Archive for December 2007
It is a staple of financial commentary that near the end of December, one offers up pearls of wisdom for the ensuing year. This can take the form of "top trades", "surprises", or even "Christmas presents." Regular readers should know by now that Macro Man marches to the beat of a different drummer, and as such his powers of prognostication, insofar as they exist, yield a harvest unlike any other. So rather then tell you what will happen in 2008, herewith is a list of eleven things that WON'T happen next year:
1) Oil will NOT rise 60% in calendar year 2008, or 100% peak-to-trough during the year. Remarkably, both of those things occured in 2007. But with global growth on a downward trajectory, demand growth for the gooey black stuff should recede a bit. Importantly, we now know that gas prices of roughly $3.00-$3.25 per gallon represent a "possum point" for the US consumer; i.e., the point at which (s)he rolls over and plays dead. $150 oil at current refining margins would send the USD into recession, thereby eliminating some demand for crude; $150 oil at current gasoline prices would kill the refining industry. The obvious conclusion is tht $150 oil ain't happening next year.
2) VIX will NOT hit single digits again. Regular readers will be familiar with Macro Man's high-conviction thesis that tightening global liquidity conditions and greater macroeconomic volatility imply greater financial market volatility moving forwards than we've seen in the past. For those who enjoy historical parallels, consider the analogy that 2007 = 1997, wherein there is a brutal localized shock that sends ripples but not catastrophe throughout the rest of the world economy. The follow on is that the aftershocks hit the next year, once growth slows. If you see VIX hit low teens or below in 2008, buy all the index options you can.
3) Inflation will NOT die as a macroeconomic issue. It may well be the case that commodity price inflation eases next year, particularly on the energy side. But the inflation story is secular, particularly in emerging markets that for much of this decade have exported deflation, rather than inflation. However, as price expectations in these countries shift and wages adjust, this should produce an upward bias to global goods prices next year. Just as the plankton population dictates the availability of sustenance across the remainder of the global food chain, so too should the inflation dynamic in the low cost producers of the world dictate inflation rates elsewhere.
4) China will NOT step-reval the RMB. The rationale is simple; they'll simply allow a faster pace of appreciation while accruing fewer official foreign currency assets next year. Macro Man has long observed that domestic inflation amongst BWII peggers would be the ultimate death knell of the system, and the recent increase in the pace of the USD/RMB decline (a "whopping" 1.1% decline this month!) suggest that the Mandarins in Beijing have reached the same conclusion.
5) The BOJ will NOT hike rates in 2008. OK, this one's hardly going out on a limb, is it? But given that markets have sort of lazily expected further tightening in the pipeline all year, it's worth pointing out directly. Japan's economic performance in 2007 will have to go down as the biggest disappointment since Waterworld.
6) GBP/USD will NOT make a new high in 2008. Sure, the dollar may continue on the back foot, particularly if the Fed keeps easing rates during a period of "muddle-through" economic growth. But why in the world would anyone want to hold sterling, the currency of a country that looks a lot like the US did six or twelve months ago? We have a pretty good idea of how the UK story will end (hint: it bears a strong resemblance to the results of the England football team for the last forty years.)
7) We will NOT see an honourably fought US presidential election with the outcome determined by the issues. Macro Man was last resident in the United States for a presidential election in 1988, the year that Bush Sr. defeated Michael Dukakis. That election was fought on soundbites and slurs, at least judging by Macro Man's enduring memories of the campaign ("Where was George?", Willie Horton, and "You're no Jack Kennedy".) From what he can see, it's gone steadily downhill ever since. Macro Man tries very hard to avoid talking US politics both in this space and in real life, given the appalling caliber of the individuals who typically contest major elections.
8) We will NOT see a US recession in 2008, as defined by the NBER. This one's a bit more contentious. But Macro Man's reading of the key drivers of the business cycle, particularly inventories, continue to suggest a "muddle through" scenario while housing remains weak. While it is likely to be the case that global demand growth will recede somewhat in 2008, the dollar remains uber-competitive against many of America's trading partners and competitors, which could/should allow US firms to gain international market share. And as Macro Man has observed recently, leading indicators are suggesting that the current slowdown is just that- a slowdown. That official and govvy rates have already tumbled should also support activity if and when credit conditions normalize to a degree (albeit with wider spreads than in 2004-06.)
9) Japan's MOF will NOT intervene in currency markets in 2008. Of all the non-predictions on this list, Macro Man is probably least confident of this one. Yet it would truly be remarkable for the yen to experience 22 year trade weighted lows in 2007, and for the MOF to intentionally weaken the currency in 2008. All the more so given the inflated levels of EUR/JPY and, more crucially, the fact that Japan has put her name to G7 statements calling out China for currency piss-taking. One can only hope that if Macro Man is wrong on this one and the MOF does decide to buy USD/JPY, that both the US and Europe abandon their recent policies of non-intervention and say "200 billion yours, at best" to the market.
10) The Shanghai Composite will NOT rise another 100% in 2008. Shanghai rose 130% in 2006 and another 100% this year. It ain't happening next year, though. Why? Two reasons. First, the Olympics represent a turning point with regards to sentiment. There are many who believe that the authorities will change their attitude towards rampant speculation after the Olympiad, but are unwilling to do so beforehand in case of domestic unrest. We are likely to see some selling after, during, and prehaps before the Olympics as a result, which could then turn a market rout into a self-fulfilling prophecy. More concretely, the monetary policy stance has already moved to "tight" for the first time in four years; in 2004, the Shanghai Comp shed 15%.
11) Macro Man will NOT find himself in this situation in 2008. Or, despite initial appearances, in any other year, for that matter.
With only two days to go until Christmas, the rush to lock up presents for friends and loved ones has reached a fever pitch. So, too, in the North Pole, where rumour has it that Santa is putting in 22-hour days in a last-ditch effort to allocate presents to boys and girls all over the world.
He's had a particularly tough load this year, as new Human Resources guidelines have mandated a policy of non-discrimination in the awarding of presents, meaning that Santa has to give a prezzie to everyone, whether they believe in him or not. And both HR and Finance have nixed coal in the stocking as an option, the former because of sensitivity issues and the latter due to cost. As for the price of year-round fodder for flying reindeer...if Santa's hair weren't already white, it would be now.
Anyhow, Macro Man has a buddy from college working in the Treasury Department of the North Pole. This old chum sent him a few finance-related highlights from Santa's list this year; Macro Man is sure you'll agree that even with Santa's increased workload, the old boy hasn't lost his touch. Among the notables on the list include the following:
Jimmy Cayne- Dazed and Confused DVD. Richard Linklater's 1993 comedy is a perfect present for the Bear Stearns chief executive. Not only will it cheer him up as he contemplates the year that was 2007, but he'll also learn some valuable and interesting historical facts. Some might argue that the title is also an apt description of Mr. Cayne's performance over the summer as a couple of high-profile Bear hedge funds imploded.
Mervyn King- How to find work when you're over 50: Make the Most of Your Maturity and Experience to Find the Right Job.
Six months ago, Mr. King's re-appointment as Governor of the Bank of England next year seemed like a formality. Now, after a rapid about-face and a bungled bailout of Northern Rock, it's far from certain that Swervin' Mervyn will be in the Threadneedle Street hot seat this time next year. Should Mr. King need to find an alternative line of employment, this present should come in handy.
John Mack- Executive membership at Costco. After Morgan Stanley's 4th quarter shocker, Mr. Mack has declined to pay himself a bonus for 2007. While this is certainly a worthy gesture, it does leave Mr. Mack rather in the hole, with a lifestyle that in all likelihood costs more than his month-to-month paycheck. What better present, therefore, than an executive membership at Costco, which will allow the Mack household to enjoy great deals on thousands of products, thereby cutting back on their cost of living during this difficult time?
Ralph Cioffi- How to Win Friends and Influence People.
Mr. Cioffi, manager of the aforementioned Bear Stearns hedge funds, could do with a little popularity these days. Not only is his name mud amongst all who got carried out in the structured credit debacle, but he's now out of a job and under investigation for his conduct during the funds' demise. Apparently, Santa also considered giving Mr. Cioffi a copy of "Things Can Only Get Better" by D:Ream.
Mark Carhart and Ray Iwanowski- A model of KITT. The Goldman Global Alpha managers have had rather a spot of bother with their quantitative process this year, so what better present than a model blessed with artificial intelligence that can think its way out of danger and is charged with protecting its operator?
Jean-Claude Trichet, "Sex Packets" by the Digital Underground. No, this isn't what you think it is- that's what Nicolas Sarkozy's getting. Rather, it's an old school rap disc from a late 80's one-hit wonder. For a central banker perturbed by a "hump" in inflation, what better present could there be than an opportunity to do the Humpty Dance?
Ben Bernanke- "The Inflationary Universe" by Alan Guth. As an old academic, Mr. Bernanke is undoubtedly fascinated by the inner workings of the universe. Mr Guth created the theory of "cosmic inflation", in which the size of the universe expanded with extraordinary rapidity immediately after the Big Bang. Sort of like what happened to headline CPI after the Fed started cutting rates in September.
John Paulson- Bugatti Veyron. Paulson and Co. have been among the more high-profile winners in the subprime credit debacle, so Santa has decided to reward him. And what better present for a successful hedge-fund manager than the world's fastest and most expensive sports car? Plus, given that the Veyron averages less than 6 mpg in urban driving, it requires a paycheck like Paulson's to be able to fill 'er up.
SAFE- "Caveat Emptor" by Ancient Chinese Secret. Apparently, Santa doesn't know anything about either the album or the band. But for an organization that holds nearly 1.5 trillion dollars and continues to buy billions per month, Macro Man is sure you'll agree that it is an apt gift.
Brad Setser- Full developing-country reserves disclosure in the IMF COFER data and good capital flow data from the UK. That way, we'd finally know with relative certainty what's going on. Then again, given that timely and accurate data of this nature would eliminate the demand for one of Brad's "niche products", it's probably just as well that the elves have already misplaced this one.
Readers of this space- A healthy and prosperous 2008. 'Nuff said.
After the successful culmination of five years' worth of bootlicking by Stephen Roach, it's worth considering what other assets might tickle the fancy of CIC, ADIA, and other sovereign wealth funds in the future. After months of deliberation, thoughtful study, and cost-benefit analysis, the crack research team at Macro Man Industries has handed him the following list of future targets for SWFs. Be warned!
1) Manchester United, the Dallas Cowboys, and Yomiuri Giants. Carpetbagging ownership is swiftly becoming the bane of professional sports in some areas, notably the English Premiership. By purchasing a flagship team on three continents, SWFs could set the standard by which all other money-grabbing owners could be judged.
2) The Eiffel Tower. The Japanese bought MGM, Rockerfeller Center, and Pebble Beach Golf Club in the 80's. SWFs have more money that the Japanese ever did, so can set their "cultural icon" sights a bit higher. And with M. Sarkozy's attention otherwise engaged, they might even get a good deal.
3) The North Pole. Word on the street is that the Russian oil stabilization fund has already got this one in the bag.
4) The Beatles' back catalogue. Wacko Jacko could use a bit of dosh to pay for, er, more "medical procedures." Apparently, "Money" is quite a catchy number in both Arabic and Mandarin.
5) Africa. Dealing with corrupt regimes in the effort to secure resources can be a real pain in the ass sometimes. So why not just cut to the chase and buy the entire continent? Sure, it would infringe upon the African peoples' sovereignty, but that won't be a concern to the people who set US market interest rates and the EUR/USD exchange rate, now, will it?
6) Saturn's moons. The Cassini-Huygens mission has so far found hydrocarbons, potential geysers, and ferrous materials on Saturn's moons. If the commodity price boom continues, it will soon be cheaper to extract strategic resources from Phoebe, Hyperion, and the like than to mine them on Earth. In the race to lock up resources, he who dares, wins!
7) The Tate Modern and Saatchi Gallery. 80's Japan paid outrageous sums for individual paintings. Nougthties SWFs can't be arsed to decide between the Van Gogh or the Monet, so why not just buy an entire museum or two? Afterwards, it'll be something like a Lucky Dip to see what it is that they've actually got. Imagine their joy and surprise when they find that they're now the proud owners of Chris Ofili "poo paintings" and thoughtful, sensitive works like Tracy Emin's bed.
8) The US Government. On second thought, given how many Treasuries they already own, perhaps we can say that SWFs and mercantilist CBs already own the US government.
9) Pearson, NewsCorp, and Google. Many of the countries with large SWFs are not exactly strict adherants to the concept of freedom of expression. Tired of the adverse coverage of their activities, mightn't the SWFs decide to buy the Financial Times, Wall Street Journal, and Blogger.com to quiet pesky journalists and wise-ass bloggers?
10) A 9.9% stake in Goldman Sachs. Perhaps the most outlandish suggestion of the lot!
As Macro Man was walking down the street yesterday, he passed a bar full of merrymakers engaged in raucous singing. Curious as to who could be the source of such a cacophany, he peered trough the window. Imagine his surprise when he saw a large banner which read "Dipbuyers of the World Christmas Party 2007"! The singing was badly off-key and had a slightly desperate tone to it. Curious as to what the DOTW could be singing, Macro Man stuck his head through the door. This is what he heard....
I’m long a CDO
The tranche is Triple A
What’s happ’ning? I don’t know
The bid has gone away!
My boss’s mobile rings
Something isn’t right
What will we do now the bleeding
Market’s gone to shite?
Oh, Jingle bells, credit smells
The bid has gone away
I cannot find a buyer
For my erstwhile Triple A (Hey!) (repeat)
A day or two ago
I bought some kiwi-yen
But then the S&P
Tanked three percent again!
And now my margin clerk
Is ringing night and day
That guy’s a frickin’ jerk
I wish he’d go away!
Oh jingle bells, the market sells
Whenever there’s a bid
But the price of all my short puts
Doesn’t seem to have a lid! (repeat)
A day or two ago
The story I must tell
I sold out my euro
Then got short as it fell
PBOC did a drive-by
It’s up two cents today
I tried to buy them back
But now the market’s run away!
Oh, jingle bells, subprime smells
My budget cannot cope
I need to tank my FICO
Then call 1-800-HOPE (repeat)
My P/L is red
I haven’t got a prayer
My bonus hopes are dead
My employer doesn’t care!
Why did I buy the dip
When circumstances changed?
Was it a dodgy trip
Or was I simply deranged?
Oh, jingle bells, credit smells
The market’s all one-way
I’m going to get the sack
If I can’t sell it out today!
Today is Macro Man's last day in the office before taking his Christmas holidays. He will continue posting occasionally throughout the holiday period, though his efforts may be somewhat less tactical than usual. Best wishes to all readers for a happy holiday season and a prosperous new year.
You know markets are feeling the squeeze when volatility is maintained in the week before Christmas. Usually this is a week to nip out shopping, enjoy long boozy lunches, and engage in quizzes with colleagues and counterparties. This year, however, there seems to be a fair amount of portfolio cleansing, with risk across a number of popular strategies getting cut. The upshot is that most directional players who made money last month are probably losing in December...as are many of those who lost money last month as well.
It's also the time for banks, strategists, and even bloggers to begin sending out their list of "Favourite trades for 2008" or "Things to watch for Next Year." Friend Cassandra had a go yesterday, wherein one of next year's expected trends was forecast as "disinvestment beats investment by a wide margin." In other words, everything's overvalued and cash is king.
While such a theory is easy for many observers to embrace in equities and credit, to date it has had little resonance for government bonds. Sure, govvys have backed up over the last few weeks, but in many developed countries yields are still perched very much to the low end of the 2007 range. The rationale, of course, is a "safe haven" bid amongst the sturm und drang of money market ruptures and equity volatility.
Yesterday Macro Man proffered the suggestion that nominal duration is an unttractive proposition; today he offers a bit of viiual evidence. The chart below shows real 10 year yields in the G4, deflated by the broadest measure of consumer prices, lagged one month. This means that that Gilts, for example, are deflated by the Retail Price Index (current reading 4.3% y/y) rather than the harmonized CPI (current reading 2.1%.) While the latter is the target used by the Bank of England, the former more accurately reflects the cost of living. Try, for example, to avoid paying your mortgage or your council tax bill by claiming that you "only consume the harmonized CPI basket", and see how far that gets you!
In any event, the chart shows that real yields have fallen across the G4, particularly in the US and Europe. Part of that is down to a base effect quirk in the CPI data, of course, but a good deal is down to the decline in nominal yields as well. In any event, real 10 year yields in the US are now not only negative, but at their lowest levels of the millennium. And all markets look much more expensively priced than at the beginning of the last global downturn. Judged from a real yield perspective, therefore, the investment prosepct for nominal government bonds bites.
What's particularly interesting is that the real yield gap between the US and Europe is now 1.37% in favour of the latter. This is the highest reading in favour of the EUR since March of 2001, a month in which EUR/USD traded through 0.90. While The Economist cover curse has done its work, generating a sharp correction lower in EUR/USD, Macro Man gets the sense that the market wants to make something more of the dollar. Could it be that people are actually turning....bullish?
On one measure, at least, so it would seem. The DB/Rusell Mellon position survey suggests a sharp increase in dollar longs at both the median and extreme levels. Such a move is difficult to reconcile with the trend in place until a couple of weeks ago, but might suggest that some deep-pocketed currency punters are beginning to use valuation as a more prominent investment metric.
Of course, that begs of the question of relative asset market valuation...which brings us back to the real yield measure noted above. Of the G4 currencies, US 10 year valuation is pretty clearly the least attractive. And since the US is still a "fixed income" currency, that should bode ill for the dollar in the medium term, barring either a bum-clenching recession (which shakes out long-term dollar shorts) or a sharp acceleration in growth (leading to higher nominal yields.) While each of these is certainly possible in 2008, neither is likely to emerge with certainty in the first quarter. Strangely enough, therefore, a bullish EUR/USD strategy into new year may have the twin attraction of being both fundamentally justified and contrarian!
One possible roadblock would be an unorthodox policy choice from the Middle East. What if, instead of allowing their currencies to appreciate against the dollar, they instead force the dollar to appreciate against other currencies? Forget the arguments on sovereignty and the appropriateness of foreign agents setting monetary conditions in the US; PBOC has been doing so for four years already.
But from the GCC's perspective, what would be easier? Breaking long-held pegs and switiching to a "complicated" basket....or just saying "200 billion EUR/USD yours"? It's not like they don't have the money to do so! And it would ease at least part of the problem, namely the decline in the trade-weighted foreign exchange value of the riyal, dirham, et al. It wouldn't of course, solve the issue of farcically low interest rates and the money creation resulting from partially sterlilized intervention...but then again these guys don't seem to care about that stuff anyway. Hell, they don't even seem to really care about the foreign exchange value of their currencies....why else would USD/SAR be at a multi-year in a week when millions of Muslims are convening on Mecca?
Finally, a bit of portfolio clean up. Macro Man will roll his short ESZ7 exposure to March this afternoon and will close the SGD swap overnight. Over the next week or so he'll look to roll out his put exposure on the Hang Seng as well. If Cassie and others are right and valuation is starting to matter, this is no time to be jettisoning short exposure to quasi-Chinese equities!
Well, well well. Macro Man was offline on Friday afternoon, engaged in one of those "rich food and expensive claret" luncheons, but it looks like he missed a doozy. He's now the proud owner of a new £20 pound note, courtesy of the high CPI inflation print. The reaction of risk asset markets was pretty apt, given that the price rise was pretty broad-based. Headline, core, food, energy....it's all going up. And not just in the US of course! Just this month, Macro Man has already highlighted multi-year highs in CPI inflation in both Europe and China. The same, it almost need not be said, holds true in countries as diverse as Singapore and South Africa. Indeed, it seems as if there's only two kinds of countries that aren't experiencing multiyear highs in inflation: erstwhile hyperinflationary economies (Brazil, Russia, Turkey) who have a recent legacy of maxi-devaluation of the currency, and Japan. The question of what ails Japan is worthy of its own post, or indeed its own blog; suffice to say that the country is back in the doldrums. More interesting is the implication for other markets.
This week, for example, sees a round of liquidity auctions from the "Gang of Five"- the Fed, ECB, BOE, BOC, and SNB. This is the first shot in the banks' attempt at a microeconomic solution to the money market crisis. Yet the Fed, BOE, and BOC have already begun pursuing macroeconomic solutions via cuts in the benchmark interest rate.
The question which was always going to arise from such an effort is now pushing to the forefront of markets' agendas: how much can CBs ease when inflation appears to be a legitimate problem? One answer is "as much as they want", but that of course ignores the lessons of the 1970's. It seems pretty clear that the Fed's been dragged kicking and screaming into the last two easings, and it's not an unreasonable assumption to say that the bar will be set even higher for further monetary stimulus int he near-term. If, indeed, one can even think of the near-term; the next Fed meeting isn't until the end of January.
In the near term, then, adverse price may well have tied the hands of the Fed (and pretty clearly, the ECB), if not other central banks. There would appear to be little chance of CBs getting "ahead of the curve" as envisaged by most market participants. The upshot, then, is that risky assets are unliely to be on the receiving end of the warm bath of liquidity that has prompted the last couple of forays to the topside.
From a tactical perpective, therefore, the outlook for risky assets would appear to be somewhat unfavourable. Yet nominal bonds are not exactly screaming "buy me!" either. True, 10 year yields have risen almost 0.40% over the last couple of weeks. Yet they've failed to keep up with y/y CPI, and on that basis yields are now negative. Errr......no thanks.
So what to do? Risk assets look set to at least explore further downside, yet nominal bonds currently pay you nowt in real terms. Perhaps it's time to look at Macro man's old friend, TIPS. Not only do they provide the safety of government securities, but they also insure one's portfolio against further adverse price moves. Moreover, there is a seasonal component to TIPS that is worth considering, as the inflation compensation is calculated off of the non-seasonally adjusted CPI index.
Basically, Q1 generally sees a sharp rise in the NSA index, presumably due to new year's mark ups and administered price rises. The table below sets out the seasonality; the NSA index has never failed to rise at least 1% in Q1 this decade, with the rise exceeding 1.5% in each of the last four years. Indeed, in six of the last 11 years, the Q1 rise in the NSA index exceeded that of the subsequent three quarters combined! Put it all together and, for the next couple of months, TIPS look like just about the best long-side bet going. Macro Man will therefore bid 104 for another $25 million of the issue that he already owns. If done, he may well look to sell a bit of crude oil to hedge against a commodity price implosion.
Finally, we're approaching levels in EUR/USD where it is safe to conclude that The Economist cover curse has struck again. Macro Man is trying very hard not to read too much into price action. While the rally in the dollar could well reflect a repricing of the Fed, a downgrade of expectations elsewhere, a repatriation of USD by American firms looking to shore up balance sheets, or a bet of valuation, the reality is that currency markets appear to be following the script observed elsewhere, e.g. he who plays, loses.
Go figure. Just two days after the Fed was lambasted for not cutting the discount rate by 0.50%, a set of data are released that suggest that Bernanke and co. should be hiking, rather than cutting, interest rates. OK, that's a bit of a simplification.
Macro Man, for one, has tried to separate macroeconomic policy drivers from microeconomic drivers. The microeconomic case for policy relief is fairly strong, as a market fairly central to the entire financial system (and by extension the economy) has more or less ceased to operate. Providing term liquidity is not about bailing out rich bankers or hedge fund managers; rather, it's about helping to ensure that Main Street banks are not so risk averse that they refuse to lend to high quality household and business borrowers. That's why he thought that doing 0.25% on the discount rate was an own goal.
And what of the macroeconomic case for policy easing? As far as Macro Man can make out, the entire case can be summarized in the chart below.
Housing has taken a dent out of growth mechanistically via reduced housing investment from homebuilders. And yes, as the chart above indicates, there has been a hit to household wealth, and thus to consumption. But housing equity doesn't tell the whole story, of course. Aggregate household wealth is still comfortably positive on a y/y basis.
One of the difficulties of writing a blog is that sometimes you don't know where to start. You know what you want to say in the main body of the post, and you might have a snappy line with which to conclude.....but you just can't come up with a "leader" as they say in the world of journalism. Macro Man is suffering from a bit of fatigue today, and cannot think of an opening gambit. So there; he can't come up with a clever opening line, so let's proceed directly to the main body of the post.
While the difficulties facing the United States are by now well-known (and, some would argue, fairly well-discounted), the UK is starting to resemble its erstwhile colony in a number of ways. Dodgy financial institutions? Check. Central bank losing credibility? Check. Inflation a problem? Check- a BOE inflation expectations survey registered its highest print in history (which admittedly is only 8 years), which certainly jives with the cost of living as observed by Macro Man. Housing market looking ropy? Check- the RICS house price balance collapsed to -40.6% in November, way below the expected -28.5%.
The recent trend looks like the NAHB, doen't it? Although the trades are to some extent in the price, Macro Man wonders if it isn't worth putting on a series of "USA redux" trades in UK markets in the new year- short the currency, long the front end of the govvy curve, short equities on a spread basis, long vol on the strip. There's no point doing it now given current pricing, but once liquidity conditions appear to improve it might be worth a shot.
The Christmas lunch and dinner circuit is well underway by now, with banks and brokers plying their customers with rich food and expensive claret. It's interesting to observe how the conversation at these occasions tends to drift towards the same topic. This year, it's all about the bifurcation of compensation in financial markets; "star performers" will get paid well enough to ensure that they stay, whereas "squad members" are seen as fungible and as such will be compensated poorly by the standards of the past few years. The upshot is that there is likely to be a good deal of staff turnover, either via redundancies or voluntary churn.
Those left standing when the music stops may be forced to seek an alternative line of work. The problem, of course, is that those of us who entered the market straight out of school are by and large utterly unqualified to do anything but stare at flashing numbers on a computer screen. To aid those unfortunates, particularly in the credit space, who may find themselves out of a job next year, Macro Man is pleased to offer some advice on potential career alternatives:
1) Garbage man: For those who have spent the past few years selling and (more to the point) buying rubbish, a career in the custodial arts may offer the opportunity to leverage one's knowledge of dealing with junk.
2) Stand-up comic: Is your pricing model a joke? Is your P/L so bad that you have to laugh (or else you'll cry)? Take it to the stage and win fame and fortune! After getting roasted by your boss, dealing with hecklers will be a walk in the park.
3) Porn actor: For those whose P/L's have been repeatedly f****d this year, a career in erotic cinema will seem like business as usual.
4) Used yacht salesman: You may not have experience in dealing with tangible assets, but there's likely to be plenty of demand for someone who can shift used yachts at a high price.
5) Barber/stylist: For those in the credit market who've spent most of 2007 dealing with haircuts, this is an obvious career progression.
6) Back-up singer for Dire Straits: A natural role for anyone who's been collecting money for nothing over the past few years.
7) Write a finance blog: After all, if you can think up a snappy introduction every day, you've already gone one better than a knucklehead like Macro Man.
Even without the Fed's help, this is a market designed to help one lose money. Higher volatility means that random noise can generate an asset price move that one would, under more normal circumstances , associate with "signal." This in turn causes many in the market to establish/close positions on the misguided notion that there is useful informational content in price moves.
Until year end, Macro Man does not expect to be able to explain much of what he sees without using the words "noise" or "positioning". In this sort of market, selling what others have just bought and buying what they have just sold is probably a useful strategy.
In that vein, Macro Man was interested to see that two of the more high profile foreign exchange technical analysts on the street were both stopped out of short USD/JPY positions at 112.20, courtesy of the TAF announcement. As such, and given the nasty fade in equities, it would appear prudent to take profits on his partial delta hedge of USD/JPY straddles. Macro Man therefore sells $15 mio USD/JPY at 112.06 spot basis.
...The Fed did have something up its sleeve, a program to auction liquidity that broadens the eligibility of tapping the Fed, both in terms of institution and collateral. At the same time, it's announced a joint FX swap facility to provide foreign currency liquidity across the world.
The Grinch has seen the light, and provided a treat (TAFfy?) to all the Whos in Whoville. Still, $40 bio this side of the Turn isn't exactly OTT, and surely the timing could have been handled better? The last 24 hours has seen substantial amounts of unnecessary financial market volatility; while the Fed doesn't have to bail out market participants, it doesn't necessarily have to go out of its way to screw them, either. And clearly, anyone short gamma over the last day has just been screwed.
So while the story apparently has a happy ending and the Grinch is everyone's new best friend, Macro Man remains wary. This may be the beginning of the end...or it may be the end of the beginning. Either way, the last 24 hours suggests that wherever we're going, we ain't gonna get there in a straight line. Stay long vol.
A day later, the Fed's policy own goal continues to baffle Macro Man. Why would the Fed disappoint market expectation when there was little risk of negative macroeconomic consequence from delivering the expected 0.50% reduction in the discount rate?
Regardless, the market impact of the 25/25 decision was not difficult to forecast, and now 1450 on the S&P 500 is literally closer to current levels than 1550. Coincidentally, the Federal Reserve is in the process of updating the official portraits of all key staff. On an exclusive basis, Macro Man is pleased to reveal Ben Bernanke's new official picture, shown to the left.
What's troubling about yesterday's announcement is that it suggests one of the following three statements is true:
1) The Fed was unaware of the policy action that was expected by markets, e.g. a 50 bp cut in the discount rate.
2) The Fed was aware of market expectation but intentionally decided to disappoint that expectation on the basis of moral hazard issues, despite the fact that current discount window borrowing is now not noticably higher than it was before the money market crisis kicked off.
3) The Fed was aware of market expectation and did not wish to disappoint it, but prefers to provide liquidity in a dripfeed fashion with incremental changes to the window rate, the term of loans offered at the window, and the acceptable collateral that can be tendered.
None of these options inspires much confidence, does it? Indeed, the Bernanke Fed is swiftly coming to resemble the Duisenberg ECB, which itself resembled nothing so much as the proverbial troupe of clowns packed into a Volkswagen Beetle. While it is admittedly easier for those of us in the peanut gallery to lob criticisms at policymakers than it is to actually bear the responsibility for making decisions, on an objective analysis the Bernanke Fed would appear to score relatively low on market nous and credibility.
Rumours are now swirling that the Fed will do something to amend the functioning of the discount window, with both the FT and WSJ suggesting that further action could happen as early as this week. But this begs the question of why, if the Fed has been carrying this policy option in its locker, did it not unveil it last night? It's not as if there isn't abundant evidence that cuts in the funds rate are not easing financial conditions, which is presumably the aim of cutting rates in the first place.
A full 100 bps of easing in the Fed funds rate has taken 1 month LIBOR down a whopping 15 bps from the levels prevailing at the end of July. Yippie-kai-yay!
Similarly, corporate boprrowing rates have no come lower in nominal terms, and have obviously blown out in spread terms. The Moody's Baa index has shown a sharp rise in borrowing costs recently, with nominal yields now higher than they were in late July. Admittedly, some of this may be driven by the poor quality of the ratings themselves, but the message is clear: what the Fed has done to date is not easing conditions, and as such will not have the desired impact of supporting moderate economic growth.
Now obviously, if the Fed were to announce sweeping changes to the current liquidity structure, then confidence might be shored up and financial conditions ease. After all, even the Grinch relented in the end and celebrated Christmas with the Whos. But when your central bank is being run by a character from Dr. Seuss, it seems fair to suggest that the problems cannot be banished in one fell swoop, and that volatility will remain aa theme into 2008.
No P/L today due to IT issues.
Very peculiar. The discount window, in its current incarnation, is little more than tinsel on a Christmas tree: an ornament that serves relatively little practical purpose. So adjustments to the rate are relatively symbolic on the one hand, and carry few macroeconomic consequences on the other.
So the Bernanke Fed, faced with a stunning degree of illiquidity in short term money markets, decides to disappoint markets on a rate that carries relatively little macroeconomic risk but could provide a useful balm to confidence in the banking system.
If they were worried about moral hazard, why not do zero on Fed funds, but take the discount rate down 75? It wouldn't be hard to argue that that would be a more appropriate solution to the current situation than 25 on funds and a half-arsed 25 on the discount rate.
Is Macro Man alone in feeling that if Bernanke were a football manager, the hometown supporters would be singing "you don't know what you're doing" right about now?
At last it's time to put up or shut up.....or, given the market torpor of the last couple of weeks, perhaps it's just time to wake up. Today sees the last FOMC announcement of 2007, and with it the provision of the next dose of liquidity to financial markets.
A broad consensus has devleoped that the FOMC will deliver 0.25% on the funds rate and 0.50% on the discount rate. The latter move, if carried out, would appear to be largely symbolic, as it would still represent a punitive rate accessible by a limited number of borrowers. Were the Fed to re-invent the discount window as offering liquidity at an actual discount to Fed funds , while at the same time broadening its scope, then we could perhaps call the beginning of the end of the seizing up of short term money markets. Word on the street is that this is highly unlikely to happen, so it could well be the case that tonight's announcement is something of an anticlimax.
The last week or two have seen a reversal of the powerful trends of early-mid November, and it would be reasonable to assume that a 25&50 outcome would prompt at least a fleeting attempt at lower stock prices and bond yields. Certainly that was the bias in last week's poll. It's funny though; is it just Macro Man, or does 1450 seem a lot "closer" than 1550 on the SPX, despite the obvious mathematical fallacy in the statement? Macro Man remains relatively nervous, but he wonders if the apparent proximity of the 1450 level doesn't suggest the threat of a late year melt-up.
Such an outcome would presumably be a surprise to Morgan Stanley, which yesterday shifted its base case US economic call to a mild recession. Macro Man quite likes Dick Berner's work and respects his views, but retains his own expectation for an export-driven muddle through next year. Certainly leading indicators have yet to fall off sufficiently to suggest imminent recession; while the ECRI weekly measure has come well off its highs, the decline is relatively modest compared to 2000-01. Moreover, the index actually bounced quite sharply last week, so weakness clearly isn't one-way traffic.
Elsewhere, we've had (yawn) yet more upside inflation surprises from Bretton Woods II countries this week. Yesterday, Saudi Arabia reported CPI at a record 5.4% (OK, the data only goes back a few years), while overnight Chinese CPI once again exceeded expectations at 6.9%. As the chart below indicates, this is the highest in 11 years. While food prices remain the principal explanatory variable, the recent rise in administered fuel prices has taken non-food inflation to 1.4%.
"Slow down. You move too fast."
- Simon and Garfunkel, The 59th Street Bridge Song (Feelin' Groovy)
Friday was the quietest payroll day that Macro Man can remember. Perhaps it was the lack of weakness in the figure, perhaps it was the looming decision from the Federal Reserve, perhaps it was the need to get on with Christmas shopping, or perhaps it was the hangovers. Whatever the cause, the market just didn't seem to care, as action was pretty lackluster in all markets last Friday.
This environment, of course, lends itself to contemplation of longer-term issues and/or specific themes. So, too, seems to be the case in Beijing, where the economic mandarins appear to be catching up on all the 60's Western music that was verboten during the Cultural Revolution. In particular, the folk stylings of Simon and Garfunkel appear to have caught on, with the 59th Street Bridge Song currently topping the charts.
Last week, the Central Economic Work Conference announced that it intends to shift the monetary policy setting to "tight" in an effort to rein in economic overheating and inflation. That presumably means that they don't believe that the rise in CPI inflation is merely down to temporary microeconomic factors, after all.
In any event, the first shot of the tightening campaign was fired over the weekend, when PBOC raised the reserve requirement ratio by a full 1% to 14.5% This was the first 100 bp rise in the RRR since 2004, the last period of intentional policy tightening in China. The move is probably not as bold as it appears; December traditionally sees a disproportionate amount of fiscal spending from central and local governments, which draws down their central bank deposit balances and puts liquidity into the system.
Nevertheless, it is probably still worthwhile paying attention to the authorities' preferences. The clampdown on new lending in Q4 has apparently been severe, and the authorities did manage to slow growth the last time they tried to, in 2004.
If we step into the "way-back machine", we can see that China's policy clampdown did appear to have significant market consequences. The most obvious starting point is base metals, given that China accounts for 40-50% of world demand for metals like copper and zinc. Looking at the Journal of Commerce industrial metals index, we can see that it basically went nowhere for more than one and a half years after the last policy tightening. One could argue that we've been in a range for the last nine months; nevertheless, if history were to repeat itself, we have another few quarters in store of sideways trade in metals .
To a degree, however, that's already in the price. Copper has fallen precipitously since early October, and at this point it looks like a poor place to layer fresh shorts. Perhaps it is worth selling, however, in the 330-340 region, which would represent a reasonable retracment of the peak-to-trough move.
Europe is yesterday's news. No, Macro Man is not commenting on the long-gone period of European geopolitical hegemony, nor indeed about the 2006 European economic recovery. For once, he is being literal, as yesterday saw rate decisions from the Bank of England and ECB.
The BOE cut rates 0.25%, finally reacting do the deterioration in financial and economic conditions. It is almost certainly the first of several cuts, particularly as borrowing is unlikely to be cheaper without substantially lower base rates. Today's Times carries an interesting table on the front page showing the sharp increase in "arranging fees", which means that the ultimate cost to borrowers continues to rise- thus necessitating more BOE easing if it is to have an impact.
Unsurprisingly, the pound got whacked on the back of the announcement, and cable is now down more than 2% since the fateful Economist cover a week ago. Interestingly, cable is approaching fairly key support, as depicted in the chart below, and EUR/GBP is close to breaking out as well. Perhaps after allowing for a tactical pullback, it will be time to re-activate the strategic sterling short dicsussed in January.
In the Eurozone, the ECB unsurprisingly left rates unchanged. But ECB president Trichet left markets in no doubt that the bank is nowhere close to even contemplating the onset of an easing campaign. Particularly telling were the bank staff's economic forecasts: while 2008 growth range was revised down by 0.3%, the inflation range was forecast up by half a percent, to 2-3%. An inflation forecast whose most optimistic outcome is the top of the ECB's acceptable range is pretty darned hawkish.
While markets have been surprisingly receptive this month to selling the euro on the basis that the ECB will have to revert towards a more dovish stance, Macro Man is wondering if these trades aren't perhaps a few months premature. The ideal time to sell euros is probably on the downside of the inflation "hump", when the ECB is more likely to change tone. As the chart below illustrates, the hump may just be getting started.
Ah, the festive season! Christmas trees are springing up, nativity plays are being performed, carols are pouring out of the radio, and all across the City copious amount of rich food and expensive claret are being consumed at lunch and dinner time. It's enough to bring a tear to the eye, especially amongst those whose bonus checks will be signed by Ebenezer Scrooge this year.
Macro Man has yet to start on his Christmas shopping (any suggstions for cool presents for Mrs. Macro gratefully received), as he has been busy writing his annual letter to Santa, complete with Christmas wish list. This year's list included the following:
1) Comeuppance for currency piss-takers. Or, put another way, a messy collapse to the Bretton Woods II arrangement. Now that the inflationary consequences of wildly inappropriate currency policy are being felt from Beijing to Bahrain, Macro Man would like to see these effects intensify until China, the GCC, and others are forced to abandon or significantly alter their pegs. Remember, chaps, those who refuse to get off a sinking ship have no right to complain if their feet get wet.
2) The correct reporting of inflation. Is it really too much to ask that the cost of living be accurately reflected in government statistics (and by extension, reflected in the price of inflation linked bonds)?
3) Policymakers admitting when they f$*& up. It's hard to know whose stock has fallen further this year: Northern Rock's or Mervyn King's? The unedifiying spectacle of the UK authorities' passing the blame for the Northern Rock debacle was surpassed only by Swervin' Mervyn's subsequent claim that the Bank of England had performed better during the crisis period than either the Fed or the ECB. Uh, Merv? No.
In any event, the BOE has an opportunity to atone for recent gaffes by doing the sensible thing and trimming rates today. Will Merv defy common sense just to make a point to the man who will get rid of him next year?
4) World peace, a car that runs on water, and a cure for cancer. See, Macro Man is not totally selfish.
5) A BMW M3. Or, more to the point, clearance from the control tower to purchase one. Assuming that the car that runs on water is not immediately forthcoming, the elder Macro Boy has now goaded Macro Man into trading in his trusty old Golf for something a bit "cooler."
6) A middle/back office that understands its place in the organizational hierarchy. Namely, that it is a service provider, not the centre of the investment universe. (Small organizational grumble here.)
7) The return of alpha. Financial market de-coupling is one of Macro Man's themes for 2008, when value will out and investors will be forced to choose quality and sell rubbish, rather than just buy everything and sell everything. While this may spell doom for Macro Man's beta strategies, he hopefully has enough market acumen to more than benefit via the alpha portfolio.
8) Getting on the distribution list for "the memo." In the event of Christmas wish number 7 not being granted, Macro Man would like to start receiving "the memo." You know, the memo that the market seems to receive early in the day that says "we're going to buy risky stuff today" or "we're going to sell risky stuff today", which leads to a host of apparently unrelated items all doing the same thing at the same time. If subscriptions to "the memo" are unavailable, a phone call from The Economist's art department the night before they put the dollar on the cover would suffice.
9) The immediate writedown of all subprime and other structured credit turds to fair value. We know it's coming, we know it's in the pipeline. It can either be done slowly, in drip-feed fashion, with rumours and speculation rampant.....or it can be done in one fell swoop. It's a situation very similar to the GCC currency peg, insofar as ripping off the band-aid would ultimately be better than trying to peel it off slowly.
10) The ability to remain objective, keep a clear head, take necessary losses, and cach up on sleep at the weekends. 'Nuff said!
Macro Man had to chuckle this morning when he read a note from Goldman Sachs declaring "victory" on the research group's decoupling thesis and warning that 2008 may be the year of "recoupling." De-coupling, for the uninitiated, is the theory that the rest of the world can shrug off US domestic economic and financial weakness and continue to party. Re-coupling is the notion that the rest of the world will finally catch cold fom the US housing market's sneeze.
Long-time readers of this space will recall that Macro Man has long thought the theory was poppycock. The case for decoupling has basically been rooted in the notion that US housing will sink the US economy because...well...it just has to, while the rest of the world appears to be doing jolly well courtesy of the BRICs.
The case against decoupling has been, by and large, just about every piece of empirical evidence that Macro Man has looked at. Lost in the hubbub over the US housing market is the fact that, through the first three quarters of the year, US economic growth has been considerably quicker than it was in 2006.
The average annualized quarterly growth of the US economy in 2006 was 2.6%. So far this year, it's been 3.1%. Even if the US economy grows at a measly 1% rate this quarter, 2007's growth rate will match that of 2006. A big reason why, of course, will be net exports. There seems to be an off assumption amongst commentators that the links between the US and the rest of the world flow only in one direction. This of course is patent nonsense, and a key reason why decoupling has been a myth is that the US has been kept afloat by strong demand elsewhere in the globe.
Looking at Europe as a comparison point, average quarterly growth so far in 2007 has been 2.4%, which is lower than both the equivalent US figure and the Eurozone's 2006 average of 3.2%. Hard to see the decoupling there. True, China has been growing at a faster clip in 2007 than in 2006. But again, isn't that we've observed so far from the US?
Similarly, inflation rates are at decade highs in the Middle East, Germany, and many Asian countries. Energy and food prices are an obvious driver there, and they are also now putting upward pressure on US headline inflation as well. Given that everyone in the world needs to eat, and fuel consumption is necessary for economic activity, it's difficult to see how the basic cost of living can decouple across regions in terms of trend (magintudes can differ because of different consumption basket weights.)
As for financial markets, the volatility observed since August has made a mockery of the decoupling thesis. If subprime and housing are US problems, why are interbank spreads blowing out across all developed markets? Why did European money market funds hit the wall in July/August? Why is Northern Rock in the UK on the brink of nationalization?
Moreover, cross-market correlations are remarkable high. Consider the case of two fundamentally unrelated financial market prices, the S&P 500 and the NZD/JPY exchange rate. In 2007, the r-squared between these two has been 0.53, a remarkably strong relationship. In contrast, the r-squared in 2006 was 0.004. In 2005, it was 0. In 2004, it was 0.004. In 2003, 0.002. How, then, does this represent "decoupling"?
Regular readers will recall a periodic analysis that Macro Man performs on a typical "balanced" portfolio in G3 markets. He looks at the rolling risk-adjusted return in the US, Europe, and Japan of a portfolio comprised of 60% equity, 35% bonds, and 5% cash. The results for rolling 1 year return:risk ratios ending last month are shown in the chart below.
At last, we have evidence of decoupling! Only it's been Japan, the great recovery favourite of recent years, that has decoupled from its major-market brethren. Ironic, isn't it, how the country perched on China's doorstep is the one with the lousy growth and asset returns.
Perhaps, though, the world's central banks have been drinking the "de-coupling" Kool-aid. Until yesterday, the Fed was the only developed market central bank to cut rates since the crisis began. However, the Bank of Canada joined its southern neighbour yesterday, surprising markets (or at least economists) by trimming rates 0.25%.
What makes this ironic is that independently-calculated leading indicators are actually more favourable for North America than they are for Europe, where there's been no easing to date. The OECD leading indicators are shown in the chart below, calculated in Macro Man's preferred 6m/6m change format.
Observe how the US and Canada leading indicators are showing a firmer rate of growth than those in the UK and Eurozone, yet it is the latter two which have yet to ease policy. That of course could change tomorrow, given that another set of lousy house price data in the UK (what's that about de-coupling?) and a poor services PMI make trimming the BOE base rate highly advisable.
So congratulations to Goldman and most other commentators on their "prescient" de-coupling view for 2007. It's a pity that the call didn't seem to yield profits in August and November, as those pesky asset-market correlations all seemed to trend toward 1 during times of stress. Ironically, just as GS is calling for global economic "re-coupling" in 2008, Macro Man is wondering if it won't be the year of financial market "de-coupling", where relative value and spread trades trump the "buy 'em all" and "sell 'em all" strategies of the "de-coupled" 2007.
Macro Man can of course be wrong in his view, but that's the wonderful thing about P/Ls as a method of keeping score. It's pretty hard to declare victory when your P/L has just handed you a big fat loss.