Friday, January 11, 2008
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 basket....as 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.