Sunday, August 31, 2008

Blast from the past

Due to family circumstances, Macro Man will be away from the market and out of touch for most of the day on Monday. It's fortunate that he is running little risk, as the low liquidity environment of Labor Day and the uncertainty surrounding Hurricane Gustav will likely make for treacherous trading conditions.

Those readers (particularly relative newcomers to this space) looking for a bit of diversion from the day's trading may wish to peruse some of Macro Man's favourite posts from yesteryear, most of which are not particularly time-sensitive:

* A Remedial Lesson in Statistics: how much "signal" is there in traders' returns?

* Cornflakes Without the Milk: on the importance of dividends

* A Ratings Agency Toolkit: an insight into how ratings agencies arrived at some of their decisions

* Some Unique Factors for Your Next Quant Strategy: making models better...or not

* The Three Axioms of Globalization

* Does the Fed's dual mandate spell doom for the dollar ? On the currency perils of going for growth

And for those of a more literary bent:

* The Curious Case of the Vanishing Bid, parts I and II: Sherlock Holmes investigates the world of risky assets

* Financial Nursery Rhymes

* Macro Man channels Shakespeare

* And again

* Other forays into financial poetry

Macro Man will return on Tuesday.

Friday, August 29, 2008

Quiet Riot

"Come on feel the noize"
-Quiet Riot, covering Slade

OK, let's take stock of a few things that we know:

1) It's the last day of the month, with the concomitant fixing/rebalancing flows from non-directional players

2) It's the week after the UK bank holiday and the Friday before Labor Day

3) There are rumblings of exotics flows going through the European fixed income market of the kind that provided so much joy in June

4) Sensationalist stories are circulating that the Chekist Republic will cease oil shipments to Western Europe; in any event, the saga in Georgia rumbles on, with Turkey somehow getting sucked into the fray

Suffice to say that market liquidity is "subnormal" and that the noise-to-signal ratio is nearly infinite. Given the low levels of staffing and interest today, price action is perhaps best described as a "quiet riot".

These sorts of markets are not Macro Man's forte, and he's reduced risk to the extent that he's now carrying almost as much VAR risk on his left hand (via his wedding ring) than he is in his book. A slight exaggeration, perhaps...but not much.

How bad is it? Consider one of Macro Man's recent trades. On August 21, with USD/JPY at 108.32 and seemingly headed to zero (having been nearly 2 yen higher the previous day), Macro Man took a tactical bet that it might mean-revert, and bought an August 28 expiry 109.50 $ call for relative peanuts. Less than 24 hours, spot was through his strike.

Thus ensued a week's worth of furious gamma trading, with Macro Man selling USD/JPY spot above his 109.50 strike and buying it back below. It's a measure of how noisy the market has been that he managed to execute 17 (!) different gamma trades in the span of five days. Part of this total is down to his style of doing multiple small clips rather than one large one. but still; spot crossed through strike every single day after he bought the option.

Now, this particular trade was a successful one; Macro Man made three and a half times as much scalping as he spent on the option. But still; it's noise trading to the very edge of reason, and the return for all the attention and trading was, at the end of the day, pretty modest.

And to be honest, Macro Man doesn't enjoy it very much. Far better to wait for the dust settle, the smoke to clear, and for macro themes to re-assert themselves.

Thursday, August 28, 2008

Anecdotal evidence

Punters who have been around the block more than once or twice know that relying on anecdotal evidence can be fraught with peril. Taking an incomplete dataset and attempting to extrapolate a larger picture is a difficult skill; such forecasts can go badly awry, as the (now discredited) 19th century dinosaur sculptures in London's Crystal Palace attest. The figures to the left were paleontologists' best guess at what an iguanodon looked like in 1850, based on an incomplete fossil record. They look nothing like the modern conception of the beast.

Still, anecdotal evidence is not totally without utility. While the UK press is busy trumpeting that the economy is indeed well and truly buggered, Macro Man could have arrived at the same conclusion on the basis of some of his anecdotal observations. He went out to dinner on Saturday evening at his local French restaurant, which is a nice enough place and, depending on the quality and quantity of the wine consumed, can run anywhere from £40 to £120 per head.

While it's normally not terribly difficult to get a reservation with a few days' notice, the place is usually packed. Saturday night, however, the place was half empty....and most of those diners who were there appeared to be past retirement age. Moreover, the place cleared out unusually early; by 11 pm Macro Man's foursome were the only people left. Now, perhaps the mass exodus is reflective of the noise coming from Macro Man's table; then again, maybe it also reflects a perception that it's cheaper (and therefore better) to enjoy a whiskey at home rather than lingering over one final digestif.

More telling (and more irritating) is the proliferation of caffeine addicts who've taken to paying for their morning cup of Joe at Starbucks with a credit card. In the UK, Starbucks is set up as a primarily cash and carry business. At Macro Man's local 'bucks, it takes literally five minutes for the staff to process a credit card transaction; at they same time, they show a singular inability to process other customers' orders while waiting for the card transaction to go through. It's gotten to the point where Macro Man does an about face out of the store whenever he sees anyone in the queue with a credit card in their hand. Over the past few months, this has become an increasingly frequent occurrence. What does it say about the state of the UK consumer if they don't have the cash for a cup of bleeding coffee (no matter how overpriced)?

While the official retail sales data has been fairly erratic, the survey data (itself anecdotal!) has been unequivocally negative. The CBI Distributive Trade Survey has collapsed over the past few months to levels normally consistent with flat/negative real sales growth. This backs up Macro Man's anecdotal impressions and suggests that the domestically generated inflation pressures in the UK are dwindling fast, with the obvious exception of the supply-side "Rip Off Britain" energy sector. Sterling has been notably weak over the past few days; ultimately, however, it might take a capitulation from Swervin' Mervyn for the move to extend.

UPDATE: Ten minutes after publication, the August CBI survey was released, with a reading of -46: the worst since the survey began in 1983.

Elsewhere, there's an interesting article in today's Nikkei newspaper suggesting that the G7 had a plan in place to intervene on the dollar's behalf in the wake of the Bear Stearns collapse in March. Of course, the dollar stabilized on its own accord and has recently recouped all of its Q1 losses, at least as measured by the DXY.
Ultimately, however, it must be at least a tiny positive for the dollar that we have reached the point where policymakers are no longer willing to see it get clubbed willy-nilly. It's obviously no reason to buy dollars here and now, but does strengthen Macro Man's conviction that for this cycle at least, the bottom is in for the buck.

Wednesday, August 27, 2008

Market Monopoly

With the Olympics and the summer drawing to a close, it's now time for market participants to get themselves back from the beach, turn off the TV, and focus on making money for the four-and-bit months that remain of 2008. Yet the Olympic spirit lives on, and many of us would love to channel our inner Usain Bolt or Michael Phelps.

Indeed, over the course of his career Macro Man has met many market people who are just as competitive as Bolt, Phelps, or Tiger Woods, for that matter. Sadly, while the mind is willing, the flesh is all too often weak (in this case, literally.) How, then, can desk-driving market people bring out the Olympian that lurks within us all and keep the competitive fires burning?

Macro Man has hit upon the answer: Monopoly. The game requires no discernible athletic ability and is predicated upon acquiring assets as cheaply as possible, levering them up, and separating other players from their cash. It's a skill set with which many (but by no means all) market punters are well-acquainted.

Of course, in Monopoly, as in life, chance can play a significant role in determining winners and losers. In real life, these slings and arrows of outrageous fortune can come from anywhere, but in Monopoly they derive from the dice and the Chance/Community Chest cards. Come to think of it, it looks like the game of Market Monopoly has already started, because some of the cards have already been drawn. Consider who's already holding the following (vintage) Monopoly cards:

ADIA, CIC, and Temasek holdings. These SWFs already own very significant stakes in a number of banks in the US and Europe, in many cases via high-yielding preferred shares. Though it may be a case of thrice bitten, four times shy, Macro Man can't help but think that at the end of the dilutive capital-raising process, these guys will be the only ones left with enough equity to get paid any meaningful dividend income.

Counterparties of Merrill Lynch and Lehman Brothers
in the structured credit space appear to have quite a few of these cards up their sleeve.

Holders of 2007 vintage AA-rated ABX. Unfortunately, to collect the prize, they have to tender $100 of face. (Since this vintage card was printed, prices have fallen further. In the modern editions of Monopoly, second prize winners only get $10.)

John Thain. Mr. Thain's tenure at the helm of Merrill Lynch has been characterized by three things: large write-downs, a fire sale of assets to clean up the balance sheet, and Merrill itself providing the funding to the buyers in the aforementioned fire sale. Alternatively, this card could represent Merrill's settlement of its part of the auction rate securities fiasco.

Give this one to Macro Man, as he still can't get rid of this %*&£ing cold.

Trustafarians. With the UK mortgage market imploding and the bid from City whiz kids a thing of the past, trust fund babies represent the only remaining source of demand for £2 million London properties, which are too expensive for ordinary people and too small for any self-respecting sheikh or kleptocrat.

Mrs. Watanabe. Not that long ago, flow in the Tokyo foreign exchange market was dominated by Japanese life insurance companies, whose investment and hedging patterns drove price action in the yen. All available evidence suggests that Mrs. Watanabe and other Japanese housewives have cashed in their insurance policies and used the proceeds to buy NZD/JPY on

Actually, this card appears to have been lost; it doesn't look like anyone's getting paid off on real estate investments these days.

Warren Buffet. The Oracle of Omaha's foray into Burlington Northern last year made headlines, with some analysts wondering what Berkshire Hathaway could see in the apparently unexciting railroad business. So far this year, the Dow Transport Index is up 9.1% despite the sluggish economy and the credit crisis. Warren's already passed "Go" a few times on this one- BNI's up 24% y-t-d.

Freddie Mac shareholders who started the year with $375 worth of stock and finally sold it at yesterday's close. In a few months, Parker Brothers will re-issue this card as "Your Agency debt is bailed out. Collect $100."

Hedge fund managers with kids in Manhattan and central London. Credit crisis? Bear market? Recession? Tell that to the proprietors of private schools, who inhabit The Land of Eternal Inflation. The card, of course, is a misprint; it should say "fees" instead of "tax", and there seems to be a "k" missing....

Residents of New York state,
who will no doubt be taxed to spruce up the public infrastructure before the state government flogs it off to the highest bidder.

The American taxpayer.
Unfortunately, after the forthcoming GSE bailout, there won't be much money left over for the next stimulus package.

Investment bank employees, many of whom get paid their annual bonuses around Christmas time. This year, most have little prospect of getting paid much more than $100 in cash unless there really is a Santa Claus.

Anyone who turns state's evidence in the orgy of prosecution and litigation that is inevitable outcome of the subprime crisis. Predatory brokers? Fraudulent borrowers? Conflicted ratings agencies? Corrupt mortgage lenders? All are angling for one of these cards. Those who don't manage to get one will be left with the card below.

Too many to list. Apparently, Parker Brothers has enlisted the US mint to help expedite the printing of these cards, which will be allocated to all of the aforementioned crooks who don't manage to snag a Get Out of Jail Free Card. Readers should feel welcome to supply their own nominees, or indeed suggestions for who's drawn some of the other Monopoly cards.

Tuesday, August 26, 2008

Does moral hazard apply to SWFs?

Here's a question for you: should concerns about moral hazard apply to central bank reserve managers and sovereign wealth funds? The question arises after recent comments from Yu Yongding, a former advisor to PBOC, suggesting that a failure to redeem GSE debt at par would be "catastrophic". Implicit in the comment was the threat "give us our money back or else."

Now, the last time that Macro Man checked, no one stood with a gun to PBOC's head and told them to buy $50 billion a month to keep the RMB artificially weak. (He is willing to concede that Hu Jintao may well have done so, but it's not quite the same as Hank Paulson standing there with his finger on the trigger.) Similarly, Macro Man is not aware of any irresistible force that compelled Voldemort to buy Agency debt, thereby collecting the "free" yield premium over Treasuries.

Yet here we are, with Fannie and Freddie on the ropes, and comments from Mr. Yu that sound like nothing so much as Paulie from Goodfellas: **** you, give me my money.

As a US taxpayer, Macro Man is thrilled with the notion of bailing out the GSEs so that serial currency manipulators can be fully compensated for their nefarious activities. (As an aside, can any readers confirm or deny weather foreign CBs pay US income tax on the Treasury and Agency debt that the Fed holds in custody for them?) This is particularly the case given that the disruptive activities of PBOC, CBR, etc. in private-sector currency markets make it more difficult to earn the money which generates his tax bill...which now will, apparently, be spent to compensate these self-same serial piss-takers.

Policymakers the world round have been quite keen to tell those of us in the private sector that we must reap what we have sown (even if, ultimately, bail-outs are inevitable in the name of "avoiding systemic risk"); do they have the cojones to say the same thing to their official counterparts?

Elsewhere, yesterday's little ditty proved to be prophetic, as the latest dismal print from the German ifo survey has prompted the latest bout of dollar strength, taking the buck to new highs for the year against the AUD and GBP, and new trend highs against the euro.

Whether this can be maintained in the near-term remains to be seen, of course; at the risk of missing the forest for the trees, Macro Man is retaining a fairly nimble investment posture until he starts seeing things a bit more clearly.

Monday, August 25, 2008

Bank Holiday Poem: The Dollar

(With apologies to William Blake)

Dollar! Dollar! burning bright
In the markets of the night
What subtle hand has bolstered thee
And caused the woeful buck's rally?

In what distant deep or land
Dwells the invisible hand?
Or as Europe sinks in the mire
Have euros been thrown in the fire?

Was it the ifo? GDP?
That caused the euro bulls to see?
Or was it oil? The fall of gold,
That turned the dollar bear trend old?

Who's the hammer? Make it plain,
Behind the rally, who's the brain?
Or is it just the P & L
Of the market, gone to hell?

When the market ran the stops,
And turned the dollar bears to flops,
Did the dollar start to smile,
To see itself now back in style?

Dollar! Dollar! burning bright
In the markets of the night
What subtle hand has bolstered thee
And caused the woeful buck's rally?

Friday, August 22, 2008

Dropping the Baton

The second law of thermodynamics states that entropy always increases. Put another way, "things change." How one reacts to changing environments can often make the difference between long-term success and failure.

Yesterday's Olympic relay action clearly demonstrated the dangers of taking a cavalier approach to changing circumstances. The abject failure of the US 4 x 100 relay teams (and indeed, the GB men's team) to manage the passing of the baton as leg-runners changed provides an object lesson in the importance of managing change well.

From Macro Man's perspective, the tone of the markets that he trades has changed markedly over the last couple of weeks. In contrast to the equity market crack addicts, he actually had a pretty reasonable run in July and the first week of August. Midway through his holidays, however, the tone of the market appeared to change, and he found it increasingly difficult to make money even where he was "right."

To Macro Man, this represented a change in market environment from one in which he was well rewarded for being right to one in which he was badly punished for being wrong. The way that he manages money is alter his style when the market tone changes; by dialing down the risk level and trading more tactically when things get difficult, he tries to avoid dropping the baton and giving P/L back too cheaply. And frankly, after a stressful holiday, dialing things down gives him a valuable mental respite.

Another set of people who need to focus on not dropping the baton are the world's central bankers. The Fed gathers for its annual brainstorming session at Jackson Hole today, and you'd have to think that they'll give quite a bit to thought on how to navigate between the central banking Scylla and Charybdis of higher energy prices and lower growth.

Not that the Fed is alone, of course; most other major central banks face a similar dilemma. Q2 growth in the UK, for example, was revised down to zero today, yet headline inflation is at fifteen year highs. Recent comments from the ECB suggest that they don't see much risk of a European recession, which leads Macro Man to wonder if they're bothering to look. Certainly the ECB officials from the PIGS can see the risk by simply looking out their front windows.

Yet the appropriate monetary action isn't clear. Bernanke has found to his chagrin that the Greenspan model of slashing rates willy-nilly carries substantial negative externalities. Yet it's not altogether clear that the European "financial Calvinist" approach is markedly superior. It wouldn't be a surprise to see Mervyn King start wearing a toga, as he resembles nothing so much as Nero fiddling while Rome burns.

The ECB, meanwhile, delivers a monthly lecture on the perils of second-round effects while appearing oblivious of the possible negative externalities from their own hawkish rhetoric. What's ironic is that despite the rise in European headline inflation, domestically-generated inflation pressures have been remarkably stable. The chart below shows the GDP deflator for a number of economies; observe how the European measure has flatlined for the better part of five years around the ECB inflation target of 2%.

Should the European economy continue to lose momentum, as seems likely, these domestically-generated inflation pressures should eventually recede, as they have in the United States. A monomaniacal focus on headline CPI from the ECB will, in the fullness of time, unnecessarily reduce the living standards of those 320 million Europeans whose interests M. Trichet claims to hold close to heart.

Whether the ECB can manage the transition from expansion to stagnation without dropping the baton will be a critical driver of financial market pricing over the next few quarters if not years.

If any HTML-savvy readers know how to get rid of the large left hand margin that's somehow appeared, please drop Macro Man a line or provide instructions in the comments section.

Thursday, August 21, 2008

Saving the Financials

Plus ca change, plus c'est la meme chose. Given the ongoing travails of the financials, particularly the Agencies, it's tempting to simply re-issue this post from early last month. However, there are a few fresh developments in the never-ending saga of financial institution distress that merit comment.

Most notable of these is the Fed's decision to import monetary policy from China, which in some ways is a welcome change from standard operating procedure. Although the PBOC has hitched its wagon to the Federal Reserve in terms of setting the level of the Chinese currency and interest rates, regular China watchers will know that credit there is allocated largely by administrative diktat rather than supply and demand.

Apparently, the Fed has adopted the same model, at least if the Wall Street Journal is to be believed. That the Fed has given CS a "nudge, nudge, wink wink" hint that they should continue to trade with Lehman isn't particularly surprising, and in many ways is justified as a pragmatic measure to avoid systemic risk.

But it seems fairly obvious that some well-known financial institutions that currently exist will, at some point in the not too distant future, cease to do so, at least in their current guise. One would hope that there are more comprehensive policy prescriptions in place than "gee, it would really be swell if you didn't pull their line" moral suasion should such an outcome arise. On current form, however, there don't appear to be any.

In that vein, your humble scribe is pleased to offer the "Macro Man Plan to Ensure That People Keep Trading With Institution X". While some of his suggestions may seem outlandish, please bear in mind that his recent modest proposal to reduce the US government funding gap appears to have resonated with the Governor of New York.

At the heart of the Macro Man Plan is that financial institutions adopt the incentive programs offered by other service industries such as retailers and minor league baseball. To encourage ongoing business relationships, banks and agencies (and maybe even the odd hedge fund or two) should offer the following suite of incentives to potential counterparties:

1) Loyalty cards. In a scheme familiar to supermarket shoppers around the world, counterparties would be issued with loyalty cards and accrue bonus points for each transaction that they conduct. Once certain thresholds are reached, these could be redeemed for goods at the bank's affiliate partners, such as Amazon, Tesco, Wal-Mart, etc. In exchange, these latter firms would receive free investment banking advice.

2) Buy one, get one free! Lehman, Merrill, Fannie and Freddie: maybe you could sell more (or, more to the point, any) of your RMBS portfolio if you offered potential counterparties a "buy one, get one free" deal. Think about it......

3) Free oil! For every ticket that generates more than $250k worth of VAR, offer counterparties one free barrel of oil. When your £170,000 sports car only gets 11 mpg, every little helps....

4) A free T-shirt with every ticket! Every time you trade with bank X, they send you a free T-shirt! In fairness, this would really only appeal to very junior traders fresh out of university, but hey; we at Macro Man Industries want to cover every demographic.

5) 1000 free shares of stock with every trade! Every time you trade with Bank X, they'll give you 1000 shares of their stock absolutely free! You win by getting free stock, they win because the infinitesimal revenue that they book from each trade will labeled as "new capital" on the balance sheet, and they can announce to the world that they have raised yet more capital from eager investors. Of course, if the stock price goes down, then you incur a mark-to-market loss. On second thought, maybe they should offer free puts on 1000 shares with every ticket....

Elsewhere, a brief follow-up to yesterday's post. One of the things that Macro Man does in his real job is to run indicators that attempt to determine which fundamental themes are driving currencies at any point in time (don't ask, he's not going to be more specific than that.) And what's interesting about the recent dollar move is that none of the fundamental themes that traditionally drive exchange rates has been in play during this dollar move.

This morning he quantified this into a combined "thematic strength" indicator, wherein a high reading indicates that currency markets are trading very thematically, and a low reading suggests that so-called fundamentals are not driving FX.

And what we can observe is that this is the least thematic market since the summer of 2003. It appears to have been micro (idiosyncratic decisions and/or momentum), rather than macro, that has driven the recent dollar rally. So if you've struggled to understand why the buck is up, don't worry; it's taken a lot of people by surprise.

Wednesday, August 20, 2008

Buck Up

Macro Man has finally breached the critical "feeling 80% of his best" threshold and is at long last back in the office for the first time since the first day of the month. Much has obviously changed since he last sat at his desk, not least the look of this very site. Feedback on the new template is welcomed; in addition to a slightly more polished look, it also includes a couple of new features such as the ability to search previous posts, which may prove useful.

In terms of markets, the most obvious change over the past three weeks has been the stunning rally in the US dollar. While Macro Man has previously noted that his anticipated three themes for August were in some ways correct, he will readily concede that he did not foresee the dollar's reversal of fortune.

Now that it's occurred, of course, the two obvious questions are 1) Why has it happened, and 2) What happens next? Macro Man intends to sketch out his initial thoughts below.


While an exclusive focus on post-hoc explanation can be misplaced, Macro Man is a firm believer in the concept that you have to understand what you have seen before you can forecast what you're going to see. In that vein, Macro Man understands the dollar's rally as a confluence of five different factors:

a) Re-coupling. Over the past few months, Macro Man has been operating under an extremely useful analytical framework when it comes to analyzing currency markets. Put most simply, the market rewards those countries where the authorities are focused on fighting inflation, and punishes those currencies where the authorities are more focused on growth. Exhibit A in this regard is of course the US dollar, where Macro Man turned structurally and aggressively bearish nearly a year ago immediately after the Fed started cutting interest rates.

So what's changed, then? A couple of things. Of the popular major-currency alternatives to the dollar, some, such as New Zealand, have already begun to cut rates. Others, such as the UK, have strongly hinted that the prior easing cycle may start up once again. The RBA in Australia has surprised markets by also strongly hinting at imminent rate cuts. And while the ECB has not offered much hope for near-term rate cuts, by the same token they've at least toned down the rhetoric on the prospect for further hikes.

Moreover, the economic cycle in Europe is clearly weakening, and it seems clear that nominal GDP growth in Europe will soon dip below the policy rate for the first time in more than a decade. While the ECB can talk as tough as it likes, it seems increasingly obvious that at some point they will have to capitulate.
This de-rating of the alternatives to the dollar has, it seems to Macro Man, played no small part in bolstering the dollar's fortunes.

b) Commodity feedback loop. For a number of months now, Macro Man has held the unorthodox view that ECB tightening was exacerbating global inflationary pressures by applying pressure on the dollar, thus boosting commodity prices via the invoice currency effect.

Whether this view is correct or not is to some extent irrelevant; what does seem clear is that commodity prices and the dollar had become entangled into the same trade. Thus, when oil started to move lower thanks to lower global demand, an inventory boost, technical selling, etc., this provided a boost to the dollar. Oil traders, seeing the dollar rally, then dumped more oil (and gold traders dumped gold), encouraging a further dollar rally.

Structural commodity longs have, according to the market intelligence that Macro Man has received, bought USD in the currency market as a hedge. What there can be no dispute of, however, is that currency people have pointed at commodities as a reason to buy dollars, and commodity people have pointed at the dollar as a reason to sell oil/gold, etc. Certainly Macro Man has witnessed an amusing repartee on Bloomberg chat between FX and commodity salespeople from the same bank, with each pointing at price action in the other's market as a rationale for movement in their own bailiwick.
As the vicious commodity/dollar cycle turned virtuous, the dollar benefited.

c) Hedging by long-term structural shorts. For the past few years, US investors in foreign markets have had the ultimate free lunch. Not only has topline nominal GDP growth in the rest of the world exceeded that of the US (thereby implying higher local currency asset market returns), but the dollar has weakened substantially as well. Whichever way you looked, these investments have been winners.

However, with growth in the rest of the world slowing and formerly bulletproof markets showing signs of mortality (Bovespa, anyone?), two things have happened. Assets in dedicated non-US funds have started to cash in. This is very imperfectly proxied in the graph below, which charts shares outstanding in the MSCI Emerging Markets ETF available to US investors (Macro Man held it in his personal account until late last year.)
As you can see, there were quite substantial redemptions during the period of equity market weakness from May-July. Although inflows recovered along with stock prices, they never matched previous highs, and recently they have turned south again.

Perhaps more importantly, however, long-term US holders of foreign assets, particularly assets in the rest of the developed world, have realized that they now have an opportunity to lock in extremely attractive exchange rates. While this will not mitigate against declines in the local currency values of foreign assets, it at least provides protection against being shot with both barrels (e.g., a fall in the local currency value of an asset AND a decline in the value of the local currency against the base currency.)

Shortly before he went on his holidays, Macro Man had begun to hear rumblings of "long term real money selling euros that they've held for five years." Subsequently he has heard from a number of counterparties that this flow continued and indeed accelerated during his absence. This type of flow provided support for the dollar at overvalued levels in 2001 and early 2002; with the dollar now undervalued against many currencies, small wonder that it is helping spur a recovery.

d) CTAs awaken. Benjamin Franklin famously said that nothing is certain but death and taxes. Allow Macro Man to add a third item to that list. If a financial asset, particularly a currency, moves far enough, fast enough, trend following models will kick in and exacerbate the trend. The chart below shows the EUR/USD exchange rate with Bollinger bands, which are basically standard deviation intervals around a moving average.

Of particular interest here is the middle section of the chart, which shows the band width. Observe how it spent a number of months at a relatively low level. In this sort of environment, many trend following models switch off, as a narrow band width suggests mean-reverting rather than trending markets. However, the sharp rise in the band width over the last few weeks will have re-ignited these models, who would then have sold EUR/USD with gusto, thus helping the dollar to strengthen.
Indeed, Macro Man has had this experience with his own trend following model, which doesn't use Bollinger bands at all.

e) Addition by subtraction: FX reserve managers find something better to do. Longtime readers will know of Macro Man's firm belief that reserve accumulation shenanigans by a number of emerging market countries (China, India, Russia, the Middle East) has exerted a substantial upward influence on the EUR/USD exchange rate.

Recently, however, the piss-taking activities of many of these countries has waned and even reversed as they have reaped the inflationary harvest sown by their serial local currency selling. Indeed, a number of countries have seen their currencies weaken to the extent that they are even selling reserves into the market. All else being equal, this would imply a need to buy USD against other developed market currencies to maintain portfolio benchmarks.
As Brad Setser would tell you, not else is necessarily equal; a decline in the EUR/USD rate reduces the need to sell EUR/USD via the valuation effect. Still, it is fair to say that the CBs have been refreshingly absent from the G10 foreign exchange market recently; call it addition by subtraction.


Ah, the million (billion? trillion?) dollar question. At this juncture the list of what Macro Man does not know is substantially larger than the list of what he does, which naturally reduces his confidence in any of the conclusions that he may reach. A useful starting point may be to consider how durable some of the above-mentioned factors may be. Very briefly:

a) Re-coupling. From Macro Man's perch, this set looks to continue, at least within the developed market. It's therefore likely to remain dollar-positive moving forwards.

b) Commodity feedback loop. This could fall out either way. If China cranks up the factories after the Olympics and/or hurricane season is a bad one, oil could be back above $130/bbl before you can say "Sell my SUV." By the same token, if the weather is a non-event and Chinese industrial activity continues to decelerate, we could easily threaten or perhaps breach $100. Confidence is low on this one, but for choice Macro Man would suggest that from here commodities are more likely to be a dollar negative than a positive.

c) Hedging/repatriation. In many ways this is a similar phenomenon to item a), and it therefore seems reasonable to expect it to continue to support the dollar.

d) CTAs. A bridge made of balsa wood provides more enduring support than these chaps.

e) CBs. Macro Man's best guess: they return to market (after all, most of these guys are still running tasty current account surpluses), but with a lower profile moving forward than they've had in the past. The acid test here will be Q4 of this year; for most of this decade, CBs have been very vigorous dollar sellers against G10 in the fourth quarter of the year.

Adding it all up, Macro Man arrives at the conclusion that the buck is likely to be more stable in the future than it has been in the past. He would be very, very surprised if we revisit the dollar's lows against the rest of G10 during this cycle.

A useful historical analogue is USD/JPY in the mid 1990's, which was a seminal event in framing Macro Man's understanding of long-term currency cycles. As readers may or may not recall, the early 1990's saw USD/JPY drop steadily from 160 to 100 by late 1994, and then collapse to 80 in the spring of 1995. After jiggling around the low 80's for a few months, in the summer of 1995 it then surged back to 100 as quickly as it had fallen, which history eventually showed was the initial phase of a new dollar bull trend.

The reversal of fortune in EUR/USD struck Macro Man as exhibiting similar tendencies, but even he was amazed when he overlaid the last few years' price action in EUR/USD with that of USD/JPY in the early-mid 1990's:

The key price action here is obviously the "hump" in the upper-right hand corner, which is remarkably similar in both shape and duration for both currency pairs.

While historical analogue overlays can be over-interpreted, in this case Macro Man believes there is a reason to believe the parallel, as in both cases the dollar has sharply recovered from badly over-sold (and under-valued) levels, thereby dispelling the notion that dollar weakness is a one-way, ever-profitable bet.

Now, the fundamental backdrop now versus the mid-1990's is completely different, so it's unreasonable to expect the analogue to hold tick-for-tick. But the follow through in 1995-96 for USD/JPY- a year of sideways, range-trading, back-and-fill price action- seems to be a reasonable forecast for the next few months and quarters for the dollar.

Whether the buck can eventually rally against the euro as it did against the yen in 1997-98 is another question altogether, and Macro Man suspects that the answer is "no."

The degree to which the dollar can "buck up" from here will, in all likelihood, ultimately depend on the extent to which the US economy and financial system can recover from the current crisis; issues which seem unlikely to see a quick resolution.

Still, the dollar moving from a one-way bet to a two-way bet is a significant change, and one that Macro Man intends to heed in his investment strategy. This month Macro Man has already taken the biggest dollar long bet that he's had in two or three years, and while he can certainly contemplate going short again, perhaps soon, from his perspective the era of the "all-in" bet from the short side is over.

Tuesday, August 19, 2008

Petroleum Jelly

If you happen to be in need of Vaseline and find that your local pharmacy is sold out, never fear. Chances are, the entire stock has been purchased by your friendly neighbourhood hedge fund manager. If you ask nicely, perhaps he'll let you borrow a tub or two.

One of the signal trends of the past month or so has been the sharp decline in the oil price. Part of this is likely attributable to the China/global growth slowdown theme that Macro Man has highlighted recently, and part of it is likely a result of some sort of dollar strength feedback loop, which itself is at least partially attributable to a softening of the ECB's rhetoric.

On the face of it, it would appear that the hedge fund world has dodged a bullet in oil. After all, the CFTC data has shown net speculative positioning to be fairly light over the past month or two, and even slightly negative for the last few weeks.
Sadly, that chart doesn't tell the whole story. It would appear that a number of people decided to play the energy patch through the equity space rather than the physical/futures. Shortly before disappearing on holiday, Macro Man observed that the performance of "market neutral" equity hedge funds had been submarined by an apparent addiction to "equity market crack": long energy and short financials.

What he didn't realize at the time is that many of his macro brethren appear to have become ensnared in the same addiction. The chart below shows the "equity crack" trade in red, and the HFR Global Macro NAV index in white. Ouch!

To put recent hedge fund performance in perspective, Macro Man had a look at the monthly returns of the Credit Suisse/Tremont hedge fund index, a broad measure of more than 5000 funds that has tracked hedge fund performance since 1994.

It turns out that last month was the worst month for hedge funds since April 2000, which was the month that the dot-com bubble started to go badly, badly wrong.
Ouch! This perhaps provides some explanation for the recent dollar move; insofar as the hedge fund universe (and, it must be admitted, the real money universe as well) had a long commodity/short USD exposure that has gone seriously wrong recently, perhaps some of the relentless supply in EUR/USD has represented some sort of proxy hedging.

In any event, this dismal performance might explain the run on Vaseline at your local Boots or Duane Reade. If you want to borrow some, however, you'd best call it by its brand name. Any reference to "petroleum" jelly to your local hedge fund manager might get his front door slammed in your face.

Monday, August 18, 2008

Cold in August

Unfortunately, it will be another day or so before Macro Man can fully re-engage with markets (or at least the market blogosphere), as he is laid up with some sort of bronchial ailment that he picked up lamentably early in his holiday.

Still, you can't say that he didn't warn you that there would be fireworks in his Colt .45, the Macro Man Summer Holiday Indicator "works every time."

While Macro Man didn't anticipate that the dollar would look stronger than a 52 kg Chinese female weightlifter (something that's much more impressive than it sounded 2 weeks ago), he didn't do too badly on his 3 themes, either:

1) Mrs. Watanabe gets stuffed. Well, she did for most of the time that Macro Man was away, though irritatingly NZD/JPY only took 2.5 days to recoup most of the prior week and a half's losses.
2) The China trade goes wrong. This one was pretty spot on. Commodities, Chinese equities, USD/CNY....all traded horribly over the last couple of weeks. Macro Man highlighted the AUD as looking vulnerable, and so it turned out to be, helped in part by dovish comments from the RBA.
3) The equity pain trade: a grind higher. Let's put it this way: Macro Man's next door neighbour is in equity derivatives. During a brief chat on Saturday evening, he observed that the equity market has been "impossible to trade" over the past few weeks. Yeah, that sounds like a pain trade all right.
Macro Man has a few thoughts on the dollar which he'll articulate over the next few days. In the meantime, he's just looking for a little light at the end of the tunnel for his August cold.

Thursday, August 07, 2008

Light in August

As virtually every reader will no doubt recall, it was only last month that the European Central Bank put up interest rates. So it would naturally appear to be premature to start looking for a policy easing, particularly with Eurozone harmonized CPI printing another fresh high- more than double the ECB's target.

To be sure, playing for an ECB policy easing has been one the "widowmaker" trades of 2008, perhaps taking a back seat only to "BOE easing" trades. Yet Macro Man cannot help but wonder if a tiny light might appear at the end of the tunnel in today's press conference.

For clearly the activity data has been poor, much worse than expected. It's all well and good for IG Metall to demand this or that, but if Germany's economy has hit the wall to the degree suggested by the recent stats office leak (-1% q/q growth in Q2), then their bargaining power will be pretty small.

More importantly, Trichet and co. should connect the dots and see what's happened since the July meeting, where they hikes rates but spoke more dovishly than expected. Sure, the euro is a bit lower, which would be inflationary, all else being equal. But all else isn't equal. The oil price has come off more than 20%, which, if maintained, would significantly reduce the forward-looking inflation threat. (Part of this is likely also a function of the China slowdown theme highlighted in the previous post.)

Trichet is fond of saying how 320 million Europeans trust him and his colleagues to maintain stable prices. But the ECB would do well to put on their forecasting hats today and offer up a little light in August. Otherwise, they might find that each of those 320 million Europeans places a portrait of M. Trichet in their a place of honour, attached to a dartboard.

Friday, August 01, 2008



Today is Macro Man's last day in the office before leaving on a two week holiday in the sun with Mrs. Macro and the Macro Boys. Those who know Macro Man will recall that his holidays are often accompanied by financial market fireworks.

In 2005, for example, he took a trip to the US in May and June...and while he was gone, France and the Netherlands voted down the EU Constitution and EUR/USD got taken to the woodshed.

In 2006, he went away in June, and the second leg of a global EM meltdown occurred- USD/TRY from 1.50 to 1.75, USD/MXN from 11.0 to 11.50, etc.

Last year, he went away at the same time as this year- the first two weeks of August. Consider the following changes that happened during his absence:

NZD/JPY was 89.78 when he left and 79.76 when he got back.

The 3 month TED spread was 0.53% when he left and 1.75% when he got back.

Fed statement during his first week of hols:

Although the downside risks to growth have increased somewhat, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the outlook for both inflation and economic growth, as implied by incoming information.

Fed statement during his second week of hols:

Financial market conditions have deteriorated, and tighter credit conditions and increased uncertainty have the potential to restrain economic growth going forward. In these circumstances, although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably. The Committee is monitoring the situation and is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.

A cut in the discount rate accompanied that second statement, and markets are obviously still dealing with the issues that intensified this time last year.

So precedent would suggest bracing yourself for some fireworks over the next couple of weeks.

Here's some of the themes that Macro Man will be watching from the Algarve:

1) Another August of pain for Mrs. Watanabe?

Even as the flightless bird has fallen from the sky, Japanese retail investors have built up record longs in NZD. The last couple of sessions suggest that Mrs. Watanabe might be pulling the "eject" handle. The last time that happened was, er, this time last year, as highlighted above. NZD/JPY is at absolutely critical long-term levels, as the chart below illustrates. Macro Man wouldn't be surprised to see a repeat of August 2007.
2) The China trade takes a beating?

The Great Firewall of China is already rousing the ire of Western journalists. By all accounts the air pollution around Beijing remains a real issue, particularly for the endurance events- Macro Man's glad he's not an Olympic marathoner. At the same time, certain datapoints suggest an economy that's juddering to a halt: China's PMI sank below 50 for the first time ever (OK, there is only a 3 year history) overnight.
The Aussie dollar has been one of the popular China proxy trades, and it's started to come under some decent pressure in the last week. While rate-cut rumours seem premature, Canada provides a precedent for a commodity-rich country that's cut rates early when its major trading partner slows down.

3) The equity pain trade

For the third quarter in a row, earnings season has seen equities put in a bounce to temporarily reverse a prior steep decline. While Macro Man's analysis suggests that the fundamental backdrop for stocks is still lousy, there is nothing to say that those fundamentals will drive price in the short term.

Indeed, he's looking for a bit of a repeat of last quarter, which is best represented by the Eurostoxx chart- a sharp pop up (which we've already seen), followed by a few weeks of slow, vol-crushing, soul-destroying grind higher.

While this may seem incompatible with themes 1 and 2, bear in mind that despite the moves described above, last year the SPX actually closed higher on the last day of Macro Man's holiday than it did when he left the office.

Given the backdrop and historical precedent, Macro Man will be watching the market- not as closely as if he were if the office, but probably more closely than Mrs. Macro would like. He'll likely post from time to time, though not with the usual frequency and length.

Readers looking to exchange views with other (largely anonymous) punters should feel free to use the comments section here as something of an open thread. And while Macro Man has already purchased his holiday reading, any readers with high-conviction recommendations for a last-minute purchase are welcome to share them.

Good luck!