Friday, January 11, 2008

Ben blinks

So Mr. Bernanke has looked into the abyss....and what he's seen has not pleased him. Yesterday's comments, suggesting the potential for "substantial" further policy easing, appear to prove that while you can take Ben out of the helicopter, you can't take the helicopter out of Ben. The Fed chairman's comments were a stark contrast to his European colleague's, as Mr. Trichet refused to contemplate even the possibility of cutting rates.

The reaction of markets seems pretty apt to Macro Man: the US curve steepened and the dollar got whacked. The latter development seemed very much in line with how the dollar traded in the last few months of 2007; while it may have confounded the emerging consensus of a dollar rebound, it came as little surprise to Macro Man.

A dollar-bearish thesis is even easier to embrace when one considers that a 0.50% easing at the end of the month, which one must consider as a realistic possibility, would give the United States the third lowest policy rate in the G10. Assuming that market rates follow, this would mean that the dollar would re-enter the G10 carry a funding currency.

Does this have implications for the buck? Macro Man ran a simple study to find out. Using data back to 1983, he constructed a simple model wherein he follows the following rules:

* If the USD has one of the 3 highest interest rates in the G10, he goes long dollars against an equally-weighted basket of the three lowest-yielding currencies

* If the USD has one of the 3 lowest interest rates in the G10, he goes short dollars against an equally-weighted basket of the three highest-yielding currencies

* Positions are held as long as the dollar is in the top or bottom three yielding currencies; when it is not, the model has no position.

The return curve of the strategy is displayed below.
For the entire 25 year period, the strategy delivers an annual return of 4% with an annualized volatility of 6.2%; a return/risk ratio of 0.65. That is pretty darned good for such a simple strategy.

It's interesting to note that the vast majority of the returns have come in the last decade or so, a period of time which has seen the explosion of quantitative carry-based hedge fund and overlay models. Since 1997, the annualized return has has jumped to 8.4%, albeit with a concomitant rise in volatility to 7.2%. That represents a return/risk ratio of 1.15, a performance figure that the vast majority of market participants would be happy to exchange for their actual 10-year performance track records.

So while there is no guarantee that the dollar will continue to fall, the weight of evidence suggests that it is a reasonable proposition.

Meanwhile, BB's demonstration of willingness to cut aggressively even with inflation remaining an issue is a classic recipe for curve steepening. This has cut Macro Man in two ways: his 2 year payer swap has been run over, while his TIPS position has eroded a little value as well (strangely, breakevens have narrowed!) While he's happy to keep the latter, the former needs addressing.

Macro Man is happy to keep his Euro 2 year position, so an alternative spread trade might be a cross-currency steepener: receiving 2 year euro and paying 10 year US. This strategy entails small negative carry, but much less than a US steepener on its own. The profit potential, particularly once Trichet relents (in March, perhaps?), should be substantial.

Macro Man therefore will execute a US 2-10 steepener, closing the 2 year leg at 3.39 and paying US 10 years at 4.49, each in $20k/bp. Seperately, the large cap/small cap spread is working well; Macro man will look to add to that position on a pullback to 0.9100 or so on the ratio.


Peter said...

i have respect for your views (after all, you are the one with the VW Golf), and I think that the dollar continues in its oct-nov07 fashion is in the cards

BUT, it could also be part of a bottom building process of the dollar, and once (and if) the data starts to weaken in Europe and the BRICs the dollar will in the end benefit. and lets say the 1.4850-1.49 range in EURUSD wont be crossed upwards

2and20 said...

TIPS spread indicating deflation. how would steepeners do in that scenario?

next thing coming is the commodity market crash.

Macro Man said...

Peter, one could plausibly argue that a moonshot rally in EUR anbove 1.50 is, in fact, what's required to get the ECB to change course.

IN the meantime, any dollar strength caused bu US-centric issues will probably concentrate most on EM, with any EUR/USD emerging as an afterthought.

2/20, I wouldn't be so sure about the commodity crash. The genesis of the current bull was the relfationary monetary policies of the early Noughties; if we're moving back to that world, then the price of "stuff" should appreciate against the price of paper.

OldVet said...

That "building consensus" for a dollar rebound always sounded suspiciously like a duck call, trying to lure down the high flyers.

Anonymous said...

what if you did the same exercise using real rates? per lex "defined here as base rates less headline consumer price inflation"

Quarrel said...


why do the exercise that way?

While it may be important to consumers in the affected economy, surely the point is that the money is searching the globe for yield. It isn't going there looking to buy bread...

Macro strategies can afford to ignore concerns that are very very real to the peoples of those countries (at least in some cases).


Gregor said...

Hi Macro Man.

I have read your blog for a year now and very much enjoyed it.

Per recent thread discussions, you might enjoy my essay written last April on the topic of USD strength as a result of deflation, here in the US. I argued, in contrast to observers like Richard Russell and Peter Theil, that a housing bust assuredly would NOT strengthen the USD

Your version of what it means to be a macro man is rather different than mine, as I do not put on the sophisticated types of trades that you do (in your notional portfolio) but rather, I invest with the trend ans stick with it. It's hard to believe I started in the weak dollar and energy trade as far back as 2002. I did not forecast it would come this far. While I have learned alot from reading your blog, I would like to make three observations.

1. In my opinion, you were way too dismissive of the Australian Dollar on fairly consistent basis over the past 12+ months, seeing it exclusively as a carry-trade currency. I've been long the AUD for nearly 10 years, back from its lows near .5000 in the post Asian Financial Crisis. And, I believe the currency remains misunderstood, with a textbook over-focus on the current account deficit of Australia. The driving force behind the AUD is that the size and value of its resource base massively eclipses its local population. Which means the default position for Australia is export surpluses for many years to come, on an increasing basis. Based on your comments, I expect you will find such a framing distasteful, but, the idea that the AUD is going to and through USD parity (just like the CAD did) seems like an idea a reasonable person could now adopt.

2. You have said almost nothing about what is likely the greatest investment trend this decade, which is energy and oil. Again, this directly ties in with still widely held but antiquated views about currencies like the AUD and CAD. Especially the CAD. I think the CAD will buy 2.00 USD by 2015. I grant these are not timeframes that interest you much. As I said, you are a very different kind of trader. But for those of us who started in Oil back in 2003/2003, it becomes increasingly notable that even at 100.00, while many money managers own energy equities, very few actually understand the global oil market and issues surrounding oil geology. As someone with both an undergraduate and graduate degree, I would assert it still takes about 4000 hours of fresh study to get a mastery level knowledge of the global oil market. Given that hurdle, I am not a critic so much of those who don't understand--but one has to ask, what price level of Oil will cause money managers to develop serious knowledge in this area?

3. Many of us here in the States have been biting our knuckles at least since late 2003 over the credit and housing bubble. When I first read your blog, I thought certainly you were British or European because in my time living in both Australasia and in London, a common view I encountered was a persistent belief in the US ability to grow, reinvent itself, and extract itself from problems. This of course is understandable given post-war history. But, it's also of course totally incorrect. To this end, I am very very surprised that you have said so little about the massive LBJ style Guns and Butter explosion of debt under Bush, with its counterpart in the private sector. In other words, I never got the sense you were terrified and I still don't. You should be!

Finally, I want to be strongly complimentary and say that you are one of the best writers in the economic blogosphere. As importanly, your data-mash-ups (as I call them) are eye-opening and exceedingly creative. You are adding/creating heuristic value, to say the least. I have truly enjoyed these creations. Your work on all things related to Japan, in particular, over the last year has had some direct benefits to my own macro views, and decisions. Cheers.


Macro Man said...

Gregor, thanks for your thoughtful feedback on this space and the views expressed therein.

In responding, I'll first address the three points that you raise above:

1) You are correct that I probably have not made as much out of the Aussie (dollar or equity market) as I could have. And yes, part of this is down to a mental characterization of the AUD as a carry currency first and foremost.

Part of this is down to my general preference for avoiding "derivative" trades; i.e, buying Aussie dollars because I think that gold and coal and copper or going up. In my professional life I've had pretty lousy luck on such trades; if I am bullish gold or coal or copper, why not just buy those, rather than the derivative currency? Superficially, the AUD and the ZAR are pretty similar: high-yielding currencies of resource-producing current accoutn deficit countries. Obviously, there's a political issue with South Africa, particularly these days, that does not affect Australia. But I don't think that explains the divergent fortunes of the two currencies since April 2006.

But in general, you're right; in this space, I've been pretty dismissive of the AUD, such as in the debate a few days about what to buy against sterling. I suppose that my defense is that I've been somewhat more involved in my professional life, though again, largely from carry-related reasons. I have, however, no objection to the view that AUD/USD will trade through parity at some point.

2. I would say that my absence from the oil market is a point in my favour, rather than the opposite. I did, in fact, have energy positions early in the life of the blog; a long OIH/short Dow position, and a Dec 07 long WTI/short Brent position.

If I had held both of those positions athroughout 2007, each would have been enormously profitable. However, the position size in each was too large, and the p/l swings were too large to stomach for a market that I was not expert in. In other words, I didn't know enough to know I was right.

However, knowing what one does not know is extraordinarily useful in trading. While I've noted in this space on a couple of occcasions that I thought oil would eventually trade to 100, my experience is that the market is a lot more difficult than just buying and going away.

So you're right. It does take a lot of work to fully understand the oil market. And that's work that I have not (fully) done. And for better or for worse, 2007 was sufficiently busy that I didn't have the time to immerse myself in it. So why take positions in that market until I feel comfortable in my knowledge base?

(As an aside, I do feel comfortable in talking about the CAD< and I think there is very little chance that USD/CAD is going to 0.50. While ALberta's terms of trade would perhaps justify that move eventually, it would mean the end of a great deal of economic activity in the more highly populated Eastern provinces. A more likely outcome would be a Norway style "offshoring" of the energy recipts so as to mitiagte the Dutch disease impact on Ontario and Quebec.

3. As an American who's lived overseas for almost fourteen years, I have a couple observations:

a. In my experience, non-Americans are typically more dismissive of the resilience of the US economy than Americans are. They are also astonished at, for example, how little holiday/vacation US employees get. I suspect these two factora are related.

b. That having been said, Americans seem to believe that the US is unique (and hegemonic) in every way, that historical parallels are inappropriate (dotcom bubble versus a myriad of prior equity bubbles), and that today is either the greatest day ever or the world is utterly, utterly going to hell. In other words, it seems to me that the American worldview is dominated by hyperbole.

This is of course a generalization, and there are exceptions on both sides of the pond. It seems to me that China's worldview bears a few similarities to that of the United States, which will make for interesting viewing over the coming decades.

I thank you for your kind words about this space and am glad to hear that you have found it useful. So too, have I, which is after all why I write here every (week)day.

I do appreciate the kind of constructive criticisms you have raised, and woudl welcome more such observations in the future. This space obviously does not capture the entirety of my worldview; rather, I tend to write about the things that are on my mind on a given day.

I do find reader feedback and comments useful, and welcome more of the same.


mOOm said...

Living here in Oz, the Aussie Dollar seems way overvalued. 70 US Cents would be close to the PPP rate for tradeable goods and many services. Medicine and education are cheaper than in the US, but pretty much nothing else is.

Gregor said...

Thanks for the reply, MM. Yes, the internet giveth but it also taketh away. Folks can connect across oceans, but our thoughts deserve the full airing that only hours and hours can provide. Looking ahead, I am starting to wonder that 2008 may finish up with more of the previous trends well intact, than the markets are thinking right now.