Back in Black

Macro Man has returned to the coal-face of global finance this morning after two days of following the mayhem from afar. It's really getting to the point where he will need to start a premium subscription service that will notify customers in advance of when he will be away from the market. Going long vol during his absences from the market has been close to an infinite Sharpe ratio strategy over the past few years, so those institutions that are left standing after this year should be more than happy to pony up.

In any event, Macro Man is engaged with the market but off the desk for the entirety of this week. This is because a) it is half-term school holidays and is a chance to spend some time with the kids, and b) the British rail authorities have finally decided to upgrade their infrastructure from 19th to early 20th century standards. As such, the engineering works will render it close to impossible for Macro Man to get to and from the office in anything approaching an acceptable time frame this week, so he's had to opt for telecommuting from his home office.

Regardless, markets appear to be wondering if today will be the newest entry in the pantheon of "black" market days. Market liquidity is execrable, to say the least, and fear is running high- though SPX futures and European markets are "only" down about 5% or so. That, however, may be down to the latest horrible squeeze in Volkswagen, where Porsche is turning the screws on a number of hedge fund shorts in VW stock (many of whom, ironically, probably drive Porsches....for now.)

Still, an out-of-the blue G7 statement on currencies has caught the eye, suggesting that the authorities are getting worried. The RBA was reported buying AUD/USD both Friday and today, and you know the Japanese aren't afraid of a little FX intervention every now and again.

USD/JPY realized vol has risen dramatically, exceeding that observed during the descent to all-time lows in the spring of 1995. However, it's still got a ways to go to breach the highs seen in the wake of the Russia/LTCM crisis in 1998. It would be a truly remarkable feat to do so, given that the likes of Soros and Tiger aren't sitting on tens of billions of long USD/JPY positions like they were a decade ago.
So why bother? Just because authorities are concerned about something doesn't mean that they can do a whole lot about it- just ask Ben and Hank! Still, Macro Man supposes they have to at least make a gesture- the downdraft has been impressive- see if you can find this month on the chart below.
Elsewhere, oil seems to have confirmed the thesis that its parabolic rise was a bubble, given that its descent has been equally parabolic. While peak oil may or may not be a reality, oil's trajectory this year is an object lesson that the fundamentals don't justify any price.
So Macro Man has found himself in a spot where he has emerged from last week's conference more bearish than ever but with relatively little risk on. Sure he's got a few bets on that (knock on wood) are working OK, but he has slashed his nominal position size to the bone. This opens up a philosophical question of how to trade these markets. Massive volatility brings massive opportunity...but also carries substantial risk.

So do you maintain a relatively normal position size, live with the volatility, and try and hit a home run? Clearly the magnitude of the moves we have observed offer the opportunity to potentially make one's year in a single month. Yet given what we've already seen and where implied vols are, adding fresh risk at current levels doesn't appear to offer tremendous risk/reward. And so any position that could make your year, even a long option position, could cost you a lot of dough if it doesn't work.

Or should one slash nominal risk to reflect the inexorable rise in realized vol and play with tiny positions, trying to maintain a relatively steady portfolio volatility and locking in a "very good" month while falling short of "epic"?

Macro Man has generally opted for the latter and is, broadly speaking, satisfied with the results. He has kept some skin in the game, allowing him to participate, but has mitigated portfolio risk to the extent that he hasn't had too much trouble sleeping-and in this market, a well-rested, alert mind is imperative. Yet after chatting last week with a couple of very successful managers, he's wondering if he's erred too far on the side of caution and not made enough hay while the sun shines (at least in terms of calling the market correctly.)

There isn't necessarily a right answer to this question- ultimately, we all need to do what works for us. At the end of the day, the name of the game is to remain in the black....regardless of what colour the day may be.
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spagetti
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October 27, 2008 at 11:01 AM ×

all just seems so uber-bearish, that a tiny contrarian position is what i have now. short yen, long em fx
i can see a move higher in equities, not because there is much justification, just because of the sentiment-contrarian argument

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Anonymous
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October 27, 2008 at 12:38 PM ×

I wonder why the EM Central banks that have collected tons of reserves aren't defending their currencies more aggressively. Maybe the money is invested in Fannie and Freddie.

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Anonymous
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October 27, 2008 at 12:42 PM ×

An interesting read as always.

One question though MM do you think there is further 'significant' yen appreciation in store considering the moves already experienced on EUR/JPY, GBP/JPY and AUD/JPY?

I would be interested to hear on your carry trade view over the medium/long term. A 'naive' question perhaps given the moves last Friday but having liquidated a prior carry portfolio in Feb 07 I'm tempted to begin averaging in again, albeit slowly.

Thanks again.

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mikarsky
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October 27, 2008 at 12:46 PM ×

My short-term sell GBP/CHF strategy worked as long as GBP made any serious upward attempts. But it now just goes south. It now depreciated about 25% over three years. Lowest USD was also 25% off which makes me think that GBP could go north again. But then, USD picked up since its low only because of heightened demand as reserve currency. 1) GBP is not so it may freefall further? 2) USD on a bull trip amid its bear journey?

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gsm_73
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October 27, 2008 at 1:16 PM ×

Dear MM, do you thibk EMs should spend their reserves supporting the currencies. India's reserves are down, there have been outflows of $3 bn in equities and another $500 mn in debt, they have probably spent another $10 -15 bn supporting currencies. Reserves are not increasing. with 300bn not likely to be adequate if something worse happens, wont it make sense to let the currency depreciate. The way things are developing no number is sacrosanct neither indices/curr levels nor reserves?

regards:

gsm_73

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Anonymous
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October 27, 2008 at 1:28 PM ×

Hi MM,

I think markets might go nowhere in the next couple of weeks: one day a huge move down and one day a (fairly) huge move up...

Indeed, main unknowns for currency markets in the weeks ahead are:

a) US presidential elections. How about a landslide victory by Barack Obama (the opposite being at the moment quite unklikely...) followed by a brief relief rally for US equities and a further wave up for USD?

b) G20 meeting on November 15th. How about some kind of coordinated intervention on currencies putting a temporary stop to the current USD strenght?

I think that both a) and b) will come true, but I frankly don't know how to translate such views in a trading equation... keep on betting on USD (and CHF, and JPY...) or choosing a different horse (all quite groggy, to say the least...), that's the question!

Have a nice day with your kids, AT

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Macro Man
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October 27, 2008 at 1:36 PM ×

Anon@ 12.42, while FX carry is certainly cheaper than it used to be, it is also, by and large, tied to the global economic cycle. I remember during the last recession scratching my head and wondering how the hell AUD/USD could be under 50c. It wouldn't be a total shock for a similar outcome this time around as the Great Unwind takes hold.

Gsm, if the CBs don;t spend the reserves supporting their currencies, it sort of begs the question of why they acquired them (particularly in he magnitude that they have done) in the first place!

AT, I originally thought that the election would send US equities and the dollar higher. Now, I really have no idea to be honest, given the speed of the $ rally. While I suppose anything is possible re intervention, it seems a bit odd to weaken the $ against, say, the euro, when according to many metrics (including my own) it is still undervalued!

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Anonymous
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October 27, 2008 at 3:02 PM ×

Intervention, part 2

I absolutely agree with you, MM. The ground is already so wet that one cannot help but wondering whether further heavy rains in the weeks ahead will change anything in the currency markets…

However, how about an intervention aimed at buying USD/JPY and selling EUR/USD? After all, it’s JPY that seems to be sitting on the earthquake’s epicentre, while the recent bout of EUR weakness might well be a welcomed relief for many European exporters… Did you hear any of European so-called leaders complaining for the weakening EUR, recently?

Read you later, AT

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Anonymous
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October 27, 2008 at 3:28 PM ×

Good chance that Dow is bouncing around in a bottom range, and Dollar and Yen have seen their max. Maybe the culling of misguided bets, the popping of bubbles is at, or close to, its peak. Novemeber the nadir.

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Anonymous
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October 27, 2008 at 3:30 PM ×

Thank you for taking the time to answer my carry query MM. I appreciate it.

Anon 12.42

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Steve
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October 27, 2008 at 3:40 PM ×

Citi is circulating a short piece over bbg talking about the possibility of portfolio rebalancing at real money funds. They do a back of the envelope and arrive at the need for them to buy 4% equities and sell 4% bonds. This (or the fear of it) explains the price action today.

Crisis be damned, I see too much value out there. I was a small short, now I'm a small long, underwater tho it be.

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SD
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October 27, 2008 at 5:00 PM ×

MM & other punters: anybody know whats been going on in the TIPS markets? From my crude math I see no inflation priced into the curve for the next 5 years (at least)... And why are the short dated ones showing up with 6-8% yields? Deflation expectations that didnt filter thru to pricing assumptions/conventions?

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Macro Man
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October 27, 2008 at 5:07 PM ×

SD, 3 issues:

1) bad liquidity

2) illiquid repo market

3) Existing issues have a lot of accrued inflation, so there is no implicit "inflation put at zero" in them. Could CPI be negative by a few percent in the next couple of years? Maybe. If oil is, say, $50 next July, that will be a y/y change of -60% or so...that would surely put sever downward pressure on the CPI.

And if you think TIPS are cheap, check out JGBis.....

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SD
admin
October 27, 2008 at 5:23 PM ×

Thanks for wisdom (as always!) MM. It looks to me as if there might an opportunity somewhere around here... zero inflation for 5yrs and +3% real yields don't seem to fit together very well. Am I missing some nominal/real yield equivalence conversion trick? Or is the market that messed up?

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Anonymous
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October 27, 2008 at 8:55 PM ×

A free option on inflation is nice, but who has patient enough capital to wait around for it to pay off? So many trades out there, so little capital...

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prophets
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October 28, 2008 at 12:50 AM ×

We've been involved very modestly in Volkswagen, less than 1% of total capital.

While we clearly got more vol/risk than we bargained for with this one, I'm glad to see Bafin (german securities regulator) is now investigating the issue. Porsche has engaged in a levered hedge fund scheme by taking on debt, selling volkswagen puts and buying calls, while pushing around the underlying stock which is under severe liquidity constraints.

It is cornering the market, pure and simple and then trying to play games with derivatives on the underlying.

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A
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October 28, 2008 at 10:24 AM ×

Hi Macro Man

Thank you for sharing your thoughts in this blog. Its great!

On your ruminations on whether one should aim for 'epic' performance in this market vs 'just' 'very good', my opinion is that the name of the game is to REMAIN in the game.

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Anonymous
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October 28, 2008 at 12:53 PM ×

Macro Man (and others),

USD/JPY/CHF started to strengthen around the start of August. Do you have any idea why it happened at that very time? Was it rate cuts by central banks that made the carry trade less profitable?

Thanks

Johan

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