If you ever needed a reminder that most short term price action is noise, rather than signal, this week has provided a timely reminder. Taken at face value, this week's moves suggested imminent US recession and asset price deflation on Monday, Tuesday, and the first half of Wednesday, while price action since then has had "soft landing" written all over it.
In retrospect, of course, much of the volatility in stock index prices has been down to the work of one or more unfortunate Frenchmen; Macro Man assumes that he is not alone in concluding that the short term price swings caused by the worst trader in history (judging by the size of his loss) have little insight to offer as to the medium term trajectory for economic growth and financial prices.
Macro Man also assumes that he's not alone in scratching his head and thinking "what now?" Next week's Fed meeting is set up to be an extraordinarily interesting one. It has emerged that despite the Banque de France knowing about SocGen's travails over the weekend, the Fed had no clue when they hit the panic button on Tuesday.
Grep Ip seems to suggest that the SocGen revelation won't impact the Fed's decision next week, but come on! If, before the equity market meltdown, the Fed was planning on doing 50.....why should they cut any more next week, thereby at least doubling the amount of their originally intended easing?
Yet to the market, it's not a question of whether the Fed eases, but by how much. The OIS market is currently pricing in 40 bps of easing. Of course, if the Fed doesn't ease, markets could then puke, delivering the kind of price action that prompted the emergency cut in the first place. The problem with allowing the market to lead you, Mr. Bernanke, is that it inevitably leads you into an uncomfortable corner.
What seems evident is that volatility is set to remain pretty high. If the Fed doesn't cut next week, equities should tank and bonds soar. If they do cut....well, let's just say that the dollar will be (French) toast.
In the meantime, Macro Man's recently-minted short risk asset delta has taken something of a beating as the market piles back into the "risk trade." While he made a gesture at hedging with his SPX calls, the size of the position was relatively small, and as such has only mitigated a small portion of the last 36 hours' losses. Macro Man originally targeted a re-test of prior support at 1360; futures are suggest a breach of that level at the opening. Retracement targets are located at 1385 and 1412; each of those could be seen without threatening the underlying bear market, if that is indeed what we are in. Discretion being the better part of valour in this environment, Macro Man therefore cuts half of his short DAX future position at 7020, locking in at least a portion of tasty profits.
USD/JPY has also had a vicious bounce and requires some attention. While an Armageddon option stop loss scenario continues to beckon in the event of further weakness, it might require price action below 102 or even 100 to prompt it. In the meantime, the DOTW have every excuse to pile back in. A similar retracement chart suggests scope to 110, and Macro Man really wouldn't want to see it breach that level.
So to further mitigate drawdown risk (and collect some decay in a low-risk fashion if for some reason this is the short term apex in vol), Macro Man implements the following strategy: He buys $50 million of a 1 month 106 $ call with barriers at 104.50 and 111.50 for 0.55%. He will leave a stop on his short cash position at 110.25. Obviously this doesn't completely insulate him from a further modest drawdown, but it should head off a negative month if the last 36 hours were to continue. 
In retrospect, of course, much of the volatility in stock index prices has been down to the work of one or more unfortunate Frenchmen; Macro Man assumes that he is not alone in concluding that the short term price swings caused by the worst trader in history (judging by the size of his loss) have little insight to offer as to the medium term trajectory for economic growth and financial prices.
Macro Man also assumes that he's not alone in scratching his head and thinking "what now?" Next week's Fed meeting is set up to be an extraordinarily interesting one. It has emerged that despite the Banque de France knowing about SocGen's travails over the weekend, the Fed had no clue when they hit the panic button on Tuesday.
Grep Ip seems to suggest that the SocGen revelation won't impact the Fed's decision next week, but come on! If, before the equity market meltdown, the Fed was planning on doing 50.....why should they cut any more next week, thereby at least doubling the amount of their originally intended easing?
Yet to the market, it's not a question of whether the Fed eases, but by how much. The OIS market is currently pricing in 40 bps of easing. Of course, if the Fed doesn't ease, markets could then puke, delivering the kind of price action that prompted the emergency cut in the first place. The problem with allowing the market to lead you, Mr. Bernanke, is that it inevitably leads you into an uncomfortable corner.
What seems evident is that volatility is set to remain pretty high. If the Fed doesn't cut next week, equities should tank and bonds soar. If they do cut....well, let's just say that the dollar will be (French) toast.
In the meantime, Macro Man's recently-minted short risk asset delta has taken something of a beating as the market piles back into the "risk trade." While he made a gesture at hedging with his SPX calls, the size of the position was relatively small, and as such has only mitigated a small portion of the last 36 hours' losses. Macro Man originally targeted a re-test of prior support at 1360; futures are suggest a breach of that level at the opening. Retracement targets are located at 1385 and 1412; each of those could be seen without threatening the underlying bear market, if that is indeed what we are in. Discretion being the better part of valour in this environment, Macro Man therefore cuts half of his short DAX future position at 7020, locking in at least a portion of tasty profits.
USD/JPY has also had a vicious bounce and requires some attention. While an Armageddon option stop loss scenario continues to beckon in the event of further weakness, it might require price action below 102 or even 100 to prompt it. In the meantime, the DOTW have every excuse to pile back in. A similar retracement chart suggests scope to 110, and Macro Man really wouldn't want to see it breach that level.
So to further mitigate drawdown risk (and collect some decay in a low-risk fashion if for some reason this is the short term apex in vol), Macro Man implements the following strategy: He buys $50 million of a 1 month 106 $ call with barriers at 104.50 and 111.50 for 0.55%. He will leave a stop on his short cash position at 110.25. Obviously this doesn't completely insulate him from a further modest drawdown, but it should head off a negative month if the last 36 hours were to continue.At this point, Macro Man is more interested in locking down profits and neutralizing portfolio risk than trying to hit a home run. Given that the Fed has just engineered the largest rate cut in a quarter century as a result of bad information, it seems hard to argue against trimming risk, particularly with next week's announcement looming.
(Only when editing this post did Macro Man realize that its title is virtually identical to Wednesday's. Tells you everything you need to know, really.)
16 comments
Click here for commentsMr. M, I'm with you on the Fed with a bucket and two walls.
ReplyI think though that if they do cut, it will spark a selloff (as well sa if they don't) - as people will feel that if they had to cut 100bp total despite being fooled by French, something is really wrong and will panic (again).
But vlade, that conclusion/reaction only makes sense if one assumes that the Fed "knows something"....whereas the events of this week seem to emonstrate pretty clearly that that is not the case.
ReplyMM, two things bothering me -- perhaps you have some insights?
Reply1) Market sentiment (equities). Too many people are saying that Tuesday/Wednesday was a short-term bottom, the market is bouncing up, but it will ultimately fail and reach new lows. Maybe this is correct, but I find the consensus is typically wrong in volatile times. But what is the alternative? Either the bounce will be much larger/longer than everyone expects, or this is merely a small plateau from which the market will fall further?
2) What the hell is going on with initial unemployment claims? This sure is one strange start to a recession. Or is long equities going to be the smartest trade of the year?
True. But isnt't that what the markets assume with each cut?
ReplyOf course, I find it fascinating how two events get tied together by the markets regardless of outcome and are happy to take entirely different stance the next day based on a semi random number (stock index) moving in different direction for entirely idiosyncratic reasons (like a bank desperately trying to square a bad position).
Too much information. Let's trade on noise and don't pretend anything really matters.
CDN, on the former, I think it depends on positioning. From what I can discern, macro guys are short equities, but the m uch larger cohort of equity guys (both real money and leverage) are still long beta. So whether the bounce fails or extends to a degree depends on who blinks first.
ReplyOn the latter, the figure is prone to be quite volatile and subject to distortions like strikes, etc. That having been said, the recent retreat is pretty curious, and suggets that there may be some life in the old "muddle through" scenario yet.
spot gold at 923.10; spot silver at 16.56 (I wonder how your SIH8 would like today…); USD losing ground again (the case for shorting sterling is quite sound, but the perfect timing never seems to come. By the way, I thought you were going to short it against JPY or CHF…) - all in, your case for an inflationary outcome seems increasingly making sense…
ReplyAT
Sorry for posting twice…
ReplyI was reading some of your older posts on how Ben & Co. are actually trying to cope with 21st century problems using a 1970s arsenal or curing microeconomic matters with macroeconomic pills… Let’s get this thing straight: do you think that ECB is therefore doing better than the FED - no rate cuts, massive repos trying to calm down Euribor rates and a sort of “no-we-don’t-hear-your-screaming” approach, despite last week’s huge losses in European equities?
Btw, I think the DAX short is run out of gas... grab that cash with both hands and make a stash (courtesy of Pink Floyd)
AT
Hi MM,
ReplyJust thought I'd draw your attention to the capital flows data out of Japan, given your argument that domestic investors will pull back their assets a la 94/95 - from what i can see, if anything, they have stepped up purchases of foreign assets since last August (last week over Yen 1.1tr). Given that we've had a very large re-pricing of risk conditions already (HG Credit & Treasuries pricing a recession), and USD/JPY barely moved around as equities tanked at the beginning of the week, one might suggest that the market is heavily short.
It is also interesting to note (our mutual friend, Fred Goodwin pointed this out) that in past easing cycles once the Fed got ahead of the curve (as judged by the Whites-Reds Eurodollar curve steepness), USD/JPY rallied. This has been gradually steepening...
Really enjoy reading your blog - keep it up!
Cheers,
C
macro, your in denial. bill gross is a socialist scum but he is dead right. fed will ease like mad this year and there will be recession. probably just 25bps because they gotta be afraid of the ten year tanking on inflation years as the dollar slides but he is right
ReplyAT, as much as it pains me to say it, given that I think Trichet is an arrogant git, I do indeed think the ECB has ben pursuing the mot sensible course- micro solutions to microeconomic problems, while keeping their eye on the macroeconomic (inflationary) ball. If anything, I'd be tempted to t/o on some of the receiver position before the remain der of the DAX- in any case, in this mkt it's pretty much the same trade.
ReplyIn terms of the 70's allusion, my belief is that in each case the Fed has responded to a negative real income shock by taking real interest rates negative. While the parallels aren't perfect- inflation was the primary source of the shock in the 70's, while it's a secondary shock (behind housing) in the noughties, I see enough similarities to believe that the outcome is the same.
Rate cuts won't "save" housing- only time can. What they can do, however, is defer/delay the needed rebuilsing of household savings, and raise the risk of a secular rise in the prices of hard goods relative to the price of paper (including dollars.)
C, thanks for the compliment. I think Fred is off base in this case, for the simple reason that the "correlation" has shifted in USD/JPY vis a vis other assets- including the Nikkei. I may be wrong, of course, which is why I have a contingency plan in place. I think you do have a point re: positioning in yen, so perhaps we need a lurch higher to shake out the weak hands (though hopefully not me!)
Here I am again, but please help me, coz’ I’m not a quant… Is the call you bought today a double knock-out call option? If that’s the case, the payoff should be as follows:
Replya) if USD/JPY moves south and touch the lower barrier, you lose the premium but profit more than that from being short in the cash position;
b) if otherwise USD/JPY moves north and touch the upper barrier, you still lose the premium but break even by being stopped out of the cash position at 110.25, i.e. 112 pips lower than the entry level of 111.37, soon after the expiration of the previous straddle position. The notional amount of the short cash position is half than the notional amount of the option position; if 0.55% stands for 55 pips, what you would lose on the option position should be offset by what you get from the short position.
Is that right?
Thanks for your reply to my previous post. Reading your daily commentaries is an educational must for would-be traders like me…
AT
I'm in your same situation, what's next?? And now what we, sorry, I do??
ReplyI've enjoyed my short term trading, low risk and long duration..but now i prefer to go cash, or at least buy senior big banks'debt, what else NOW??
i think that markets are betting on a resolution of monoliner debacle (but I'm scared, anyone read wonderful Pershing Square presentation??), fed and US goverment are doing TOO much (it's obvious now that they don't care their currency and devaluate..) and let markets expect TOO much.
Trichet and his friend Weber have their guns versus market expectations, will ever been smoking guns?? However they're doing a THEORETICALLY good job..
To conclude I'll play only one trade, long bund versus 10 year US, or better steepening US versus steepening Euro..
AT, bingo.
ReplyJust occured to me - Mr.M, my "trade on noise" and irrationality comments were in no form or shape aimed at you and hope they were not taken like that.
ReplyAu contraire, vlade, I share the sentiment. The preponderance of noise is a great reason to trim risk, lest one get carried into (stop) loss at extremes because of random price action.
Reply