A bit of 2007, a bit of 2008

Macro Man is back in the saddle, at his desk and in front of his screens. While he followed markets during his holidays, as always there is a bit of an adjustment process coming back to the office after a couple of weeks off. Not least because there remains something of a holiday flavour to markets so far today; unlike Macro Man's waistline, liquidity is feeling rather thin.

There were a couple of developments over the last couple of weeks that warrant comment, some of which bear on the market outlook moving forwards.

* The Q3 IMF COFER data was released, showing the dollar's share of global currency reserves falling to 63.8%. However, this data is worse than useless when taken at face value, given that most of the agents responsible for financing the US current account deficit either don't report their currency holdings (PBOC) or fall outside the remit of the survey (SWFs.) As Brad Setser suggests, a lot of the dollar decline was down to valuation changes rather than genuine diversification, though the aforementioned actors were clearly evident selling dollars for other convertible currencies in Q4.

* China has gone from subsidizing grain exports to penalizing them over the last month. At the same time, a labor law that is meant of offer some protection of workers' rights (and incomes) came into force yesterday. While the inflationary consequences of these measures may be up for debate, it is fairly clear that insofar as they have an impact on global prices, it will be to push them higher. As noted in the list of non-predictions, it seems unlikely that the inflation theme will go away any time soon.

* Sterling has been crushed as pessemism on the UK mounts. While Macro Man warmly embraces the sentiment, he struggles to see the attraction of fresh GBP shorts at current levels. He's prefer to wait for a pullback.

*The first TAF auctions were a moderate success, and underscore the Fed's (appropriate) desire to draw a line between macroeconomic and microeconomic liquidity measures. Yet the market remains priced for a virtually straight line easing of Fed funds throughout 2008; Dec Eurodollars price a rate of 3.37%, which corresponds to a Fed funds rate of between 3% and 3.25%, assuming the basis normalizes. Tonight sees the release of the minutes for the December FOMC meeting, where one has to presume the appetite for aggressive macroeconomic easing was grudging. Might there be room for a bearish surprise?

At the same time, the market has largely priced out any chance of a rate cut in Europe this year after the recent upside surprises to inflation. Yet growth is clearly slowing; would the ECB really leave rates unchanged in the event of a near-recession? Given the collpase of the US-German 2 year swap spread over the past few months, there might be an opportunity to play for a pullback. Macro Man therefore pays US 2 years at 3.85 in $20k/bp and receives German 2 year at 4.54 in €14k/bp. He'll stop out of the spread should it look like breaking -100 convincingly.
2007, meanwhile, ended in profit if not with a flourish. While the 0.48% positive return was Macro Man's third worst month of the year, it was pleasing nonethless given his lower risk profile and the generally poor performance of passive equity and FX carry strategies. Macro Man's equity beta plus portfolio wore the pain as well, shedding 1.05% on the month (albeit with 0.33% of that loss accounted for by SPY going ex-div.) The FX beta plus portfolio, on the other hand, fared rather better, generating a positive monthy return of 0.63% courtesy of a timely bit of profit-taking early in the month.The alpha portfolio made money in all three sectors in which it was positioned. The index hedge on the S&P 500 made up for modest losses in the large cap/small cap spread (both of which wen ex-div as well- the portfolio will be adjusted upon payment tomorrow) and the expiry of the Hang Seng puts. All in, the equity alpha portfolio made 0.11%. Fixed income also contributed modestly, with losses in the TIPS position more than offset by a timely profit-take in the Singapore swap position. Combined, the two added 0.18% to December performance.

Finally, FX alpha was a strong performer, with the powerball strip making money on both delta (lower EUR/USD) and vega (higher vols) considerations. There was a useful scalp of USD/JPY gamma during the month, while the late-December swoon in USD/JPY mitigated some of the losses from the 120 straddle, which was exercised on Boxing Day. All together, these trades made 0.60%.

For the year as a whole, the utility of segregating portfolio performance into alpha and beta strategies was evident. The beta plus portfolio was a strong performer in the first half of the year, but shed money in H2-particularly in November. Yet the alpha portfolio provided a useful offset and clear diversification; while both the beta and alpha portfolios lost money in 4 months of the year, the portfolio as a whole only had one down month. Satsifyingly, however, alpha was the strongest contributor to overall portfolio performance, generating 11.5% returns; beta strategies made 5% on the dot. The 16.5% 2007 return was naturally a pleasing one, particularly given the noisy volatility of many of the markets that Macro Man traded.

He expects more of the same in 2008; while there may well be periods in which beta strategies perform well, high volatility environments are naturally suited to alpha. If the 2008 alpha performance can repeat 2007, he will be a happy (macro) man indeed.