(Sub) Prime Time

Has the day of reckoning arrived? Macro Man’s email box and Bloomberg message cache is chock full of missives on the subprime market and the serious deterioration in the price of the lowest-rated credits in the sector. And indeed, it does look grim...the ABX BBB- chart reminds Macro Man of the price action in GKOs in the summer of 1998.
Soure: http://www.markit.com/information/affiliations/abx/history

So has Macro Man changed his stripes? Has he come to his senses and realized that his domino game is about to be played out in real life? That the yen carry trade is the root of all evil, that US equities are farcically overvalued, and that gold holds the key to financial salvation?

Not really. While Macro Man concedes that the subprime market does indeed look fugly, he retains his belief that contagion is probably unlikely. Overall mortgage delinquency rates in Q3 were just 1.72%, according to the Fed; while this is admittedly off its lows of a couple of years ago, it remains well, well below the average of the past 15 years.

So does this mean that risky assets are bulletproof? Far from it. Indeed, Macro Man has had a growing sense of unease for some time, hence the alpha portfolio hedges in TIPS, the SPH7 seagull, and gold puts. Macro Man sold some Treasury futures last week to turn his TIPS position into a partial, purer inflation hedge. In retrospect, this was a mistake, as Treasuries will catch a safe haven bid on a risky asset unwind. Moreover, on balance the data to be released this week is likely to underscore the popular (and, in Macro Man’s view, misguided) notion that housing is finally killing the US economy.

Macro Man therefore covers his TYH7 short at 107-27.

Elsewhere, Macro Man notes that central banks have expressed an interest in buying equities in a recent survey. Indeed, this is one of the reasons why many, including Voldemort, are establishing separate investment vehicles. However, consider the impact if even 10% of global FX reserve assets are deployed into equity markets: $500 billion into a market where global net issuance is a fraction of the size. Yowsah!

If this theme ever gains broad currency (pardon the pun), then equities are going to be a screaming buy.

In the meantime, however, Macro Man continues to worry, but is pleased that the subprime story is at last playing out. It’s much better to take the risky-asset hit now when everyone’s worrying already...

Next Post »


Click here for comments
February 26, 2007 at 2:19 PM ×

but what would taleb say...
i completely understand your worry. grant's IR observer, ever the bearish barometer, is full of ABX angst. but i'm still not so sure, yet anxious to see what happens next.

Macro Man
February 26, 2007 at 2:42 PM ×

Presumably, Taleb would say that carry traders and insurance writers have been lucky so far, per some of the examples in Fooled by Randomness.

The problem is that we are not getting unified signals at the moment. ABX, USD/JPY, EUR/CHF, SENSEX, and bond yields are all lower, consistent with a risk aversion event.

However, as I type, NZD and AUD have gone psycho bid, stocks have opened higher, and commodities chug merrily along.

As I have mentioned previously, I struggle to see how risks that are so well-telegraphed can lead to a systematic unwind. By the same token, when one of these risks goes tabloid, there is every chance for a bit of noise. And if it is relatively cheap to hedge (to smooth returns), my belief is that it is churlish not to.

February 26, 2007 at 5:30 PM ×

It may be Bombay exchange is reflecting rising interest rates and inflation based on supply bottlenecks, rather than a risk aversion event. Foreign direct investment is still pouring in, while hot money comes and goes as usual. I'd look at Malaysian and Indonesian indexes as better signals of "risk aversion" this time around.

Of course why would anyone in his right mind flee to USD beats me. Maybe US troubles in mortgage market are for the little people only, who are economically invisible in the grand scheme. Hedge away, amigos! OldVet