F(oil)ed again

Just when you thought the reflation trade might be getting a head of steam, equities ran into a tumbling crude market, which itself ran into Saudi oil minister Ali al-Naimi, who suggested that the taps are going to keep running.  While prompt  WTI and Brent shed roughly a buck and a half, in fairness it probably could have been worse; yesterday's candles don't stand out in any way at all when looking at a chart of the last few months.  Still, it's an all-too-familiar story, as an equity rally gets f(oil)ed again.

In any event, the prospect of another W shaped bounce in the SPX has been deferred but not destroyed; if you look closely, during the previous W stocks retreated for a couple of days when first testing the neckline.   Per yesterday's post, Macro Man is fairly agnostic on equity beta at current levels, insofar as the SPX is more or less smack dab in the middle of the range.  Frankly, he wouldn't be surprised by a 3-5% move in either direction.

One source of legitimate concern is that the nascent recovery in Europe could already be fizzling.   Yesterday's ifo survey was little short of execrable, and worryingly confirmed the recent weakness in the PMI.  Of the various components, Macro Man has always found the expectations measure to be the most useful in gauging the cycle; suffice to say that the sharp tumble from 102.3 to 98.8 doesn't exactly engender much confidence in the resilience of the German, and by extension European, economy.  Gee, it's almost as if conducting a monetary policy that eviscerates the profitability of your banking sector could be detrimental to growth!  Who'da thunk it?

The pressure is now squarely on the shoulders of the ECB to rectify what is now widely considered to be a mistake committed at the December meeting.  Certainly the weakness of the euro appears to be anticipating such an outcome, but it's unclear what realistic options the ECB has.  More QE, perhaps, but with large swathes of high quality Eurozone debt already in negative yield territory, it remains far from certain that a further decline in yields is beneficent.   The same holds for the increase in reserves generated by purchasing bonds, given that the ECB immediately starts clawing some of that dough back via the negative depo rate.  A program to buy bank debt could certainly soothe financial markets, though it's unclear how much they could buy and how politically palatable it would be to certain segments of the governing council.  Macro Man will be on the lookout for any "sources" stories in the run up to the meeting, given that they've been very accurate recently.

Switching gears, Macro Man thought he would address an issue that's occasionally raised in the comments, vis-a-vis the relationship between equities and the JPY.   There has been some suggestion that the ongoing strength of the yen should instigate further weakness in the SPX and other equities, given the apparent strength of the relationship.   Macro Man has generally been sceptical of this viewpoint, as it sounds a lot like the tail wagging the dog; while currencies often react to developments in other markets, it's generally more rare (particularly outside of EM) for FX to cause them.

Anyhow, Macro Man figured he might as well run some correlations over a large sample to verify the relationship- or lack thereof.   He looked at the 6 month rolling correlation of daily changes in USD/JPY and the SPX, which is a long enough window to iron out noise and give generally meaningful readings.  he has to confess at being somewhat surprised by the results, which you can see below:

Holy regime change, Batman!  As you can see, from 1990 until the end of 2006 there was only a scant relationship between the yen and the SPX over meaningful periods of time.   Sometimes the correlation was positive, sometimes it was negative, but it was never particularly large.  That changed at the beginning of 2007, when the relationship became very strong indeed.   Some of this may represent the "Quantmageddon" of a number of prominent multi-asset models in the summer of 2007, which resulted in the selling of both equities and yen crosses.   Thereafter, of course, we had the crisis, which prompted extreme risk aversion across a broad swathe of asset classes. 

How to explain the strength of the correlation since then?   To some extent, this surely exemplifies the wretched "risk on/risk off" mindset that dominated many asset markets until a couple of years ago.   With most central banks sidelined, there were very few independent thematic opportunities, thus encouraging all markets to trade off of each other.   To some extent, the proliferation of algorithmic strategies may have played an important role in this regard; if they are programmed to expect the yen and SPX to move in lockstep they will trade accordingly, at least partially rendering the relationship a self-fulfilling prophecy.

Just when it looked as if the wheels were falling off the relationship in 2012, meanwhile, Abenomics came along and it was "party at Shinzo's house!" for a number of assets.  Recently, however, the cops have arrived, busted the party, and confiscated the Asahi kegs and jars of sake.  While risk aversion and algo issues persist, it seems reasonable, indeed likely, to Macro Man that the SPX/yen relationship should weaken further as Japanese macro policy becomes less of a hegemonic driver of global sentiment and asset prices.

One final observation is that the strong yen/SPX correlation has emerged at a time when  FX carry as a strategy has slunk into the shadows.  The reason for this is obvious: with low rates everywhere but the basketest of basket cases, there really isn't any carry to harvest, particularly relative to the level of vol.  The Abenomics trade, of course, resembled an FX carry strategy, insofar as the yen has been a cornerstone funder of FX carry for a quarter-century.   However, as markets get washed out of that trade, the resemblance should wane.

As an aside, the chart above represents a pretty decent approximation for the performance of your median global macro strategy.  While some carry strategies were smarter than others, the fact remains that the returns generated from FX carry trades paid the bills for a lot of other bets, some of which were successful and some of which weren't.  In the post-crisis period, not only have there been fewer independent bets to make as noted above, but macro hasn't enjoyed the tailwind of the FX carry return stream.

While it doesn't look like the pomp of FX carry is going to return any time soon, fortunately the last 12-18 months have seen the emergence of a number of more independent opportunities as economic and policy cycles begin to diverge.  Who knows: selling that correlation between the SPX and JPY just might be one of them.