An early test

Rarely will you see a trade more execrably timed, with the rationale more brutally incorrect, than yesterday's US-German 2 year swap spread. Not only were the Fed minutes dovish (as opposed to Macro Man's presumption of a hawkish out-turn), but the ISM was considerably worse than expected: the 47.7 result was the lowest reading since April of 2003. It looks as if Macro Man's "muddle through" thesis is getting an early test this year.

For now, he is content to retain the view. ISM weakness, which is broadly consistent with the 1% pace of economic growth so widely expected by forecasters, can perhaps be explained as an inventory adjustment phenomenon. In Macro Man's view, timely inventory management is probably the most important explanatory factor of the so-called "Great Moderation" in macroeconomic volatility. The chart below, which shows the spread between the "new orders" component and the "inventory" component of the ISM, suggests that firms are already paring back production so as to shed undesired inventory, similar to what occurred at the end of 2006. The upshot is that we may see a quarter or two of substandard growth, as is widely forecast, before normal service resumes. Nevertheless, with both the consumer and the credit market in worse shape today than twelve months ago, the margin for error in the US economy will be lower in 2008 than was the case in 2007.
In any event, the spread trade lost money immediately after execution, and is now 9 bps wider than at inception. However, the news is not all bad. You see, Macro Man already had a long US 2 year bond delta. No, not from futures or even from his TIPS position; rather, from his long yen position. The chart below demonstrates the remarkable correlation over the last year between USD/JPY and US fixed income. In many ways, the spread trade has mitigated, rather than added to, portfolio risk.
The yen has taken on something of a life of its own over the last couple of sessions, though obviously yesterday's data helped spur it along. Having suckered the market into establishing/adding to yen shorts above 113.60 last week, USD/JPY collapsed yestrday and is now looking very ropy indeed. Even worse is the chart of some of the yen crosses; GBP/JPY was the focus of market attention yesterday as it cratered through a (non-textbook) head and shoulders neckline at 217.80. The traditional interpretation of the break would suggest scope to 190. The reader who yesterday queried what to buy against a sale of sterling could do worse than to look at the yen, particularly in light of the gloomy BOE credit conditions report issued today. Bear in mind, however, that the one-way train is unlikely to endure past tomorrow, as the Japanese return from a weeklong holiday on Monday and may provide scope for a near-term squeeze. In any event, yesterday was probably a rough start to the new year for many of the quant strategies out there, whose returns tend to bear an uncanny resemblance to a yen-funded carry basket.


At the risk of beating a dead horse, Macro Man feels compelled to point out that not all of yesterday's developments were an unalloyed positive for nominal Treasury bonds. One would have to presume that the headlines "Gold makes all time high", "Oil makes all time high", "Dollar makes all time low", and "Treasuries rally sharply" have rarely been observed on the same day over the past few decades....and yet it was the case yesterday.
WTI briefly touched $100/bbl yesterday, and gold bullion finally and definitively broke the $850 high from 1980. The next obvious target is $1000. The combination of these and the seasonality reinforce Macro Man's long-held belief that TIPS are the best US bond long out there. As for currencies, the wind clearly seems to have shifted in Beijing. USD/RMB has fallen another 0.35% today; over the past month, the annualized rate of change has been in excess of 20%!!!! It would appear that at long last, inflation is forcing the authorities' hand into allowing a stronger currency. Ask not for whom the bell tolls, Bretton Woods II: it tolls for thee.
If Macro Man's belief in the impact of CBs on the EUR/USD exchange rate is correct, then a slower pace of reserve accumulation consistent with an erosion of BWII should weaken a key pillar of support for the euro (and, perhaps more interestingly, sterling.) Yet easy Fed policy, which would appear to be a foregone conclusion after yesterday's developments, would still argue in favour of a weaker dollar.
A case be made for dollar weakness to manifest itself primarly against undervalued c/a surplus currencies and commodity liquidity proxies. Macro Man would list precious metals as among the more conspicuous examples of the latter. With gold alread at fresh highs and appearing poised for a melt-up, might not silver (which has rallied but not made new highs) follow suit? The chart looks pretty bullish, with well-defined risk levels on the March future around $14 on a closing basis. Volatility is naturally pretty high, and this is a pretty speculative punt. Small positioning is therefore warranted. Macro Man buys 50 SIH8 futures at $15.50, looking for an initial test of $16.50 with a possible extension to $20.
It all appears to be kicking off, and it's tempting to throw risk at this market given the type of moves that are occuring. However, a degree of caution remains warranted; liquidity is thin, and a number of key market players (Russians and Japanese, for example) are out of the market. Last year saw the dollar caned on the first trading day of the year, only to reverse course and correct for a month or so. Macro Man is happy to add moderate defined-loss risk, but betting the farm in this market could have unpleasant consequences.



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Fabio
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January 3, 2008 at 11:15 AM ×

In these two days, and particularly today we're seeing scaring market reactions, something similar to August 2007, but with conditions as oil, dollar, macro data and inflation really worst...
Maybe something can be related to the lack of liquidity, however bad environment to trade.. Your trade 2 year US/EU is theorically good, but I've been scared by really and continuos hawkish ECB member declaration. 2 year US however is expensive..
Fabio

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Fabio
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January 3, 2008 at 11:40 AM ×

Sorry what instead about long 10yr EU/ short 10yr US, isn't better? why so much steepening in EU???
Fabio

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Anonymous
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January 3, 2008 at 11:50 AM ×

if you returned 16% for the year but the dollar went down 10% then isnt your return only 6 which begs the question, why are you not levering up to juice these returns

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Anonymous
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January 3, 2008 at 11:53 AM ×

silver should be hit hard by a global slowdown. it seems that gold on dips might be the way to go as far as currency shorts go. are you not worried about that

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Anonymous
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January 3, 2008 at 2:01 PM ×

What is "muddle through" exactly? Presumably you are referring to the notion that somehow the U.S. is going to come out of the whole credit and housing disaster unscathed? How? By printing more worthless money? Has there ever been any evidence that this works in the long run? Hint: where is gold and oil today? :) i^i

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Macro Man
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January 3, 2008 at 2:25 PM ×

Fabio, I chose 2 year because given a real possibility that US and EMU growth and inflation are at braodly similar rates this year, I just can't see a rationale for US hort end to trade so far through Europe.

Anonymous #1, is I lose 20% but the dollar goes up 25%, does that mean I've made 5? Somehow I think not. The portfolio is demoninated in dollars, and as such the goal is to generate dollar returns. In the real world, it is relatively simple to create currency-hedged share classes which capture the investment returns but which eliminate the currency risk you mention.

Anonymous #2, that is a very good point on a medium-term horizon; the view I'm trying to play here is a liquidity and dollar-driven melt-up in metals. From a medium-tmer perspecitve, perhaps something like long gold/short copper is a good way to play slowing activity and still-ample dollar liquidity.

Anonymous #3: Muddle through is the view that economic stabilizers (eg, stuff like net exports and fiscal policy) offset some but not all of the US domestic pvt sector weakness, producing a period of below trend growth (but no recession) while housing et al work themselves out. Through November, the US monetary base (i.e, that aspect of money supply over which the fed has direct control) is only up 2.2%. Granted, MZM growth has been accelerating, but some of that is down to cash being raised from equity sales, no doubt.

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Quarrel
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January 3, 2008 at 3:35 PM ×

MM,

A purely cosmetic observation-

The larger P&L screenshot is much better. Readable enough without needing to get the full size version for most casual purposes.

Not sure how you maintain it, but it seems you screenshot a spreadsheet to produce it. If you've got the option to save them as a GIF rather than a JPG then they should be lots clearer. JPG's are "lossy" by nature, which is great for compression (particularly of photos etc) but bad for straight text like this.


--Q

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Macro Man
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January 3, 2008 at 3:56 PM ×

Hmm, I noticed it looked bigger as well. It was nothing I did, I can assure you, other than to reduce the size of the underlying sheet by compressing last year's monthly data into one row. I'll try the GIF thing tomorrow and see if it works. Sadly, Macro Man Enterprises is decided low-tech in its publishing; spreadhseet and MSFT Paint is what I'm stuck with.

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jdc
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January 3, 2008 at 5:41 PM ×

So, the dollar peg stays... not causing inflation, apparently!

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Macro Man
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January 3, 2008 at 6:12 PM ×

In fairness, it's difficult to see why a) a currency declining against that of your major source for imports, b) artificially low interest rates, c) inflated money supply due to unsterilized intervention, and d) currency weakness impacting the wage demands of migrant workers, could possibly be construed as contributing to inflation. Sheesh!

One can only posit that there was behind the scenes deal-making going on....or perhaps they're being clever. The UAE CB said they are keeping the dollar peg...he didn't, however, say that they'll necessarily keep it at the same level!

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Anonymous
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January 3, 2008 at 6:53 PM ×

macro man --

a faster but still controlled pace of rmb appreciation is, i think, fully consistent with a very fast pace of reserve growth. indeed, if more hot money floods in, it might even coincide with a stronger pace of reserve growth.

in the gcc, for example, expectations of a change in the pushed reserve growth way way up ...

bsetser

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Macro Man
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January 3, 2008 at 6:59 PM ×

Brad, I think the interesting thing to see is what happens over the next 2 weeks. As the chart shows, these periods of rapid appreciation tend to last for only so long then slow down dramatically. I presume the slowdowns are when a lot of the reserve accumulation occurs. Eyeballing the chart suggests that we're rapidly approaching the time when a "typical" appreciation burst starts to decelerate. If it doesn't happen, then perhaps we should conclude that something has changed. The real proof, of course, will be when we get December's reserve data in a few weeks.

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January 3, 2008 at 10:36 PM ×

MM,

I'm curious as to why you choose futures rather than the ETF (SLV) to speculate in silver. Is it just the convenience of the built-in leverage?

Obviously SLV prices and silver futures track each other quite closely. Arbitrage between the two markets is quite straightforward But there are some interesting herd effects that make the two quite different indeed.

There are a few things that make the PMs different from all other commodities. The principal one is extremely low storage costs (even lower for gold of course) relative to market price.

Contrary to popular belief, in a normal commodity market such as oil, speculative activity has a minimal power to affect the price of the underlying good. Since it is expensive to store oil, speculators who drive up the price through hoarding have to sell again in a fairly short timeframe. This is the familiar "burying the corpse" problem.

In PMs the corpse does not need to be buried. It is small and can sit around in your living room. It can also sit at Brink's or wherever (I forget where SLV keeps its silver).

The result is that hoarders, speculators, rootless cosmopolitans, economic royalists and other social parasites can actually drive up the spot price of the metal. Which is pretty much how these goods got to be used as "money" in the first place.

So, for example, if you buy SLV, this creates a premium in SLV over the Comex spot price. Arbitrageurs resolve this disparity by buying physical silver and delivering it to to Brink's (or wherever).

From the perspective of the spot market, this demand for metal is indistinguishable from the demand of Navaho turquoise jewelry makers. Metal goes out the door. Note that there is no effect even remotely comparable in oil, corn, etc.

So this kind of speculation can drive the market up. Momentum can feed on itself. This makes the PM markets very different from a game theoretic perspective.

The same can happen in reverse. A big downturn in the PMs would very likely see a huge river of metal flowing out of the vast, Smaugian hoards that GLD and SLV have built up, back into the physical market. The PMs can melt down as well as melting up. A true deflationary scenario, with Volckeresque rates, might well produce this result. It certainly did in the '80s, although of course there were no ETFs.

What's interesting about futures versus ETFs is that it's not clear to me that, when hedgies like you buy a silver future, it exhibits the same feedback effect.

Someone has to be on the other end of that trade. If he balanced his books by buying physical silver, the effect on the spot market is the same as in the SLV case. Or he could have SLV shares, or whatever. But does he? I kind of doubt it. I suspect he is naked short, as you are naked long.

Herd dynamics aside, one situation in which this might matter is a delivery suspension on Comex. In this case, a price divergence between the fully-backed ETFs and the somewhat watered futures markets could well appear. The divergence would certainly be in favor of the former.

Two other things about silver. One, anon2 is definitely correct in noting its relatively base-metal-like behavior. Two, it's also worth noting that, for a traditional monetary metal, TPTB have unusually low reserves of it - basically, squat. Obviously this is not the case for gold.

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Macro Man
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January 4, 2008 at 8:57 AM ×

Moldbug..it is indeed the leverage aspect of futures which make them attractive as an instrument of speculation. This transaction is a "trade", betting on the price going up in the short term, rather than an "investment", e.g. a desire to actually own allocated bars of silver in a vault somewhere. As such, the high-leverage aspect of futures trumps any secondary pricing distortions such as those that you point by a large margin.

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Anonymous
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January 4, 2008 at 3:02 PM ×

MM -- Dec reserve growth won't settle anything. The Minfin likely bought a ton of fx for the cIC as they issued a huge bond in Dec, the banks have been forced to buy fx to meet their reserve requirement and who knows what other steps have been taken to keep stated reserve growth down. sure you can estimate transfers to the CIC and the impact of forcing the banks to meet the reserve requirement in dollars, but you have to trust the adjustment -- and right now, i doubt any one does.

remember, the economist neither thinks the rmb is undervalued nor thinks exports have contributed to chinese growth ... they are inclined to give china the benefit of the doubt on this.

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Macro Man
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January 4, 2008 at 3:12 PM ×

One really wonders how China's c/a can go from roughly balanced to a 10% of GDP surplus in 4 years and The Economist reaches the conclusion you allude to. Certainly it doesn't display a terribly impressive grasp of....err...economics. Given that you've debunked their view in the past, there's no reason for me to preach to the choir here. point taken on the Dec reserves though...I'd forgottne about the bond issue.

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January 4, 2008 at 8:46 PM ×

MM,

I recognize that from a subjective perspective there is a considerable difference between a "trade" and an "investment," but from an economic perspective there is none at all.

A silver future and an SLV share are both pieces of paper, or bits on a hard drive, which appear as pixels on your screen and convey some kind of legal right to silver. To own them is to own them, and whether you intend to own them for a day, a year, or the rest of your life, no meaningful distinction can be drawn between "trading," "speculation," "investment," "saving," "hoarding," etc.

To the extent that there is a difference between the two, it is the consequence of the legal structure of the contract that you own when you buy this good.

I actually think the market should price an SLV share higher than the equivalent silver future. Here's why.

When we look at the "market cap" of SLV in silver, versus the "market cap" of all Comex obligations outstanding, we see that the former's books are balanced in silver. There is no scenario under which SLV can default. The risk is zero, unless you count force majeure and acts of God.

This is not the case for Comex. Its silver obligations are backed by the full faith and credit of... Comex. Comex has the right to suspend delivery and enforce liquidation-only trading, and it has exercised this right in the past. Since Comex is operated by people who happen to be large commercial shorts, we see motive, opportunity and propensity.

The quantity of silver in the Comex warehouse is not directly comparable to the number of shorts outstanding. Because anyone can own warehouse silver and anyone, pretty much, can go naked short. But it is easy to see that the backing percentage is much lower than 100%.

In a world which contains SLV, if Comex suspends delivery, what happens? Arbitrage is no longer possible. So the prices diverge. The market price for silver is now the SLV price. And if you own a Comex future, all you can say is ouch.

I am hardly an expert on this market, but I would say that the likelihood that this will happen any time soon is small. It is not 1980 again, at least not yet.

However, the risk is nonzero, and if the risk is nonzero the premium should be nonzero as well. If there is any premium on SLV, however, silver flows from Comex into SLV. You do the math.

Serious metalheads actually are not fond of SLV and GLD. They think the expenses are high and the legal security is shaky. Frankly, some of these people are nuts and some aren't. It's often very hard to tell the two apart.

As for me, I am simply surprised that these instruments exist, because from a regulatory standpoint they are ticking bombs. The belief that a fiat monetary system can coexist indefinitely with a free market in the precious metals is dubious to begin with. Approving an instrument that is basically a 100%-reserve bank, however crude, demonstrates a level of confidence in the BW-era financial system that I find wholly unwarranted. And SLV is especially risky because the CBs have no silver to throw on the fire.

In any case, when it comes to leverage, is leverage really that hard to come by if you're a serious trader? If you want 10x leverage on, say, AAPL, can't you just set that up with your prime broker? Does it even take a phone call? Pardon my naivete, but I was under the impression that for a hedgie, leverage is a matter of arrow keys.

Also, calling herd effects "secondary effects" obscures the point a little. A herd effect is a herd effect precisely because there is no individual motivation to engage in it. Unless you are Warren Buffett (or, more to the point, Bunker Hunt) and you throw a billion dollars at SLV tomorrow, your P/L will be unaffected by your own actions.

But when you look at all the money that all hedge funds are putting into PMs, whether they buy backed or unbacked instruments makes quite a large difference in the dynamics of the market as a whole. It is interesting to see this difference being decided by what strike me as relatively trivial factors, like the automatic leverage of silver futures.

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