Monday, June 30, 2008

It's a great day for golf

It's a great day for golf today- sunny and warm in the Southeast of England. So Macro Man has spent the morning on the links with his father, who's visiting from the States. Despite getting caught behind the group picture to the left, it was still a highly enjoyable day. Certainly it was more profitable than trying to trend-follow some popular positions, such as short European equities....



...short NZD (pictured below versus AUD)....
...or even short USD/JPY.
Still, Macro Man supposed that you have to throw a bone to the quarter-end window dressers, fixing front-runners, and assorted noise-makers.

Tomorrow is another day, month, and quarter; fortunately, the problems in the US and elsewhere are the same old, same old.

Friday, June 27, 2008

Slip Slidin' Away

Although equity markets are currently bouncing as Macro Man writes, and the blog reader indicator ticked up yesterday, do any of the following make you comfortable picking the bottom in stocks here?

1) VIX ticks up, but only modestly so- particularly given the vehemence of yesterday's sell off. Is the street a little too confident in the Bernanke put?
2) The sweetest little head and shoulders pattern you're ever likely to see. Macro Man has previously pointed out the H&S in Eurostoxx, but check out the weekly formation in the Swedish OMX. It's straight out of a textbook!
3) The yen getting its mojo back? After the collapse of the SPX/ USDJPY correlation shook out yen longs, USDJPY is breaking its uptrend line off the March lows this morning. Such a break, if sustained into this week's close, could provide the JPY with a dose of giddyup next week.
It looks to Macro Man like stocks will continue to keep slip slidin' away until someone hits the panic button. Still, if you're long and wrong, or bearish and not short, chin up. Things could be worse. How'd you like to be Mr. Watanabe, who came home from work today and found that his missus paid up for NZD/JPY while he was at the office?
Ouch!

Thursday, June 26, 2008

Inconceivable!

So, Vizzini said his piece last night, observing that growth risks, while mitigated, remained to the downside, while inflation risks were somewhat more acute than previously thought. And hey- Fezzik voted for a rate hike! Macro Man thought that on balance, the statement was a tad more hawkish than he'd feared, but clearly the market didn't agree. To be sure, Macro Man doesn't think that the Fed will hike rates any time soon, but the reaction of markets appeared to suggest that such an outcome is, to quote the original Vizzini, "inconceivable!"

Macro Man was frankly surprised at the reaction of equity and currency markets to the statement. After the SPX bounced above 1330 and came back to 1325, Macro Man seriously contemplated an aggressive sale of ESU8 with a stop loss at 1335, just above the high of the day. Having taken back his SPX short earlier in the week, he didn't want to miss out on the downside party. Fortunately, he stayed his hand, as the trade would have produced the worst possible outcome: a stop-loss purchase near the highs, followed by the subsequent expected decline. This market really isn't getting any easier, is it?

Fortunately, Macro Man retains reasonable short risk in European equities, which have followed on from the limp US close. Stock market weakness has been exacerbated by yet another bearish report on Citigroup- Goldman expects a cheeky $8.9 billion writedown and has put C on their "sale of the century" list. In Europe, Fortis is feeling the hangover from its share of last year's ABN purchase; it's raising additional capital and has suspended its dividend.

Moving on to currencies, Macro Man is wondering whether it's time to resurrect the Rule of Four Point Two. Long-time readers may recall last spring's thesis that the EUR/USD tends to meander in a range that is roughly 4.2% wide for several months before embarking on an explosive move in the direction of the trend. Since the sharp rally of January/February, EUR/USD has spent three months in a range that's been 4.5% wide- a range close enough to qualify for the Rule, in Macro Man's view. Notably, Voldemort and co. have been observed selling at the top and buying at the bottom, just as they did during prior applications of the Rule.

How best to play this? Tough as it may feel, the profitable strategy is to buy weakness and sell strength while spot is constrained within the range. However, once the range breaks, run with it, because it should be good for a 3%-5% move. For the past several years, these breaks have come to the topside of the range, and yesterday's price action would suggest that the same will happen this time around.

And yet....Macro Man can't help but think that EUR/USD has run its course, and that the next big macro change will be the European economy finally slowing enough over the next few months to change the ECB's view. We've already had the first rise in German unemployment since early 2006, and the ECB's hawkish rhetoric appears to have crushed business confidence. G3 FX has been a P/L morass over the past few months, and Macro Man has little inclination to jump the gun whilst the market's in the middle of the range.

He can't help but think, though, that his worldview, combined with the Rule of Four Point Two, will make EUR/USD an attractive sale in a percent or two. While a large EUR/USD decline might seem inconceivable at the moment, as Inigo Montoya observed, that word doesn't always mean what you think it does.

Wednesday, June 25, 2008

Vizzini takes charge of the Fed

There was a remarkable development at the start of the Federal Open Market Committee's deliberations last night which somehow managed to stay out of the financial press. Fortunately, Macro Man has a mole in Washington who's filled him in on what went down.

Shockingly, Ben Bernanke and the rest of the committee have abdicated responsibility for determining monetary policy this month. Fortunately, the policy vacuum has been filled by an incomparable intellect: Vizzini, the Sicilian of Princess Bride fame. Macro Man's mole has provided him with a verbatim transcript of yesterday's policy deliberation after a black-cloaked stranger walked into the Federal Reserve conference room:

Vizzini: So it is down to you, and it is down to me. If you wish the economy dead, by all means, keep moving forward.

Dread Pirate Inflation: Let me explain--

V: There is nothing to explain. You are trying to kill the consumer that I have rightfully supported.

DPI: Perhaps an arrangement can be reached?

V: There will be no arrangement, and you're killing the consumer.

DPI: Well if there can be no arrangement, then we are at an impasse.

V: I'm afraid so. I can't compete with you physically, and you're no match for my brains.

DPI: You're that smart?

V: Let me put it this way. Have you ever heard of Bernanke, Greenspan, Volcker?

DPI: Yes.

V: Morons.

DPI: Really. [pause] In that case, I challenge you to a battle of wits.

V: For the economy? [DPI nods] To the death? [Pirate nods] I accept.

DPI: Good. Inhale this. [DPI pulls out a small vial and uncorks it.]

V: I smell a viscous, tarry substance.

DPI: What you smell is called petroleum. It powers the global economy, as well as the US consumer. And despite a drop in US vehicle miles traveled, its price continues to rise.

V: Hmmmm.

DPI: [Turns away from Vizzini, then turns back and places two pieces of paper on the table.] All right. Which is the appropriate monetary policy statement? The battle of wits has begun. You must choose whether to turn hawkish in the face of high and rising headline inflation, or to remain dovish in the face of significant consumer distress. It ends when you have made your decision, and we find out who is right....and who is dead.

V: But it's so simple. All I have to do is divine from what I know of you: are you the sort of problem that will respond well to a tightening of domestic monetary policy that will not kill the consumer? Now, an endogenous inflation problem will respond to reduced demand and a slackening of labour markets, so I can clearly not choose the dovish policy in front of me. But only a great fool would think that US consumer demand is driving the price of oil. I am not a great fool, so I can clearly not choose the hawkish policy in front of you. But you must have known I was not a great fool, you would have counted on it, so I can clearly not choose the policy in front of me.

DPI: You've made your decision then?

V: Not remotely. Because oil comes from the GCC and Russia, as everyone knows, and the GCC and Russia are entirely peopled by currency piss-takers who would be bailed out of their piss-taking by tighter US monetary policy, so I can clearly not choose the policy in front of you.

DPI: Truly, you have a dizzying intellect.

V: WAIT TILL I GET GOING! Where was I?

DPI: The oil producers.

V: Yes, the oil producers. You must have suspected I would have known petroleum's origin, so I can clearly not choose the policy in front of me.

DPI: You're just stalling now.

V: You'd like to think that, wouldn't you? You've beaten my jawboning, which means you're exceptionally strong, so you could trust in your ability to overcome a moderate policy tightening, so I can clearly not choose the policy in front of you. But you've also bested my econometric models, which means that you've studied, and in studying you must have learned that the sacrifice ratio has risen, so you would have put the suboptimal policy as far from yourself as possible, so I can clearly not choose the policy in front of me.

DPI: You're trying to trick me into giving away something.

V: IT HAS WORKED! YOU'VE GIVEN EVERYTHING AWAY! I KNOW WHAT THE OPTIMAL POLICY IS!

DPI: Then make your choice.

V: I will, and I choose-- holy cow, how bad is that confidence data? [Vizzini points at the chart below. Inflation turns and looks.]

DPI: What? Where?

V: Well, I- I could have sworn I saw something. No matter. [Vizzini smirks.]

DPI: What's so funny?

V: I'll tell you in a minute. First, let's announce policy. I'll use this statement in front of me.

DPI: You chose the wrong policy.

V: You only think I chose wrong! That's what's so funny! I switched policies when your back was turned! Ha ha! You fool! You fell victim to one of the classic blunders! The most famous is never get involved in a land war in Asia, but only slightly less well-known is this: never offer more than one policy choice to a two-handed economist! Ha ha ha ha ha ha ha ha--

[Vizzini stops suddenly, as the US consumer falls dead to the ground.]

Vizzini: Who are you?

Dread Pirate Inflation: I am no one to be trifled with. That is all you ever need know.

Vizzini: And to think, all that time the suboptimal policy was in front of you.

Dread Pirate Inflation: They were both suboptimal. I've spent the last few years getting ready to bugger the Western consumer.

Tuesday, June 24, 2008

If you whack it, they will come

There seems to be a phenomenon in the financial news/entertainment sphere (a region that Macro Man in some way inhabits via this space) that, to paraphrase Field of Dreams, "if you whack it, they will come." In other words, capitulative lows in equities tend to be accompanied by capitulative spikes in traffic.

Macro Man has commented on the utility of tracking traffic figures in the past, though he's hardly the only one. The charts below provide an example of the "traffic signaling capitulation" phenomenon. Consider the "Bear Stearns bottom" put in on St. Patrick's Day of this year, marked with the arrow below. Not only did it mark the nadir of the S&P 500 for the year, but was followed by a rather sharp rally in the ensuing week (and indeed couple of months.)
Comparing the chart above with Macro Man's own daily visitor figures (from Google Analytics) is instructive. As you can see, the blow-off low generated a surge in traffic well in excess of anything observed a few weeks on either side.
Which brings us to today. Last week's price action in equities was pretty bad, to say the least. Over the weekend, Barry Ritholtz observed that traffic at his site was not indicative of a captiulative low; in fact, it went down ever as stocks did. Macro Man can report that he's observed the same thing, with traffic edging lower in line with the market. While it is tempting to put down the decline in traffic down to the onset of school holidays in the US; however, a quick geographic study reveals that traffic declined across just about all major countries, including those (like the UK) where the kids are still in school.

What are we to take from this? Well it seems as if despite the horrible market price action, no one (or at least no one who reads this blog) is panicking. And until panic sets in, the most likely direction for equities is down, down, down.

Monday, June 23, 2008

Euro 2008: A Glimpse at the Future of Europe

It's often said that "art imitates life." Sometimes, so, too, does sport. In watching the 2008 European football championships, Macro Man has been struck how each of the four semifinalists in some way represent the future of Europe in a way that, for example, the host nations (Austria and Switzerland) never could. Consider the impact of the following four countries:

1) Germany. It's fitting that Germany's made the semifinals, as they have been, are, and will continue to be the most important country in the European Union. For the past several years, ECB monetary policy has been made for the primary benefit of the German economy; it's almost been like having the Bundesbank back again. Waiting for an ECB rate cut? When the German economy shows definitive signs of rolling over, you'll finally get one.

2) Russia. If Germany is the most important nation in the European Union, Russia may well be the most important country in the European continent. In a resource-hungry world, Russia's been blessed with an abundance of fuels and minerals that give it significant economic leverage. And Czar Vladimir I of the Chekist Empire is, by all accounts, not afraid to use this leverage. Much like their erstwhile Communist colleagues in China, the Russians have burst upon the global economy in the past half-decade in a less than subtle fashion. And while they've been happy to participate in organized multilateral events such as these Championships, in the economic sphere they've been mostly unilateral. How they choose to deploy their energy resources and manage their currency piss-taking could be vital to the European economy (and, potentially, security) in the coming years.

3. Turkey. Turkey represents a choice facing the European Union. Do they embrace multiculturalism and engage the world's most Western-facing large Muslim country? Or do they drive yet another barrier between the Islamic world and the West by denying the Turks membership to the EU? Certainly the latter option is favoured by certain xenophobic segments of the European population and the politicians who cater to them. Fortunately, by the time that Turkey has negotiated all the acquis chapters for EU membership, the time of the xenophobes may have passed. And while Turkey's importance may currently be more geopolitical than economic, in the fullness of time its large, youngish population may be just the thing to energize the European economy and support its ageing workforce.

4. Spain. Spain represents all those Eurozone economies harmed by the ECB's "one size fits all, as long as it's Germany" monetary policy regime. For years, ECB policy was too easy for the likes of Spain and Ireland, leading to substantial property bubbles. Now that those bubbles have popped, policy in those countries is arguably too tight (though perhaps not, given the rate of inflation.) What does seem clear is that as it approaches age 10, the single currency experiment is facing what may be one its largest challenge: a real disconnect amongst the constituent economies that cannot be solved with a single monetary policy. While the Spanish weren't allowed to vote on the Lisbon Treaty, Ireland (facing similar problems to Spain) rejected it, perhaps in part because of the suboptimal monetary policy that they've received. How Europe deals with dissonance between core and periphery will be vital in determining the future of the single currency.

Still, things could be worse. There was one team in the competition which represented the cynical pragmatism and, ahem, willingness to push the boundaries of both sportsmanship and the rules that has made the EU bureaucracy such a morass of corruption and waste. Macro Man refers, of course, to Italy, with their defensive catenaccio "eleven men behind the ball" tactics and their eagerness to dive at every opportunity. For those watching last night's quarterfinal against Spain, there was poetic justice in the fact that Antonio di Natale ("let me roll back onto the pitch with my 'injury' so the ref will be sure to stop play") missed the decisive penalty in the shoot-out which brought Spain victory.

Hey, perhaps there's hope for Europe yet.

A note to Italian readers: when your teams play football, they can be a pleasure to watch. Sadly, diving appears to have become an epidemic in the Italian game in recent years. Sort it out!

Friday, June 20, 2008

The witch's hat

It's triple witching day today in equity land, and on the evidence so far the old crones have cooked up a stonker. The bubbling witches' cauldron has been aided by a rather amusing game of banking "nickie-nickie-nah-nah", wherein one troubled institution downgrades another: UBS has lowered Citi this morning, while the embattled Lehman has downgraded Deutsche, Credit Suisse, and- you guessed it- UBS.

So there's been a few fireworks in Europe this morning, which has no doubt left various holders of index option positions either celebrating or gnashing their teeth. The morning action in Eurotstoxx was pretty mundane leading up to expiration (the settlement time is marked by the arrow in the chart below), after which the index has fallen off a cliff.

From a longer term perspective, the Eurostoxx is at pretty crucial levels. On the weeklies its sitting on the neckline of a head-and-shoulders pattern, a formation which also happens to resemble a witch's hat. A weekly close below the 3440-ish level would theoretically target the low 2000's eventually. Yowsah!
While the SPX doesn't have such an obvious witch's hat formation threatening to cast a hex, it, too, is at pretty crucial levels. While logarithmic charts aren't really used in day-to-day charting, they are pretty handy when looking at long time frames of data. And as UBS' Andy Lees has pointed out recently, the SPX is basically sitting on the uptrend from the (in)famous 1982 Granville bottom on the logarithmic monthlies.
A conclusive monthly close below this trend line at 1330 would be fairly ominous indeed, and threaten to turn the SPX into a pumpkin. Yesterday's Philly Fed, which showed weaker activity, higher input costs, and lower prices received, provided a heady witches' brew for the macro equity bear.

Of course, the trick in this game is to avoid Macbeth's fate and follow the witches' guide to one's doom. Then again, badly limping financials, a struggling US consumer, and rampant global headline inflation are substantially less formidable an opponent than Macduff. For now, Macro Man is content to follow the witches' prophecy but not force the issue; if the brim of the witch's hat gives way, there will be plenty of opportunity to add risk.

Thursday, June 19, 2008

Hits, Runs, and Errors

Macro Man's going to have to figure out how to assign a macro to the shift-F9 keystroke that will automatically type out "it isn't getting any easier, is it?" Because it isn't getting any easier, is it? Just when you thought that sanity had returned to short-end interest rate markets, out comes the UK with a piece of data so far off the charts that it literally beggars belief.

Yes, despite rock-bottom consumer confidence, a plunging housing market, a rise in unemployment, and dire warnings from retailers, apparently retail sales in the UK rose by 3.5% in volume terms last month. On a value basis, sales rose even more- 4% m/m. To put this figure into context, the last time monthly sales rose this much, Margaret Thatcher had only been prime minister for two months.
According to the ONS, sales were powered primarily by food and apparel prices, the latter of which evidently rose more than 9% on the month. Riiggggghhhhhtttt. If something looks like a duck, walks like a duck, and quacks like a duck, but someone tells you it's a race horse, would you really expect to see it at Royal Ascot today? Probably not. This number is literally unbelievable, but the gap lower in short sterling is all too real. Once again, this market appears to be pretty much unplayable.

In that vein, Macro Man decided to do a bit of portfolio introspection this morning to see where he's had some hits, scored a few runs, and (perhaps most importantly of all) made his errors. Now usually, Macro Man enjoys a pretty good hit ratio on his trades, both at his old shop and in the old blog portfolio. Traditionally, roughly 55%-60% of his trades are winners.

It's instructive, therefore, to see that since he started the new gig, his hit ratio has been substandard- only 40%. As much as anything, this tells him what a difficult three months it has been for his style of trading. Fortunately, his position sizing has been relatively conservative, as he at least had the sense to recognize how difficult the market has been and has just tried to "chip away."

What's clear is that there have been a couple of classic "macro trades" that have worked over the last few months, and a host of others (as well as shorter term punts) that have not. The large cap/small cap RV trade in particular stands out as a high conviction trade that's not worked; fortunately, Macro Man had the sense to cut most of the position before it really fell off a cliff. The lack of success in that strategy would seem, it appears, to illustrate the difficulties of RV trading over the past couple of months.
What seems clear is that straying from his core competency has not been rewarded; in particular, forays into commodity and fixed income markets have been relatively luckless. Fortunately, some moderate success in his bread-and-butter skillset have given him a tiny positive result since inception. But he would be curious if other risk-taking readers have had the same experience: lower-than-normal hit ratios, RV trades gone wrong, a high correlation between core skillset and performance, and, ultimately, an unwillingness to swing the bat aggressively when hits and runs are so hard to come by and it's easy to make an error.

Wednesday, June 18, 2008

Fair game?

While summer doesn't officially start until Saturday, in many ways it feels as if summer markets are already here. Vol sellers have emerged in equities, fixed income, commodities, and currencies, while conviction and trading interest is reported to fairly light across different products. Closer to home, both traffic and commenting in this space have dropped off over the last few days, though that may say more about a dearth of insight from your author than any underlying market condition.

In any event, yesterday saw a pretty limp reaction to what Macro Man thought would be a touchstone event, namely the release of Goldman Sachs' earnings (more on which below.) Action has been similarly tepid today in Europe, though Asian markets seem to have de-coupled, if only temporarily, overnight. Macro Man retains a short in various European indices, and has seen little to dissuade him that this is the right position to have.

Indeed, perhaps the biggest threat to equity shorts at the moment is that the regulators change the rules of the game. In the UK, for example, the FSA has taken Deutsche Bank to task for proposing a perfectly legitimate trading strategy. Indeed, the UK regulator seems to be more interested in squeezing/screwing shorts than they do about addressing malfeasance on the part of companies, particularly finance firms, which are the very reason that shorts are established to begin with.

Not that misguided regulatory zeal is confined to the Square Mile- far from it. Although the pre-ho Spitzer revolution has cracked down on the worst of the excesses in Wall Street research, the fact remains that analysts are, in aggregate, habitually overoptimistic on the market. The chart below compares the 12 month forward I/B/E/S consensus earnings estimates for the SPX with the actual result; as you can see, over the past 20 years the consensus has overestimated earnings by more than 7%. To put that into context, the actual annual earnings growth over that period has averaged 8.5%.


In fairness, the recent degree of over-estimation has been much less than previous cyclical peaks. But these index-level (over) estimates are only half the story. Because bizarrely, as far as Macro Man can make out, over history a majority of company-level earnings surprises tend to be positive. That is, comfortably more companies beat expectations than fail to beat. (Macro Man has tried and failed to access hard historical data on this phenomenon going back longer than a few quarters; if anyone has the data, by all means pass it along!)

So we're left with a situation where most analysts overestimate earnings on a 12 month forward basis but underestimate earnings on an ongoing quarterly basis. Hmmmm.....something smells kind of rotten there. If this earnings estimate game were truly a fair one, it would be reasonable to expect companies to beat earnings 50% of the time. yet clearly that's not the case.

Consider our friends at Goldman, who currently enjoy universal acclaim as "the smartest guys in the room." That may well be the case, but unless the analysts covering GS are at the other end of the scale, wouldn't we expect them to mark their estimates accordingly? Evidently not. Bloomberg stores quarterly estimates for GS since the beginning of 2006. Since that period, GS have beaten those estimates ten out of ten times. In a "fair game", the cumulative probability of that occurring is less than 0.10%. Indeed, the best model for predicting GS earnings appears to taking the consensus estimate and adding a buck per share.
Judge for yourself whether this is the result of analyst incompetence, or whether GS is gaming the system. It's not like every other IB hits the ball out of the park every quarter. Lehman and Merrill have famously had recent difficulties, and even Morgan Stanley (reporting today) has disappointed expectations three times since the beginning of 2006.
Unfortunately, regulatory zeal apparently doesn't extend to determining just how Goldies (and to be fair, they're hardly alone in this game) manages to beat expectations quarter after quarter. Naked Capitalism highlights potential dodgy goings-on at Lehman with respect to how they managed de-lever in such a crappy market.

That equity markets are gamed isn't exactly new news, and Macro Man doesn't want to come across as a doe-eyed naif who's just discovered that Santa Claus doesn't exist. But just as equities were de-rated in the wake of the late 90's/early Noughties corporate scandals, Macro Man can't help but wonder if a similar de-rating won't occur now, sourced in the twin concerns of inflation and the fact that stocks aren't a fair game.

Tuesday, June 17, 2008

The joys of writing

When Macro Man began scribbling down his thoughts in this space in September 2006, he didn't really know what to expect from the endeavour. As it's turned out, his daily scribblings have turned into a valuable part of his investment toolkit, both in terms of organizing his thoughts on a daily basis a well as interacting with other market participants across the world.

Now, he knows that central bankers across the world are faced with a real conundrum, namely how to address the twin trends of slowing growth and rising inflation. Fortunately, at least one will have the opportunity to "think with his fingers" and exercise his writing skills. Macro Man refers, of course, to the BOE's Mervyn King; the image to the left was taken this morning from the MM "Spycam" installed in the Bank's Threadneedle Street offices.

Yes, Merv the Swerve has been forced to write a letter to the Chancellor, thanks to today's CPI release. It should be published just after this post (and is now linked above), as a matter of fact. (As an aside, the temptation to use the simple salutation "Darling", as opposed to something more formal, must be nearly overwhelming.)

The rationale for the letter is today's CPI print in excess of 3%; in excess, for that matter, of every other CPI print since the summer of 1992. Readers of a certain vintage will recall what happened to the UK in that era after a prolonged period of high rates were used to prop up sterling and fight inflation.

Somewhat alarmingly, the old target measure of inflation, RPIX, printed nearly 2% above its erstwhile target of 2.5%. It will be interesting to read Mervyn's letter to a Chancellor who has, in the recent past, suggested that the Bank has room for further rate cuts. A change in target, anyone?

For the time being, the most likely outcome will probably see the BOE adopt the same policy as the Fed: Talk the talk, but try not to actually have to walk the walk.

Monday, June 16, 2008

Ireland's call

It's not often that developments in the political sphere bring a smile to Macro Man's face, but he has to admit that he enjoyed the spectacle of Ireland's rejection of the Lisbon Treaty, which was announced on Friday. Not necessarily because the Treaty is a bad idea; like 99.9999% of other European residents, he's not read the full 277 page document, and so is not able to pass an informed judgement.

But that's just the point; the European political elite has, in every country but Ireland, chosen to jam the Treaty (which fundamentally changes the political structure of the EU) through without a public vote. The Irish, who enjoy the constitutional right to referenda on such matters, answered the call of democracy and rejected the treaty- not necessarily because it was a good idea, but because they could. The rejection has prompted a hail of criticism from the euro elites, prominent among whom is Luxembourg's prime minister Jean-Claude Juncker. In what can only be described as a stunning coincidence, Juncker was in line to fill one of the powerful roles created by the Treaty.

All of which is perhaps a reminder that Europe is as bloated, corrupt, and sclerotic as it was in 2000-2001, when the euro was pummeled in a crisis of confidence. However, the loss of stature of the US, both in terms of its political leadership and its financial markets, has perhaps obscured the warts on the European project for the past few years. Nevertheless, with a change in political leadership around the corner in the United States, might longer term investors take stock of their positions and begin to close some long-standing dollar shorts?

Maybe. What does seem clear is that EUR/USD is approaching some pretty key technical levels, a break of which could spur a nice dollar rally.
However, it's probably premature to get too excited about buying dollars. Last weekend's G8 meeting whiffed in terms of being remotely relevant, and the market is still pricing some pretty punchy expectations for Fed tightening. Some commentators have suggested that if there were going to be a US recession, it would be here already.

Who's to say it isn't? The labour market has deteriorated to a degree that is typically only observed in recessions. Sure, the last unemployment reading may have been distorted by odd factors....but does anyone not think that the birth/death model isn't artificially inflating monthly payroll figures. And sure, recent retail sales figures were better than expected, reading a "whopping" 2.5% y/y gain. Of course, if we deflate it by the CPI (yeah, yeah, I know, there are different things in each basket), we get a comfortably negative volume reading...which we haven;t seen since...er...the aftermath of the last recession.
So for now, Macro Man is content to leave EUR/USD to the mercantilists, spivs, and masochists. Now if only those guys would lave equity markets alone, perhaps there'd be some money to be made this summer!

Friday, June 13, 2008

Kicking and screaming

Another day, another bloodbath. Following on from yesterday's limp close in the S&P 500, Macro Man's screens are a sea of red this morning (USD/JPY excepted, naturally), with yet another bout of capitulative selling in European front ends. Intriguingly, a couple of sell side shops are now expecting the Fed to at least partially validate the tightening that's priced into the Fed funds/OIS markets; given the Fed's predilection for "not disappointing the market", this pricing could well turn into a self-fulfilling prophecy.

And so it seems that the Fed, like many other central banks, may be dragged kicking and screaming into running a tighter monetary policy than the growth data would ordinarily warrant. Well, perhaps not kicking and screaming; some Fed heads, such as Charles Plosser, seem to positively relish the idea of ratcheting up rates. But following on from other CBs such as the ECB, the RBA, and the Bank of Canada, it seems clear that the world's central banks are hiking (or at the very least not easing) not because they want to (i.e., tightening into a cyclical upswing), but because they have to (tightening because of inflation regardless of the cycle.)

And so we come to a rather important datapoint this afternoon, namely US CPI. While yesterday's retail sales figures buoyed confidence, if only temporarily, Macro Man couldn't help but notice that the actual y/y dollar figure only rose 2.5%; this is highly suggestive that sales in volume terms are probably falling. The reason, of course, is rising prices. Now, there's a school of thought that suggests that while food and energy prices may indeed continue to rise in the west, there will actually be disinflation/deflation for many consumer goods, given the lack of labour market pricing power.

This is fairly compelling, given that Western workers' wages are being hit by both a slackening of domestic labour markets and by ongoing competition from lower-cost foreign producers. And this explanation works, as long as one believes that labour is the hegemonic determinant of consumer prices. However, thanks to the higher cost of feeding foreign workers and shipping foreign-made goods to the US, the price of foreign-made manufactured goods is rising sharply; indeed, the inflation rate on imported manufactured goods in May was higher than US headline CPI in April.
So if the price of foreign-made goods is rising, why wouldn't US manufacturers also follow suit? In that vein, Macro Man was interested to hear recently that Ethan Allen, a maker of premium home furnishings, is set to raise prices by 6-8% across the board in July. Given that luxury furniture is the ultimate consumer discretionary and also linked closely with the housing market, Macro Man feels comfortable in concluding that these price hikes are not demand-driven; they simply reflect the marginal cost of making the stuff, which is going up, up, and away.

It would, of course, be reasonably to expect Ethan Allen's sales to be hurt by raising prices in a soggy demand environment (yesterday's retail data notwithstanding.) And that, ultimately, is the crux of the bear argument for financial assets. Like central banks, firms are getting dragged kicking and screaming into doing things that they'd rather not, because they'll either hurt margins or top-line sales.

Macro Man's pet indicator of financial asset returns, the rolling two year typical pension fund local asset portfolio, is still comfortably positive in the US and Europe, and even bounced in May. Compare that to the readings of the last recession/financial crisis, when the two month rolling returns went comfortably negative.

One reason for the uptick last month was the fact that May of 2006 slipped out of the rolling calculation. Not coincidentally, that was the last time that the Fed dropped the hawkish hammer because of inflationary concerns.

Add in a dose of the expected- currency volatility because of an Irish "no" vote on the Lisbon Treaty referendum, or even a sudden bout of relevance from this weekend's G8 meeting- and paper assets continue to look like a dicey proposition.

Thursday, June 12, 2008

When bad hedges happen to good people

It ain't getting any easier, is it? While Macro Man has escaped, if only temporarily, from the House of the Fat Tail (which has a lawn dotted with pink flamingos), he cannot help but think that he's left a number of market colleagues still residing there. Discrete jumps in asset-price volatility, as Macro Man's recent experience can amply demonstrate, are difficult enough to deal with. But when correlations break down as well, the resultant P/L hit can be very unpleasant indeed. This is particularly the case when one's engaged in cross-market hedging of core positions, a strategy that helped nail Lehman Brothers to the wall in their May quarter. There is little more frustrating than an environment when bad hedges happen to good people.

Let's engage in a little though experiment here. Take a stroll with Macro Man down memory lane, all the way back to Thursday of last week. On that day, the S&P 500 closed at 1404, up 2% on the day. USD/JPY closed in New York at 105.94 on the same day. Looking forward, if Macro Man had told you that the S&P 500 would be 70 points lower, where would you have guessed that USD/JPY would be? Probably nowhere near the current spot rate of 107.50! So any equity or EM punters who have sold USD/JPY to hedge their core book of assets (and from what Macro Man can make out, their numbers are legion) have been royally and utterly buggered. Welcome to the House of the Fat Tail, folks!

UPDATE: The two series are labeled incorrectly; the red line in USD/JPY and the blue line is the S&P 500.
Elsewhere, the news just gets worse and worse for the UK. The equity market (where Macro Man retains a short delta) has been submarined by homebuilders and financials; recent comments from retailer extraordinaire Philip Green don't exactly engender a helluva lot of confidence. Macro Man follows an indicator that compares the lagged second derivative of UK unemployment with the BOE base rate. As the chart below shows, this indicator does a pretty good job of anticipating the Bank of England's reaction function. And while inflation (and inflation expectations) remain uncomfortably high, it seems pretty evident that it's "mission accomplished" for the destruction of domestic demand. As Merve the Swerve himself recently observed, there's little that the BOE can do to bring inflation to target in the next twelve months. And dealing with usurious utility companies is a job for Gordon Brown, not Mervyn King. Having resisted the siren call of short sterling (a/k/a "the widowmaker") for the last three months, Macro Man is beginning to wonder if, with rate hikes priced in by year end, it isn't time to have a flutter from the long side.
But Merv may choose to focus on inflation expetations, which have admittedly deterioated markedly. The latest survey shows an uptick to 4.3%, a whopping 100 bp rise since May. Still, that's child's play when compared to the situation in Australia, where expectations rose 0.7% from May to June, to a record 5.9%.

At the same time, unemployment in May rose for the first time in eighteen months. Even in commodity powerhouse Australia, therefore, some form of stagflation appears to be taking hold.
While equities are enjoying a brief respite so far today (and may bounce further on a decent gas-related reading on retail sales), the overall environment appears overwhelmingly negative to Macro Man, so he's happy to retain his short bias.

Wednesday, June 11, 2008

Life in a fat tail

You can never say never in this business. Although it's not a terribly noble thing to admit, many market participants, Macro Man among them, have felt a bit of schadenfreude at the travails of serial turd-buyers, equity quants, and other erstwhile Masters of the Universe who've recently fallen on hard times. As Cassandra has observed on several occasions over the past year or so, the fatal flaw in the business model of these funds has been the systematic overestimation of the market liquidity available for them to exit their positions. The outcome of this miscalculation has been brutal. Those of us observing from the peanut gallery have resolved not to repeat the errors of these hedge fund Icaruses (Icari?) and to concentrate on liquid investments that can "never" share the liquidity characteristics of the likes of, for example, structured credit.

It is thus with great regret that Macro Man is forced to admit that he's been living life in the fat tail on the left side of the return distribution so far this week. You can see him in a recent portrait below. The culprit has, ironically enough, been an instrument that is both exchange-listed and highly liquid (with an aggregate volume yesterday of 4.3 million contracts.) Macro Man refers, of course, to the eurodollar futures contract. What makes the fat-tail phenomenon particularly bemusing is that it's a non-directional curve strategy rather than an outright directional bet. What makes it irritating is that Macro Man identified significant fixed-income distress in this very space on Monday, yet failed to connect the dots to his own position because it was trading resiliently in the European morning.

In any event, he was long a spread, which, for the past month, had traded in a pretty smooth intraday fashion, albeit with a bit more volatility towards the end of last week. The chart below shows the intraday price movements in the four weeks ending last Friday.
Now look at the chart below, which includes the intraday price action so far this week. Ouch! The arrow indicates where the spread was when Macro Man received his 1.15 am phone call early on Tuesday morning. When he picked his jaw up off the floor and checked the contract table on Bloomberg, he observed that one of the contracts in his spread had traded exactly one lot over night. When he asked his Singapore futures broker for a price in the spread, he was made 12 ticks wide in 100. Hint: his position was considerably larger than 100 contracts.
For the first time, he felt that same pit in his stomach that the turd buyers and equity quants have felt intermitedly over the past year. And all for a spread in the most liquid futures series in the world!

The ultimate outcome, while highly unpleasant, has fortunately not been crippling. After incurring a 2.4 standard deviation loss on this position on Monday, Macro Man was forced to eat a 4.8 standard deviation loss on Tuesday. It didn't feel good, he can assure you.

Fortunately, this strategy was only a modest piece of what is a reasonably diversified book. And while yesterday's P/L report was not pleasant, happily Macro Man is still up on the month and year, albeit only modestly.

As for the offending eurodollar trade, he still believes in the rationale for it. However, if we're living in a world where a simple curve trade can be 25 ticks offside at 1.15 in the morning, position sizes need to be cut or optionalized. Fortunately, Macro Man was able to steel himself yesterday and reduce his curve trade 13-14 ticks from the low once liquidity improved in London and New York.

Having experienced life in the fat tail this week, Macro Man can report to you that it ain't pleasant, and he doesn't want to go back there any time soon. Still, it's important to always look on the bright side of life, and there's been a happy side effect to this week's trauma: Macro Man set personal bests at the gym on Monday and Tuesday while working off the stress of his positions. Perhaps European footballers should consider a p.a. investment in US subprime mortgages over the next few weeks....

Tuesday, June 10, 2008

Red Eye

One of the perils of macro trading is that markets move 24 hours a day, and newsworthy events are not confined to the normal trading day in any particular time zone. When market-moving events occur in the middle of the night, one occasionally (or, depending on one's proclivities, nightly) receives a phone call to say that something's going on. Macro Man generally tries to manage his book in a way that minimizes the need for late night phone calls and trading, but on occasion such outcomes are unavoidable.

Such was the case last night, when Ben Bernanke brought his own version of Hammer time to financial markets. The impact was instantaneous, especially in fixed income, with both directional and RV strategies gapping on virtually no liquidity. Such environments are not exactly conducive to going quickly back to sleep, and in retrospect Macro Man feels like the picture above left- like a rabbit caught in the headlights, with a case of red eye to boot.

There's not much you can do except sell what you can, a strategy apparently pursued by more (and bigger) punters than Macro Man. As noted yesterday, the moves in some of these short term interest rate contracts are historic, and has led to such perverse situations as the following:

*Between Thursday's close and Monday's close, December short sterling fell 34 bps

* Between Thursday's close and Monday's close, 94.50 calls on that Dec short sterling calls were unchanged in value.

Ay caramba! The rise in implied vol completely offset the delta loss of the option. That, Macro Man would suggest, is a market that is close to ungameable.

And that, ultimately, is a decision that each of us have to make. What is cheaper: the opportunity cost of missing a "lay up" trade at current levels, or the actual cost of putting on the lay up trade, misjudging your market liquidity, and losing more money than you thought possible?

Given that Macro Man already accomplished the latter on certain positions this week (thankfully, at least partially offset by other, more successful trades) , he's happy to opt for the former.


And make no mistake- market pricing is currently pretty aggressive. The market is now pricing in more than 2 Fed rate hikes by the end of the year; this time last week, 14 bps were priced. The one week shift in the Fed funds curve, pictured below, has been substantial.Somewhat amusingly, Macro Man's good buddies the Russkies have chosen this moment of maximum market distress/minimum market risk appetite to finally allow the rouble to strengthen. In what appears to be a reval of the currency, the RUB has broken through the erstwhile support of its 55c US/ 45c EUR basket.
These markets are hard enough as it is. But when the world's third largest holder of FX reserves is actively trying to screw you over, Macro Man has to believe that he's not the only macro man suffering from a bit of red eye this morning

Monday, June 09, 2008

Make no mistake

There is something very, very wrong with financial markets at the moment. Cash 2-10 yield curves don't make 18 bp round trips in a single day...but the one in Europe has. The carnage in strips, particularly the reds, is unprecedented. In looking for historical parallels, the market has perhaps erred in gazing at 1987; it seems that 1998 is the more apt comparison (with the small proviso that markets are MUCH more leveraged now.)

If the day ends in y

Well, that was an enjoyable weekend respite, wan't it? Wonderful warm, sunny weather, which suited Macro Man down to a T, as he had sole charge of the Macro Boys for the weekend. After a week of the sturm und drang of financial markets, it was refreshing to deal the calmness and rationality of two children with the combined age of 11.

However, it's once more unto the breach this morning, and after Friday evening's equity market meltdown, the market's exhibiting signs of extreme dislocation again today. The theme of 2008 seems to be that if the day ends in y, somebody, somewhere is blowing up.

Today's carnage comes courtesy of European fixed income markets. Obviously, the short end received a rather rude jolt from the ECB on Thursday, but at least a recalibration of the very front end of the yield curve makes rational sense. It's hard to conjure a fundamental explanation why Trichet's hawkishness should have prompted a massive rally at the back end of the European curve, but that's exactly what's happened. German 30 year yields have collapsed 30 bps in 2 days, a remarkable move in any context (US 30's have had a 2 day, 30bp move exactly once in the last dozen years), but particularly when the central bank surprises hawkishly.
What we're seeing is a complete and utter meltdown in fixed income exotic structures. These structures entail payouts depending on the shape of yield curves, and are extremely popular in Europe. Typically, the holder of the structure will earn a payout if yield curves are above a certain level x, but nothing if below. Against this, they may a floating rate such as LIBOR/Euribor.

Against this, the issuing bank will have curve steepeners on as a hedge. The problem arises when the curve flattens/inverts; not only does the holder of the structure lose money, but the issuing bank must take off some of its steepening hedges. All of this is fine for the bank in a marketplace offering a continuous liquidity spectrum. However, these banks are short gap risk and can find themselves badly offside if curves flatten (i.e., intensify their inversion) without and de-hedging activities taking place.
Such is the case at the moment, where the euro 2-10 swap curve has flattened 50 bps in 3 days, a move that has not been reciprocated in other major markets. This bodes ill for European financials, and Macro Man is frankly surprised to see European equities only slightly in the red this morning. He's responded by adding to shorts there.

Among the biggest perpetrators are French banks, so perhaps M. Sarkozy will legislate that every day should be Sunday (the only day of the French week that does not end in "i"); for the time being, however, anyone involved in the European exotics market is surely humming the Boomtown Rats this morning.

Saturday, June 07, 2008

The ECB's Vicious Circle

Friday, June 06, 2008

Trichet's message to Euribor longs

Stop! Hammer Time

Man oh man. Just when you think things can't any weirder, they turn around and do so. Yesterday saw ECB president Jean-Claude Trichet provide further evidence of his affection for late 80's hip-hop music. For having noted that consumer price inflation was likely to perform the Humpty Dance earlier in the year, JCT switched tack yesterday and in his monthly press conference said "Stop! Hammer time!"

For what else can you call promising to re-embark on a tightening cycle, possibly as early as next month, into a slowing economy? "Hammer time" is also a pretty good description of action in European fixed income, particularly at the front end, over the past 24 hours. Euribor has been crushed (check out December Euribor below), dragging short sterling, eurodollars, euroswiss, and many a punter's P/L with it. Eurostoxx sold off a bit yesterday, but today have roared back to trade at pre-Trichet levels.
And what, pray tell, can be more bullish for equities than a central bank forced to tighten into a slowing economy by inflation? Judging by yesterday's evidence, having your credit rating dropped by the ratings agencies, and both Ambac and MBIA rallied after S&P lowered their financial strength ratings.

No doubt job losses of "only" 30k or so in today's payroll report will be taken as a further cue to buy stocks. Clearly, yesterday's chain store sales report was uber-bullish; at +3% y/y, they were only down 1% y/y in volume terms! And the impact of the stimulus checks is clearly beginning to boost spending growth: just check out the recent 12 week surge in those chain store sales!

And hey- what could be more bullish for the economy and equities than a y/y decline in household wealth? Just look at how great is was to own equities during previous periods of wealth contraction, such as 2001-2002 and 1974!
But hey- at least the low level of interest rates is helping the economy to resuscitate. Hey, the housing market's gonna revive any day now....and mortgage refis can only go one baby, and that's up!
Yeah, Macro Man's a bit confused and, frankly, bitter at the resilience of equities. A little "f*** you" transactional friction hasn't helped, either. Judging from a couple of the comments yesterday, Macro Man is not along in his short-equity pain. And perhaps that's the real story here...markets are still trading off of positioning.

Because everything else that Macro Man looks at with respect to equities, including Mr. Trichet yesterday, screams "U can't touch this."