Stress Testing

This is the way the world ends
This is the way the world ends
This is the way the world ends
Not with a bang but a whimper.

T.S. Eliot, The Hollow Men

Later in life, Mr. Eliot repudiated the ending to "The Hollow Men", quoted above. One would have to presume that if he were alive today and a practitioner of financial poetry, he would be equally averse to claiming that the world would end with a whimper.

Or so we'd have to judge by price action today, wherein all things risky are tracing out an Icarus-like descent, and the only thing preventing a Black Monday-style crash in the US today is that the market is closed. This month has already been a testing one, and on the basis of today's gruesome start that trend appears set to continue.

Where to begin? How about with the monolines insurers, where last week's Fitch downgrade of AMBAC surely spells the beginning of the end in that space. Certainly the stock chart appears to be a re-run of American Home Mortgage, New Century, and Northern Rock. While Macro Man is far from an expert in this field, it would appear to be fairly evident that buying insurance from a non-AAA provider defeats the purpose of insuring oneself; what's the point of merely exchanging one ropy credit risk for another? Should another agency swing the axe on AMBAC's rating, one would have to conclude that the company will cease to exist.While this would appear to be self-evident, it has apparently escaped the notice of some of the analysts covering the stock. One research report that crossed Macro Man's desk this morning downgraded AMBAC from "buy" to "hold", while reducing the target price on the stock from $27 to $19. Now, in Macro Man's world, if you expect the price of something to triple, it is probably a buy. Then again, in Macro Man's world, the price target on AMBAC is similar to his NRK target issued last September: zero. While the frailities of equity research are well known, this report would appear to be a particularly egregious example of failing to realize that the horse has already bolted.

This is actually a great environment to be a (lower case) macro man, your humble srcibe's early-month P/L scuffles notwithstanding. The ability to be short risk assets relatively quickly is useful in times of stress, and it would appear that the macro community is grasping the opportunity with both hands. The rolling 40 day correlation between the S&P 500 and the HFR Macro hedge fund index is now -0.8, the joint lowest reading since immediately after the invasion of Iraq.

What's interesting is that EUR/JPY, a currency pair that owes its lofty status to the compression in global risk premia, is starting to look decidedly ugly. A couple of weeks ago, Macro Man suggested that selling EUR/JPY and its ilk was the real trade to do in the event of a US recession; it appears that the market may have come around to the same view. Clearly markets are now assuming that US recession is a base case, and Macro Man has seen his first 1% Fed funds forecast this morning. Observe that EUR/JPY is now flirting with a three point monthly trendline off of its all-time low below 90. Given that fair value for this pair is probably 125 or so, there appears to be plenty of juice in the trade should a bear market follow on.

While Macro Man is actually long a bit of euro cash via his EUR/GBP positions, his overall euro delta is actually small short, thanks to his powerball strip of downside one touches. The DEM receiver position should also be negatively correlated to the euro FX rate. It's gratifying to see one of Macro Man's cherished tenets panning out, meanwhile; namely, that in times of stress, all financial market implied volatilities should rise.

The chart below shows one year implied voaltility in the EUR/USD exchange rate over the past few years; observe how it's risen nearly three vols since last spring. While the realized vol of the pair has risen, it's almost certainly not enough to justify such a sharp rise in back-end implieds. Then again, those implieds were woefully underpriced a year ago, thanks to structured product related selling. Either way, being long EUR vol as the "cheapest vol on the block" has paid dividends.
Finally, Macro Man would like to give a "smooth shout out", hip hop-style, to one of his favourite analysts. Fred Goodwin, Lehman Brothers' "Mr. Prop" (whose pieces influenced the narrative style of this space) has written his last piece and moved over to the proprietary risk-taking side. Good luck, Fred: you've now left Macro Man as the sole torch-bearer for third-person financial commentary.