Thursday, February 07, 2008

A couple of apparent mispricings

This post is being written on Thursday evening, as Macro Man has gradually revived throughout the day. There may be a worse feeling that that caused by dodgy tapas and indifferent rioja, but if so it's been a while since Macro Man has had the misfortune of encountering it. In any event, your humble scribe is at least feeling human again, and given that he is spending much of Friday in an immigration office in Croydon, he thought it might be useful to scribble down a few thoughts while he has the time.

While Macro Man was wishing he was dead earlier today (Thursday), he missed out on some developments in Europe. Specifically, the Bank of England fulfilled the expectation of all bar two of the 61 economists surveyed by Bloomberg and cut rates by 0.25%. The accompnaying statement was, if anything, hawkish, highlighting upside risks to inflation caused by food, energy, and sterling. While the recent decline in the pound has been fairly dramatic, the £ TWI is still within a well-established long-term range, so it seems somewhat perverse for the Bank to be wringing its hands over it. Surely it's nowhere near the biggest problem on their plate at the moment?

In the Eurozone, meanwhile, Jean-Claude Trichet signalled an immediate about face and proclaimed that the next move in rates will be a cut. At least that's how the market seems to have interpreted the press conference, as the strip has rallied while the euro's been caned. Frankly, reading through the comments, Macro Man really can't see what is so uber-dovish in Trichet's remarks. Tellingly, he started off by focusing on continued upside risks to inflation- which is a pretty good indication of where the ECB's primary worries lie- and didn't introduce any cute new code words for the market to use in timing a forthcoming ease. Markets appeared to fixate on the comment that market turmoil is generating am "unusually high" amount of uncertainty , and Trichet's acknowledgement that a US slowdown will have an impact on Europe. Well, duh!

Perhaps next month's staff forecast revisions will give the ECB an opportunity to exchange their hawks' talons for the gentle cooing of doves. But from the sound of it, M. Trichet still sounds several months away from beginning to seriously contemplate trimming rates. Unsurprisingly, that's pretty much what's embedded in cash markets at the moment. Three month Euribor fixed at 4.35% today, which is much lower than December's panic highs but still represents an unusually large basis for a central bank firmly on hold. The June Euribor contract, however, rallied 17 bps today, closing at an implied rate of 3.765%. Will three month cash rates really fall 60 bps in the next four and a half months? Perhaps, but it would take both an ECB easing and a normalization of the basis to the degree that Euribor could trade flat with the refi rate. It might happen, but it seems slightly dubious to Macro Man.

Given that Macro Man is long the front end of the euro curve through his receiver position, this is a cause for concern. However, there is an option startegy available that looks to be an appealing overlay to his current position and what is in the price. Friday morning, Macro Man will look to buy 500 June 96.00 Euribor puts, which are 23 bps out of the money versus the future but 35 bps in the money versus current cash rates. He will sell 1000 96.625 calls, which are 40 bps out of the money versus the future and nearly 100 bps out of the money versus cash. Based on closing bid/ask spreads, he should earn a credit of 2 ticks per spread to do this trade. Maybe 3 month Euribor really will fall 100 bps by the end of June...but if it does, Macro Man likes his chances of making money with his receiver and short DAX positions!

The other thing that Macro Man finds odd is encapsulated in the chart below. The chart shows the fortunes of the currencies (measured against the euro for convenience) of five countries, each of which has a large current account deficit as a percentage of GDP and relatively high inflation. In other words, currencies that are classically vulnerable to global risk aversion. As you can see below, most of them have been so far in 2008, with the South African rand performing particularly execrably.
Yet one of these currencies has weathered the storm remarkably well; it's the only one that is closer to its highs of the past six months than its lows, and the only one that is stronger in nominal terms (i.e. has a lower reading on the chart) than at the beginning of last year. It's the Turkish lira.

Now granted, Turkey's fundamentals are stonger than those in, say, Romania, given the high level of nominal interest rates and high levels of FDI cover for the current account. But it's not like Turkey has always been bulletproof; it got hit pretty hard in August, and of course it got massacred in 2006. Granted, there probably isn't an Israeli bloke almost singlehandedly blowing up the market this time, but still- its resilience is startling, all the more so when you consider that local equities are down 25% year-to-date already!

One possible explanation is that many TRY longs are held against the ZAR, and as such are actually making money hand over fist. That might explain the behaviour of some currency and fixed income punters, but not the broader market as a whole. And let's face it; if a spread as innocuous as Macro Man's large cap/small cap is causing pain, shouldn't the same hold true for a market like Turkey?

A useful rule of thumb is that crises typically don't end until even the best trades go sour. In that vein, it should be a question of when, rather than if, the TRY endures a trying time. Macro Man has been musing about this for a while, but was beaten to the publishing punch by the dodgy tapas and by Goldman, which advocated long EUR/TRY on Thursday morning.

Macro Man prefers a cheap lottery ticket, because if this sucker's gonna blow, it will REALLY blow. And chances are that it will be relatively soon. So Macro Man will spend $200k or so on some upside; 3 month 1.40 $ calls cost about 66 bps (on a 21 vol), so Macro Man will buy $30 million at the market opening tomorrow. And hey- if it all comes to naught, maybe those 96 Euribor puts will finish in the money!


Cheesehedgie said...

It would seem the choice of scale is important in assessing the over/undervaluation of TRY. It has certainly outperformed the others since November 06, but is arguably rallying from much more distressed levels following the May 06 mini-crisis (indeed EURTRY has yet to recover its former lows). If you use 2002 as a benchmark, TRY has underperformed ZAR, HUF, PLN, BRL, and the rest by an extensive it further room to rally despite skepticism. It definitely pays to get timing right as bleeding the 12% interest differential against EUR or USD can make even correct directional calls into losing trades.

Peter said...

TRYZAR is probably a good way right now to mitigate the negativ carry. i kind of missed the boat on the rand selloff.. and i bet others did too. it wouldnt have sold off like this otherwise..

HUF is such a classic case of how sentiment turns. now im beginning to get the comments from my favourite sell side researchers, who all began to 'suddenly' see risks.
a few months ago, the same analysts were singing odes to Hungary's fiscal consolidation. which is btw about to turn out to be a house of cards as the economy slows and the govt is headed towards a crisis because of its unpopularity

have a good weekend all of you

Macro Trading Ideas said...

Hi MM,
you've noticed too a real strange thing, for example yesterday i've lent money on interbank market to a real Aa2 big bank at 4.3%, and then i shorted
Euribor Decemeber ERZ8 at 95.6, 3,4%.
So a 0,9% to take counterparty risk, with about every borrower?? I can't understand, but i want to be short Euribor futures december!
What do you think??

Macro Trading Ideas said...

Just to clarify, i've lent interbank money to 1 year versus Euribor december, about same duration..

Anonymous said...

MM, whats your thoughts on the BRL?Analysts are saying rate hikes will come in brazil this year due the big growth in money supply and inflation

Macro Man said...

Fabio, it does seem like a pretty reasonable trade. Hell, you could just sell the next 4 contracts and bootstrap a sythetic series of FRAs to lock in positive carry the whole way through.

vlade said...

Mr. M, that's what I thought. I'd think that covering 3m exposition 9 months out vs. 12m would be a bit iffy - more potential gain, but higher exposure to strange events. But maybe I'm just a bit overcautious.
Glad you survived the Lunacy.

Macro Trading Ideas said...

Thanks MM!
Vlade, I'm in agree with you, I know that it isn't a right hedge, but it' s also because I have a cash portfolio long until december and the n i'd like to take some curve risk.