Thursday, June 12, 2008

When bad hedges happen to good people

It ain't getting any easier, is it? While Macro Man has escaped, if only temporarily, from the House of the Fat Tail (which has a lawn dotted with pink flamingos), he cannot help but think that he's left a number of market colleagues still residing there. Discrete jumps in asset-price volatility, as Macro Man's recent experience can amply demonstrate, are difficult enough to deal with. But when correlations break down as well, the resultant P/L hit can be very unpleasant indeed. This is particularly the case when one's engaged in cross-market hedging of core positions, a strategy that helped nail Lehman Brothers to the wall in their May quarter. There is little more frustrating than an environment when bad hedges happen to good people.

Let's engage in a little though experiment here. Take a stroll with Macro Man down memory lane, all the way back to Thursday of last week. On that day, the S&P 500 closed at 1404, up 2% on the day. USD/JPY closed in New York at 105.94 on the same day. Looking forward, if Macro Man had told you that the S&P 500 would be 70 points lower, where would you have guessed that USD/JPY would be? Probably nowhere near the current spot rate of 107.50! So any equity or EM punters who have sold USD/JPY to hedge their core book of assets (and from what Macro Man can make out, their numbers are legion) have been royally and utterly buggered. Welcome to the House of the Fat Tail, folks!

UPDATE: The two series are labeled incorrectly; the red line in USD/JPY and the blue line is the S&P 500.
Elsewhere, the news just gets worse and worse for the UK. The equity market (where Macro Man retains a short delta) has been submarined by homebuilders and financials; recent comments from retailer extraordinaire Philip Green don't exactly engender a helluva lot of confidence. Macro Man follows an indicator that compares the lagged second derivative of UK unemployment with the BOE base rate. As the chart below shows, this indicator does a pretty good job of anticipating the Bank of England's reaction function. And while inflation (and inflation expectations) remain uncomfortably high, it seems pretty evident that it's "mission accomplished" for the destruction of domestic demand. As Merve the Swerve himself recently observed, there's little that the BOE can do to bring inflation to target in the next twelve months. And dealing with usurious utility companies is a job for Gordon Brown, not Mervyn King. Having resisted the siren call of short sterling (a/k/a "the widowmaker") for the last three months, Macro Man is beginning to wonder if, with rate hikes priced in by year end, it isn't time to have a flutter from the long side.
But Merv may choose to focus on inflation expetations, which have admittedly deterioated markedly. The latest survey shows an uptick to 4.3%, a whopping 100 bp rise since May. Still, that's child's play when compared to the situation in Australia, where expectations rose 0.7% from May to June, to a record 5.9%.

At the same time, unemployment in May rose for the first time in eighteen months. Even in commodity powerhouse Australia, therefore, some form of stagflation appears to be taking hold.
While equities are enjoying a brief respite so far today (and may bounce further on a decent gas-related reading on retail sales), the overall environment appears overwhelmingly negative to Macro Man, so he's happy to retain his short bias.


Anonymous said...

The JPY/SPX chart, is it possible that you have mixed up the two components?

Macro Man said...

It's not only possible, it's fact. Doh! Good catch.

Anonymous said...

yae, I didnt see the logic when i tried to relate the text to the chart, but no worries, still the best blog in town...

Macro Man said...

*Blush*. My only excuse is I was dead busy this morning and didn't have time to proofread....

Anonymous said...

... that's why historical correlations are useless... Instead, pay attention to Fed speak! "We are attentive to the implication fo changes in the value of the dollar ..." these are watershed remarks.. and remarks of this nature will break any historical correlations which are mostly the byproduct of a herd of market makers looking into the rear view mirror as they attempt to translate flow noise into price action. Stay away from correlation and betas. In fact short them.

Richy Rich said...

I am amazed at all these "hedges" against positions using something that once correlated to it. If you need to hedge your position then get rid of some or all of it.

The only good hedge is one you buy in a garden center.

Macro Man said...

Richy, the market's already been to Mr. Market's Garden Center...and come away with a giant hose job.

CV said...

Hi Macro Man,

You basically read my mind with that chart of the USD/JPY to the SP500. I have been thinking myself about whether the chain was broken as per reference to my previous study of the idea that the USD/JPY was a 'negative beta' asset (assuming that you quote it directly that is)

Interesting it could seem as if Ben B's (and indeed the rest of the CB gang's) renewed focus on inflation is a prime driver of the USD here. I mean, clearly; nobody thinks that the BOJ will raise eh :)?

More generally and while I can symphatize with anon @ 2.00 pm and Richy Rich's comments I still think there is an important story here. My own studies have shown that many of the most liquid CHF and JPY crosses have been pretty solid hedges the past 1 and a half year on a daily return basis. (Perhaps it even goes further back, I don't know). My simulations run them as hedges against the DAX, SP and the Nikkei.

So, even though the chain is broken with the USD/JPY it remains to be see whether it will stay this way. I mean, after all this game of yours is all about timing is it not?

Oh and by the way ... I am happy to hear that you survived your little trip to the fat tail this week :) ... nicely told, if a bit scary, story.


Anonymous said...

The other side to this story is that the move in spot has been negated by equity risk aversion and left the term structure over the past couple of weeks unmoved. Small consolation to the texas hedgers who paid 10 vol for jpy instead of 20 for spx but a character-building one not unlike my recent experiences in short sterling..


Macro Man said...

Wasn't there a Hank Williams Jr. song about this market?

"All My Hedges Live in Texas"?

D said...

Vampire Bat Market - Live upside down and suck the lifeblood right out of you.

Remember my comment a couple weeks ago: Do the opposite of what makes sense to you or sit on the sideline?

There is a lot of pain being distributed to market participants of all sophistication levels...LOL

Adrem said...

"We are attentive to ...the value of the dollar..." Do we really believe Bernanke has the gumption to back words with deeds if, and when, unemployment starts mounting? A helicopter that drops steel balls not paper bills.

Macro Man said...

Interestingly, JPM's Bruce Kasman, who I quite rate, is apparently now calling for a rate hike in September. He's the only one I've heard to make such a forecast thus far.

Anonymous said...

JPM call aside, the market is pretty much pricing in 25bps in hike in September.
JPY has also "broken" out very convincingly (I hate going on 'technicals' alone), but it would seem to apply a move to 114? Is Yen gonna return to a normal direct rel. with equities, or is it gonna tag along 10y. Meanwhile, looking back at the inflation bout of 1973-1974 it's pretty clear that stocks moved lower, as yields moved higher, but that wasn't really a net positive for the $, as it implied a failure of the CB to adhere to its mandate.
However, could this time be different? We get a move up in yields (can we go beyond upper end of the range at 4.30-4.40?) and higher inflation- and yet it be a $ positive, because of it being largely undervalued (debatable, but some would argue it based on PPP, prospects of reduced c/a, etc.)
OR is the Fed gonna blink when push comes to shove, and ECB steal the show and actually hike rates.
OR are the bond yields going up less on inflation expecations, and more on prospects of economic recovery?

Sorry, I only have observations and questions, and few answers.

MM, props to you on having the most amusing blog, not to mention an informative one as well.

Anonymous said...

September? AUGUST FF futures traded as low as 97.76 today. That implies (assuming a perfect match between the effective rate and the target rate, and also assuming no hike in two weeks) a one hundred percent chance of a twenty-five basis point increase on August 5th WITH a greater than ten percent chance of a FIFTY basis point increase.

Steve said...

Great post. It's the $10mm question (to put it in practicaly terms.)

It has been very scary trading from the long side in the short end. I have never seen euros drop 20 ticks faster, and I've been doing this for 20 years.

Here's my read on cost push inflation: Many agree that commodity inflation is like a tax. You have to pay it, but it comes out of your pocket, and that's that. There is zero impact on the core rate. This is what we can observe today.

In Japan the government (stupidly) increased the VAT by 2% back in 1997, if memory serves. The CPI had been zero. What happened? The CPI spiked up to 2% more or less, since the measure included the VAT. But after the year on year increases to CPI were observed, the CPI went back to zero (in fact it went NEGATIVE, in part due to the demand-killing VAT.)

What I take from this is that once commodity prices stabilize--they don't even have to go down--we will see the CPI collapse back to the core rate. The year on year rise will have been neutralized, the contribution of commodity price increases will fall to zero, even if oil stays at $135.

In fact since the CBs pretty much have to raise rates now to maintain some sort of credibility, this will further drag the global economy and we could end up with a period of outright deflation.