Very ugly, very quickly

Yesterday's off-topic rant was certainly an eye-opener, as it generated a record level of comment (by a comfortable margin) for any post in this space. While Macro Man could take this as a comment on the relative paucity of insight offered up by his daily market musings, he prefers to regard it as a measure of the universality of disdain in which the general public holds bureaucratic institutions.

In any event, it's time time to put the nose back to the grindstone and focus on markets, where things appear to have gotten very ugly, very quickly. Where to start? How about with yesterday's jaw-dropper, the horrific service sector ISM in the US. There was more than a faint whiff of sulphur from the very get-go, as the Institute of Supply Management released the figures early, citing probable "security breaches", i.e. leaks. When the subsequent release showed a multi-standard deviation miss, and indeed the second worst reading in the survey's decade-long history, the reason for the apparent leak became clear, as the data was clearly of a market-moving nature.
While the data was so bad as to be scarcely believable, move the market it did. While fixed income received something of a bid, particularly at the short end, the back of the curve is still well, well off its lows in yield. No, the real impact was felt in equities, where the warm and fuzzy, "kumbayah" feeling of the past couple of weeks was replaced by a down 3% day in the SPX, which conveniently (or not, depending on your position) broke through the recent uptrend, apparently confirming it as a correction.

How ugly was yesterday's price action? So ugly that even erstwhile intramarket "hedges", such as Macro Man's large cap/small cap trade, relocated to Texas. That position, which was doubled at the end of last month, has cost Macro Man $460k in less than a week. Ouch! As the chart below indicates, that spread (long OEX/short Russell 2000) has also gotten very ugly, very quickly. The deterioration in the spread probably speaks volumes about distress in the quant space, and it is beyond the capacity of mere mortals like Macro Man to determine precisely when the downdraft will end. He still believes in the funadamental rationale for the trade, and so will hold tight for the time being. However, price action below 0.87 on the ratio will force a rethink; Macro Man may take his losses on the cash position and look to implement a lower-risk option strategy instead.
There is some ugliness developing in currency markets as well. In the developed space, the euro has taken a bit of a dump after German G7 sherpas warned that the single currency should not bear the burden of adjustments in the foreign exchange market. It's sentiments like these that encourage Macro Man in his belief that Japan will find it politically tricky to intervene to weaken the yen this side of 100. A break of prior lows in EUR/JPY would confirm an impulsive five wave sequence, suggesting that the underlying trend is now bearish.

In the EM space, the South African rand has gotten absolutely mullahed over the last week or two, and USD/ZAR is now within hailing distance of the panic highs of 2006. As Macro Man has mused before, South Africa is one of the few "old skool" EM countries left, with a large current account deficit, high inflation and interest rates, and a corrupt political leadership to boot. Recent power cuts have done little to alter this image. Macro Man has contemplated shorting the rand for some time; it looks like he may have missed the boat.
If Macro Man's trigger pulling in the ZAR has left something to be desired, his efforts in the US curve have left the RSPCA and PETA on his trail, so badly has he screwed the pooch. He's basically watched the 2-10 curve steepen from 50 bps to 160 in a straight line and not been able to pull the trigger. Ay caramba! In fairness, it's not quite that bad; Macro Man has had a sort of cross-market ratioed curve trade on, paying the back end of the US and receiving twice the bpv in 2 year Europe. That position's actually done quite well.

But if one takes the view that the economic slowdown is indeed global, and will hit Europe with sufficient force that either growth or inflation slow materially, than an ECB easing would appear to be in the bag at some point in late Q2 or Q3. And when that happens, the European curve should steepen nicely. As the chart below illustrates, the European curve has lagged the US by a few quarters for the last decade or so; if that's the case this time around, then the steepening party could just be getting started.
Of course, it's probably foolhardy to pull the trigger now, especially with an ECB meeting and press conference tomorrow. Have Trichet and co. seen enough to make them take their foot off the monetary break and press the accelerator? Almost certainly not. So Macro Man will bid his time, especially as he already has a highly-correlated trade on the books.

And as he discovered with the large cap/small cap trade, adding fresh risk at inopportune moments can turn very ugly, very quickly.