to treat Watson to a spot of Mendelssohn.”

Ogden’s shoulders slumped at this rebuke. “I’m sorry, Mr. Holmes,” he said. “I’m just so worried about my fund that I’m not sleeping or thinking straight.” His body crashed into the chair that Holmes gestured him towards. “Here’s the story.

“Our fund has been running for a year and a half. For the first year or so things went swimmingly, with steady monthly returns and a nice growth in assets. Early in the summer, though, we ran into a bit of a bother, as some of our holdings appeared to decline in value; however, they don’t really trade so it was difficult to know exactly what sort of hit we were taking.

“In August things got quite bad, really, with credit imploding and funding rates blowing out. Some of the fund-of-funds investors that we picked up in May and June told us that if we didn’t make money in September, they’d pull their assets.

“Naturally, this was a stressful time for us, and we felt a bit adrift. However, one of my trusted brokers sent us a research piece that seemed to show the way to recouping our losses. Here, here it is.” Ogden’s hand dipped into his jacket pocket and emerged clutching a rumpled sheet of paper, which he handed to Holmes.

Looking over my friend’s shoulder, I read the following pearl of financial market wisdom:

To: charles@cdofunds.com

From: johnny.wideboy@bigi-bank.com

Date: August 31, 2007

Subject: How to make money in equities

Cheat sheet: reacting to data and market releases

1) weak data = Fed ease, stocks rally

2) consensus data = lower volatility, stocks rally

3) strong data = economy strengthening, stocks rally

4) bank loses $4bln = bad news out of the way, stocks rally

5) oil spikes = great for energy companies, stocks rally

6) oil drops = great for the consumer, stocks rally

7) dollar plunges = great for multinationals, stocks rally

8) dollar spikes = lowers inflation, stocks rally

9) inflation spikes = will inflate all assets, stocks rally

10) inflation drops = improves earnings quality, stocks rally

“We were a bit desperate for returns, and this research seemed more insightful than the usual rubbish coming out of investment banks. So in early September we went limit long the S&P, AUD/JPY, EEM, and the Hang Seng. By mid September it was working so well that we figured credit was going to tighten back in hard, so we bought some of the A-rated tranche of the latest ABX index. When the Fed cut 50 basis points on September 18, it was like we’d won the lottery. Stocks moved so far, so fast that by the end of the month we’d made a new high water mark for the fund and were mentally spending our performance fees.

“Sure, the credit trade wasn’t working so well, but we were making so much money in equities that it didn’t matter. We had Fed liquidity supporting the S&P and the carry trade, and de-coupling plus Chinese investment buoying EEM and the Hang Seng. It was bid, no-lid, and we were making money hand over fist.

“But by the time mid-October rolled around, things had cooled off. Our ABX position was sinking like a stone, most of our structured credit holdings had actually been downgraded, the yen quit going down, and then even some of our equity longs started to retreat. EEM and the Hang Seng were the only things keeping our P/L afloat.

“I tried getting ahold of Johnny Wideboy, the analyst who’d made us so much money with that research piece. But my contacts at BigI-Bank said that he’d been made redundant following a $12 billion subprime writedown.

“And now every bit of our portfolio is falling in value, even the emerging market equity position! Mr. Holmes, it’s doing my head in! Our fund-of-funds investors are once again ringing up and threatening to pull their assets unless we right the ship quickly. So I ask you, Mr. Holmes, to tell me: what happened to the bid? Why has it vanished, and when will it come back?”
Sherlock Holmes sat back in his chair and stared earnestly at our visitor. “I must tell you, Mr. Ogden, that this is not my area of expertise. Watson here spends more time reading the financial pages than I.” Charles Danforth Ogden looked crestfallen. “Nevertheless, I will look into the matter. I shall ring you at the number on your card when I have reached a satisfactory conclusion.”

Ogden sprang from his chair and shook Holmes warmly by the hand. “Oh thank you sir, thank you very much! I’m at my wits’ end, and if I don’t discover where the bid has gone to, my fund is finished for sure!” And with that, he turned on his heel and strode out the door, leaving Holmes stroking his chin thoughtfully. Sensing that my friend was entering one of those contemplative reveries that so often yielded fruits of progress, I returned to my pipe and my newspaper. Not a word was spoken in our Baker Street rooms for the rest of the evening.

Will Holmes get to the bottom of the mystery?

Why has the bid for risk assets vanished, and when will it come back?

To be continued.....

Before Macro Man (an expatriated Yank) settles into a day of heavy food consumption and late-afternoon NFL, it's time to count his blessings and be thankful for the following:

1) That he works in an industry that allows him to indulge his intellectual curiosity and competitive instinct while providing a handy method of keeping score (the P/L.)

2) That his real-world portfolio has been empty of CDOs and all manner of structured credit turds.

3) In a similar vein, that he doesn't have to rely on third-party agencies to do his analysis for him.

4) As a UK resident, that he is paid in sterling rather than dollars!

5) To have gotten Q3 and, to date, Q4 right, investment-wise. In future years the second half of 2007 will join October 1987 and August-October 1998 in the pantheon of stress-test environments.

6) That Mrs. Macro, the Macro boys, and he himself are healthy and happy.

7) That he's kept the TIPS position all year. A total return of 11% for a bond-holding in a little more than ten months ain't bad!

8) That he had the foresight or luck (or perhaps a combination of the two) to change his mind on the yen and hedge near the highs in USD/JPY.

9) That he does not have to manage the England football team.

10) That, contrary to all expectations, this space has attracted a modest following and, gratifyingly, reasoned, intelligent commentary from other market participants and observers. Thanks to all who read and share their thoughts.

While one might normally expect Thanksgiving week to be a relatively quiet one, nothing could be further from the case this year. Market participants may not be having a whole lot of fun (then agin, if they've been on the right side of some of these moves, maybe they have), but at the very least they've been kept on their toes. A month or so ago, there was an amusing email the wended its way around the world, with the punchline being that no matter what happens, the stock market goes up. Those days seem like ancient history now...

The big news overnight was the release of the minutes of the Fed's Halloween meeting, complete with an impressive annex detailing their economic forecasts. What immediately struck Macro Man was the relatively downbeat tone of the contemporaneous commentary. The text is replete with "yeah, but" qualifiers and references to downside risks. It's quite a stark contrast to the defiant comments coming from the recent speakers, which reinforces Macro Man's view that the hawkish remarks are an attempt to try and wean the market off of trying to dictate policy to the Fed.

If so, then the campaign ain't working; not only are markets pricing in a virtual certainty of an easing at next month's meeting, but sundry talking (or is that writing?) heads at Realmoney.com last night were calling for an immediate inter-meeting rate cut. Given that the S&P 500 is still up year-on-year, Macro Man does have some sympathy for the Fed in resisting the demands of beleaguered equity managers.

Less deserving of sympathy was the Fed's forecast profile, which included the proviso that all forecasts were based on the assumption of appropriate conduct of Fed monetary policy. These, then, are the outcomes that the Fed expects if and as it does the right thing. It's basically the Fed saying "trust us, we're experts." Righhhtttt.....

A couple of interesting nuggets can be gleaned from the forecast profile nonetheless. The first is that the Fed is relying on commodity prices to quit going up. The central tendency for core PCE over the next few years is centered on 1.75%, which more or less confirms that that, rather than 1.5%, is the Fed's implicit price target. However, the central tendency for headline PCE is only 0.1%-0.2% above core.

This despite the fact that the headline PCE deflator has, on average, been 0.5% higher than core over the past three years. Unsurprisingly, the year-on-year discrepancy between the headline and core measures can be explained by commodity prices. So in forecasting virtually no difference between headline and core PCE, the Fed is taking the view that commodity prices will flatline. In a world where demand growth for energy and food continues to outstrip supply growth, feel free to judge for yourself where the risks to the Fed's forecasts lie.
The relatively benign inflation forecasts are all the more remarkable given the apparent further downgrade to the Fed's estimate of trend GDP growth in the US. The chart below lays out the Fed's forecasts for real GDP growth and unemployment. What's interesting to see is that the mode in both 2009 and 2010 is around 2.5% real GDP growth with a flatlining unemployment rate. From this we can distill that the FOMC sees real growth of roughly 2.5% as around trend.

source: Federal Reserve

Whether the rest of the week proves to be a holiday, or merely a turkey, of course remains to be seen. But liqudity is atrocious and erstwhile favourites (FX carry, Hong Kong equities, the KRW) are getting ejected from portfolios. Per yesterday's post, fear is pretty clearly trumping greed at the moment, which may ultimately deliver some opportunities for tactical risk trades. However, we may have to let things go a bit further first. Trust me.....I'm an expert.

There's a well-worn market cliche that economic agents are driven by fear and greed, and in particularly difficult conditions they seem to straddle the divide between the two. Indeed, the overlap between fear and greed is one of the primary drivers of market volatility, wherein investors find themselves navigating an emotional minefield and, more often than not, doing the wrong thing.

Macro Man now finds himself in the uncomfortable position of having one foot in each camp. As he looks around, he sees several apparent mispricings which might generate some tasty alpha. At the same time, he has to acknowledge that the fundamental picture as he sees it has deteriorated; disposable income and aggregate net wealth are much more important in determining his worldview than house prices, for example, and the outlook for neither is particularly pleasant at the moment.

Moreover, financial market prices are also determined by the collective result of the fear/greed equation, and in times of severe distress notions of "value" and "ought to" go out the window. The following is a brief, non-exhaustive sampling of some of the issues that Macro Man is grappling with at the moment:

1) VIX suggesting equity sell-off is overdone? Macro Man was quite surprised to see that his favoured indicator of risk aversion barely moved yesterday, despite the sharp sell-off in the S&P 500. The reason is that despite the new recent low in stock prices, the VIX is well off its recent highs, and indeed barely rose yesterday (see below.) Such a divergence, which may suggest that the street has been layering option hedges even as Macro Man's have rolled off, would ordinarily suggest that a near-term bottom is in sight. A similiar phenomenon can be seen in EUR/USD, which, unlike in August, has plowed higher despite weaker stock prices/higher VIX. Indeed, even USD/CHF has finally made a new all time low today. All this would normally make Macro Man relatively comfortable with his new long equity market posture (following the recent option expiry)....and yet...and yet:

2) The credit market is still buggered, and there's still no bid for assets of questionable quality. ABX continues to plummet, including the "high quality" tranches, to a degree that suggests that bidders have completely stepped away from the market. Meanwhile, Northern Rock, which could be considered an equity version of structured credit, is rapidly approaching the price target that Macro Man set two months ago.

The problem with the Rock, summarized here, is that it's unclear who has the authority to dispose of it, and in any case such potential buyers as actually exist simply wish to cherry-pick the less odious aspects of the franchise. So in a very real sense, Northern Rock is a barometer for credit conditions generally: it is a deeply flawed asset, the ownership structure of which is opaque, that in certain aspects appears to have some intrinsic value but in others very little at all. Perhaps we need to see this sucker go bust in one fashion or an other in order to mark a near-term low in sentiment? In that case, there's more bad news ahead- another lender, Paragon, has admitted significant distress just this morning.

Well, recent stock price declines, if sustained, would surely push gains in aggregate net worth closer to zero. And that also has implications for consumption. While inventories currently look fairly healthy, a disappointing Christmas retail season could change that pretty quickly. And recent earnings disappointments from retail are also not encouraging.

Last night I had the strangest dream. I was back in 2007, worrying about things that seemed so significant then but now seem like the slightest of trifles. Remember 2007? That was the last year that we went skiing in France, the last year that we could actually afford to go to Courchevel. Hard to believe that it was more than three years ago; it seems like it was only yesterday.


Remember what they told us when the dollar went to hell? About how it was actually a blessing in disguise, how American companies were going to be able to sell into markets where they’d never done so before? About how it was going to safeguard American jobs, how jobs would be coming home from China and India?

Man, these politicians never tell the truth, do they? (As an aside, do you think the Congress will really try to repeat history and impeach President Clinton for perjury?) I’m not sure what’s worse: that they didn’t tell us that gas prices were going to $5/gallon by the end of the decade....or that they didn’t know.

Anyhow, that Chevy Dreadnought 4x4 that I had just became too expensive to drive, even though it was a hybrid. I loved that car, and the day that I sold it was one of the worst of my life. I guess now I know how my Dad felt when he had to sell the Eldorado back in ’79. There’s one thing for sure, though, and that’s that the kids know how I felt waiting in line for an hour in the back of my mother’s car at the gas station back in the 70’s.

It’s been a couple of years, but as I remember it the dollar was finally let go in the first half of 2008. I seem to recall that the stock market did OK, since everyone talked about how great the foreign profits were going to be. Really, it wasn’t until Hurricane Patrick hit in September ’08 that things started to get really bad.

That’s when gas went from $4 to $5 and the economy went into recession. They’ve been saying for a year that things are getting better. Me, I don’t know. I mean, a guy like me can always find work, always take care of me and mine. But I’ve got plenty of buddies who are still worse off than they were in 2007, even those that have managed to find work again.

Back then you could afford just about anything you wanted, and borrow to buy if you didn’t have enough scratch in the bank. Hmmph, banks. Maybe the only good thing about the last few years is that at least there are fewer banks these days, fewer of these Wall Street jerks and their fancy Italian sports cars. Plenty of good people got ripped off on their mortgages by those guys, so it’s good to know that what goes around comes around, eh?

Anyhow, where was I? Oh yeah, the recession. So the dollar tanked after China and the Middle East quit pegging to it. They made a big deal about it on the news, but things seemed to muddle through OK until the hurricane. After that, everything went kaput. Sure, the Fed cut interest rates, and I mean hard, to try and support the economy.

For some reason, it didn’t seem to work. That bearded guy in charge kept talking about ‘no traction’, like he was driving a car with bald tires or something. I’m not really sure what he was talking about, to be honest. What I do know, though, is that the dollar kept falling...and eventually, so did the stock market. What didn’t fall, though, was the cost of living and the cost of borrowing.

I’m not an economist, so I don’t really understand these things. Maybe you can explain them to me. After the dollar peg broke, the cost of everything imported went up. By a lot. In the paper they said something about “firms protecting margins” or something like that. Anyhow, we all figured that if the cost of buying stuff from China rose, we’d just make it here in the good old USA. Funny enough, though, it hasn’t happened. I just can’t figure it out.

Anyhow, inflation just kept rising and rising, and it made it more or more difficult to maintain a good standard of living. Sure, we got a bit of a raise every year, but with a recession on you have to be careful not to push The Man’s buttons too much. Still, I seem to remember 5% raises being a good thing, not meaning that every Thursday before payday is Spam Night.

In the good old days, we would have just maxed out the credit cards or taken out a home equity loan. But Jesus, have you seen the rates they’re charging these days? It’s 30% now on my credit card, and it’s not worth mortgaging what little equity I have left in the house at 12% rates. I dunno, maybe that’s what that bearded fella meant about “no traction”. The news kept saying that he was cutting interest rates, but all I know is that every time that I look at borrowing, the rate goes up, up, up.

And the damnedest thing is that the jobs still haven’t come home from China. Turns out that even though it costs a lot more than it used to import things from China, it’s still cheaper than it is to make ‘em here. So we still have a trade deficit: what a bummer!

But hey, I’m a patriot. The Toyota Yaris that I bought when I sold the Dreadnought was made right here in America. Trust me, I really wanted to buy from Detroit. But I’m not exactly flush with cash at the moment, so I’ve gotta make every penny count. And the Toyota gets better mileage and is more reliable than anything made by GM or Ford. I’m not counting Chrysler, not since they were bought up by Guangzhou Auto and China Investment Corp.

So yeah, I kind of wish that it was still 2007. Hell, I wish it could be 2007 forever. Instead, I’m stuck here in 2010. Crappy job, crappy paycheck, crappy TV. I mean, it’s a four year old 42” plasma! I can’t remember the last time I had a TV that old in my family room, and I certainly can’t remember the last time all my stuff was this far behind the latest technology. I guess my only consolation is that none of my buddies have gotten a new TV, either. No one can really afford it. For the first time in our lives, we really have to worry about saving.

Still, it’s not all doom and gloom. A couple of months ago I treated the wife to a nice weekend away while her folks looked after the kids. Who’d have ever thought that Clemson would win the NCAA tourney last year? But hey, with 75 bucks on them at 50-1, I’m not complaining. Yeah, I know $3750 is chump change these days, but at least we could afford two nights at a pretty good Holiday Inn and a nice dinner at Applebee’s.

It’s all kind of weird, though, when you think about it. Most of us have never been outside America, never seen how the rest of the world lives. I suppose we all just assumed that a weaker dollar could bring nothing but more jobs and more money. But I guess when you buy a lot of stuff from the rest of the world, a weaker currency makes it more difficult to afford things.

So, too, when Hillary threatened China with those tariffs. Who’d have thought that some guy ten thousand miles away could make a decision that would make it more difficult to borrow money here in the Heartland of America. Not me, that’s for sure. I have to say one thing, though. I felt a little burst of nostalgia when Hillary started the Whip Inflation Now program...it really took me back to my childhood.

Well, I suppose that’s enough of my yakking. I’d better get back to work. It’s more than my job’s worth if this report doesn’t make it to Abu Dhabi by tomorrow morning.

Macro Man's youngest son (age 4) was playing with one of his friends in the back garden earlier in the week. They gathered an assortment of balls and toys by the swingset and opened a "shop." Macro Boy then asked his mother if she wanted to buy anything.

Mrs. Macro tried to take something, but Macro Boy insisted that she fork over some cash. "But sweetheart," she said, "I don't have any real money."

"That's OK," said Macro Boy, "you can pay in dollars."

It's one of those days again, with markets jumpy and spreading more stories than the Brothers Grimm and Hans Christian Andersen combined. Whether market gossip proves to be accurate or merely the latest financial fairy tale remains to be seen in the fullness of time. In any case, among the talking points this morning include the following:

1) Dude, where's my deed? Another downside of structured credit rears its ugly head as an Ohio court denies Deutsche Bank the right to repossess 14 homes because they cannot prove that they own the mortgages to the specific properties in question. So much for subprime borrowers getting chucked out of their homes!

2) Fannie Mae slides 10%. LIBOR spreads continue to widen (the 3m TED is up 60 bps this month) as the credit crunch, Mk. II continues to escalate

3) IKB has even bigger losses, perhaps requiring even more refinancing? That's the word on the strasse.

4) A Chinese daytime talk show says "Sell, Mortimer, sell!" when it comes to household dollar holdings. One would presume that the dollar really is in trouble when the Chinese Oprah Winfrey starts dispensing currency trading advice.

5) Is a bank other than Northern Rock getting emergency liqudity from the Bank of England? So speculates The Times today.

6) The GCC de-pegging story gets even more press. Friday is the weekend in the Middle East, so bids for dollars are few and far between. Markets are now pricing in a 2% reval in the AED over the next six months.

And of course, today sees the release of September's TIC data as well as equity option expiration. The TIC data could be quite telling, coming as it does after August's epically bad figure. That number helped stoke an accelerated bout of dollar selling, which in turn has got us where we are today. Moreover, the G20 meets this weekend in Cape Town, where it seems likely that China is going to be on the receiving end of a concerted call to quit screwing around with the RMB.

And while CBs continue to sell dollars for euros in the open market, the trend has, for the moment at least, run out of steam. Macro Man suggested earlier in the week that he is getting close to profit-taking mode, and a glance at the gold chart is pushing him even closer to taking something off the table, as it's coming awfully close to crashing through the uptrend line off the August lows. Macro Man will probably look to lighten up his long euro position close to 1.47.

The equity option expiry also leaves him with a conundrum. Having previously expressed a broadly constructive view on risk assets and equities, does he now maintain a "naked" long exposure via the beta portfolio? Such a course of action appears risky given current credit market ruptures, at least until the Fed shows signs of capitulation (at which point the dollar probably gets smoked again, per yesterday's post.)

What to do? On the one hand, recent price action looks to be just enough to confirm that the sell-off from the highs is corrective, rather than the start of a new trend. Wednesday's price action briefly exceeded the October low, which by definition means that the bounce was not Wave 4 of a new 5-wave bear move. Rather, it appears that current weakness is the same sort of A-B-C pattern that Macro Man has written of before.

So a technical framework provides some comfort, and suggests that Macro Man should now be shifting towards a more bullish positioning in equities. On the other hand, the fundamental backdrop is deteriorating: gas prices are rising, housing remains a mess, and money-market conditions are queasy, to say the least. Moreover, for the time being at least, the Fed has withdrawn the near-term prospect for another go at the milk-teat of liqudity (via a lower Fed Funds rate) that the market craves.

However, since 2004 this margin proxy has spent most of its time in deeply negative terrritory, and has made a new low in the October data. What's going on here? Are producer costs overstated? Consumer costs understated? Or does this measure miss out on the whole offshoring phenomenon, and indeed explain the outsourcing of production wherever possible (due to negative domestic production margins.)

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

[12 USC 225a. As added by act of November 16, 1977 (91 Stat. 1387) and amended by acts of October 27, 1978 (92 Stat. 1897); Aug. 23, 1988 (102 Stat. 1375); and Dec. 27, 2000 (114 Stat. 3028).]


In the wake of the Fed's 0.75% easing over the past couple of months and the subsequent collapse of the US dollar, Macro Man has been giving thought to the notion that the fundamental construct of US monetary policy is inherently disadvantageous to foreign holders of dollar-denominated assets, and that the apotheosis of this long-term trend may be upon us. He briefly sketches out these thoughts below, and welcomes reader comments.

The Federal Reserve Acts of 1913 and 1977 laid out the policy objectives of the Federal Reserve System. The text of the latter Act, quoted above, spelled out in specific terms what has become known as the Fed's "dual mandate": namely, to promote maximum employment and low inflation. Of course, taken literally, one could argue that there is in fact a triple mandate, with asset-price targeting in the bond market as the third leg of the policy tripod.

Now, whether one assumes a dual or a triple mandate, it is clear that the Fed's policy objectives differ from those of most other major central banks. The Bank of England, for example, has a specific CPI target of 2% over a two year horizon. The ECB has a "primary objective of price stability", which the ECB has chosen to define in its own fashion. There is a secondary objective of supporting the economic goals of the EU (maximum employment and stable non-inflationary growth), but price stability takes primacy. The RBNZ has an explicit policy target of keeping future CPI inflation between 1% and 3%.

The difference here should be clear. Banks like the ECB, BOE, RBNZ, and others have an explicit primary policy target of price stability. That comes first and foremost. The Fed, on the other hand, must balance its focus on price stability, which it shares with other CBs, with an explicit focus on supporting economic activity so as to reach its equally important goal of maximizing employment.

Now many commentators, including Macro Man, have given Alan Greenspan and Ben Bernanke a lot of stick for being serial bubble blowers. But perhaps some of that criticism is misplaced. Perhaps where we should really direct our ire is the Federal Reserve Act itself, which essentially directs the Fed to ignore the inflationary consequences of its actions if it judges those consequences to be less severe in relation to its policy goals than a potential loss of employment. What Macro Man is saying here is that there is no such thing as a "Greenspan put" or a "Bernanke put"; what it is is a "Federal Reserve Act put."

When you think about it, the practical implications of this policy structure are quite significant. The Fed's dual mandate essentially carries with it an implicit promise that Fed policy will be more "dilutive" (to borrow a term from occasional poster Mencius Moldbug) than policy in most other developed economies. While this is not necessarily a bad thing for US residents, for whom maximum employment, broadly stable prices, and moderate long-term interest rates are surely worthy goals, it is a decidedly unpleasant outcome for non-resident holders of US dollar assets.

Simply put, the Federal Reserve, as a matter of policy, is less interested in protecting the international purchasing power of its currency than other central banks are. Such a policy focus is really quite remarkable for the central bank of THE hegemonic reserve currency, and no doubt explains why the FX reserve managers are, broadly speaking, trying to reduce (or at the very least not increase) their dollar holdings as a percentage of their reserve baskets.

It is also a damned good reason why the dollar pegs of current account surplus countries, particularly those with high inflation, are wildly inappropriate. The Fed's implicit promise to sacrifice the international purchasing power of the dollar (and by extension under current policies, the renminbi, riyal, dirham, etc.) to support domestic employment as a matter of course is wrong, wrong, wrong for China, Saudi Arabia, the UAE, etc.

Policymakers in these countries are finally becoming aware of this, with the UAE the latest country to suggest a change to its dollar peg- and not before time. Private investors evidently knew the score a year or two ago, which has resulted in a buyer's strike of US dollar-denominated financial assets, leaving the mercantilists and the oil producers holding the bag.

So where to go from here? Unless something changes, it is very difficult indeed to see private sector investors step in to buy dollar assets unless they are allowed to get cheaper (either in dollar terms or via a much lower dollar.) That having been said, a couple of caveats.

The Fed took a small step, in Macro Man's opinion, towards recovering an element of credibility by suggesting yesterday that their medium-term price target is headline, rather than core, inflation. By starting to forecast headline inflation (which necessitates that they pay attention to it), investors can derive at least a modicum of satisfaction that they may not be completely sacrificed at the altar of ex-food and energy.

Moreover, the currencies that have heretofore carried the load in strengthening against the dollar are starting to develop some serious warts. Yesterday's UK inflation report hinted at a significant downturn in growth even if the BOE cuts rates. Unusually, Mervyn King noted that currency tensions will be discussed at this weekend's G20 meeting in Cape Town. EMU monetary conditions are the tightest in 15 years, and surveys are suggesting an imminent downturn. Canada's leading indicator posted its lowest reading in several years yesterday, and BOC deputy governor Jenkins has complained about the strength of the loony recently.

What it all means is that we may be rapidly approaching that Minsky moment when dollar-peggers have to change policy. At that point, we could actually see currencies like the euro and sterling decline against the buck, with dollar weakness manifesting itself most against erstwhile peggers. For the time being, reserve diversification flows should keep the euro broadly supported for the next month and a half, but Macro Man is now entering profit-taking mode on his euro long.

Ultimately, what we are witnessing is a second Nixon shock played out in slow motion. And the Fed's dual mandate ensures that John Connally's remark from 1971 holds true today: "the dollar is our currency, but your problem."

Man oh man. The "Macro Man absent from his office" trick worked once again, as financial markets performed more gyrations than a gold medal-winning gymnast on Monday and Tuesday. Those who chased the price action such as, alas, Macro Man's carry basket model, have no doubt rued their impetuosity, as the volatility has proved sufficient to enable one to lock in a tasty loss by selling weakness and getting squeezed into covering.

And really, we're none the wiser, as the S&P 500's bum-clenching round trip over the past few days has occurred on realtively no news. All the more reason, then, to try and keep one's head and avoid over-trading.

There has, on the other hand, been a raft of key data released in China this week, and the developments are sufficiently curious as to inspire Macro Man to devise a simple game for the pleasure of his readers. Hearkening back to the old Sesame Street song, which of the following developments is not like the others; which of the following just doesn't belong? Answers on a postcard addressed to Macro Man Towers (or at least via the comments section!)

1) China's CPI inflation registers 6.5% in October, the joint highest level in more than a decade. Macro Man's jaw continues to drop at the number of commentators who appear willing to blame the rise in CPI on one-off factors, such as the blue ear disease that has driven up pork prices. Non-food CPI remains well-contained at 1.1%, the argument goes, so there's no real reason to worry about the medium term inflation trend.

Riiiggghhhhtttt. While it's true that food inflation has been extremely high at 17.6%, it would appear to be inaccurate to lay the blame solely at the door of temporary factors such as the porcine malady noted above. True, pork prices are up 54.9% y/y, and Macro Man is happy to put that down to temporary distortions. But how in the world does blue ear disease drive up the price of eggs by 14.3% y/y? The price of fish by 7% y/y? The price of vegetables by 29.9% y/y? Any farm-working readers should feel free to chime in. More to the point, if Chinese food inflation isn't a durable phenomenon, why has the delta of inflation been virtually identical to food inflation in the US over the past several years (see chart below)?
Moreover, the non-food pricing looks decidedly dodgy. The "vehicle fuel" component of CPI is down 1.4% y/y. Now, maybe petrol prices really have fallen in China, unlike anywhere else on planet Earth. Of course, that's difficult to marry with the stories on multi-hour queues and fuel rationing at petrol stations. While there may be distortions to Chinese CPI, it would appear more likely that they are depressing rather than elevating the true level of consumer price inflation- the recent 10% rise in administered energy prices looks like nowhere near enough to replicate a market equilbrium price. In Macro Man's view, inflation remains a very real problem for China.

2) A record trade surplus. Yes, October's trade surplus fell short of market expectations. But it still registered a whopping $27.1 billion. Perhaps the growth in trade is showing signs of deceleration, but if so that only represents the achievement of the policy preferences spelled out by the regime. In any event, it's still a bloody big number....and it's growing.

3) M1 growth of 22.1% y/y in October; M2 growth rose to 18.5%. Chinese money growth remains very robust, exceeding both expectations and the PBOC's target levels. The reason isn't particularly difficult to understand; PBOC is intervening heavily in the FX market but only partially sterilizing the proceeds, thus leading to a net "printing" of RMB in the process. Given growth and inflation in China, it's small wonder that banks are not terribly thrilled about parking their money in sterilization bills yielding peanuts, particularly as their deposit bases are beginning to contract. Perhaps that is how the stock market bubble will finally feed therough into macroeconomic policymaking; if banks' deposit bases continue to shrink, then it will make it very difficult indeed to force banks to participate in exchange rate sterilization via bill purchases or even RRR hikes without finally slowing the economy.

4) USD/RMB has reversed its decline this week. So CPI, the trade surplus, and money growth all accelerated in reports released this week....and the policymaker response is to weaken the currency?

Go figure....

Financial markets were beaten with the ugly stick on Friday, with USD/JPY and the S&P 500 prominent recipients of a good lashing. What's curious is that quant models appear to be breaking down again; Friday saw small caps handily perform large caps, the bank stocks (as proxied by the BKX) post a nice gain, and popular funding currencies surge higher.

Certainly Macro Man's own relatively simple quant strategies have been stuffed like a Christmas turkey so far in November, although he is exiting the carry basket Monday morning. Anyhow, if the models are having a spot of bother once again, we should all probably be prepared for elevated levels of volatility in the period ahead. Indeed, Friday's swoon had all the hallmarks of a margin clerk-driven liquidation, similar to what we saw in August and in May/June 2006.

As markets go haywire, there are nevertheless some interesting macro trends continuing to bubble along in the background. Exhibit A is the impact of the weak dollar and slowing domestic demand in the US. The US trade account posted its smallest deficit since May 2005 in September, with August's deficit also revsied lower. Macro Man was slightly amused to see that Morgan Stanley is now tracking Q3 GDP at a rather robust 5.3%. Didja ever think you'd live to see the day when the Fed cut rates 0.50% in a quarter when growth posted 5% plus and the stock market rallied? Strange days indeed.

Anyhow, recent data has delivered another convincing argument that currencies do indeed matter in impacting global imbalances. At the same time that the US deficit was announced, Canada posted its smallest trade surplus since the 1990's, despite the relatively healthy state of the Great White North's terms of trade. Earlier in the day, the UK had posted its largest-ever trade deficit, at £7.75 billion for September.

The UK now runs a larger visible trade deficit as a percentage of GDP than the United States, has a more overvalued housing market than the United States, has similar credit issues to the United States, and has a much more overvalued currency than the United States. Oh, and the weather's worse than much of the United States. Yes, the UK is a wonderful place to be at the moment!

Regardless, the chart below sets out recent changes in currencies (as measured by y/y change in the latest observation of the OECD's real effective exchange rate estimate) and trade (as measured by the USD change in the latest monthly trade figure from the corresponding month a year earlier) for the US, Canda, Japan, and UK. Perceptive readers will observe a strong negative correlation between the two series. As Brad Setser and I have suggested for some time: yes Virginia, currencies do matter.
Over the weekend, PBOC raised its reserve requirement ratio another half a percent to 13.5%. On would have to posit that reserve accumulation has ticked up sharply in Q4, and raising the RRR is a cheap way of passing on the costs to China's banks. In any event, PBOC has allowd the RMB to appreciate "sharply" since the end of the CCP Congress, though whether this is a temporary phenomenon ahead of delicate meetings with Europe and the US or a new policy remains to be seen.

In any event, one of Macro Man's favourite datapoints has continued a recent trend, as US import prices from China have now risen 2.2% y/y. Of course, insofar as Chinese demand has buoyed commodity prices, the inflationary impact from China could be argued to be closer to the headline import price figure, which in October rose a resounding 9.6% y/y.
Now that China is no longer a source of global deflation/disinflation, could it be that the old models of exchange rate pass-through, neglected in recent years because they didn't seem to work, should be revived? If the Fed ever reaches that conclusion and acts accordingly, perhaps that could be the trigger to get the Treasury to care about the external value of the dollar. Until then, however, dollar weakness will continue to be seen as an offset to frailities in the housing market as the American growth model switches, if only temporarily, to exports. Who'da thunk it?

In the end, yesterday's central bank trifecta was a lot like price action in the S&P 500: a lot of sound and fury, but you pretty much ended up where you started. Neither the BOE nor ECB moved rates, which was hardly a surprise. M. Trichet did, however, manage to introduce a new term to the financial market lexicon, in describing the current high level of Eurozone inflation as a "hump" which will eventually be unwound. Macro Man was left to wonder if, in the late 80's when he used to go out clubbing with Credit Lyonnais bankers, M. Trichet ever used to do the Humpty Dance.

M. Trichet also resurrected a term from three and a half years ago in mentioning that any "brutal" currency moves would be unwelcome. However, he declined to opine on whether current moves represent brutality, aggravated assault, a gentle love tap, or a walk in the park. Gee, thanks Jean-Claude! It looks like "brutal" is the new "vigilant". Perhaps we need to put the Plain English Campaign in touch with M. Trichet....

Big Ben's comments, meanwhile, more or less represented a fleshing-out of the statement from the October 31 FOMC announcement, with the added injunction on lawmakers to ecnourage cooperation between distressed borrowers and their lenders. Unfortunately for Mr. Bernanke, the dollar and ABX indices continue to plummet, and the costs of credit and living continue to rise. While he denied that the current set-up is a replay of the 1970's stagflationary scenario, in point of fact it is resembling the 70's more every day.

Ominously, Macro's Man's gas-price model has risen very sharply this week, thanks to rising oil prices and much higher crack spreads. If retail prices converge with his model, the outcome for growth, inflation, and risk assets will not be pleasant. Ultimately, Ben may be forced to choose whether he wants to be William Miller or Paul Volcker; unfortunately, the early signs are that he is pursuing the former option.

Perhaps unsurpsingly, the dollar has received a fresh battering today, with the yen in particular outperforming. That having been said, the buck has also reached fresh lows against the euro and the RMB, and speculation is mounting that China may be preparing for another one-off revaluation. Not only is the next strategic economic dialogue with the US slated for next month, but PBOC's 3rd quarter monetary policy report suggested a new synthesis of currency and interest rate policy to manage unwelcome inflation.

To be sure, the RMB has strengthened against the dollar this year....but then again, that doesn't exactly put it in terribly select company. What's interesting to note is that the RMB has fallen more against the euro than it has risen against the USD. And while it's true that the dollar is more important on a trade weighted basis, the gap may not be as big as you think. In September, for example, Chinese exports to the US + Hong Kong were 42% larger than its exports to Europe. Just two years previously, that gap was 80%. So EUR/RMB is an important exchange rate for China, and it's been dropping like a stone.

Elsewhere, it appears that Macro Man isn't the only one getting antsy at China's equity bubble. Goldman has downgraded H shares to neutral for the first time in three years, citing valuation as a primary rationale for the less aggressive posturing. Earlier this week, UBS observed that Asia ex-Japan equities are getting close to bum-clenchingly overvalued, driving largely by Shanghai and Hong Kong. The macroeconomic impact of China's share-price rise shouldn't be ignored; from representing an inconsequential share of financial assets as recently as end-2005, Chinese stocks now comprise a greater share of financial wealth than in the US or Europe. Look out below!

Finally, some new readers may be wondering what this blurry little box is at the end of every post. Macro Man runs a model portfolio of trades, both as a laboratory to try out new ideas /products, and as an objective test of the accuracy of the views that he expresses in this space. He may or may not have any of these positions in his real job portfolio, so please do not construe these trades as recommendations, because they are not. But his view is that the ultimate arbiter of success for the analytical efforts of any financial market participant is the P/L...so Macro Man bares all, at least in the context of what you read here, every day in the blurry box (which you can click to enlarge.)

Well....whoever was at 1490 in the SPX must have gone out to lunch at an inopportune time yesterday, because the level finally broke and generated a pretty aggressive follow-through. The chart suddenly looks pretty ugly, and with little near-term prospect of monetary relief this market may decide to have a proper go at the downside. This may ultimately provide the opportunity to scoop up some handsome bargains, but the for the time being Macro Man is content to stand aside and let his hedges do their work.

Today sees news from three different central banks, all of whom find themselves in a different situation confronting different problems. How they choose to address these issues may ultimately tells us quite a bit about the resepctive institutions.

First off is the Bank of England, which announces its rate decision at noon local time today. While a few are looking for a 25 bp cut, recent hawkish comments from a number of MPC members make this a highly unlikely outcome, in Macro Man's view. A more pressing issue for the Bank is its stature, its reputation, and even its very independence from government meddling, which is being called into question for the first time since Gordon Brown freed the Bank in 1997.

Over the past week markets have subjected to the rather unedifying spectacle of a pissing match between Chancellor Alistair Darling and BOE Governor Mervyn King over who should carry the can for the Northern Rock debacle. The arguments, summarized in the graphic below, at least raise the possibility that the Bank delays any required monetary easing to avoid the impression of caving in or supporting the Government's wishes.
Forty-five minutes after the BOE, the European Central Bank will also announce its rate decision, followed by a press conference at 1.30 pm London time. It is the latter event which will be the primary object of focus, as the market scrutinizes M. Trichet's comments for signs that the tightening cycle is over and/or that the euro has become a source of concern.

It is incontrevertible that the euro has led to a tightening of monetary conditions; indeed, the EUR's real effective exchange rate, combined with real interest rates in the Eurozone, have generated the tightest monetary conditions in Europe since 1992. While this comes in the context of higher-than-target inflation, it also seems clear that the level of the currency is beginning to have a material impact on corporate profits and, by extension, growth.

EADS announced Q3 "earnings" today, wherein they reported a loss of "only" €776 million, better than the expected €1.15 billion loss. But the insight on currency hedging is instructive; through the first 9 months of the year, EADS saw $11.8 billion worth of hedges mature: the average rate was 1.14 EUR/USD. In their stead, EADS has placed fresh hedges totally $15.1 billion, with an average rate of 1.37. That is a material change in competitiveness that is no doubt being mirrored elsewhere in Europe (or at least France); why else would Nicolas Sarkozy warn the US Congress that dollar weakness could lead to "economic war"?

This is exactly the sort of concern that Macro Man raised yesterday- namely, that the potential inflationary consquences of a free-falling dollar force the Fed to maintain its monetary course even in the face of tumbling equities. In May 2006, such tough talk eventually spurred a sharp correction in stocks, emerging markets, and even (albeit temporarily) the dollar.

All the more reason, then, to watch today's developments clsoely; Macro Man dearly wishes to avoid seeing central bank problems become his problem.

Well, you can't say that Macro Man didn't warn you. More than two months ago, he suggested that Fed easing of 0.50% or more could generate a 'dollar down bubble.' After the initial Fed easing, he warned that the buck was toast. And so it's come to pass, with the USD falling steadily since he first voiced his concerns. Until recently, however, the dollar's decline has been relatively orderly, and not characteristic of the "throw caution to the wind" price action that one normally associates with bubbles. All that may have changed today, however, as the buck is falling hard against every currency under the sun, including erstwhile whipping-boy the yen. It looks like the real meat of the dollar down bubble has begun.
The immediate cause of the dollar's collapse today was frankly something of a joke. Cheng Siwei, vice-Chairman of the National People's Congress, said that China will "favour strong currencies [for its reserve basket] over weak ones, and will adjust accordingly." The dollar has collapsed ever since the words left Mr. Cheng's lips.

Now, there are three basic facts that one should know about Mr. Cheng in interpreting his comments:

1) He has no position at SAFE, and no position of influence over SAFE. In other words, his comments carry no particular policy insight.

2) This is the same chap who tried to talk down Chinese equities in Q1. Needless to say, those that acted on his advice have regretted it.

3) Mr. Cheng is actually the leader of an opposition party. Given what we know about the Chinese Communist Party and their desire to retain power, you can reach your own conclusions about the type of chap that they would allow to run a legal opposition party.

Simply put, Mr. Cheng is talking out of his 括約肌 when he discusses financial markets. But the reaction has been very telling indeed. EUR/USD has traded a percent higher from yesterday's NY close, and USD/JPY is at its lowest level since early September. CAD, AUD, and just about everything else under the sun (including the RMB!!!) have also surged against the dollar. And as noted above (and forecast on October 1) , the USD has traded to a new all-time low against the EUR as proxied by the old Deutsche Mark.

So does it matter? Will anyone but currency speculators and exporters give a damn? In Macro Man's worldview, when dollar weakness morphs from orderly and economically justified to bubble territory, macroeconomic consequences begin to arise. For example, S&P futures have already erased all of yesterday's stunning gains. Perhaps more importantly, however, commodity prices have surged, with oil flirting with $100 and gold with its all time highs of $850.

This is where the weak dollar begins to have negative consequences. One could argue that the hawkish comments from Charles Plosser may have been partially motivated by dollar weakness. More importantly, breakevens are starting to widen sharply; at 2.45%, the 10 year breakeven is near its wides of the year. If the Fed receives market signals that inflation is becoming more of a worry, then they will set monetary conditions tighter than would otherwise would be the case. The upshot for risk assets is a negative one, one one might even argue that the dollar down bubble could sow the seeds of its own destruction if it provokes a policy response.

It therefore would appear prudent to do more than take a victory lap (that is not Macro Man's intent with this post, though it may come across that way) on the dollar bear view; Macro Man is now prepared to take some profits. He therefore exits the Dec gold position at just over $845. If Macro Man is right and we're now in dollar bubble territory, he can run a smaller notional and still generate substantial profits.

And if The Economist decides to put the buck on the cover and call an interim top in the euro....it's easier to book more profits having already done so near the highs.

It's a little-known fact, but Macro Man is the richest man in the world. Why, he can hear you ask, is his name not known across the globe, and his face not splashed on business magazine covers from Wall Street to Shanghai?

Well, in truth, most of his wealth is unrealized. But last week, he borrowed a pound (£1) from a friend when short of change. Rather than pay his friend back, in compensation he offered his mate a small share (1/500 billionth, to be precise) of his new company, Macro Man Industries, in exchange for his pound coin. Macro Man retains ownership of the remaining 499,999,999,999 shares. When his mate accepted the MMI equity stake, Macro Man's share was immediately valued at £499,999,999,999, which is more than a trillion dollars at today's exchange rates. It's good to rich, baby!

Such logic, with only a slight exaggeration, is what underpins the trillion dollar valuation of PetroChina. To be sure, PetroChina is a real company with real assets, and in that sense it does differ from Macro Man Industries, whose only asset is the meagre talents of your humble scribe. But the Chinese government controls almost 99% of the shares, leaving insitutions and retail punters to fight over the remaining one-and-a-bit percent listed in Shanghai, Hong Kong, and via ADRs. The result is a supply/demand imbalance that is eerily reminiscent of the Nasdaq craze in late 1999/early 2000, when the only meaningful data point for corporate highfliers like WebVan and Pets.com was the offer side of the bid/ask spread.

Further evidence of the bubblicious market environment in China and Hong Kong comes from Alibaba.com, a recent HK IPO that is now valued at a cool US$25 billion. The company's primary asset appears to be that it has a website, according to one Singapore-based fund manager. (UPDATE: Bloomberg has removed the quote from the story. Drat!) Hmm...so does Macro Man Industries. Perhaps that £500 billion valuation wasn't that far off! Regardless, Macro Man would advise investors in Alibaba to beware of the Forty Thieves: if you can't find them, they just might be the guys who sold you your stock.

These anecdotes make Macro Man all the more confident that a bum-clenching correction/reversal in all things China is inevitable. Not to say that it will happen imminently, of course; these things have a habit of taking longer than you might think. That having been said, the consensus seems to be that the time to sell China will be after next summer's Olympic Games. Presumably that means that 'smart money' will be selling in the spring....so could the great crash happen in Q1 or Q2? Stranger things have happened. (As an aside, there was a typo in yesterday's post. Macro Man bought 50, rather than 500, of the Hang Seng puts. He's happy to risk $350k on the trade, but not $3.5 million!)

Elsewhere, price action in Western equities continues to confound. The steady stream of bad news from the credit space remains a pressure point for stocks....and yet they keep holding in there. For the past couple of weeks, someone/something big appears to lurk at 1490 on the cash S&P 500 index. If we ever get any good news on credit, the market could be posied for quite a nice rally.
A market that has had little difficulty in falling this year is of course Japan, which a quick look at WEI on Bloomberg reveals is the worst performing major market in both local currency and dollar terms. A bit of a data milestone was reached last night, as the leading economic index printed 0 for just the fourth time since 1970 (the others were in 1974 and two months in 1997, in case you were wondering.) Macro Man's preferred measure, the 3 month average reading of the LI, unsurprisingly also lurched lower. Somehow, with an ultra-competitive yen and a booming China, Japan once again finds itself perched on the brink of recession. Go figure....

Of course, the US has its own problems, and last night's release of the Fed senior loan officer survey unsurprisingly revealed a sharp tightening of lending standards for residential mortgages and, somewhat more surprisingly, commercial real estate. Standards for commerical and industrial loans also tightened, but less than during the LTCM episode and the last recession, as the Fed chart below illustrates. For the recessionaires to be proven correct, you'll need to see a further tightening of these types of loans; that having been said, the survey provides yet another piece of data that the credit cycle has turned and that spreads should widen on a structural basis.

In FX land, a very significant milestone beckons. No, not the all time low in USD/Europe (though that does in fact beckon as well), but the crossover of the USD/CAD and AUD/USD exchange rates. Anyone who was trading currencies six or seven years ago, when USD/CAD traded 1.60 and AUD/USD at 0.48, must be shaking their heads at this development. Macro Man wonders how many misquotations will occur today, given that USD/CAD and AUD/USD tend to be on top of each other on most FX punters' quote screens.

Finally, Macro Man was a fool, a fool! to question the currency trading acumen of Gisele Bundchen yesterday. EUR/USD has traded within a few pips of the equivalent all-time low in USD/DEM, and it would appear to be only a matter of time before that threshold is breached. Henceforth, to aid him in his trading, Macro Man has decided to wear one of those trendy rubber bracelets emblazoned with the slogan WHAT WOULD GISELE DO?

Farewell, sweet Prince, the hope of chivalry!

-Shakespeare, Edward III, Act III, Scene V

So at long last, Chuck Prince has fallen on his sword and taken leave of Citigroup. Not before time, most observers would say, particularly as Chuck left Citi with a parting gift: another $8 to $11 billion write-down of subprime rubbish. While Chuck may not have been the hope of chivalry, to many Citi employees and shareholders (disclaimer: Macro Man is neither), he was truly a Black Prince.

One might think that global markets would have taken solace in such a high-profile departure, but au contraire: Asian markets were sharply lower on the day, Europe is trading on the back foot, and S&P futures are down 11 points at the time of writing. One possible explanation is the weakness in Hong Kong, where the Hang Seng plummeted 5% today on news that China may delay QDII investment into HK shares.
To say that the HSI has been a bubble is an understatement; the index rose 64.8% from its August lows to October highs, and is still up 45% on the year. Insofar as China/EM remains the predominant source of global liquidity, a meaningful and durable deflation of the China equity bubble could have rather unsettling consequences for markets in the West. With the uptrend firmly broken, risks must point towards further weakness in the near term. Perhaps the DOTW will ride to the rescue again, but in case they don't, Macro Man buys 500 Dec 27000 puts at 1100.

Elsewhere, Friday's payroll number was what we thought it was: inconclusive. The reaction of markets was telling, however, as Treasuries surged on the day and stocks required a strong late-session raly to close in the green. Credit concerns are clearly rising in prominence again, and the problem for markets is that the nature of the beast naturally lends itself to rumour and innuendo at the expense of cold, hard, facts. It's not hard to see more volatility this week, and it will be especially interesting to see if either Fed speakers or ECB/BOE acknowledge the renewed credit jitters.

Finally, we have had ultimate confirmation (well, aside from an Economist cover) that dollar weakness has gone tabloid. Supermodel Gisele Bundchen now refuses to accept payment in dollars, requiring that her contracts be denominated in euros. While Gisele is no doubt an investment heavyweight within the supermodel community, one might reasonably question whether the dollar's grim outlook is fully in the price when her currency views are trotted out alongside those of messrs. Buffet and Gross. Perhaps the most interesting nugget of information in the linked article is that Gisele is managed by her twin sister. Hmmm....wonder if she will accept dollars?

Well, THAT's more like it. Yesterday's risky-asset lurch was pretty much what Macro Man expected from a more hawkish (or, more realistically, less-dovish) Fed statement. Whether it proves to be yet another buyable dip, or a state change as credit conditions deteriorate again, of course remains to be seen.

That the Fed chose to inject $41 billion in repos yesterday offers a hint about the likely solution to any concerns of renewed market seize-up, and we should all probably be prepared for similar operations over the next couple of months as the Fed (and ECB, and BOE) seeks to avoid a year-end liquidity crunch.

As a brief follow-up to yesterday's post on crack spreads, Macro Man constructed a crude (boom-boom!) two-factor model of US gasoline prices, with crude prices and crack speads (3:2:1 formation) as the inputs. Unsurprisingly, there is an excellent correlation, not least because the gas prices are on both sides of the equation. But it's nonethelsss a useful to for gauging the potential magnitude of gas price shifts on the basis of some simple assumptions. With crude at $95 and crack spreads at their 1 year average, for example, the model yields a gas-price forecast of $3.43. Hard to see anyon enjoying that kind of move but the Grinch!
Yesterday's risk asset weakness was partially sparked by renewed rumours of massive, massive losses at Citigroup, partially driven by a CIBC analyst's report. Now, while it is obvously difficult to ascertain how much of the rumour is true, it certainly seems as if the reputation of Wall Street executives has taken a beating recently.

Consider:



Chuck Prince, Citigroup: The man Jim Cramer loves to hate. He may still be dancing, but alas the venue would appear to be the shattered dreams and broken P/L's of his investors.




Jimmy Cayne, Bear Stears.

Macro Man will leave the more scurrilious rumours about Mr. Cayne to others, but when the WSJ is reporting that you spent much of the July crisis period playing cards and on the golf course, it does suggest rather less attention to detail than investors, clients, and employees might have a right to expect. Is it any wonder that Bear's stock price has gone into hibernation?




Stan O'Neal, Merrill Lynch.

Stan's performance is reminiscent of another Stan the Man, complete with extremely large losses. Evidently, it takes a special, virtually unique, talent to lose as much money as Merrill did under O'Neal's watch, as Stan was handomely rewarded for his departure. As an aside, did anyone else find the manner of O'Neal's departure as amusing as Macro Man? Stan "retired" from Merrill Lynch? Yeah, just like Julius Caesar "retired" from politics in 44 B.C.E.






Anyhow, today sees another sacrifice at the altar of statistical noise- US nonfarm payroll data. Regular readers will know by now that Macro Man is more interested in the revisions than he is in the headline number, which contains much more noise than signal.

Insofar as any aspect of the October data bears watching, the unemployment rate is probably the thing to look at, as it provides a measure of the rate of labour force utilization. Certainly yesterday's spending and income data did not suggest a consumer on the ropes: y/y wage and salary gains were reported up 7%, and real disposable income continues to grow nicely courtesy of muted gas prices (for now.)

Where will we be at market's close today? Your guess is as good as mine; however, the sharp increase in volatility may be serving as a warning to dial risk down until things get a bit clearer.

Energy...
Sometimes I think I'm runnin' out of energy
Seems like we use an awful lot for
Heatin' and lightin' and drivin'
Readin' and writin' and jivin'
Energy ... You'd think we'd be savin' it up.

- "The Energy Blues", Schoolhouse Rock

Did you ever think that your financial future would be dictated by something called a "crack spread"? The more that Macro Man thinks about this issue, the more he reckons that the single most important economic variable in the United States these days is the energy crack spread.

This, for the uninitiated, is a measure of refining margins: how much refiners earn for buying crude oil and turning it into gasoline and heating oil. The higher the spread, the bigger the margin; the lower the spread, the smaller the margin.

At the moment, crack spreads are well below the average of the past couple of years, and way, way below the highs of earlier this year. The upshot is that despite the record high and stunning rise in oil prices, the US consumer has not really felt the pinch in motoring or heating bills. Updating a chart posted a couple of weeks ago reveals the massive disparity between crude and product prices.
Why is this important? The lack of energy pass-through has provided a very significant buffer to consumers by maintaining or even raising growth of disposable income. At the same time, it has kept a lid on headline inflation and, by extension, inflation expectations, thus allowing the Fed to reflate by 0.75% over the past six weeks.

Imagine, however, what would happen if crack spreads, pictured above, were to normalize. Eyeballing the top chart, it would appear to imply gasoline prices in excess of $3.75: a full dollar higher than recent levels. How important would that be?

Even the commodity trades performed, though in typical fashion Macro Man turned a potentially great month in the space into a merely good one by turning $750 gold calls into $740 gold puts with bullion at $760.

Crack spread commentary notwithstanding, Macro Man is not a commodity expert and knows it. The relatively small risk allocation appears justified given the poor intramonth trading.

A source of pride, however, was the performance of the beta plus strategies, which correctly stayed with FX carry during the mid-month hiccups. Macro Man's preferred indicator remains firmly planted in risk-seeking territory, unsurprisingly, so he remains positioned even at apparently nosebleed levels.

Perhaps a recvoery in crack spreads will be the very thing to push Macro Man and and others off of the FX carry bandwagon....