Wednesday, February 06, 2008

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.


Anonymous said...

told ya, you were acting like tony snow with regards recession scenario. probably of recession this year is 99%. the 1% is the chance jugdment day comes before year end

Macro Man said...

To be honest, I don;t know if there's going to be a recession this year and quite frankly, I don't care. What I do care about is how the market reacts to its own worldview...and for the time being, the market is trading the recession view, and thus I am obliged to as well. In three months' time the world could look different.

Anonymous said...

macro man as an aussie married to a pom..i feel yr pain mate..move down here and enjoy the beach, wife will be happy but you will be up working 24 hrs a day (minor downside)...glad to see you can see the sense inthe eur du jour (if not of the year) is long shatz short us tens...wild n bumpy but check out the 8yr correlation graph and you will see it is well out of whack and worth some serious conditional zero cost action..enjoy the home office ..

Bruce said...


You must have posted this earlier, but I don't see it. What is your Large Cap/Small Cap trade, and what is the rationale behind it?

Thanks for your great stuff! And I loved the bit yestreday about "centred."

Macro Man said...

Bruce, see here.

As for the spelling, I originally spelled it the American way, then caught myself and changed it- hence the comment. That's the weird thing about living here for so long (though clearly not long enough to obtain residency/passport!); I still spell things like "center" and "meter" the American way, whereas "labour" and "colour" look better the English way.

And don't get me started on Premiership duh-FENCE or NFL DEE-fence.

Bruce said...

MM, I'm half Canadian myself, though raised mostly in the US, so I'm familiar with the spelling issues. Canadians sometimes pick and choose spellings, so you get interesting combinations like "Tire Centre" (as opposed to yank "Tire Center" or brit "Tyre Centre") sometimes. It makes life more colo(u)rful, albeit more labo(u)rious.

Thanks for the Lg/Sm cap reference!

2and20 said...

anonymous, i'm not so sure about the long schatz/short us 10s trade.

whilst i don't have much of a view on schatz, i do think the ECB are going to be very reluctant to start cutting, so getting long 2yrs miles through ECB base rates doesn't seem a no-brainer to me.

whereas look at the US...absolute disaster over there, and only going to get worse. it seems to me the curve steepener has been over-played, just cos its the "obvious" trade to do going into a recession. bigger picture, you can get 3.60% on the 10yr, with the Fed at 3%, definitely going lower, and a massive risk of an extended recession/depression and personally i think almost guaranteed deflation...and even if we don't get deflation, i betcha the market will start talking about it soon. so being long 10y US at 3.60% looks like the no-brainer trade to me (i had it on the other week, took it off at 3.56% and just about to put it back on, fyi).

curious reader said...

macro man,

great blog! i love reading your posts on the markets. out of curiosity, do you trade for a hedge fund, ibank or your personal account?

Anonymous said...


so being long 10y US at 3.60% looks like the no-brainer trade to me

Hi 2and20,

I have a question regarding the "no-brainer"-ness of a 10Y treasury trade. To start off I'm no pro and I'm going to assume 10Y note futures are interchangeable with the 10Y trades you're talking about. If thats all crap then never mind.

Looking at the FF and 10 year note futures charts on CBOT shows me in 2001 after the Fed eased aggressively within a range similar to now (4% down to 2.5% in second half 2001), the 10 year note tanked for the first half of 2002 (from 112 down to 105) before rallying eventually up to 118 or so.

The last time the 10Y future was trading at current levels (117ish), the Fed had already eased down to 1%, suggesting all other things being equal that maybe the 10Y is already quite a bit ahead of the FF at least compared to last time.

I wasn't paying attention to this stuff back in 2001-2003 and don't know the background, but just by looking at the charts, this would suggest maybe upside is limited and there's lots of potential for downside in the short run.

Is this overly simplified? Were inflationary/deflationary pressures entirely different at that time?


Macro Man said...

Curious, for the past several years I have run a successful absolute rturn strategy on an unlevered but relatively substantial amount of money. I started this blog a year and a half ago a) to aid me in organizing my thoughts, so as to improve my eral-life investment performance, and b) to demonstrate to myself (and others) that the skills required to manage a "real money" portfolio can translate into running a leveraged, hedge fund sytle portfolio.

2and20 said...


yes 10y futures and bonds can be considered interchangeable for all intents and purposes (i use the futures usually).

i think the difference between now and 2001/2002 is that the market thought the Fed was ahead of the curve, and that the recession would be relatively short. so low rates were inflationary, hence the initial tanking in early 2002. it wasn't until after that that the market then decided that it was maybe worse than normal, and there was a lot of deflation talk, hence the huge rally (i think the 10y yield hit 3.07% or something close to that).

today, i think the conditions are a whole lot worse, and a systemic crisis seems more likely, as does a huge unwind of leverage, falling asset prices, and a deeper and longer recession. so my call is that the Fed has to lower rates much further, but they could be there to stay for a substantial period of time. at that the point, you'll get the inevitable comparisons to japan, and then 10y yields at 3% will practically look like a bargain.

anyway, that's my thoughts. in "normal" circumstances, yes, low Fed rates would mean I wouldn't want to be in the long-end, but i think it's "different this time".

Anonymous said...

Hey MM,

When you can spare a moment, can you please on "cross-market ratioed curve trade on, paying the back end of the US and receiving twice the bpv in 2 year Europe." tks

marc said...

I think you gentlemen are underestimating inflation. Last week Panera Bread Company raised coffee to go by 50%, small rolls by 58% and other small ticket items by similar amounts. The manager told me that another set of price increase were sent to the restaurant to take effect in another month or so. They are assuming prices are inelastic for these small ticket items. Place your bets gentlemen.

OldVet said...

You may be misunderestimating the price of banking risk, too. Flies in the borscht? Enter the Brothers Karamazov? From the Moscow Times it seems some Russkies have appeared in the SocGen affair: 2 Russians Seen in SocGen Fraud Case

There's now enough liquidity, but still the drip drip drip of info out of banks is keeping markets unsettled.

druckenmiller said...

Time to put on a curve-steepener trade in the Euro debt markets

2and20 said...

marc, i hear you and that is one thing that bothers me...there does seem to be pricing power in a few lower priced industries. maybe it's just the trickle down effect from a dying consumer, that can still afford stuff that's only a few bucks, so maybe this pricing power disappears soon. not sure. least back up your statement with some rationale.

4and44 said...


The market never thought the Fed was ahead of the curve in the period you speak of , that's way off base