Macro Man

Well, that was fun. ADP strong = the world is good. US GDP weak = maybe not. Fed cuts rates by 50 bps = happy days are here again. Fitch cuts FGIC = no, they're not. Got it? Good.

The FOMC statement was probably as in-line with consensus expectation as the Bernanke Fed has ever been, so from that perspective could perhaps be taken as a victory for risk assets, insofar as there was no gratuitous injection of volatility a la the December statement. The observation of further downside risk to growth would appear to open the door to further easing. Interestingly, John Berry has written a piece suggesting that the Fed could be hiking again by the end of the third quarter. Whether they do or not probably depends on the degree to which Fed concerns on inflation are genuine, as opposed to merely lip service. (For an amusing take on monetary policymaking, readers are encouraged to check out some of Cassandra's recent efforts.)

As for GDP, the headline was weak but the details encouraging. Yes, residential construction remains horrible, and yes, non-res construction growth can only go lower from here. But inventories, highlighted in this space yesterday as a factor to watch, subtracted substantially from growth. If firms are already de-stocking, there is less risk in an abrupt slowdown in corporate demand in H1 2008.
So everything was looking peachy until the FGIC downgrade, and now things are looking a tad ropy. Data out of Europe has been poor, a foul-tasting cocktail of upside inflation surprises and weak activity and sentiment figures. The euro has remained broadly resilient, however, thanks to the utter crapness of the dollar against most other currencies out there. For the time being, the safer way to play a European slowdown may be receiving the short end, which Macro Man already is. That may seem perverse with inflation high and the ECB hawkish, but markets seem confident that it is only a matter of time before the ECB blinks. As such, pullbacks in 2 year swaps are likely to remain shallow.

All the more so if equities turn back down. As if the monoline downgrade wasn't enough, from a purely technical perspective yesterday's price action generated a warning sign that the upside correction may have run its course. The candlestick produced by Wednesday's late session swoon is basically the reverse of the hammer-type formation that prompted Macro Man's call for a spurt higher last week. This candlestick, known as the "hanging man", generally forebodes lower prices.
Macro Man added a little bit of short directional beta yesterday, as the large cap/small cap spread currently trades like a short SPX position. Macro Man was filled at 0.9108 in the spread, and his exposure is now up to $15 mio per leg. The fills are in the P/L below. Macro Man will also look to sell out his March 1375's at 40; they've made him a bit of cash, and 'twould be a pity to ride them all the way back down below 1300. Finally, the dividend for the SPY beta position is paid out today after the close, and is accounted for in the P/L. Per the usual, it will be mechanically re-invested into SPY at tomorrow's open.

Fresh off the successful passage of his Life in the UK exam, Macro Man is now ready to get stuck into the rest of the week. He suspects he's not alone in that regard, as the preliminaries of the first two days of the week now give way to more heavyweight event risk: GDP, ADP (OK, that's more of a welterweight), and the Fed today, PCE and the Chicago PMI tomorrow, and of course unenjoyment/ISM day on Friday. You can almost hear Michael Buffer stepping up to the the mic and bellowing "Let's get ready to rumble!"

The most obvious event risk of the day is the Fed, though by now a further 50 bp cut is widely discounted. Macro Man's take is that another half-pointer would ignite at least a bit more upside in equities and other risk assets, weigh on the dollar, and naturally steepen the curve. However, these moves could easily be short lived, particularly in equities, in the event of unfavourable developments on Thursday and Friday. It would apprear prudent to not bet the ranch on a single datapoint, such is the potential for these markets to turn on a dime over the next few days.

In the last few months of 2007, Macro Man took the view that the Fed was perhaps making too much use of macroeconomic tools like Fed funds, and insufficient use of microeconomic tools to address the ruptures in the money market. Well, in mid-December they announced the TAF, and six weeks later we can assess the initial impact of the program. The chart below shows the 3 month TED spread, and as you can see it has narrowed sharply since the TAF announcement was made.
It begs the question of "what took them so long?", but being late is still probably better than doing nothing at all. Observe that the spread has been relatively sticky around 1%, well above the levels prevailing before the crisis kicked off in mid-2007. That's not necessarily the end of the world, mind you; the world's central bankers (and, it must be said, many market participants) bleated for a long time about the low level of risk premia embedded in financial asset prices, so swinging the other way for a while is no bad thing. And given that we're still firmly in the world of writedowns and bailouts , you can hardly say it's not justified.

Macro Man's "muddle through" view on the US economy received something of a fillip yesterday with the release of much-stronger-than-expected durable goods data orders data. Mechanically, the strong core shipments data (+2%) and inventory data (+0.8%) should buoy the Q4 GDP figure released today, as they are plugged straight into the GDP model equation. Incidentally, the latter figure conforms to Macro Man's view that much of the recent softness in the data has been down to an undesired inventory build-up late in the year, which will take a couple of months to work out- just as it did this time last year.

However, Macro Man is not yet prepared to dislocate his shoulder in patting himself on the back for his prescience. The orders data is extremely volatile, and on a 3m/3m basis the trend is still negative. If not matched off with final sales, heavy orders can generate an even larger inventory build...and that is the stuff of which recessions are made. So while the inventory figures are not terribly timely, and not sexy at all, if you want to know where the US economy is going you could do much worse than to follow inventory trends- either via the official data or through surveys such as the ISM.
Elsewhere, in Macro Man's soon-to-be adopted "homeland", Swervin' Mervyn has been re-upped for another 5 years in the Threadneedle Street hot seat, while mortgage approvals sank to their lowest level in a dozen years. Several readers have asked about whether Macro Man has the inclination to add to his sterling short at current levels. For the time being, he does not; the time to add will be when Merv throws in the towel and starts slashing rates more aggressively. And for that, he'll need to see a more pronounced drop in either inflation or activity. Macro Man is prepared to wait.

Finally, as noted yesterday, recent quant fund ruptures seem to have generated a small pullback in Macro Man's large cap/small cap strategy. The OEX/RUT spread is now approaching the uptrend line of the past year, and now would appear to be a reasonable time to add risk to a position that Macro Man would expect to carry for a long time.
Macro Man will therefore up the nominal position size to $15 million per leg, buying 99,000 OEF and selling 93,250 IWM half an hour after the market opens today.

Yawn. Another 1.75% day in the S&P 500, this time to the topside. It's all getting to be old hat, really. Those days when people were highlighting the lack of volatility seem a long time ago, indeed.

Yesterday's rally could easily have been a paper-shuffling exercise ahead of tomorrow's FOMC meeting. There appears to be some evidence that popular shorts were being squeezed and that quant models of various description are once again coming under the cosh. Macro Man's own equity RV trade, the large cap/small cap trade, has given back all of its monthly gains and now is sitting slighty in the red for 2008. However, he still believes the rationale behind the trade. He'll give it another day to unwind, and then look to pull the trigger on adding tomorrow ahead of the Fed.

What made yesterday's stock market rally curious was the execrable set of macro data that accompanied it. New home sales, and there's no other way to put this, sucked. Not only were the sales figures the lowest in a dozen years, but those weak figures came in the context of tumbling prices as well. While the median sales price data is subject to significant distortions, dependent as it is on the geographic and value mix of the monthly sales, it is nevertheless telling that the y/y figure fell nearly 15%, the lowest since at least 1970. And the monthly supply of unsold homes made a new cyclical high as well. So naturally, the homebuilders spiked higher yesterday.
Anyone not believing the "quants getting squeezed" explanation for yesterday's action might instead offer the explanation that the data was so weak that it has cemented a 50 bp rate cut tomorrow. Why that should be a near-term benefit when the prior 1.75% of easing has failed to meaningfully buoy the market over the last few months is something of a mystery.

One source of hope cited in some quarters is the recent rise in mortgage refi applications. To be sure, the recent decline in interst rates across the curve has prompted increased demand for refinancing credit, as show in the chart below. Macro Man has a few thoughts on this matter.
While it is the case that refi apps have surged, they remain well below the levels observed a few years ago. It's curious to note that apps for purchase have also rebounded recently, though as yesterday's data demonstrated, that has yet to translate into increased buying activity. Meanwhile, Macro Man would question the very desirability of spurring further mortgage refis. It was that very process that ultimately landed us in the current pickle, so why start a new cycle while we're still picking up the pieces of the last one?

Finally, we also need to distinguish between demand for credit and the supply credit. While it may well be the case that Mr. and Mrs. John Q. Public would like to borrow large sums at the the rates they read in the newspaper, most professional investors can tell you that the rate you see on the screen ain't always the price you get in real life. That's particularly the case in the current environment; the securitization market is still seized up, and banks' willingness to take fresh mortgages on balance sheet is pretty low at the moment. So applying for a mortgage is all well and good, but there's no guarantee of success. After all, Macro Man could apply to be the new England football manager in 2010 after Fabio Capello leaves in a huff following the World Cup, but there's no guarantee he will get the job.

Speaking of Mr. Capello, today Macro Man has the dubious pleasure of taking a test on life in the UK. He's doing so as part of a Home Office requirement to attain permanent residency, a status which confers a few marginal benefits and opens the door to obtaining a passport (which itself confers the benefit of enabling him to choose the shortest passport queue when flying into the UK.)

Sadly, Mr. Capello does not make the list of required knowledge about life in Blighty. Among the requisite items of knowledge, however, include the following:

* What proportion of the UK is Buddhist? (0.3%)
* In the early 1950's, the UK held a recruiting drive in the West Indies for which profession? (Bus drivers)
* How many members are there in the Scottish parliament? (129)
* When did women win the right to divorce their husbands? (1857)
* On April Fool's day, one plays tricks on other people until which time of day? (noon)

To prepare for taking this test, Macro Man was forced to spend £9.99 on a Government-issued handbook. For the pleasure of taking the 24-question exam (average time taken to complete a practice version: 2 minutes), Macro Man incurs another £34 charge. And to actually get the stamp in his passport, he has to fork over £950. All in, that's a £993.99, just to keep getting taxed by Gordon Brown. If ever there was a statement about life in the modern UK, that is it.

After the rallies on Wednesday and Thursday, along with the revelation that the earlier meltdown was rogue trader-related, markets were perhaps justified in expecting an extension of the snapback in risk assets (though some, like the Turkish lira, had already recouped 70% of their losses.) After Friday's steady selling into the close, traders can now ask themselves "was that it"?

Certainly last Wednesday, Macro Man had targeted 1360 on the S&P 500 as a possible retracement target. Well, we got there, Macro Man cut some of his short risk, and then we turned back down. Could that really have been all there was to the rally?

Well, clearly it's possible; after all, the move to Friday's 1368 high fulfilled a number of retracement criteria. As noted above, it was an attempt to recapture the erstwhile support level, which was rejected. It was almost exactly a 38.2% retracement of the move down from the mid-December high. And it bounced neatly off of the downtrend line off of that mid-Dec high around 1500. All in all, it looks like a classic corrective pattern.
Paul Kedrosky did an interesting little study on intraday bounces last week, following on from Wednesday's sharp reversal. What struck Macro Man about the study was not the conclusion, which was pretty ambivalent, but the data itself. As far as Macro Man could make out, 8 of the 10 largest intraday spikes in the Dow occurred during what could be termed bear markets. The other two, in 1987 and 1997, occured during times of extreme financial market stress (The '87 crash and the Asian crisis, respectively.) While Wednesday's spike didn't make the top 10 list of percentage intraday moves, it was still pretty impressive. And judging by the weight of history, these types of moves occur during secular bear, rather than bull, markets.

Unfortunately for many hedge fund investors, their managers may not be positioned for such a development. The Sunday Times published a by-now well-circulated article alluding to signs of stress in the European hedge fund community. Macro Man decided to investigate, and ran a broader version of the correlation study he did a few days ago. He ran rolling correlations on the SPX and the HFR NAV indices for global macro, equity, market neutral, and market directional hedge fund strategies. (Note: he regressed price, rather that daily returns, to filter out any reporting lags. Using daily returns, the correlation signs are identical, albeit with smaller absolute values.)
The chart makes ugly viewing for equity hedge fund investors, and not just because of the garish Excel 2007 colours. (As an aside, can someone please explain why MSFT decided to radically change Excel, making it more difficult to copy forumlae and to format charts? Why change a tried and tested winner? Can somone say "New Coke"? Macro Man likes Vista but hates the new version of Office.)

All three categories of equity hedge fund are displaying a high degree of correlation with the SPX- including the so-called "market neutral" funds. Perhaps this is the real reason the market failed on Friday; funds are long and oh-so-wrong, and looking for any opportunity to trim their long positions. If that's the case, then bounces may well be short lived until we see equity funds with a short(er) exposure to market beta, in which case rallies will be the pain trade.

And given what we've seen so far in 2008, wagering on the pain trade seems like the only safe bet in town.

...why were they looking for a Delta one trader (Monsieur Kerviel's role) last week?

If you ever needed a reminder that most short term price action is noise, rather than signal, this week has provided a timely reminder. Taken at face value, this week's moves suggested imminent US recession and asset price deflation on Monday, Tuesday, and the first half of Wednesday, while price action since then has had "soft landing" written all over it.

In retrospect, of course, much of the volatility in stock index prices has been down to the work of one or more unfortunate Frenchmen; Macro Man assumes that he is not alone in concluding that the short term price swings caused by the worst trader in history (judging by the size of his loss) have little insight to offer as to the medium term trajectory for economic growth and financial prices.

Macro Man also assumes that he's not alone in scratching his head and thinking "what now?" Next week's Fed meeting is set up to be an extraordinarily interesting one. It has emerged that despite the Banque de France knowing about SocGen's travails over the weekend, the Fed had no clue when they hit the panic button on Tuesday.

Grep Ip seems to suggest that the SocGen revelation won't impact the Fed's decision next week, but come on! If, before the equity market meltdown, the Fed was planning on doing 50.....why should they cut any more next week, thereby at least doubling the amount of their originally intended easing?

Yet to the market, it's not a question of whether the Fed eases, but by how much. The OIS market is currently pricing in 40 bps of easing. Of course, if the Fed doesn't ease, markets could then puke, delivering the kind of price action that prompted the emergency cut in the first place. The problem with allowing the market to lead you, Mr. Bernanke, is that it inevitably leads you into an uncomfortable corner.

What seems evident is that volatility is set to remain pretty high. If the Fed doesn't cut next week, equities should tank and bonds soar. If they do cut....well, let's just say that the dollar will be (French) toast.

In the meantime, Macro Man's recently-minted short risk asset delta has taken something of a beating as the market piles back into the "risk trade." While he made a gesture at hedging with his SPX calls, the size of the position was relatively small, and as such has only mitigated a small portion of the last 36 hours' losses. Macro Man originally targeted a re-test of prior support at 1360; futures are suggest a breach of that level at the opening. Retracement targets are located at 1385 and 1412; each of those could be seen without threatening the underlying bear market, if that is indeed what we are in. Discretion being the better part of valour in this environment, Macro Man therefore cuts half of his short DAX future position at 7020, locking in at least a portion of tasty profits.
USD/JPY has also had a vicious bounce and requires some attention. While an Armageddon option stop loss scenario continues to beckon in the event of further weakness, it might require price action below 102 or even 100 to prompt it. In the meantime, the DOTW have every excuse to pile back in. A similar retracement chart suggests scope to 110, and Macro Man really wouldn't want to see it breach that level.

So to further mitigate drawdown risk (and collect some decay in a low-risk fashion if for some reason this is the short term apex in vol), Macro Man implements the following strategy: He buys $50 million of a 1 month 106 $ call with barriers at 104.50 and 111.50 for 0.55%. He will leave a stop on his short cash position at 110.25. Obviously this doesn't completely insulate him from a further modest drawdown, but it should head off a negative month if the last 36 hours were to continue.

The cheeky SPX option purchase that Macro Man wrote about this morning has not had time to get executed yet, and it's already threatening the stop loss level. Macro Man will therefore adjust the parameters slightly; he'll still buy 100 March 1375's on the open, but will lower the stop level on the trade to 1250 on the cash index.

What a difference a day makes. Yesterday, it seemed like markets were in free fall, volumes were exceedingly heavy, and (eventually substantiated) rumours of Fed rate cuts were doing the rounds. Today, markets have stabilized, trading is quiet, and a patently ludicrous rumour of an emergency ECB easing is doing the rounds.

On the latter issue, as if yesterday's "stark" warning that inflation remains the ECB's primary concern weren't enough, this morning Jean-Claude Trichet passed up a chance to guide expectations lower. We now seem to have reverted to pre-2005 mode vis-a-vis the ECB, wherein the market apparently knows where the Bank is headed before the ECB itself does.

Regardless, markets are scratching their heads this morning and asking "what next?" As Macro Man writes, early session optimism has given way, and both equities and yen crosses are lower. A simple reading of the charts would suggest a decent prospect for a bounce; yesterday's candlestick formation is the same sort of "hammer" formation that marked an intermediate low in August. Macro Man would therefore not be surprised to see the SPX have a go at testing former support at 1360; an obvious pivot point to the downside is yesterday's low at 1274.
How best to play for a bounce, even if it's short-lived? Despite high levels of implieds, the current situation naturally lends itself to some optionality. Macro Man will therefore spend $250-$300k of premium on March 30-ish delta calls. The strike is 1375; if that seems rather far away, consider that we closed above that level just eight days ago. The trade will be executed at the CBOE open and jettisoned if the 1274 level gives way. We may well get some resolution when the Fed announces next week whether yesterday's action was an appetizer or the main course.

Elsewhere, yesterday's fixed income price action was curious, to say the least. To see the US curve steepen after the emergency 0.75% easing was hardly a surprise, but Macro Man was really struck by the furious rally in the back end in the New York afternoon- even as equities continued to claw back losses. Two-year note yields are now just 2% and look set on having a date with destiny, or at least the previous all time low yield of 1.06%.

A Dow theorist would look at a long-term chart of 2's and conclude that the long-term bull market remains intact, pointing to a series of lower highs (in yield) and lower lows. It does seem inevitable that 2's will at least attempt to revist the extremes of 2003, particularly if the Bernanke Fed continues to cut rates with such alacrity. Price action once we get to the sub 1.5% region will be very telling indeed, and could provide guidance on whether the ultimate outcome of the current crisis is Japan-style deflation or Macro Man's base case outcome of accelerating inflation.

Either way, Macro Man cannot bring himself to position for a further rally at the front end. He may be constitutionally unable to buy 2 year bonds with a nominal yield of 2% and a real yield of of -2%. He thought it would be interesting to put the aggressive easing conducted by the Bernanke Fed into persepctive. The chart below shows the real Fed funds rate and real 10 year yield since 1971, segregated into discrete time periods by Fed chairman.

Two things really stood out to Macro Man. The first is the remarkable synchronicity of the Fed funds and 10 year rates since Bernanke took over; the complete elimination of the term premium is unprecedented in Macro Man's lifetime. For this, we probably have to thank Voldemort and other price insensitive Treasury buyers have have generated a structural flattening of the curve.

The second thing that struck your humble scribe is that just four months into his first easing campaign, Mr. Bernanke has managed to engineer a lower real 10 year rate than "Easy Alan" Greenspan ever accomplished in 19 years at the helm of the Fed. It just goes to show that while you can take Ben out of the helicpoter, you can't take the helicopter out of Ben.

To Macro Man, the implication is that the dollar should continue to trade poorly and that inflation remains the most likely outcome. As he has observed in the past, Mr. Bernanke appears to be pursuing a 1970's solution to a 21st century problem. The upshot is that if the market does try to take 2 year note yields to all time lows, it could ultimately represent the shorting opportunity of a lifetime.

In fairness, the prospect of a "Great crash of 2008" isn't a particularly appealing prospect. But assuming the Fed cuts another 50 next week, you'd have to think that the dollar down bubble could soon reassert itself.

S&P futures are limit down in overnight trade (-70 points), the SENSEX has been beaten senseless, and the IBOV (Bovespa) is definitely bovvered at the moment. Two year US swap yields are 25 bps lower and European equities are down 3-4% in pre-market trade, having shed 5-7% yesterday. Meanwhile rumours are flying that some recently-announced capital injections into US banks may be scuppered as the SWF investors get cold feet. Today is shaping up as a day that could live in infamy, one of those days that in subsequent years is prefixed with the word "black."

Will it happen? Will US and, by extension, global stock markets pay a visit to the extreme left side of the return distribution today? It's certainly possible, but unfortunately such events are products of psychology more than sober fundamental analysis, and as such are vrey difficult to predict with accuracy. What is clear is that market liquidity is extremely poor, and dealer appetite to warehouse risk in any market is zero.

There are some stories that the Fed may cut rates today, but such rumours are more the product of hope than expectation; similar whispers have been heard on and off for the past several weeks. On the one hand there would appear to be little macroeconomic utility in cutting rates today with a regularly-scheduled FOMC meeting in a week's time; on the other, if markets show signs of disorderly collapse, an emergency cut could perhaps stop the bleeding temporarily and be followed up with a regularly-scheduled 50 bps next week. Macro Man would frankly be surprised if the Fed did cut rates today, but would not be particularly shocked if the SPX finished down 100...or closed higher on the day. It's that kind of market.

While succeeding today will probably depend on one's trading nous, there are a number of medium-long term trends that warrant review. Macro Man specifically refers to his view that despite the rise in volatility, the expected return in classic "risky" trades would remain positive. This view is receiving a significant challenge, and at this juncture Macro Man wishes to consider whether we may indeed be on the cusp of a secular change in trend, an idea that he kind of rubbished a couple of weeks ago.

One notable development yesterday was in Europe. Yes, the scale of the decline in European indices verged on the historic, but that in and of itself was not that remarkable. No, what struck Macro Man was the incredibly sharp rise in implied volatility, proxied by the VDAX below. While it could of course be a false alarm, the scale and speed of the rise in volatility is reminscent of H2 2000 and H1 2001, the onset of the last bear market. And for one of the few times since the onset of the crisis last summer, VDAX has traded above the VIX...suggesting the potential for considerable downside in German markets. If so, the DAX short should continue to be a star performer.

Other equity markets are looking vulnerable to a trend change as well. Consider the Bovespa, the darling market of the darling country of the darling asset class. It's come so far, so fast that it's best viewed on a logarithmic scale, in which equal percentage moves are reflected by equal physical distances on the chart. While it's yet to breach its bull-market uptrend, the Bovespa is sitting perilously close to doing so.

The FTSE in the UK has been flirting with such a trend break for the past several months, but looks to have conclusively shattered support with this month's downdraft. While much of the investment into the UK has been of the fixed income variety, courtesy of FX reserve managers, the implications of lower stock prices for the City, the economy, and sterling should not be terribly pleasant. Macro Man is happy to retain the sterling basket short.

A broader perspective on sterling is sketched out below, with a long-term chart showing the nonpareil intra-European carry trade, GBP/CHF. Much like the FTSE, this month has seen GBP/CHF definitively break through long-term support, in this case an uptrend line drawn off the 1995 low. This chart reflects not only the bearish potential for sterling, but perhaps also a bullish case to be made for the Swissie. Insofar as the CHF has been caned as a result of carry trades/excess global liquidity, the withdrawl of the latter and closing of the former bolster the Swissie's prospects on a cross basis, much like that of the yen (viz. the EUR/JPY chart posted yesterday.)

And of course, intra-market thematic trends have also shown signs of trend reversal. One of Macro Man's favourite positions is the long large cap/short small cap spread trade, which has been pretty successful so far. Trends in this relationship, proxied by the OEX/RUT spread below, tend to endure for 5-10 years. The sharp downtrend broke a year and a half ago, but it is only recently that the spread has started to move impulsively in large caps' favour. As the scale of the chart indicates, there is ample potential for further gains of 20%+, an outcome that would fit quite well with the consensus view of US consumers finally rebuilding their savings.

If one long term trend looks set to break, it can be written off as noise. If it's two, then perhaps it can be called a coincidence. But when a large number of long term trends are breaking, it behooves one to take notice. Macro Man is not prepared to go all in on the short side, just as he is not yet prepared to scrap his "muddle through" economic base case. But he has to respect what he sees and at least countenance the possibility that we are in fact in the early stages of a bear market in equities, credit, and other risk assets.

In the short term, a consequence of volatility and uncertainty is that the world may be turned upside down. Consider that as of last night's close, the best performing global major stock market in dollar terms year-to-date was....wait for it....the Nikkei. Perhaps Cassandra will have her day in the sun.

And what of the very long term? Well, if this truly is a bear market, we really haven't even scratched the surface of how low stock prices could go. The chart below shows the SPX since 1928, using quarterly data presented in logarithmic form. While the bear market following the tech bust stands out as being relatively acute, the current downdraft is scarcely a blip on the chart. If (and it's still a big if, though perhaps more likely than it seemed a few weeks ago) we have entered a new secular bear, there will be plenty of money to be made on the downside.

In the meantime, Macro Man has to respect the fact that markets are trading on the basis of fear and psychology rather than on the basis of what are commonly referred to as "fundamentals." As such, a little portfolio surgery is probably in order. The silver long has gone from a tidy profit to close to flat; Macro Man cuts that at 15.63 to avoid moving into the red. Similarly, short fixed income, no matter how rich it may seem, would be appear to be foolhardy in the event of a "black" event. Macro Man therefore cuts his US 10 year payer position in half, receiving at 4.12% in $10k/bp. This leaves him with a longer duration position, which is not a bad place to be when markets appear perched on the brink of a precipice.

Note that the P/L has been amended so that the SPY price reflects levels currently priced into futures markets rather than Friday's closing levels.

This is the way the world ends
This is the way the world ends
This is the way the world ends
Not with a bang but a whimper.

T.S. Eliot, The Hollow Men

Later in life, Mr. Eliot repudiated the ending to "The Hollow Men", quoted above. One would have to presume that if he were alive today and a practitioner of financial poetry, he would be equally averse to claiming that the world would end with a whimper.

Or so we'd have to judge by price action today, wherein all things risky are tracing out an Icarus-like descent, and the only thing preventing a Black Monday-style crash in the US today is that the market is closed. This month has already been a testing one, and on the basis of today's gruesome start that trend appears set to continue.

Where to begin? How about with the monolines insurers, where last week's Fitch downgrade of AMBAC surely spells the beginning of the end in that space. Certainly the stock chart appears to be a re-run of American Home Mortgage, New Century, and Northern Rock. While Macro Man is far from an expert in this field, it would appear to be fairly evident that buying insurance from a non-AAA provider defeats the purpose of insuring oneself; what's the point of merely exchanging one ropy credit risk for another? Should another agency swing the axe on AMBAC's rating, one would have to conclude that the company will cease to exist.While this would appear to be self-evident, it has apparently escaped the notice of some of the analysts covering the stock. One research report that crossed Macro Man's desk this morning downgraded AMBAC from "buy" to "hold", while reducing the target price on the stock from $27 to $19. Now, in Macro Man's world, if you expect the price of something to triple, it is probably a buy. Then again, in Macro Man's world, the price target on AMBAC is similar to his NRK target issued last September: zero. While the frailities of equity research are well known, this report would appear to be a particularly egregious example of failing to realize that the horse has already bolted.

This is actually a great environment to be a (lower case) macro man, your humble srcibe's early-month P/L scuffles notwithstanding. The ability to be short risk assets relatively quickly is useful in times of stress, and it would appear that the macro community is grasping the opportunity with both hands. The rolling 40 day correlation between the S&P 500 and the HFR Macro hedge fund index is now -0.8, the joint lowest reading since immediately after the invasion of Iraq.

What's interesting is that EUR/JPY, a currency pair that owes its lofty status to the compression in global risk premia, is starting to look decidedly ugly. A couple of weeks ago, Macro Man suggested that selling EUR/JPY and its ilk was the real trade to do in the event of a US recession; it appears that the market may have come around to the same view. Clearly markets are now assuming that US recession is a base case, and Macro Man has seen his first 1% Fed funds forecast this morning. Observe that EUR/JPY is now flirting with a three point monthly trendline off of its all-time low below 90. Given that fair value for this pair is probably 125 or so, there appears to be plenty of juice in the trade should a bear market follow on.

While Macro Man is actually long a bit of euro cash via his EUR/GBP positions, his overall euro delta is actually small short, thanks to his powerball strip of downside one touches. The DEM receiver position should also be negatively correlated to the euro FX rate. It's gratifying to see one of Macro Man's cherished tenets panning out, meanwhile; namely, that in times of stress, all financial market implied volatilities should rise.

The chart below shows one year implied voaltility in the EUR/USD exchange rate over the past few years; observe how it's risen nearly three vols since last spring. While the realized vol of the pair has risen, it's almost certainly not enough to justify such a sharp rise in back-end implieds. Then again, those implieds were woefully underpriced a year ago, thanks to structured product related selling. Either way, being long EUR vol as the "cheapest vol on the block" has paid dividends.
Finally, Macro Man would like to give a "smooth shout out", hip hop-style, to one of his favourite analysts. Fred Goodwin, Lehman Brothers' "Mr. Prop" (whose pieces influenced the narrative style of this space) has written his last piece and moved over to the proprietary risk-taking side. Good luck, Fred: you've now left Macro Man as the sole torch-bearer for third-person financial commentary.

Friend-of-the-blog Cassandra has been waxing lyrical on the subject of leverage recently, perhaps because of first-hand observation of what appears to be significant deleveraging activity in single name Japanese stocks.

When Macro Man proffered a modest contribution to Cassie's collection of leverage verse, occasional poster/impressive polymath/tastefully-initialled Mencius Moldbug suggested that he republish in this space. And so, by popular demand, Macro Man presents his first-ever financial sonnet!

Shall I compare thee to a levered trade?
Thou art more lovely and more temperate.
Rough winds do shake the market call you made;
Perhaps thou erred in selling options of short date.
Sometimes too hot the market darling shines,
And oft the ertswhile star is dimmed;
And every trade from time to time declines,
Alas! The over-levered ones are trimmed;
Just as a short-term extreme is made,
And soon a tidy sum thou ow'st;
Forsooth, thou start to feel afraid,
In real time, thy loss it grow'st and grow'st:
The levered trade, in time of volatility?
A dang'rous game, as you can finally see.

Panic on the streets of London
Panic on the streets of Birmingham
I wonder to myself
Could life ever be sane again?

- The Smiths, Panic

While "panic" might not yet be the word to describe the feelings of policymakers and risky asset longs, it may not be far off. In the meantime, "extreme discomfort" is probably a reasonable encapsulation of the angst being felt on Main Street, Wall Street, and the corridors of power.

Where to start? Housing starts slipped in December to their lowest level since the 1991 recession. While this is a necessary result of the continued issue of excess inventory in the US housing market, it's still pretty bloody painful. The Philly Fed survey, meanwhile, collapsed 19.3 points to -20.9. While the survey may not capture a terribly high percentage of economic activity in the United States, these levels are usually consistent with recession.
Meanwhile, Merrill's Q4 earnings announcement was worse than even the most ursine forecaster imagined. A quarterly loss of $12.57 per share was quite literally shocking. The obvious interpretation is that John Thain is exhuming all the skeletons at once, blaming them on Stan O'Neill, and moving forward with a fresh slate. That's probably the right thing to do. However, if there are more writedowns and losses in the future, one would have to think that the reaction will be very unpleasant indeed.

We took another step towards the dreaded monoline downgrade yesterday when Moody's put Ambac on negative review. In any event, the SPX broke what some were terming "line in the sand" support in the 1360-1370 region. A particularly bearish interpretation of the chart might suggest that the target of the "three mountain top" formation could be as low as the mid-1100's.

It's pretty clear that Macro Man's reasonably constructive view on equities has been wrong, wrong, wrong. Survival instinct has forced him to hedge the bulk of his risk, but there seems little doubt that he's missed the boat. Is it too late to sell? Not if the SPX is going to 1150, that's for sure.

Yes, boys and girls, after a wild two weeks it's time for another round of Macro Man's favourite game. And so without further ado....

1) At what level (assuming "orderly" markets) would Japan's MOF intervene in USD/JPY?

2) If the answer to #1 is >100 (or >150 EUR/JPY), how would the US and Europe respond to their G7 colleague's descent into mercantilism?

3) How bad will today's Merrill earnings announcement be?

4) Do Newcastle United fans really expect Kevin Keegan to repeat his mid-90's magic?

5) When will the ECB next cut interest rates?

6) How much will the Bank of England cut interest rates in 2008?

7) How glad is Macro Man that he has nothing in the Icelandic krona? (Remember, kids: you can't spell "risk" without "ISK".)

8) Is Ben Bernanke going to hold his hand up before Congress today and admit "we haven't got a clue what's happening"?

9) Since Halloween, the Hang Seng is down by 21%. Is this the beginning of the end of the Great Chinese Melt-Up?

The year is barely two weeks old, but there have really been some extraordinary developments in financial markets already. The abject performance of developed market equities is striking, to say the least, as is the concomitant rally in fixed income. What makes each of these especially peculiar is the generally robust performance of undeniably risky EM currencies, at least until today.

The Turkish lira, for example, has traded at its cyclcial high against the $ in each of the three sessions before today. If, however, the world economy really is in bad shape, it's difficult to see how those countries that have enjoyed a substantial amount of capital inflow over the past year(s) can avoid a more pronounced correction.

Yesterday's US retail sales data shouldn't have been terribly surprising given the inventory readings from the ISM, but it gives Mr. Bernanke another excuse to take his helicopter for a spin. A 0.1% monthly print on core CPI would surely cement expectations of a 0.50% easing at the end of the month and, in all probability, drive US fixed income to even more eye-watering levels. Macro Man's foray into paying various points on the US curve has been little short of a disaster; in the event of a 0.1% reading on core this afternoon, he will close the 10 year leg and lick his wounds.

It's interesting to observe more and more evidence that the pain which originated with US subprime borrowers is being shared by an increasing number of people worldwide. While the cause and effect relationship are debatable, it is still striking to see charts like the one below, which plots the year-on-year change in New Zealand housing sales. (The equivalent figure for US existing home sales is -20%.)
Tonight sees the release of Q4 CPI in Kiwi-land, where base effects are expected to push the y/y figure to 3%, the top of the RBNZ's tolerance band. However, should the figure undershoot by any great degree, what odds that the market once again begins romancing the notion of future RBNZ rate cuts, and buys the front end of the NZ curve while whacking the NZ dollar?

Another place that could start sharing more in the pain is Europe. Looked at from a broader term perspective, Europe has growth that is almost certain to slow in 2008, combined with high inflation and, to date, a hawkish central bank. It seems as if the market has thus far tried to play this view through the euro, but surely that is a lethal combination for equities? Especially so when one considers that the DAX, for example, has broken a couple of key technical supports.
Macro Man's short-bias equity alpha trades have been spectacular winners so far this month, but have not fully compensated for the execrable performance of the beta plus portfolio. Given that risky EM is finally showing signs of cracking today, it looks like the time is ripe to add to the short equity bias in the alpha portfolio. Macro Man therefore sells 100 Dax futures (GXH8) at 7560.

Is it time to say "bye, bye USD/JPY, hello 95"?

USD/JPY has broken its prior 107.22 low, which from an Elliot persepctive suggests that a move to the mid 90's is on the cards/
On a longer term basis, a monthly close at current levels would break the thirteen year uptrend line off of the 1995 lows at 79.75.
It's hard to escape the idea that the worm has indeed turned for the yen, and that Mrs. Watanabe has, at long last, found something better to do than day trade NZD/JPY. Let's get ready to rumble....

Last week, Macro Man was having a chat about the UK with one of his friends in the market. How could the Bank of England cut rates, this friend inquired, when the cost of living is rising so strongly, particularly the cost of energy? Ah, responded Macro Man, the price of energy has nothing to do with monetary policy and everything to do with Rip-off Britain, a view espoused in this very space a year ago this week.

So imagine Macro Man's surprise and pleasure when the Sunday Times published a report suggesting collusion on the part of UK power companies, and an accompanying editorial trumpeting the return of Rip-off Britain. As if one needed another reason to sell sterling.....

There have been some interesting developments in international trade recently which probably warrant comment. The most obvious is, of course, the much wider than expected US trade deficit in November. Now, one of the key planks in Macro Man's "US muddles through" view is that trade should contribute positively to growth. The sharp increase in y/y import growth is something of a base effect, given the massive y/y increase in the price of oil. Yet oil imports rose 17.3% m/m in November, and non-oil imports actually rose a percent as well. Meanwhile, export growth looks to be moderating; the export orders component of the ISM hardly suggest that December will post a strong rebound.

Either way, it's hard to construe the data as anything but dollar bearish; even if the bulk of import gains are from oil, the producers of the gooey black stuff have demonstrated a willingness to transfer some of their dollar receipts into European goods and financial assets. As such, the recent weakening of the buck looks pretty justified.

The US was not the only major country to report trade data at the end of last week. So, too, did China, and the details made fascinating reading. Exhibit A in the "currencies matter" department was the devleopment in Chinese trade with US; not only has China's surplus apparently peaked, but check out the recent trends in import and export growth! Obviously, imports are coming from a tiny base, and are perhaps distorted by political concessions and/or airplane orders. Neverthless, it's hard to avoid noticing that the faster the RMB's appreciation against the dollar, the faster US exports to China are growing relative to imports from China.

Interestingly, China's overall surplus is clearly showing signs of peaking. Despite the macro tightening in Q4 of last year, the narrowing appears to have via exports rather than imports; indeed, import growth is actually rising, perhaps courtesy of energy-related terms of trade. The common-sense explanation is that the weakness of the US consumer is having an impact, and perhaps there's something to that; neverthless, it's probably worth considering the impact of a slowdown in global trade.

Certainly the Baltic Dry Index is pointing to just such a development; after peaking in the autumn, the shipping index has corrected sharply lower. When that happened at the end of 2003, commodity-sensitive currencies like the AUD moved sharply lower.

Macro Man was (gently) chastised over the weekend for missing the boat on AUD, a charge that is probably justified on a backward-looking basis. Looking forward, however, the risks surrounding a deceleration in global trade and elevated financial market volatility make Macro Man wary of piling into high-beta trades like Ozzie. Saying that the US can avoid recession is not the same thing as saying that global growth will not slow, perhaps substantially.

For now, therefore, Macro Man prefers to play the short dollar view against the yen. Not only is the JPY the only G10 currency not overvalued against the buck on a PPP basis, but a secular rise in risk premia should make Mrs. Watanabe think twice before exporting as much capital in 2008 as she did in 2007.

So Mr. Bernanke has looked into the abyss....and what he's seen has not pleased him. Yesterday's comments, suggesting the potential for "substantial" further policy easing, appear to prove that while you can take Ben out of the helicopter, you can't take the helicopter out of Ben. The Fed chairman's comments were a stark contrast to his European colleague's, as Mr. Trichet refused to contemplate even the possibility of cutting rates.

The reaction of markets seems pretty apt to Macro Man: the US curve steepened and the dollar got whacked. The latter development seemed very much in line with how the dollar traded in the last few months of 2007; while it may have confounded the emerging consensus of a dollar rebound, it came as little surprise to Macro Man.

A dollar-bearish thesis is even easier to embrace when one considers that a 0.50% easing at the end of the month, which one must consider as a realistic possibility, would give the United States the third lowest policy rate in the G10. Assuming that market rates follow, this would mean that the dollar would re-enter the G10 carry basket....as a funding currency.

Does this have implications for the buck? Macro Man ran a simple study to find out. Using data back to 1983, he constructed a simple model wherein he follows the following rules:

* If the USD has one of the 3 highest interest rates in the G10, he goes long dollars against an equally-weighted basket of the three lowest-yielding currencies

* If the USD has one of the 3 lowest interest rates in the G10, he goes short dollars against an equally-weighted basket of the three highest-yielding currencies

* Positions are held as long as the dollar is in the top or bottom three yielding currencies; when it is not, the model has no position.

The return curve of the strategy is displayed below.
For the entire 25 year period, the strategy delivers an annual return of 4% with an annualized volatility of 6.2%; a return/risk ratio of 0.65. That is pretty darned good for such a simple strategy.

It's interesting to note that the vast majority of the returns have come in the last decade or so, a period of time which has seen the explosion of quantitative carry-based hedge fund and overlay models. Since 1997, the annualized return has has jumped to 8.4%, albeit with a concomitant rise in volatility to 7.2%. That represents a return/risk ratio of 1.15, a performance figure that the vast majority of market participants would be happy to exchange for their actual 10-year performance track records.

So while there is no guarantee that the dollar will continue to fall, the weight of evidence suggests that it is a reasonable proposition.

Meanwhile, BB's demonstration of willingness to cut aggressively even with inflation remaining an issue is a classic recipe for curve steepening. This has cut Macro Man in two ways: his 2 year payer swap has been run over, while his TIPS position has eroded a little value as well (strangely, breakevens have narrowed!) While he's happy to keep the latter, the former needs addressing.

Macro Man is happy to keep his Euro 2 year position, so an alternative spread trade might be a cross-currency steepener: receiving 2 year euro and paying 10 year US. This strategy entails small negative carry, but much less than a US steepener on its own. The profit potential, particularly once Trichet relents (in March, perhaps?), should be substantial.

Macro Man therefore will execute a US 2-10 steepener, closing the 2 year leg at 3.39 and paying US 10 years at 4.49, each in $20k/bp. Seperately, the large cap/small cap spread is working well; Macro man will look to add to that position on a pullback to 0.9100 or so on the ratio.

While the Bank of England stood pat, the follow through in sterling has been tepid. to say the least. Macro Man will therefore dip his toe, executing half of his sterling basket trade (described below) at 1.9650 and 0.7468 spot basis (1.6520 on the basket.) He'll offer the balance at the level described this morning, i.e. 1.6550.

Now you know why Macro Man is attemping to exercise patience rather than impetuosity. It looked for all the world like US equities were plunging down the abyss (and they may, of course, still do so.) The head and shoulders neckline was broken, MBIA cut its dividend and received a downgrade, and yet another positive opening had withered into a sea of red.

With less than two hours left in the session, the S&P 500 was down nearly yet a percent....and then executed an August 15-style comeback to close up nearly a percent and a half. Was it Warren Buffett? The plunge protection team? The Rosicrucians? Who knows. What yesterday's price action demonstrated, however, is that caution remains warranted, especially when it comes to pre-empting key technical breaks.

One financial price that seems to have broken just about every technical level possible is sterling. The pound would appear to have few redeeming qualities, and seems to be in the same place as the dollar was in September/October: the market is extremely bearish but not extremely short. Or are they? Macro Man is struggling to come to grips with exactly how the market is positioned in sterling.

Today sees the Bank of England announce its rate decision, an event for which Macro Man has waited before going short sterling. Caution in this market has proved to be costly, as the pound has plummeted in virtually a straight line. In many ways, Macro Man hopes that the BOE will remain on hold today; we all know that they're going to cut quite a bit more, but an unched outcome today might squeeze a few latecomers to the sterling-going-down party.

What's clear is that despite its recent caning, sterling is nowhere near cheap, as anyone walking the streets of London can surely attest. Even against the euro, another eye-wateringly expensive currency, Macro Man estimates that the pound is only now returning to "fair value" as estimated by PPP. Macro Man is interested in selling sterling after the BOE; initially he will sell £20 million against a 50/50 basket of euros and dollars. In the event of no change, he will offer the basket (GBP/USD and GBP/EUR) at 1.6560; in the event of a cut, he will close his eyes and sell at best.
Of course, the ECB also meets today, and the market will eagerly parse M. Trichet's comments for signs that the Bank is prepared to reverse course. It would seem as if this might be a few months too early; surely the ECB will need to see more definitive signs of a slowdown in activity (rather than merely sentiment) and/or a reversal of the inflation hump? The latter, at least, would appear unlikely until Q2.

A hawkish outcome would likely pressure Macro Man's 2 year receiver position, though could support the euro (assuming he gets his EUR/GBP in.) One idea to keep in the bottom of the drawer until March or April, which was suggested in the comments section yesterday, is a European steepener. Such a trade will make a lot of sense once the market begins to price ECB easing...and of course one could argue the downside risks to the trade are fairly minimal, given that the ECB is highly unlikely to tighten further from here.

It's one to keep an eye on, for sure; prior steepenings have pushed the swap curve to 150 bps, versus the current 17. Probably the greatest near-term risk is a strong recovery in equities, which would pressure back ends around the world. For now, Macro Man will wait and watch. After all, even the best-laid plans can be foiled by factors coming out of left field. And coincidentally, Ben Bernanke speaks this afternoon....

These markets ain't getting any easier, are they? While Macro Man's alpha portfolio remains a strong performer- up 2.9% already this month- the beta performance has obviously been wretched. And even the alpha performance has been less than what one might reasonably expect; given the decline in both the S&P 500 and US yields since last Thursday, one might reasonably have forecast that USD/JPY would be lower.

Instead, it's actually a touch higher; could the "final insult" of the ongoing bout of volatility be that the yen ceases to perform as a macro hedge to risky assets? Perhaps, though it's probably premature to reach such a conclusion. For one, "risk asset" weakness has been largely contained to credit and US equities; EM, for example, is trading very well. Moreover, Japanese retail has returned to the market this week, filling its pent-up demand for the usual high-yielding currencies. Such demand has been spurred by strong data from Australia, which has propelled the AUD higher against other developed currencies.

Meanwhile, sterling has continued to underperform, with the latest bout of weakness courtesy of horrible results from Marks and Spencer. Thus far, his patience in setting GBP shorts has not been rewarded. Still, Macro Man cannot have too much cause for complaint; thus far, his 2008 theme of "differentiation" has been evident.

No, the rant alluded to in the title of today's post has nothing to do with financial market prices. After all, if you're going to play the game, you should be prepared to meet with adversity on occasion. Rather, Macro Man was struck by the absolute inutility and cack-handed presentation of one of the newest pieces of economic "data", the US pending home sales figures.

This release only intruded on the market's consciousness over the last year or two, and indeed has only been calculated since 2001. As the name implies, it does not reflect an economic activity or transaction, but rather the intent to perform one. Per the description on Bloomberg:

The pending home sales index tracks the number of home resales under contract. The majority of pending home sales become existing home sales one or two months later and therefore, this index can be used to predict actual home sales activity.

Fine. That sounds reasonable enough, doesn't it? It's a leading indicator of home sales, and given the market's fetish with all things housing these days, there's an understandable demand for good leading data. The problem is that this data is evidently subject to significant revisions. As one of Macro Man's brokers put it yesterday when the November figure was released: "Weak headline, strong revisions."

Huh? What, exactly, is the point of revising the previous history of an indicator that is only supposed to lead official activity figures by a month or so? And how/why exactly does it get revised? Last month you thought that the amount of homes about to get sold in October were up 0.6%, and now you realize that they actually rose 3.7%? Where did these extra intentions come from? What are we, the market, supposed to do with this information?

Now, Macro Man realizes that this is a minor issue surrounding what is, after all, a minor piece of data that isn't actually calculated by the government. It's produced by the NAR; you can peruse Barry Ritholtz's site for plenty of analysis on the reliability of that organziation. But the fact that people actually trade off of an indicator that is essentially useless (the underlying data is an index, and Bloomberg only reports monthly changes) just underscores the degree of noise to which modern day financial market participants are subjected, and emphasizes the importance of filtering out the vast majority of "information" that crosses one's desk and instead focusing on the things that truel matter. And Macro Man feels safe in concluding that pending home sales ain't one of 'em.

Rant over. Now about that yen.....

Jumpin' Jack Flash,
It's a gas gas gas

- The Rolling Stones, Jumpin' Jack Flash

Are we having fun yet? Financial markets are struggling to come to grips with 2008 so far, as price action across a number of markets has been erratic, to say the least. Attempts at timing the market from a quasi-fundamental perspective have been ill-fated, as anyone who traded in the aftermath of Friday's payroll figure can attest. Is the risk trade on or off? Are you making or losing money? If you don't like what you see, wait five mintues, and it will be all change.

What does seem clear is that the equity bears are coming out of the woodwork, sensing blood in US equities at the very least. And to be sure, the price action in the SPX has been pretty horrible. On a weekly line chart, the index has formed a fairly obvious head-and-shoulders pattern whose neckline is currently at 1428. A break below this level would project a move down to 1305.


However, it still seems rather premature to call the end of the equity bull from a technical perspective. After all, even if the neckline were to break (and Macro Man has been around long enough to avoid pre-empting that!) and reach its target projection, that would represent a peak-to-trough drawdown to 17.5%. To put that in perspective, the SPX registered a decline of 22.6% in July-October 1998. Eighteen months later, the index was 68% higher.

True, the fundamental backdrop is decidedly different today than it was then, not least because of inflation. And it may be the case that the fundamentals eventually argue in favour of lower stock prices. But to conclude purely on the basis of charts that the equity bull is over seems decidedly premature.

Macro Man remains struck by the degree to which housing remains a focus of commentators on US consumption. For fun, Macro Man searched his 2007 email archive for communications containing the word "housing." 1350 pieces of email turned up.....and these were the ones that escaped the automatic delete treatment! In contrast, searching for "gasoline", "fuel", and "petrol" yielded just 468 missives, despite an inherent selection bias (Macro Man is, relative to the market, more interested in fuel than housing.) Housing may have been the story of 2007, but on a purely macroeconomic basis it's nothing like three times as important as energy.

Indeed, Macro Man retains the view that the recent slowdown in household spending has more to do with rising energy prices than it does ARM resets or falling house prices. For fun, he decided to run a little study wherein he compared current US gas prices with those of the past 37 years. Sadly, high frequency data doesn't seem to exist before 1991; fortunately, the California Energy Commission has retained data on annual average gas prices in California from 1970-1990, as well as noting the spike high price of March 1981.

Macro Man compared today's price with history using two metrics; constant dollar prices, deflated by the headline PCE price index, and expenditure on gas and motor fuels as a percentage of total household spending. Unsurprisingly, there is a strong correlation between the two, given that demand is highly price inelastic in the short-medium run.

What's evident from the chart is that energy has presented a steadily rising headwind since 2003, with particularly acute shocks in 2005 and 2007. Between November 2006 and November 2007, the percentage of household spending going towards fuel gas risen from 2.8% to 3.6%. That's $80 billion out of consumers' pockets, comfortably more than aggregate impact of ARM resets. To be sure, housing has also had a wealth effect; Macro Man estimates that US households' equity in their homes declined by $309 billion in the 4 quarters ending in Q3 2007. Unless you assume that 25 cents out of every dollar on household equity is spent (WAY above the usual estimates of 4-5 cents on the dollar), the housing wealth effect also pales in comparison to the impact of energy.

What makes the rise in fuel spending interesting is that US gasoline consumption actually declined on a volume basis last year. Perhaps US consumers are finally adjusting their behaviour and eschewing Chevy Dreadnoughts in favour of fuel-efficient (and inevitably foreign-brand) rides?

For fun, Macro Man performed a back-of-the envelope calculation on what level of oil prices would send household spending on motor fuel back to the all time high of 5.2% of total spending. He calculated scenarios of annualized gas consumption of 115 billion gallons, 118 billion, and 124 billion. (As an aside, these numbers were purely backed out of the macro data, and may differ from the EIA estimates, which Macro Man could not locate.) The upshot is that nominal gas prices would need to rise to $4.20 (124 billion gallon consumption) to $4.50 (115 billion gallon consumption.) Assuming a crack spread of around 8, that translates to $130-$140/bbl on crude.

Now, Macro Man does not purport to be any sort of energy expert, and he really is not qualified to pontificate on issues like peak oil. What he does know, however, is that energy prices matter-and matter a lot- to US households. Macro Man read with interest that Honda is set to debut the FCX hydrogen fuel cell car into commercial use in Southern California this year. Production costs are currently prohibitive, and Honda reckons it would take another decade to put the car into mass market production.

But given the seemingly inexorable rise in oil prices, and that the only emission from the FCX is, er, water, what odds that this vehicle is the future of the automotive industry (and that Detroit will utterly miss the boat)? An interesting long-term play might be to figure out how to invest in the people responsible for building hydrogen filling stations/and or storage facilities. It all sounds like science fiction today; then again, 20 tears ago, so did most of the features on Macro Man's (free) mobile phone.

Macro Man is in a bad mood this morning. Having enjoyed a relatively hot hand for most of the second half of last year, he's started 2008 ice-cold. Every trade he's done so far this year has been a loser- long silver, the US/Euro swap spread, and the FX beta plus carry basket. The latter was exited early this morning....and now it is coming back hard. The upshot is that Macro Man frittered away a strong start to the month and is now in the hole. While ideas are percolating in his head, his cold hand dictates a degree of caution in throwing risk at the market.

The performance of the dollar since 8.31 EST on Friday has certainly been interesting. The buck had every reason to get caned, and while it certainly gapped that way it's subsequently come back to retrace all of its post-payroll losses and more against the G3. What's going on here?

One possible explanation is an emerging school of thought that a US recession/quasi-recession is actually good for the dollar. According to the proponents of this theory, weak/negative US growth is both damaging to the rest of the world and a catalyst to encourage US investors to bring money back home. The upshot is that there is less demand for foreign assets/currencies and more demand for US assets/currency; hence, the dollar rallies.

Morgan Stanley is among the adherants of this view, with Stephen Jen using a framework known as the "dollar smile." According to this construct, in the event of very weak US growth the dollar goes up for reasons cited above. In the event of very strong US growth, the dollar goes up because of the attractive return on US financial assets. Only in the middle, trend-ish growth scenario does the dollar fall, as investors have sufficient appetite to take risk but US returns are unappealing compared to the rest of the world.

It seems remarkable to consider that a country with external deficits the size of the US could see its currency rally in two of the three "states" described above. Of course, the trend-ish growth scenario can well comprise the lion's share of the time spent in aggregate. Nevertheless, it is probably worth checking to see if the notion that a US recession is bullish dollars holds water.

Macro Man constructed a simple study wherein he looked at the 4 quarter moving average of the normalized deviation of quarterly GDP growth from its ten year trend. He then compared this reading with the subsequent one year change in the Fed's broad USD TWI. The results, while not conclusive, nevertheless represent something of a victory for what one might call common sense. Over the last 25 years, the correlation between GDP growth and the subsequent change in the dollar is 0.4. In other words, when the US economy slows, the dollar tends to fall afterwards. Call it the "dollar sneer."
Of course, the degree of lag appears to vary, which is probably down to the speediness of the monetary response of the Federal Reserve, among other things. Taken at face value, the strong US growth from mid-2007 would suggest that the near-term outlook for the dollar is actually fairly neutral. Yet a GDP forecast profile that's probably reasonably close to consensus suggests that we should expect pressure on the dollar to resume. The fact that real Fed funds rates are already zero offers a powerful disincentive to hold dollars; by the end of the month, real Fed funds will likely be negative.

None of this is to say that a period of US growth of 1% or lower means that the dollar will fall against all things. Weak growth, particularly if it spreads, should have an impact. Macro Man's rule of thumb is that when the poo hits the fan, the money comes home. This is the "left side" of the dollar smile described above.

And who, pray tell, has been the primary recipient of "hot money" capital inflows over the past year or two? Emerging markets and Europe. It's not terribly difficult to construct a scenario wherein weak US growth broadens, and the currency game finally abandons growth (or more to the point, its first cousin, carry) and focuses on value. If so, then the dollar is not the obvious trade, given that it is undervalued against some currencies and overvalued against others. Surely the real trade is to sell those currencies that are overvalued against everything (EUR and GBP) and buy those that are undervalued (BWII currencies and yen)?

Last week, Macro Man highlighted the break of key suport in GBP/JPY. That break has held, though if the MPC doesn't cut rates on Thursday there may be another squeeze on the cards. Another egregiously mispriced pair, and one where there is a political will to see it move closer towards fair value, is EUR/RMB. It remains above its uptrend line since the end of 2005, but that support isn't massively far away. A move to the middle of its range since the euro's inception (hardly something that is out of the question from a fundamental perspective) would yield a move of 15.65%, less carry.Macro Man is somewhat positioned for a "value matters" regime in currencies, via his EUR/USD powerball strip and the short USD/JPY cash position. There is ample scope to add. However, given his cold start to the year and the potential for a further squeeze this week, he'll wait for more attractive levels before layering fresh risk.

Billy Dee Williams says: just like Colt 45, jobs hard to get works every time!

It's the first Friday of the month, which means that it's time for the next episode in that periodic exercise in statistical futility known as the US payroll data. Not for nothing is today known in some circles as "Unenjoyment day"; the degree to which the market fixates on today's release (nonfarm payrolls, the unemployment rate, average hourly earnings, hours worked, et al) far outweighs the amount of usable information contained therein. Yesterday's price action around the ADP report (wherein rumours of a -82 print circulated widely, only to be confounded by a +40 out-turn) perhaps gave a preview of today's "fun."

Regular readers will know that Macro Man views the headline NFP release as useless at best, particularly as the underlying trend in payroll growth is now much less than the acceptable statistical margin for error. Insofar as there is anything to watch, it is probably the unemployment rate, which, while lagging, at least filters out a bit of the noise inherent in the NFP data. Macro Man's preferred ancillary indicator, the "jobs hard to get" component of the Conference Board consumer confidence data, suggests that we should see a new cyclical high in the u-rate today; might Holmes lay his hands on the missing missing construction workers?
Elsewhere, a few other items are worth noting:

* The UAE is keeping its dollar peg after concluding that it has not contributed to inflation. In a frankly puzzling conclusion, CB governor Sultan Bin Nasser al-Suwadi announced that the dollar peg, the maintenance of which has produced massively negative real rates, explosive money supply growth via unsterilized intervention, an undervalued exchange rate, and rising wage demands from migrant workers, has not caused inflation. No doubt the real reason is down to sunspots, El Nina, and the whims of fashion....

* For the first time in recent memory, inflation is an issue in Switzerland! December CPI exceeded expectations and printed 2% y/y, the first time that that threshold has been reached in a dozen years. After three years of steady bleating about the level of the CHF, might the SNB finally feel comfortable actually doing something about it? (The flash estimate for EMU CPI registered another 3.1% reading as well.)

* PBOC announced that it will tighten policy further in 2008 and that the yuan's flexibility has increased "noticeably." 'Twill be interesting to see if this is maintained, and what the impact will be on reserve accumulation.

* Those fund managers who now find themselves out of a job can now apply to CIC. Good luck!

*Macro Man's FX carry beta plus portfolio was triggered again this morning, fortunately in advance of a nasty short squeeze in sterling. However, the day isn't over yet, and it would hardly be a surprise if the position were exited on Monday.

Rarely will you see a trade more execrably timed, with the rationale more brutally incorrect, than yesterday's US-German 2 year swap spread. Not only were the Fed minutes dovish (as opposed to Macro Man's presumption of a hawkish out-turn), but the ISM was considerably worse than expected: the 47.7 result was the lowest reading since April of 2003. It looks as if Macro Man's "muddle through" thesis is getting an early test this year.

For now, he is content to retain the view. ISM weakness, which is broadly consistent with the 1% pace of economic growth so widely expected by forecasters, can perhaps be explained as an inventory adjustment phenomenon. In Macro Man's view, timely inventory management is probably the most important explanatory factor of the so-called "Great Moderation" in macroeconomic volatility. The chart below, which shows the spread between the "new orders" component and the "inventory" component of the ISM, suggests that firms are already paring back production so as to shed undesired inventory, similar to what occurred at the end of 2006. The upshot is that we may see a quarter or two of substandard growth, as is widely forecast, before normal service resumes. Nevertheless, with both the consumer and the credit market in worse shape today than twelve months ago, the margin for error in the US economy will be lower in 2008 than was the case in 2007.
In any event, the spread trade lost money immediately after execution, and is now 9 bps wider than at inception. However, the news is not all bad. You see, Macro Man already had a long US 2 year bond delta. No, not from futures or even from his TIPS position; rather, from his long yen position. The chart below demonstrates the remarkable correlation over the last year between USD/JPY and US fixed income. In many ways, the spread trade has mitigated, rather than added to, portfolio risk.

The yen has taken on something of a life of its own over the last couple of sessions, though obviously yesterday's data helped spur it along. Having suckered the market into establishing/adding to yen shorts above 113.60 last week, USD/JPY collapsed yestrday and is now looking very ropy indeed. Even worse is the chart of some of the yen crosses; GBP/JPY was the focus of market attention yesterday as it cratered through a (non-textbook) head and shoulders neckline at 217.80. The traditional interpretation of the break would suggest scope to 190. The reader who yesterday queried what to buy against a sale of sterling could do worse than to look at the yen, particularly in light of the gloomy BOE credit conditions report issued today. Bear in mind, however, that the one-way train is unlikely to endure past tomorrow, as the Japanese return from a weeklong holiday on Monday and may provide scope for a near-term squeeze. In any event, yesterday was probably a rough start to the new year for many of the quant strategies out there, whose returns tend to bear an uncanny resemblance to a yen-funded carry basket.

At the risk of beating a dead horse, Macro Man feels compelled to point out that not all of yesterday's developments were an unalloyed positive for nominal Treasury bonds. One would have to presume that the headlines "Gold makes all time high", "Oil makes all time high", "Dollar makes all time low", and "Treasuries rally sharply" have rarely been observed on the same day over the past few decades....and yet it was the case yesterday.

WTI briefly touched $100/bbl yesterday, and gold bullion finally and definitively broke the $850 high from 1980. The next obvious target is $1000. The combination of these and the seasonality reinforce Macro Man's long-held belief that TIPS are the best US bond long out there. As for currencies, the wind clearly seems to have shifted in Beijing. USD/RMB has fallen another 0.35% today; over the past month, the annualized rate of change has been in excess of 20%!!!! It would appear that at long last, inflation is forcing the authorities' hand into allowing a stronger currency. Ask not for whom the bell tolls, Bretton Woods II: it tolls for thee.

If Macro Man's belief in the impact of CBs on the EUR/USD exchange rate is correct, then a slower pace of reserve accumulation consistent with an erosion of BWII should weaken a key pillar of support for the euro (and, perhaps more interestingly, sterling.) Yet easy Fed policy, which would appear to be a foregone conclusion after yesterday's developments, would still argue in favour of a weaker dollar.

A case be made for dollar weakness to manifest itself primarly against undervalued c/a surplus currencies and commodity liquidity proxies. Macro Man would list precious metals as among the more conspicuous examples of the latter. With gold alread at fresh highs and appearing poised for a melt-up, might not silver (which has rallied but not made new highs) follow suit? The chart looks pretty bullish, with well-defined risk levels on the March future around $14 on a closing basis. Volatility is naturally pretty high, and this is a pretty speculative punt. Small positioning is therefore warranted. Macro Man buys 50 SIH8 futures at $15.50, looking for an initial test of $16.50 with a possible extension to $20.

It all appears to be kicking off, and it's tempting to throw risk at this market given the type of moves that are occuring. However, a degree of caution remains warranted; liquidity is thin, and a number of key market players (Russians and Japanese, for example) are out of the market. Last year saw the dollar caned on the first trading day of the year, only to reverse course and correct for a month or so. Macro Man is happy to add moderate defined-loss risk, but betting the farm in this market could have unpleasant consequences.

Macro Man is back in the saddle, at his desk and in front of his screens. While he followed markets during his holidays, as always there is a bit of an adjustment process coming back to the office after a couple of weeks off. Not least because there remains something of a holiday flavour to markets so far today; unlike Macro Man's waistline, liquidity is feeling rather thin.

There were a couple of developments over the last couple of weeks that warrant comment, some of which bear on the market outlook moving forwards.

* The Q3 IMF COFER data was released, showing the dollar's share of global currency reserves falling to 63.8%. However, this data is worse than useless when taken at face value, given that most of the agents responsible for financing the US current account deficit either don't report their currency holdings (PBOC) or fall outside the remit of the survey (SWFs.) As Brad Setser suggests, a lot of the dollar decline was down to valuation changes rather than genuine diversification, though the aforementioned actors were clearly evident selling dollars for other convertible currencies in Q4.

* China has gone from subsidizing grain exports to penalizing them over the last month. At the same time, a labor law that is meant of offer some protection of workers' rights (and incomes) came into force yesterday. While the inflationary consequences of these measures may be up for debate, it is fairly clear that insofar as they have an impact on global prices, it will be to push them higher. As noted in the list of non-predictions, it seems unlikely that the inflation theme will go away any time soon.

* Sterling has been crushed as pessemism on the UK mounts. While Macro Man warmly embraces the sentiment, he struggles to see the attraction of fresh GBP shorts at current levels. He's prefer to wait for a pullback.

*The first TAF auctions were a moderate success, and underscore the Fed's (appropriate) desire to draw a line between macroeconomic and microeconomic liquidity measures. Yet the market remains priced for a virtually straight line easing of Fed funds throughout 2008; Dec Eurodollars price a rate of 3.37%, which corresponds to a Fed funds rate of between 3% and 3.25%, assuming the basis normalizes. Tonight sees the release of the minutes for the December FOMC meeting, where one has to presume the appetite for aggressive macroeconomic easing was grudging. Might there be room for a bearish surprise?

At the same time, the market has largely priced out any chance of a rate cut in Europe this year after the recent upside surprises to inflation. Yet growth is clearly slowing; would the ECB really leave rates unchanged in the event of a near-recession? Given the collpase of the US-German 2 year swap spread over the past few months, there might be an opportunity to play for a pullback. Macro Man therefore pays US 2 years at 3.85 in $20k/bp and receives German 2 year at 4.54 in €14k/bp. He'll stop out of the spread should it look like breaking -100 convincingly.
2007, meanwhile, ended in profit if not with a flourish. While the 0.48% positive return was Macro Man's third worst month of the year, it was pleasing nonethless given his lower risk profile and the generally poor performance of passive equity and FX carry strategies. Macro Man's equity beta plus portfolio wore the pain as well, shedding 1.05% on the month (albeit with 0.33% of that loss accounted for by SPY going ex-div.) The FX beta plus portfolio, on the other hand, fared rather better, generating a positive monthy return of 0.63% courtesy of a timely bit of profit-taking early in the month.The alpha portfolio made money in all three sectors in which it was positioned. The index hedge on the S&P 500 made up for modest losses in the large cap/small cap spread (both of which wen ex-div as well- the portfolio will be adjusted upon payment tomorrow) and the expiry of the Hang Seng puts. All in, the equity alpha portfolio made 0.11%. Fixed income also contributed modestly, with losses in the TIPS position more than offset by a timely profit-take in the Singapore swap position. Combined, the two added 0.18% to December performance.

Finally, FX alpha was a strong performer, with the powerball strip making money on both delta (lower EUR/USD) and vega (higher vols) considerations. There was a useful scalp of USD/JPY gamma during the month, while the late-December swoon in USD/JPY mitigated some of the losses from the 120 straddle, which was exercised on Boxing Day. All together, these trades made 0.60%.

For the year as a whole, the utility of segregating portfolio performance into alpha and beta strategies was evident. The beta plus portfolio was a strong performer in the first half of the year, but shed money in H2-particularly in November. Yet the alpha portfolio provided a useful offset and clear diversification; while both the beta and alpha portfolios lost money in 4 months of the year, the portfolio as a whole only had one down month. Satsifyingly, however, alpha was the strongest contributor to overall portfolio performance, generating 11.5% returns; beta strategies made 5% on the dot. The 16.5% 2007 return was naturally a pleasing one, particularly given the noisy volatility of many of the markets that Macro Man traded.

He expects more of the same in 2008; while there may well be periods in which beta strategies perform well, high volatility environments are naturally suited to alpha. If the 2008 alpha performance can repeat 2007, he will be a happy (macro) man indeed.