Thursday, January 31, 2008

Time to "hang" up the tactical bull suit?

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.

Wednesday, January 30, 2008

Let's get ready to rumble!

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.

Tuesday, January 29, 2008

Life in the UK

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.

Monday, January 28, 2008

Was that 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.

Friday, January 25, 2008

If SocGen on ly found out about their trading loss over the weekend....

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

Perhaps the conspiracy theorists are onto something, after all!

What now?

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.
At this point, Macro Man is more interested in locking down profits and neutralizing portfolio risk than trying to hit a home run. Given that the Fed has just engineered the largest rate cut in a quarter century as a result of bad information, it seems hard to argue against trimming risk, particularly with next week's announcement looming.
(Only when editing this post did Macro Man realize that its title is virtually identical to Wednesday's. Tells you everything you need to know, really.)

Thursday, January 24, 2008

For everything else....







£25 - £55 BILLION






Wednesday, January 23, 2008

Stopped out before entry?

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 next?

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.

Tuesday, January 22, 2008

Ben Bernanke hits the panic button

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.

As an aside, is Macro Man the only one whose Bloomberg utterly froze for 5 minutes as soon as the announcement of the 75 cut hit the tape?
Mikey, before you pursue further political ambitions, sort out your bread and butter!

Black Tuesday?

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.

Monday, January 21, 2008

Stress Testing

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.

Saturday, January 19, 2008

Weekend Special: Financial Poetry by Popular Demand

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.

Friday, January 18, 2008


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.
In the meantime, a fairly obvious step would be to eliminate any vestiges of short duration from the portfolio. Yesterday's Bernanke testimony added relatively little to what we'd heard the previous week, other than perhaps the outright endorsement of quick-acting fiscal policy aimed at "the little guy."
As for monetary policy, a 50 bp easing this month is down fully baked in the cake, and markets are starting to romance the notion of 75. At this point Macro Man would judge the latter to be unlikely, though of course things can still change. However, even if the Fed "disappoints" with a 50 bp easing, in this mood the market will just price aggressive easing in March.
While a few commentators are calling for an oversold bounce in the SPX, which we all know can be truly vicious, Macro Man would look at such a development as an opportunity to extricate himself from his US 10 year payer position. Given that futures are currently up 13 points, the opportunity may come as early as today.
In Europe, meanwhile, gentle cracks are starting to form in the ECB's wall of granite. Yves Mersch of Luxembourg has been all over the tape this week, first suggesting downside risks to European growth and then reminding markets that the ECB remains vigilant on wages and did not discuss a cut this month. If Mr. Mersch's earlier comments reflect the view of several ECB voters, then perhaps cuts will be on the agenda soon. This, at least, is what the market seems prepared to price, so the German 2 year receiver will stay in the portfolio.
Having asked 20 questions yesterday, here are a quick fire 20 answers:
1) 95
2) With lots of talk and little action
3) Bloody awful
4) They do, and they're wrong
5) May
6) 1.5%
7) Extraordinarily
8) He kind of did
9) Yes
10) Another week, then pause
11) Drift ssomewhat lower, then sideways
12) Not enough
13) Seriously, but perhaps not as seriously as many seem to think
14) Added; they took profits at the end of last year
15) Not enough and too much
16) Tax cuts
17) It is, but you might have to buy and hold to maximize profits
18) Red Ken, sadly. London transport cannot even handle commuter traffic; how is it supposed to deal with the Olympic crush? Macro Man is considering taking a long vacation when the Olympics are in London.
19) Barack
20) Dems if Barack runs; GOP if Billary runs
21) Rafa; Tom Hicks and Gary Gillette can't roll over their financing loan, so will be forced to sell up. Word on the street is that Steven Gerrard has a live TED spread feed on his phone...
Finally, Macro Man was filled on the balance of his £ basket trade, which has entered the P/L below.

Thursday, January 17, 2008

20 Questions

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?

10) How long will Beijing allow the RMB to appreciate at a 20% annualized rate against the dollar?

11) Will London property prices crash, or will they remain supported by lack of supply and the execrable transport infrastructure?

12) How many US homebuilders will go bust in 2008?

13) How seriously should we be taking the collapse in the Baltic Dry Index?

14) Has the leveraged community added or taken profits on risky asset shorts in 2008?

15) How quick and how large will the US fiscal response be?

16) Will it take the form of tax cuts, spending programs, or an RTC-style slush fund to buy up all the non-performing credit turds?

17) 1 and 2 year inflation breakevens in the US are around 2%. How is that not a do?

18) Who will win: Red Ken or Boris?

19) Who will win: Barack or Billary?

20) Who will win the White House: Dems or GOP?

Bonus question: Who will last longer- Keegan at Newcastle or Rafa Benitez at Liverpool?

Wednesday, January 16, 2008

Time to share the pain?

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.