Taking stock

OK, let's take stock of what we know:

* The worst-of-the-worst subprime index in the US has gotten killed
* This week's economic data is likely to be weak in an absolute sense
* The dollar has sold off across the board against G10 currencies, but
* Funding currencies have rallied harder than carry currncies, and
*The dollar has rallied against high yielding EM
* Chinese equities got smoked overnight for no obvious apparent reason
* The same thing happened in India last week
* Treasuries have rallied across the board, with no obvious out/underperformance from TIPS
* Commodity prices have remained firm until a couple of hours ago
* Developed market equities are off their highs but have not broken uptrends; VIX is off its lows but remains low in an absolute sense

So what are we seeing here? Three possibilities include:

a) A slight wobble, not dissimilar to the one observed in January of this year. These can last a few hours to a couple of days, and then normal service is resumed. A lot of the people Macro Man has spoken to today seem to think this is what we are experiencing. Macro Man finds that troubling, as it smacks of complacency. Indeed, believing that this is no big deal is more like to result in it being a big deal.

b) A full blown risk aversion event. It is too early to say with certainty that this is the case; we'd probably need the SPX to fulfill the current futures move (-9.5 points at the time of writing) and a concomitant move in VIX to spur more broad-based risk aversion. EM and credit spreads are wider than the lows, but still well narrower than at the turn of the year. Risky currencies like TRY, AUD, and NZD remain near their strongest levels of the year against the dollar. We need mroe proof.

c) Pricing in a second downleg in US growth and the possibility of recession. Certainly that would fit with the likely outcome of this week's data and the rally in Treasuries. However, Macro Man would have expected inflation breakevens to narrow more than they have done, and for the belly of the eurodollar strip to rally more (EDZ7 is still below its 2006 closing price.) Moreover, a US recessionary outcome should ultimately be negative for commodity type currencies, and indeed overvalued stuff like the Europeans. Perhaps that will be the sting in the tail later this week; it's hard to say.

For now, Macro Man remains cautious and somewhat defensive. While the beta plus portfolio is carrying plenty of risk, the alpha portfolio is more defensive, carrying short deltas in equities, NZD and ZAR, and gold. Given Macro Man's view that gold has rallied on the basis of financial liquidity and leverage, a risk aversion event should in his view lead the yellow metal lower; hence the presence of the puts in the portfolio.

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Click here for comments
February 27, 2007 at 8:58 PM ×

I'm taking this opportunity to cover half of my shorts , then I short out-of-money puts with their huge volatility spikes (VIX rallied from 12 to 19 ) to cover those remaining positions ...
crossing my fingers as usual, but this is usually a good trade even if the timing is wrong

Macro Man
February 27, 2007 at 9:16 PM ×

If you are short, selling puts can be a nice way of getting out of the position.

I guess the real issue is how much technical damage has been done to the stock market? After what seemed like 8 months of 5 points per day gains in the SPX, a -50 is a bit of a shock to the system.

I suppose whether others join you in covering and writing puts will help determine how far this goes, if indeed it goes any further. 'Volatility events' like this, and indeed like last May, are rarely completely isolated events, in my experience....

February 27, 2007 at 9:26 PM ×

I agree with you there , hoping that this is not the same 2-month drop we had last summer into July , but will take it as it comes and let the market tell me how to trade next

best wishes on your deals

February 27, 2007 at 10:15 PM ×

I vote half b and half c.

I covered none of my shorts, closed out most of my short-carry currency options and let a few ride, and bought index calls at the close (a loser, but insurance is there to be eaten).

What a fun day.