Assessing US equities

Wednesday, May 28, 2008

One of the frustrations about being short stocks in the current environment is that one hears a constant refrain of how "cheap" they are. Indeed, Macro Man saw a US equity strategist from a C-list house a couple of weeks ago, and this guy was ashamed to admit that his analysis of the numbers would allow him to envisage "only" a 30-40% rally over the next year.

Now, eighteen months ago, Macro Man took a look at US stocks and liked what he saw. And so he remained constructive on equities through the end of last year. Early in 2008, however, he changed his mind on the fate of the US consumer, and thus his opinion on equities. Ever since, he's been biased towards neutral to short positioning in indices. Still, when in an introspective mood the other week, he realized that it was time to get cracking with trying to develop a more robust version of his old equity beta portfolio. In 2006, his work prompted him to go long despite his underlying suspicions about the sustainability of earnings. Would 2008 generate the same result?

Now, at first glance, US equities don't look particularly cheap at all. Punching up the SPX on his Bloomberg, Macro Man finds that it has a trailing P/E ratio of around 23...that hardly has "buy of the century" written on it, does it? The man from the C-list shop showed Macro Man a chart suggesting that the P/E was actually about 14 if you strip out all the writedowns, and that this level represented good value.

Uhhh...OK. Presumably if we strip out the writedowns, we should also strip out the accounting profits in 2005-2007 that were caused by the securities that were written off? And if we're stripping out the writedowns, surely we also need to strip out the "profits" generated by the fall in the financials' liabilities? Finally, Macro Man's friends at Merrill Lynch and Citi might also take issue with the notion that writedowns should be stripped out because they are a "one off."

Regardless, perhaps trailing P/Es don't tell the whole story. We also need to look forward, not back. And absent the kind of failsafe crystal ball that Macro Man has yet to locate in his 15 years in this business, that means relying on analysts. Now, simply looking at expected earnings growth isn't going to cut it, because of the Panglossian cloth from which equity analysts are cut: they almost always expect earnings growth. However, we can look at how their optimism changes over time; the chart below shows the six month momentum on analysts' rolling 12 month forward EPS estimates for the SPX. And what we observe here is that analysts' expectations have only slowed this much during recessions. And in each of the previous two recessions, downgrade momentum troughed before equities broke out to the topside. Chalk one up for the "not so cheap" camp!
Now granted, SPX earnings yields (the inverse of the PE) look pretty attractive relative to bond yields, even when using trailing data. This was the metric that Macro Man used in his old beta plus portfolio. But using that metric to evaluate equities carries the implicit assumption that bonds are fairly priced. And if there's one lesson of all that's happened since last July, it's that bonds of all description have not been fairly priced for quite some time. Comparing the S&P's earnings yield with another metric, the cost of living, yields a less satisfying result; the real earnings yield is less than 1%, down sharply from the levels in excess of 3% that prevailed this time last year. Again, not exactly compelling, is it?
Macro Man took these factors, and a couple of other fundamental inputs (no sentiment or momentum data allowed), and developed a couple of simple models to determine the attractiveness of US equities. Now, one thing that he found, which backed up his prior results, was very clear: just because stocks are not a buy does not make them a sell. In fact, he could find no consistent signals to market time the stock market from the short side without torturing the data to the degree that he violated the Geneva Convention.

So the output of his efforts is basically a signal that says "go long" or "stay flat." The first of these was a scorecard approach, wherein each of his factors provide a positive (+1) or negative (-1) signal, and the sum of the factors is totted up, much like in an investment manager's scorecard. Gratifyingly, Macro Man found a strong positive correlation between his scorecard reading and subsequent market returns. And it was pretty clear from sifting through the data that for any reading below +3, you might as well go to Vegas and put all your money on red, as equities are not a winning proposition.
Macro Man was quite pleased to see that his intuition was mirrored by his research result; after a long period in which US stocks looked very attractive, the scorecard recently fell through the key threshold and actually registered a negative reading in April.


He also took a different approach, taking the same basic factors but using regression analysis to generate a forecast market return over the next twelve months. The r-squared of this analysis was high enough to suggest statistical significance but low enough that Macro Man could be pretty sure he wasn't over-fitting what were, after all, a pretty simple set of factors.

He then compared this return forecast with a measure of trailing volatility (though perhaps VIX would be better) to get a "forecast Sharpe ratio." The benefit of this methodology over the scorecard one is that it accounts for the magnitude of the signal from each of the factors, rather than simply assigning a binary rating. It should provide an idea of just how good or bad the outlook for stocks is. And currently, the outlook is, ahem, less than rosy, with negative returns forecast for the next twelve months. Macro Man found that it's really only worth being long equities when the forecast Sharpe is in excess of 1; over the past 20 years, a strategy of being long the market when this ratio is above 1 and flat when below has delivered a risk-adjusted return of....err...1.0.

Now, this methodology has been kept deliberately simple to avoid the traps that many of the equity quants found themselves in last summer. But Macro Man approached it with a tabula rasa; he was more than prepared to accept a signal that the US market was a buy, to implement it, and then trade around it. But he can't make the numbers lie. On the basis of what's worked since 1988 (and indeed since 1970, on the basis of a stripped-down model that excludes analyst expectations), US stocks may be cheap, they may be expensive; but one thing they are clearly not is a buy.

Posted by Macro Man at 1:21 PM 11 comments Links to this post  

Picking a bottom in the US housing market.....or not

There's an old trading aphorism that is worth being followed by both veteran fund managers and market neophytes: picking bottoms gives you stinky fingers. The point, of course, is not to catch the falling knife, not to stand in front of the runaway train, and not to say that "enough is enough" before sings of reversal emerge.

So it was with some trepidation that Macro Man read a couple of analyses of yesterday's US data that attempted to put a positive spin on new home sales. Mind you, the authors, among whom included Goldman Sachs' US research team, didn't have the temerity to say that "the low is in." However, they did suggest that a bottom is, in the words of Goldman's Jan Hatzius, "coming closer."

After perusing the data, Macro Man can't help but wonder if these chaps aren't about to experience "stinky finger syndrome." While yesterday's new home supply actually fell slightly when expressed in months' worth of sales, the recent figures on the supply of existing homes (far greater, obviously, than the supply of new homes in terms of number of units) reached a new high. No signs of a bottom here!
Another of Macro Man's favourite tricks is to look at the 6m/6m change in certain indicators. And while it's true that the six month change in existing home sales has recently ticked a bit higher (or, to be precise, a bit less low), the rate of change for other metrics- new home sales, starts, and permits- remain at their nadirs.
Call Macro Man crazy, but the experience with credit and the financials since last July have been lesson enough in the folly of calling the bottom in anything. In a world where being early is the same as being wrong, picking a bottom in the housing market would appear to be a low Sharpe-ratio enterprise, to say the least.

It's not as if Joe Sixpack, the putative buyer of houses that would help establish a bottom, is feeling terribly rosy at the moment. Last night's ABC consumer confidence survey printed an all-time low, and the Conference Board measure was similarly dire earlier in the day. So naturally the S&P rallied on the day; don'tcha love window dressing week?
Macro Man retains the view that consumers are feeling the squeeze from low real incomes, a phenomenon partially buit not totally explained by rising energy costs. Clearly, rising gas bills are beginning to impact drivers' behaviour; the year-on-year decline in March vehicle miles traveled was the lowest since records began in 1942.

Youl'll pardon Macro Man if he tries to avoid picking bottoms in anything at the moment....

Posted by Macro Man at 8:50 AM 25 comments Links to this post  

Old School

Tuesday, May 27, 2008

Old school. To some, it means one of those Will Ferrell film vehicles, with all that that entails. To others, it means a certain bygone era in hip-hop music...usually when spelled "old skool." And for market graybeards like Macro Man, the phrase "old school" conjures up something else entirely; the image of an "old school" emerging market crisis.

For most market punters under the age of 30, crisis is something that affects the credit guys and not much else. Sure, the subprime crisis has eliminated any semblance of a bid for certain categories of credit instruments, but in other areas you can still get stuff done, even if bid/ask spreads widen a bit. And as for emerging markets, hey- they're the best game in town! Haven't you heard of decoupling? Well, the nature of the game might be changing. For in the past week or two, a situation has been brewing in emerging Asia that reminds your author of the EM blow-ups of the 1990's.

For the last few years, Vietnam has been something of a frontier market darling. With a large population willing to work for low wages, Vietnam has begun to erode Chinese market share in certain low-end industries such as textiles. And as Chinese wage costs continue to rise, Vietnam was supposed to be in the catbird seat to win market share and embark on its own bout of explosive growth. This in turn spawned such products as the Vietnam Opportunity Fund, a London listed closed-end fund investing in Vietnamese shares. Hell, even Macro Man threw a little bit of money into it.

Recently, however, the story's gone badly wrong. Terms of trade shocks have sent the external accounts spiralling badly out of control; Deutsche Bank forecasts a trade deficit of 25% of GDP this year. Overnight, inflation printed 25.2% y/y....ouch! Meanwhile, the formerly safe, attractive fixed income/curreny market has completely blown up. The chart below shows the USD/VND fixing rate in Singapore. There was an early warning sign in March, when the official State Bank fixing rate rose from 15800 to 16100. Recently, however, the offshore markt has been fixing markedly higher than the official rate. Today, the market has imploded. While the State Bank fixing rate was 16216, the Singapore fix was above 17000. This morning, one month VND was traded at 18900. For anyone involved with VND who expected a 0.50% annualized volatility, which is the vol of the official fix, this must come as a rather nasty shock. If you're keeping track at home, that one month trade implied an offshore annualized dong interest rate in excess of 100%.
The pain hasn't been confined to uber-frontier markets, either. While the Philippines isn't exactly the most liquid markte in the world, it has definitely gone a bit mainstream over the past few years. And while the pain there isn't as pronounced as in Vietnam, it's still pretty unpleasant for trapped longs. Since the end of February, USD/PHP has risen 8.7%- ouch! This was not altogether unforeseeable- Macro Man went long USD/PHP in mid April on the theory that rising food and energy prices would have a deleterious impact on the balance of payments.. Still, liquidity has completely dried up over the past week, and NDF markets were pricing offshore PHP interest rates at 30% this morning, which is a tad higher than the onshore rate of 6.37%.
This meltdown in low-quality Asia has yet to show meaningful signs of contagion. And we can be pretty sure that positions there are exponentially smaller than in credit instruments linked to US subprime mortgages. But just as pain in those turds were the canary in the coal mine for last summer's volatility, could the distress in frontier Asia suggest more pain ins tore for risk assets? Macro Man is, on balance, short "risk"; given what he sees in Asia, he's happy with the position.

One place that should be immune from external market shocks is China, where data released overnight revealed a record monthly increase in SAFE's FX reserves in April. Early in that month, USD/CNY ground to a halt, going essentially nowhere for six weeks and squeezing out the offshore specs. Quelle coincidence....

Posted by Macro Man at 9:35 AM 8 comments Links to this post  

Bank Holiday Special: Should the West put Wogan in Charge of Economic Diplomacy?

Monday, May 26, 2008

Ah, that's more like it. It's a UK bank holiday, and the weather's more fitting for the Grand Banks in late November than for a late spring day. The puzzling sunshine of the first May bank holiday is now but a distant memory...

This weekend saw the passage of the annual Eurovision Song Contest. For those non-Europeans fortunate enough to live in ignorance of this monument to bad music, allow Macro Man to enlighten you. Every year, each European country submits an act to this contest, which is hosted by the previous year's winner. All of the acts perform live, and are voted on by the citizens of Europe. Each country can award points to the acts on the basis of a national vote, though voting for one's own national champion is prohibited. Although the contest's winning alumni include the like of Abba in the early 70's, in recent years the artistic quality of the contest has been such that American Idol/X Factor type programs seem like Verdi operas in comparison.

Now, it wasn't that long ago that countries like the UK and Ireland fared well in this annual monument to cheese. Indeed, such was Ireland's success rate that the cost of staging the annual event began to burden the country's finances. This in turn led the country to "tank" it for a few years, as parodied by Father Ted:



But then a funny thing happened. The UK and Ireland not only quit winning, but started to fare rather badly. To be sure, the artistic quality of the entrants wasn't the best, but when you finish well behind entrants like this year's Bosnian effort-



-you've gotta wonder what time it is. In point of fact, the Eurovision has become plagued by a phenomenon known as "tactical voting"- in other words, all sorts of countries, notably Slavic ones, vote for their mates, regardless of quality. And thus emerged a rather sneaky suspicion that the UK (and its perceived buddy, Ireland) were faring so poorly because a lot of other European countries don't like them very much.

Now, if each country contributed equally to the staging of the event, even the doughtiest of British Europhobes would have little cause for concern. In fact, the four rich countries- the UK, France, Germany, and Italy, foot the bill for the whole thing. Heck, the BBC stumps up 40% of the cash every year, only to have new Europe's ingratitude thrown back in its face.

While Macro Man doesn't watch or care about Eurovision, he couldn't help but observe a similarity to a more familiar sphere, that of global finance. In his world, new entrants have emerged that don't play by the established rules....much like the tactical voters in Eurovision.

To date, developed market policymakers have opted for what might be termed the "Irish Eurovision route"; namely, making a protest that falls on deaf ears (or, in the case of Dustin the Turkey, is actually booed.)




And until recently, the "big four" have retained a stiff upper lip in the face of rejection from its European partners. However, the times, they are a changin'. Some countries, such as France, have had enough of rejection: this year's Gallic entry featured a Neanderthal looking chap singing in- wait for it- English. Sacrebleu!

As for the UK, enough is evidently enough. The British entrant finished joint last, nearly 100 points behind the Bosnian monstrosity linked above. As a result, the doyen of Eurovision, the BBC's Terry Wogan, wants to call time on the whole debacle. Refreshingly forthright commentary of a type rarely heard in the financial sphere. Perhaps the West should put Terry in charge of its next "strategic dialogue" with serial interveners in global currency markets.

Finally, this post wouldn't be complete without linking to the victor, Russia's Dima Bilan. Enjoy, if you can:


Posted by Macro Man at 10:58 AM 10 comments Links to this post  

Thrown for a curve

Friday, May 23, 2008

The sport of baseball is unusual in the extent to which a player's contribution to a particular game, season, and career can be measured through statistics. As such, there is a thriving industry of baseball analysts who evaluate the true worth of present, historical, and indeed prospective baseball players on the basis of their statistical records.

Among this community, one of the more celebrated players of the past forty years in Bert Blyleven, pictured left. Mr. Blyleven was not the best pitcher of the past forty years, but he is one of the most under-appreciated by mainstream analysts and casual fans. Part of the rationale for this is that many of the teams he played for were mediocre, and it's difficult for a pitcher to assemble a winning record with no run support. Then there's the nature of his pitching; Blyleven was a curveball specialist. While he notched up plenty of strikeouts with his wicked "deuce", he also gave up a prodigious number of home runs when his curves were a bit too straight. The treatment of Mr. Blyleven, whose Hall of Fame case is a cause celebre amongst baseball's analytical community, suggests that perhaps curveballs are structurally under appreciated by the mainstream baseball community.

Regardless, the curveballs thrown up recently by the fixed income market have not been appreciated by the financial community. The carnage in short-end yield curves has been messy and bordering on the epic. Rate hikes are now priced in by year-end in each of the G4, according to OIS curves; the price action in LIBOR-based products, such as December short sterling (pictured below) has been gruesome.

So what's going on here? Have markets finally woken up to the secular inflation threat that Macro Man's been banging on about for a year and a half? Perhaps; US 5y/5y breakevens have widened quite sharply over the last couple of weeks.
But even Mervyn King, the uber-hawk, has suggested that there's not a heck of a lot that the BOE can do about inflation in the short term, and indeed that the Bank shouldn't be trying to get inflation back to target in the short run. So if inflation is a legitimate worry, and central banks are constrained from tightening by the economic cycle and credit crunch, surely that's a screaming sign that yield curves should be steepening?

Nope. Yield curves everywhere have flattened, confounding economic analysis and, oh by the way, generating a gazillion dollars worth of losses.
Such a curve ball is hardly unprecedented. If way enter the "way-back" machine and have a look at the last aggressive Fed easing cycle, what do we find? A horrible squeeze higher in 2 year yields in the months following 9/11, with the trough-to-peak rise totalling nearly 150 bps.
Ultimately, of course, 2 year yields traded very substantially lower. It just goes to show that when the market starts throwing curve balls, discipline is important. Far better to wait for the market to hang one of its curveballs and knock it out of the park than to strike out like one of the 3,701 guys that Bert Blyleven dismissed in his career.

Posted by Macro Man at 9:29 AM 14 comments Links to this post  

Motor up....power down

Thursday, May 22, 2008

Oil. If one wished to summarize May's financial market trading in one word, that would be the one. Crude's stunning rise has befuddled many, including regular posters D and Mr. Prop, as well as Macro Man himself. Anatole Kaletsky blames the speculators; unfortunately, the quality of the CFTC data on specs is insufficient to reach an accurate judgment of the matter, as index "investors" show up as commercials. One of Macro Man's favourite analysts, Goldman's Jeff Currie, suggests that oil's been dragged up by the back end of the curve, which has needed to rise to attract appropriate levels of investment into the industry. Perhaps, but that doesn't explain why Dec 2015 oil has risen 34% (!) so far this month; surely the seven-year fundamentals of the industry haven't changed that much in three weeks! And unfortunately for Mr. Kaletsky's theory, volume in this Dec '15 contract, pictured below, hasn't been that much higher than in March, when the contract traded sideways to lower.

Frankly, Macro Man doesn't know what's going on here, and from what he can make out, neither does anyone else. Crude certainly looks to be a bubble at the moment, similar to wheat in February; that Icarus crashed to earth with a resounding "thud." Perhaps oil will trace out the same pattern as wheat, but Macro Man remains wary of Keynes' maxim when it comes to calling the top in a bubble. Perhaps Cassandra's suggestion of higher margin requirements is what's required to stop the madness; at the very least, it would be interesting the impact from an intellectual perspective.

Intriguingly, the Jeff Currie view of the world suggests that oil is already entering a cyclical bear market, buried deep within the secular bull. The chart below shows the percentage difference between 24th Nymex crude contract and the front contract. Observe how how it is moving into contango, with the ratio turning negative. Equally interesting is the fact that on a percentage basis, the backwardation since the 2006 bear market has been very, very modest in comparison with previous secular bulls; perhaps the energy market has been pricing in slower US/world growth, even as the nominal price has risen. Frightening...
Regardless, rather than try to call the top in something with a rocket up its rear end, Macro Man would prefer to direct his attention to the fallout from higher oil prices. The candidates are relatively obvious; US consumers specifically and risk assets generally. As anyone reading this site is probably aware, many major equity indices have broken key uptrends this week, including the S&P 500. As such, Macro Man is looking to spread out his equity shorts as he builds up a position.
Another place to look for weak spots is in FX, targeting those countries reliant on foreign inflows and facing a negative terms of trade shock. Macro Man is generally favourably disposed towards the Turkish lira, for example, because the CBT is reacting to an inflation spike by tightening policy, thereby maintaining a high real interest rate for investors. Compare that with the situation in South Africa, where the SARB offers scant real interest rate cover for the country's high inflation rate; obviously, there are other headwinds facing SA as well. But even the TRY has broken a pretty well-defined uptrend against the buck recently, which offers further support for a "risk off" mentality.
That the Fed has promised to greet near-term economic weakness with stony silence is another reason to look for a bout of risk reduction; like a petulant child, the market has not responded well to threats of taking its toy/liquidity away. Oil may be motoring higher....but it looks like just the thing to force risk assets to power down.

Posted by Macro Man at 10:04 AM 23 comments Links to this post  

The Dog Ate My Homework

Wednesday, May 21, 2008

The Financial Times isn't exactly known as a quality source of humour. They don't even have a featured "fluff" article such as that which graces the front of the WSJ on a daily basis. So it was with surprise that Macro Man read a little blurb in today's FT that had him guffawing out loud: evidently, the reason that Moody's mistook CPDO turds for filet mignon was because of a "computer glitch."

As "dog ate my homework" excuses go, that one's pretty rich, and will no doubt be fertile hunting ground for lawyers in the coming years. Moreover, it begs the question of how and why the other ratings agencies managed to designate this crap AAA as well; did the same ghost enter their machines?

Regardless, the avoidance of personal responsibility for one's actions is regrettably pervasive in modern society, and is certainly endemic in the financial sector. Let's peruse some of the other excuses proffered for financial mishaps over the past decade or so:


LTCM blows up: The fund's losses were caused by a correlation breakdown so extreme that according to the fund's Nobel Laureates, it should not have occurred since the Big Bang.

JWM (run by John Merriwether, latterly of LTCM) suffers large losses: Fool you once, shame on me; fool you twice, shame on you!






The Fed slashes interest rates at the slightest hint of financial distress, thereby inflating a series of bubbles: It's a little known fact, but both Alan Greenspan and Ben Bernanke are huge fans of English premiership club West Ham United. When Macro Man used to frequent the Upper East Stand at Upton Park in the late 90's, he was often bemused at the sight of his elderly compatriots singing the West Ham fans' signature song with gusto. For those unfamiliar with the club and its traditions, the song goes like this:



I'm forever blowing bubbles
Pretty bubbles in the air
They fly so high
Nearly reach the sky
Then like my dreams, they fade and die
Fortune's always hiding
I've looked everywhere
I'm forever blowing bubbles
Pretty bubbles in the air!

Clearly, the Fed chiefs take their passion for West Ham to work with them.


The Central Bank of Russia screws currency speculators, just because they can: You might be able to take Communism out of Russia, but can you take Russia out of Communism? The CBR seems to be taking a page out of the book of a certain V.I. Lenin.

Among the quotes attributed to Lenin include the following:

"Until we apply terror to speculators - shooting on the spot - we won’t get anywhere."

".. catch and shoot the...speculators and bribe-takers. These swine have to be dealt [with] so that everyone will remember it for years."

"The best way to destroy the capitalist system is to debauch the currency". In what can only be a coincidence, Russia and China have re-emerged as prolific dollar sellers in the open market over the last couple of weeks.

The Asian financial crisis of 1997-98: This was caused by a mysterious cabal of the Rosicrucians, Pentavirate, and Illuminati- just ask Dr. Mahathir Mohamed. Of course, now the shoe's on the other foot, and Asian central banks are among the prime movers of this illustrious order.

Bear Stearns blows up: This one's easy. As market volatility escalated, Jimmy Cayne took his firmwide risk runs with him to a bridge tournament. Unfortunately, one of the other players (pictured, left) ate the runs, so poor Jimmy couldn't possibly have known the true state of Bear's finances. Woof woof.

Posted by Macro Man at 9:21 AM 8 comments Links to this post  

Feeling nervous

Tuesday, May 20, 2008

All of a sudden, it's gotten a bit nervy, hasn't it? Yesterday's late-session swoon in the SPX wasn't particularly unique- we saw very similar price action last Wednesday- but it was still enough to illuminate a few amber warning lights on the market's mental dashboard.

What makes the market's nerves all the more understandable is that all but the doughtiest of risk-asset shorts has been carried out of positions; indeed, one of Macro Man's few remaining outright short risk positions was stopped out overnight. And the degree of complacency seems quite remarkable, given that we're still in the Greatest Financial Crisis Since the Depression TM . One bank reported a 19 year high in their risk appetite index yesterday; while Macro Man's is not at quite such an extreme, it is just off of 5 year highs, too long ago to feature on the chart below.
Similarly, VIX has been taken down a lot, and is much closer to its lows of late 2006 than it is to the recent highs. There was some discussion in the comments section of yesterday's post on how best to play this.
In that discussion, Macro Man suggested buying index puts, either naked or on a delta-hedged basis; not a breathtakingly new insight, to be sure, but sometimes the obvious trades are the best. Having given the matter some thought overnight, he has decided to dabble in puts on the FTSE. Not only does the index have a heavy concentration of miners, which one can only conclude are well-owned, but a recent piece of bank research suggests that the miners expensive relative to the stuff that they actually dig up. Throw in a high level of skew in the FTSE (which means that vols have come off a lot on the rally), and we have a winner. The icing on the cake is the fact that the FTSE has reached the edge of its Bollinger band; a retracement to the moving average pivot at 6112 would put Macro Man's little trade solidly in the money.

Posted by Macro Man at 10:50 AM 11 comments Links to this post  

Non-predictions for 2008: Marking to market

Monday, May 19, 2008

Having been a sell-side researcher in the latter years of the last millennium, Macro Man knows better than most the folly of trying to make predictions and point forecasts. Amongst both analysts and risk takers, the temptation is that, having made a forecast, one selects one's facts on the basis of the forecast, rather than changing the forecast on the basis of the facts. As such, one finds as much myth as science in modern-day markets.

For this reason, Macro Man doesn't do predictions or forecasts. He does, however, do non-predictions, and at the last year wrote down a list of stuff that he thought would not happen this year. Given that he is in an introspective mood, now seems as good a time as any to mark his views to market as he tries to determine how he's gonna make money for the rest of the year.


1) Oil will NOT rise 60% in calendar year 2008, or 100% peak-to-trough during the year. Oh dear. In retrospect, Macro Man underestimated the degree to which the three axioms and the dollar down bubble would drive commodity prices, and overestimated the degree to which US consumer demand destruction would cap energy prices. While oil has not yet rallied 60% this year, it is on pace to do so. By any possible criterion, this has to be called a MISS.
2) VIX will NOT hit single digits again. The first month of the year, this looked like a dead cert to be right. However, since March equities have ground higher, sending VIX deep into value territory for those who believe that the world financial system and economy are not out of the woods yet. All Macro Man knows is that every single option/option strategy that he has purchased since Easter has finished out of the money. Ugh. For now, the JURY IS STILL OUT on this call, though a grind to 1500 would likely render it a miss.

3) Inflation will NOT die as a macroeconomic issue. Food riots. A hawkish ECB. 15 year high CPIs across Asia. Some US inflation measures at their highest point in more than a quarter century (the chart below shows the average 1 year Michigan inflation reading alluded to in the weekend special.) This can only be called a HIT.
4) China will NOT step-reval the RMB. The first three months of the year, it looked as if they wouldn't need to, as USD/RMB tumbled at a nearly 20% annualized pace. Since then, downside progress has ground to a halt, although curiously it has begun to fix lower again after the recent spec goolie-squeeze. Regardless, it appears as if policy-makers remain content to operate within the current regime, so for now Macro Man calls this a tentative HIT.

5) The BOJ will NOT hike rates in 2008. The irony of this prediction is that underlying Japanese CPI inflation is at its highest in nearly 15 years, and the nwe BOJ governor was the first to vote for rate hikes. Yet the deterioration in Japan's domestic economy, along with ongoing strains in financial markets, make it unlikely in Macro Man's mind that the BOJ will pull the trigger. Still, markets are pricing greater than 50% chance of a rate hike by year-end, so the JURY IS STILL OUT on this call.

6) GBP/USD will NOT make a new high in 2008. EUR/USD zoomed through its old highs with ease this year, peaking at a level 7% higher than its previous high. GBP/USD hasn't come within 3.5% of its old high, meanwhile, as Macro Man's bearish UK view has been realized and priced by the market. A HIT.

7) We will NOT see an honourably fought US presidential election with the outcome determined by the issues. The Democratic primary season has already rendered this one a HIT.

8) We will NOT see a US recession in 2008, as defined by the NBER. D'oh! The miss in number one forced Macro Man to change his view on this one fairly early on in 2008, as running the numbers forced him to conclude that the US consumer is finally stuffed. While the official figures and the stimulus package may forestall an NBER announcement this year (but then again, looking at the labour market, maybe they won't), the very fact that he had to change his view early in the year renders this one a glaring MISS.

9) Japan's MOF will NOT intervene in currency markets in 2008. USD/JPY dropped 11.5% in three weeks, going below 100 for the first time since 1995...and the MOF still didn't intervene. While the year isn't over, Macro Man will still chalk this one up as a HIT.

10) The Shanghai Composite will NOT rise another 100% in 2008. Wow. Macro man isn't sure what is more remarkable; the degree to which his relatively bearish view on Chinese stocks has materialized (the Shanghai Comp's down 31.5% YTD!), or how little it's mattered. Suffice to say that the market has had bigger fish to fry...Macro Man cannot remember the last time anyone mentioned Chinese equity indices to him, despite the currency shenanigans and the tragic earthquake. A HIT, but something of a hollow one. So there you have it. Six hits, two misses, and two "jury still outs." It would be a pretty good scorecard for a set of predictions; for a set of non-predictions, it's less impressive. That's particularly the case given the two that have missed; getting oil and the US economy wrong has meant some missed opportunities so far. Ironically, however, even getting everything right wouldn't necessarily have been much help over the last couple of months; being bearish on the UK hasn't exactly been the path to riches in short sterling, for example.

Markets are, after all, all about Keynes' beauty contest; it's more important to figure out which way the market will change prices than it is to get the economics right. Over time, of course, one should expect a good correlation between economics and prices. There are times like the present, however, when the Keynesian beauty pageant is chock full of nothing but mingers.

Posted by Macro Man at 10:02 AM 15 comments Links to this post  

Weekend special: What happens when you hit the panic button and stick your currency in the toaster?

Saturday, May 17, 2008

Yesterday's University of Michigan survey was a remarkable piece of data, and Macro Man could not let it pass without comment. The headline reading was the lowest since 1980, providing further evidence of the emergence of a consumer recession, whatever the retail sales figures might say. But the truly remarkable aspect of the data was the sharp rise in consumers' inflation expectations; to Macro Man's mind, this is an entirely logical outcome when a central banks decides to abuse its currency.

Regular readers will recall that when the Fed cut 50 bps in September, Macro Man opined that the dollar was toast. When BB and co. slashed rates by 75bps when the stock market got Kerviel'ed, it seemed like they were hitting the panic button. And what's happened since then? Median one year inflation expectations have rocketed from 3.1% to 5.2%. Sadly, Bloomberg doesn't have historical data for average 12 month inflation expectations; those are now a resounding 7%!!! It seems as if not everyone is living in the Fed's hedonically and seasonally adjusted, core goods world.

The rise in inflation expectations is all the more remarkable when put into historical context; they are now the highest since February 1982. Now, just because you expect higher inflation and demand higher wages doesn't mean you'll get 'em, especially in the context of an incipient recession. But with the balance of probability favouring a Democratic sweep come November, what odds that there emerges a legislative response to the juxtaposition of near-record corporate profits as a % of GDP along with stagnant/negative real wage growth?
Macro Man has long believed that inflation would be the straw that broke the Bretton Woods II camel's back; what's interesting is that the inflationary feedback mechanism is hurting not only those economies that are BWII participants, but the anchor itself, via inflation.

Sadly, we still appear to be a long way away from allowing common senses to prevail amongst the BWII peggers; far better to send the world into an inflationary spiral than allow a few currency punters to make money speculating!

Posted by Macro Man at 10:44 AM 13 comments Links to this post  

A short introspection after a difficult week

Friday, May 16, 2008

Macro Man has had a difficult, difficult week, so today's post is meant to be something of a catharsis and a somewhat jumbled attempt at self-analysis.

When Macro Man left his previous employer in late January, the market was a rich one for macro; there was a high level of volatility, central banks were panicky, and the market price action was highly directional and driven by classic "macro themes." When Macro Man walked out of his office for the last time, his highest-conviction idea was probably short USD/JPY.

And in February and March, while he was spending time on the ski slopes (as well as the less salubrious environs of Croydon), that was a great trade to have. It was 108 when he walked out the door, and on the 17th of March, the Monday after Bear Stearns blew up, traded below 96. Macro Man walked in the door of his new shop two days later.

Since then, it's been a bloody difficult market. Really, it's been like standing on the beach amidst a herd of pink flamingos, watching them get clubbed to death by an invisible predator. Take, for example, Brevan Howard, one of the most successful macro funds out there. Since Macro Man started in hew new shop, Brevan (as proxied by the BH Macro feeder fund listed on AIM) has shed 11%. Ouch!


Now, in fairness, Brevan is still up on the year, thanks to hitting the ball out of the park when the macro going was good. And hey, let's not forget that these guys have been incredibly successful (and gotten very rich) over the past few years.

But their recent struggles are emblematic of a change in conditions. There are some markets where you are rewarded for being right and easily let out for being wrong. Such was the case for the few months ending in mid-March. Then, there are other markets where it's bloody difficult to make money even when you get the economics right and you get crucified for being wrong. Such, it would appear, has been the case since Macro Man started work at his new shop, alas.

Now, Macro Man's modus operandi is typically to take aggressive risks when the going is good, making good returns of several percent per month....and to chip away, trying to make half a percent or so when things are difficult.

And so he has done since starting work; between his first day and last Thursday, he'd managed to chip away employing limited risk and generated profits of P/L of roughly 0.75%. Not the path to eternal riches, to be sure, but bang in line with the plan. Over the last week, he's given it all back. Short cap equities have rallied hard. Bunds have been crushed. The eurodollar curve has flattened. And all his little bets seem to enjoy 6 hours of joy and then race away from him with alarming speed.

Now, broadly speaking, Macro Man has been running money in much the same way as he did in the old blog portfolio: relatively simple beta strategies overlaid with alpha strategies (of both the hedging and money-making variety.) The one thing that he hasn't had is an equity beta model, because he's still doing the research.

And maybe that's one of the reasons he's scuffled over the last week. His alpha strategies, which were a wonderful offset to the long beta positioning of "cheap" equities that he had in the old blog portfolio, have given him more directional risk in the absence of a static long equity position. The SPX was roughly 1350 when Macro Man started; it closed yesterday more than 5% higher. Had he had his 60% of AUM allocation to an equity beta portfolio, like he had in the old blog portfolio, that would have added another 3% to his returns....and he would be much, much happier.

So perhaps he should intensify his research and get that equity beta portfolio up and running. It's actually comforting to know that had he been running money a la the old blog portfolio, he'd be doing better than he has done (and presumably be less frustrated.) Ahhh....the catharsis is working already.

Posted by Macro Man at 10:05 AM 22 comments Links to this post  

Economic Policy in the 21st Century

Thursday, May 15, 2008

One of the inevitable outcomes of the Three Axioms is the rising importance of the new entrants/BRICs in global financial markets. However, as Macro Man has observed on and off since the creation of this space, these new entrants don't always follow the same rules and conventions as existing participants. Scanning the headlines over the past twenty four hours provides a couple of particularly egregious examples of this "21st century policymaking."

Yesterday, the central bank of Russia announced changes to its currency regime. Ostensibly, this was to "help fight inflation", a stated aim of the Putin government. Yet the measures, which involve the potential sales of roubles for foreign currency, are pretty clearly inflationary- both in terms of weakening the domestic currency and increasing the money supply. The Bloomberg story headline gets to the heart of thissue straight away; these measures were designed to screw speculators. And so they have....the Russian basket trade, a highly popular destination for spec capital over the past three weeks, has suffered a rather ugly reverse.
So the Russians want to prevent foreign currency speculators, even to the cost of increasing domestic inflation. Meanwhile, the CBR runs over the EUR/USD market on a daily basis, while Russian "private sector" banks (Kleptokratbank Nizhny Novgorod, Oligarkbank Arkangel) regularly treat currency markets like an orca treats a baby seal. So while the Russkies are more than happy to speculate in your currency, they'll shoot themselves in the foot to stop you from speculating in theirs.

The race for energy, meanwhile, is becoming more visible in developed economy equity markets. China, for example, has seen the price of its energy imports skyrocket, particularly coal. Despite attempting to apply heavy pressure to their Ozzie "partners", Chinese importers have been hit with price increases of several hundred percent. Although Macro Man cannot find a price series for Aussie coal export prices, the chart below (coal products in the PPI) give you a flavour of the trend.
So imagine the Chinese dismay at the thought that two of their main suppliers, Rio Tinto and BHP Billiton, might merge, thereby giving the combined firm even greater pricing power. So what's a 21st century Machiavellian to do? It's obvious! Take advantage of the relatively open markets of the developed economies and buy a stake in each company to prevent the merger.

Now in fairness, Chinalco was joined by Alcoa in buying a decent chunk of Rio. But Alcoa is a private company; Chinalco isn't. And it is only the word on the strasse is that it is Chinalco
buying up a stake in BHP. Still, it's hard to imagine China looking too kindly on, say, the Australian Treasury lending BHP A$50 billion or so to buy up resources in China. In fact, such a proposition is little short of preposterous. So it would be kind of refreshing if the new Aussie premier Kevin Rudd got his Chinese counterpart on the phone and said "kindly f*** off."

If only somebody would tell SAFE's FX trading desk (pictured left) the same thing....

Posted by Macro Man at 9:34 AM 15 comments Links to this post  

The Fed finds religion

Wednesday, May 14, 2008

Has the Federal Reserve found religion? Yesterday's verbal barrage from a host of Fed speakers, both voters and non-voters, suggested that the FOMC has started to notice that the cost of living is going up. A lot. It is probably through that prism that yesterday's strong US retail sales report should be viewed; it is hard to credit that spending growth has encompassed much beyond basic necessities. Such a conclusion, at least, is the least that can be reached on the basis of a chart posted on The Big Picture yesterday.

Now, central banks are in a tough spot here. One might (and indeed, Macro Man would) argue that the Fed has found religion after the inflationary horse has already bolted. Still, perhaps it's better to see straight late than never; less clear is what to do about. An obvious starting point is to quit inviting financial markets to shag the dollar, and it is through that prism that the Treasury's recent volte face should be viewed. It seems as if US officials have connected the dots and realized that the dollar down bubble might have at least a little to do with import prices rising 15.4%, and moreover that this imported inflation is being passed through domestically.

The Bank of England is in a similar boat. The macro data has deteriorated markedly; today saw the first rise in unemployment claims in more than eighteen months; meanwhile, the news from the housing market remains nothing short of execrable. Yet inflation remains persistently high; for an inflation targeting central banks, this makes aggressive easing on the back of weak activity data difficult, unless one assumes an endogenous disinflationary impact from lower growth.

And throughout the history of inflation targeting, that's been a reasonable assumption. Yet one could plausibly argue that for the first time since the 1970's, global inflation is largely exogenous for most countries, a product of the three axioms and prior underinvestment. In such a case, it's unclear that high rates will do much to ease headline inflation. On the other hand, tight policy can, on the margin help prevent the second round effects that helped to endogenize the external inflationary shocks of the 1970's.

Macro Man is starting to wonder if we're aren't seeing the beginning of the end of inflation targeting as we know it, much as the 1980's spelled the doom for monetarists. Targeting inflation is great in a world an endogenously-generated price rises when core and headline converge over time; in a world of exogenous inflation pressure and divergent core and headline, focusing on one inflation measure is likely to generate suboptimal policy.

Macro Man wonders if we won't move towards a a world where central banks begin to target nominal GDP growth, rather than simply inflation. In a world of exogenous inflation, high frequency tradeoffs between growth and inflation are, to a degree, out of the central bank's control; if those shocks feed through into domestic prices, this will be reflected in nominal output growth.

What's interesting is to look at a chart of nominal GDP growth in the US and three other inflation-targeting central banks. In New Zealand, nominal GDP growth is just north of 8% y/y...close to the level of the RBNZ's OCR. In the Eurozone, nominal GDP growth is just over 4% y/y....again, close to the ECB's refi rate. Interestingly, nominal GDP growth in both the UK and US are well above the respective central bank policy rates. Small wonder, then, that the dollar and sterling are two of the three worst performing G10 currencies this year (the third, the Canadian dollar, also has a central bank policy rate well below the level of nominal GDP growth.)

So if central banks do find a new religion, it looks like the conversion may be easier for some than for others.

(And yes, I know that trailing y/y nominal GDP growth rates are not optimal policy targets; in an actual nominal GDP target regime, forward-looking indicators would be used.)

Posted by Macro Man at 9:51 AM 20 comments Links to this post  

My least favourite kind of market

Tuesday, May 13, 2008

This is Macro Man's least favourite kind of market. Volumes and interest are low, noise to signal ratios are high, and the last order is what drives the price. These are summery, trading markets....and for a "signal trader" like Macro Man, there is the inevitable frustration of losing money for no apparent reason. In this environment, most positions don't have a chance to grow into pink flamingos; they get taken out when they're still pink hummingbirds.

Sadly for Macro Man, there do appear to be a couple of flamingos out there...and at least one is lurking in his portfolio. The last couple of days have seen a pretty dramatic outperformance of small caps, as proxied by the Russell 2000, over large caps (measured any way you like.) This rally has come just after the Russell index appeared to be breaking through support last week. Macro Man's only consolation is that volume has been modest at best (indeed, yesterday's NYSE volume was the lowest for a non-holiday in more than a year), which is symptomatic of bear market rallies.
Another pink flamingo has been the short sterling strip, an accident that Macro Man has thankfully avoided. Today's CPI print in the UK, which (un)comfortably exceeded expectations, now means that Swervin' Mervyn will have to write a letter of apology to Alistair Darling...representative of the same government that recently said that the Bank could trim rates due to low inflation. D'oh! In any event, the selloff in the strip has been extraordinarily painful; at the timing of writing, neither short sterling nor SONIA is pricing in much chance of another rate cut this year. Such a development on a day when the RICS survey showed a record balance of surveyors expecting lower house prices is remarkable.
If anything, though, the UK's conundrum merely provides supporting evidence for the axioms of globalization. Yesterday's PPI data was extremely interesting; input prices reached their highest rate of inflation since 1980, and appear to finally be feeding through into output prices. This, in a nutshell, is why Macro Man feels that the ultimate impact of globalization is inflationary.
Further evidence comes from British Petroleum, which publishes annual estimates for energy consumption. To illustrate how the US has moved from a quasi-price setter for energy to a price taker, he plotted the annual change in energy consumption (as measured by millions of tons of oil equivalent) for the world, the US, and China. The result was instructive; US energy consumption is broadly unchanged since the end of 2000, whereas that of the world has surged higher, powered by China.
Small wonder that the oil price has managed to surge despite the US slowdown...and small wonder that most macroeconomic models have underestimated inflation over the past few years. Ultimately, the signals from these trends should remain very powerful indeed, and Macro Man looks forward to markets where the noise recedes enough to trade them.

Posted by Macro Man at 9:40 AM 10 comments Links to this post  

Three Axioms of Globalization

Monday, May 12, 2008

Why is it that laws, like misfortunes, always seem to come in threes? Kepler devised three laws of planetary motion. In classical physics, there are three laws of thermodynamics (though that's sort of cheating, given that there's a 'zeroeth law' and a tentative fourth law.) As he was cutting the grass over a wonderfully warm and sunny weekend, Macro Man got to thinking about an issue near and dear to his heart: globalization. And what he thought about was drilling down to devise some fundamental principles, or axioms, of globalization, from which all other conclusions can be deduced. The following is what he came up with.

1) There are more new entrants to the global economy than there are residents of rich industrialized nations. This is hardly controversial, as the populations of both China and India exceed a billion people: more than the European Union, United States, and Japan combined. The scale of where these people are coming from is staggering: one analyst that Macro Man spoke to last week noted that 400 million people in India still don't have access to full electrification.

2) That which the new entrants buy will tend to rise relative to that which the new entrants sell. For much of this decade, this axiom was misinterpreted as "the price of manufactured goods will be flat to lower forever," thanks to the apparently limitless supply of labour in places like China. However, the sheer size of the new entrants means that when they start buying something (oil, rice, copper, Treasury bonds, EUR/USD) with intent, the price goes up. Ultimately, this means that the wedge between headline and core measures of inflation will not only remain in place, but probably intensify.

However, this does not mean that there will be no inflation in goods and services that the new entrants sell- merely that it will be lower than amongst those things that they buy. After all, the minimum cost for a good made in China is the cost of the raw materials (which is rising), the cost of clothing/feeding/sheltering the employees who assemble it (which is rising), and the cost of shipping it to its final destination (which is rising.) Even the cost of haircuts in Shanghai depends on how much it costs the barber to light his shop and feed his family.

In any event, the empirical data certainly suggests that while the change in the price of manufactured goods remains lower than that of commodities, these prices changes are now firmly positive:
3) Resources are finite. Oil. Food. Water. None of these grow on trees (OK, OK, some food does), and all are in demand by the new entrants to the global economy. And this demand is only going to increase as the new entrants become less poor in aggregate.

The implications, when combined with axioms one and two, are incredibly bullish for commodity prices over long periods of time. This is hardly a revelation, and indeed there are probably some pink flamingos as a result. For Macro Man, the more interesting impact of this axiom is the competition for resources. To date, the competition has been conducted along a set of agreed rules and codes of conduct. Call it the economic equivalent of 19th century warfare, with its fancy uniforms and official declarations and treaties.

Many of the new entrants were not part of that system and show little sign of wishing to join it. So the competition for resources will be more like the type of warfare that evolved in the second half of the 20th century: unconventional conflict wherein practitioners of traditional methods find themselves at a disadvantage against highly-motivated opponents employing guerilla tactics. China's investments into Africa are an example of this: they draw opprobrium from the West (no stranger itself to supporting morally bankrupt regimes!) , but help maintain the Chinese growth engine.

If these axioms are correct, then the world economy (and indeed the world, via the environment) are undergoing a tectonic shift. While it's easy to extrapolate the trends of the past few years into the future, as Friday's discussion highlighted, the true test comes under duress. If, in a few years' time, we can look at these three points and still call them axioms, then be prepared to change the way you live your life, for the world in the 21st century will be very different from the one that people of Macro Man's vintage grew up in.

Posted by Macro Man at 9:17 AM 15 comments Links to this post  

Passing the pink flamingo

Friday, May 09, 2008

Recent market price action has started to remind Macro Man of an episode from his distant youth, nearly 30 years ago. People did strange things in the 1970's, and he remembers a "game" played by various households in his neighbourhood in what must have been 1979 or so. One family bought a pink lawn flamingo, such as that pictured to the left, and stuck in the lawn of a neighbour. There followed several months of "pass the parcel", wherein the flamingo would magically appear on the front lawn of a different house every few days or so.

And it seems to have been for macro thematic trades, where the "pink flamingo" of position unwinding has been passed from market to market. First the equity and cerdit shorts got squeezed. Then the curve steepeners got flattened, followed by a vicious squeeze in USD/JPY. The front end strips got whacked as basis blew out, taking bond markets lower generally. Recently, the sacred cow of short USD/Asia has been taken behind the woodshed for a beating.

So the question has for his market compadre readers is this: what's the next pink flamingo, if any? Where are the remaining high conviction, deeply-positioned trades that might get washed out by the hand of fate (and/or the tap on the shoulder from the market risk manager?) He's struggling to come up with many more that are out there. Indeed, some erstwhile favourites seem to be getting traction again; yield curves are steepening, and yesterday's price action in Bunds (a strong rally that appeared to shatter trendline resistance) wasn't justified by Trichet's comments.
So Macro Man wants to know: are there any more pink flamingos out there, or is time to do the Electric Slide on the macro dance floor?

Posted by Macro Man at 9:45 AM 28 comments Links to this post  

Thoughts in the back of my mind

Thursday, May 08, 2008

Macro Man's pretty tied up today with market vol and admin. In the back of his mind, though, he's thinking about the following:

* The FT reports that the US has performed an about face and now legitimately wants a stronger dollar. If true, this would represent a change from the "word on the strasse" that the US Treasury was telling people after G7 that they wer relaxed about the dollar. More interesting from Macro Man's point of view was the mention that the weak dollar was pushing up energy prices; this jives with one of his hypotheses as to why China et al may have turned EUR/USD sellers.

* What odds that the ECB is more hawkish than expected today? On part perform, pretty darned high. Such an outcome might squeeze out some of the overnight euro sellers.

* USD/Asia is starting to remind Macro Man of recent action at the front end of global yield curves; broad and deep high-conviction positioning is being shaken out in ugly price action. Selling the front end of the USD/CNY NDF curve is now a positive carry trade!

* The downside of the Fed liquidity quid pro quo is starting to materialize. The SEC is going to require greater public disclosure from investment banks moving forwards, particularly vis a vis their liquidity and risk positions. Presumably this means that these calculations will no longer be made on the back of an envelope; now they'll be done on the back of a postcard.

*So much for efficient market theory; last night Macro Man was told about some suggested Senate measures (windfall tax on oil companies, changing futures margin requirements, halting SPR puchases) to deal with high energy prices, and that this announcement had sent stocks lower. This morning, he spoke with a buddy who manages an energy fund, and this chap couldn't find any mention of these stories.

* A story is circulating that Bush would veto the Graham/Dodd bill if it is passed in Congress. Now, Macro Man doesn't know enough about the specifics of the bill to comment on whether this would be a good idea or not. However, given the national mood and the amounts of taxpayer money that are being wasted elsewhere, it would seem to be a spectacular own goal to veto the legislation on the basis taxpayer cost, which Macro Man has seen cited as a couple of billion dollars.

Posted by Macro Man at 9:28 AM 8 comments Links to this post  

Dollar/Asia: time for a reversal?

Wednesday, May 07, 2008

Is the worm turning, if ever so slightly, for the dollar? Regular readers will recall that last summer, Macro Man began to contemplate the notion that aggressive Fed easing would generate a "dollar down bubble." The view played out as well as possibly could have been expected, in both the currency and the commodity space; Macro Man's only regret is that he was hors de marche when the most impulsive breakdown in the dollar occurred. And yet he now finds himself less tactically bearish of the buck than he's been since August of last year.

Recent data from Europe suggests that some of the pain of tighter credit is starting to spread. While there is still no assurance that the ECB will act in the near or even medium term to cut rates, it seems clear that the endgame will be an ECB rate cut. That, combined with the nosebleed valuations of EUR/USD (and many of its closely correlated peers), makes dollar shorts less attractive at the moment. When when considers that Voldy and co. have been selling EUR/USD, there's even more reason for concern on dollar shorts.

An even more interesting dynamic is playing out in Asia. China has seen its trade surplus shrink markedly; part of this is seasonal, but part of it appears to be cyclical: China's export growth has fallen off, thanks in part to weak demand in the US, but import growth remains firm, no doubt partially due to a negative terms of trade shock. And part of that ToT shock is, in Macro Man's view, a direct result of the "commodity leg" of the dollar down bubble. And that is why Macro Man postulated that CBs could be trying to support the dollar against euros, rather than their usual euro buying.

Regardless, the dynamic in Asia seems to have changed. For most of the past several years, short USD/Asia has been a favoured "fundamental" dollar short, given the relative imbalances that Brad Setser has written so much about. However, a few people, most notably Stephen Jen of Morgan Stanley, are being to question this trade, at least tactically. Given that China is shutting down next month for the Olympics (they need a few months to clear the air), one could argue that CBs will be less willing to tolerate the appreciation of their currencies without an ongoing growth driver.

Whether that's true or not, there's pretty clearly been a change in market view on China. The 6 month NDF has put in its largest correction higher since the RMB floated in July 2005.
A broader Asian currency index, on the other hand, has shown little signs of such a substantial correction. While some are cetainly well off their highs (KRW springs to mind), overall the recent hiccup is little more than a blip on the chart.
USD/JPY, on the other hand, is more interesting. Macro Man ran a little study to determine the historic scope of bear market rallies, wherein a bear market is defined as a negative 6 month change, and a 'bear market rally' is the difference between the spot rate at time t and the minimum of the last 6 months. The chart below shows the results; the current bear market rally in USD/JPY is the largest since early 2000- a rally that marked a medium term low in the pair.
At this point, Macro Man isn't prepared to call an end to the dollar down bubble- after all, real policy rates in the US are laughably low. However, he finds himself more neutral than he's been in the better part of the year, and tactically his position against "stuff that moves" has edged towards the long side.

He's aware that he has a lot of company in wondering if the dollar is set to bounce, a lot of which has more conviction and, in all probability, bigger positions than him. For this reason he's allocating a pretty small risk budget to a "dollar bounce" trade. But as he looks around, he sees some interesting RV trades in the EM space: certain CBs (Bacen, CBT) are clearly worried about inflation and are/will soon be acting on those concerns. If Asia starts dropping the ball on inflation, perhaps a rotation out of Asia and into high carry EM is on the cards- particularly if equities continue to confound the bears and grind higher.

Posted by Macro Man at 9:50 AM 6 comments Links to this post  

Has Voldemort fallen out of love with the euro?

Tuesday, May 06, 2008

Macro Man is still struggling to pick his jaw up off the floor this morning, still attempting to come to grips with what he saw over the long bank holiday weekend. You see, for the first time since John Major was PM, the UK enjoyed a sunny and warm May bank holiday weekend. Not that such beautiful weather is without demerits, however; not only did Macro Man get stick from Mrs. Macro for allowing Macro Boy the elder to get sunburned playing football sans shirt yesterday, but he'll now have the memory of last weekend thrown in his face when he dares complain about UK weather when it's 55 degrees and rainy on the 4th of July. Ah, the crosses we must bear....

In any event, recent price action in currencies has been instructive. The dollar has tried to sell off this week, led in part by record high oil prices and a rebound in gold that will no doubt delight the tin-foil hat brigade. However, the euro rally above 1.55 has been met by reported sales from Asian central banks, a theme that's been ongoing for the last week or two. Now, what's peculiar is that the euro was essentially frog-marched up to 1.60 by central bank demand....but since then has been sold off aggressively, with some of the same names that had previously been buying cited as the sellers. This has led Macro Man and others to speculate: has Voldemort (and others) fallen out of love with the euro?
What's beyond dispute is that something has changed chez Voldy. Having allowed the RMB to appreciate at a record pace earlier in the year, the rate of change in USD/RMB has slowed to a standstill, touching a zero rate of change over one month for the first time since late summer. While some of this could perhaps be attributed to a higher import bill/lower trade surplus and short covering, it seems highly likely indeed that SAFE has been buying dollars in their usual egregious volumes to slam the brakes on RMB appreciation. (Why they should want to do so is another question altogether; Macro Man would put it down to wanting to screw speculators as well as a misguided attempt to defend exports.)
Regardless of the reason, it's clear that FX reserve manager assets are continuing to rise at a nearly parabolic pace. The BRICs alone managed to add $242 billion to their reserve assets in Q1 alone. Now, what's interesting is that a lot of that can be explained by the sharp increase in the dollar value of non-dollar reserve assets; or, put another way, despite the marked increase in reserves, Macro Man calculates that Voldemort and co. had relatively little EUR/USD to buy to maintain portfolio benchmarks. Indeed, Macro Man's model put the required quarterly EUR/USD purchases at their lowest level since Q3 2004.
And yet, anecdotal evidence suggests that FX reserve managers were highly active in the FX market buying euros in the first three and a half months of the year. What's going on here? Macro Man can come up with a few possible explanations:

1) After their early April buying spree in EUR/USD, Voldy and co. found themselves overweight euros at 1.60, put on their value hats, and said "oh sh**. Sell, Mortimer sell!"

2) French Finance Minister Christine Lagarde got SAFE on the dog and bone and gave them the same "hairdryer treatment" she treated the G7 to. To avoid more of the same, they've agreed to let EUR/USD come a bit lower for a few weeks until she's found something else to complain about (ECB rates, anyone?)

3) Perhaps...just perhaps...they've realized that in walking EUR/USD higher, they have helped drive food and energy prices higher via the invoice currency effect, and that they are shooting themselves in the foot by generating social unrest (via food and energy inflation) through their FX market activities?

On second thought, maybe none of these is the case. Maybe they're just selling euros because they're ****s.

Posted by Macro Man at 9:22 AM 24 comments Links to this post  

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