Thursday, June 12, 2008
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.