19 марта, 08:10

The Anatomy of a LIBOR Panic: New Wides For LIBOR/OIS

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Welcome back MM readers--apologies for the unscheduled hiatus last week. I spent a few days enjoying the technological miracles of the US healthcare system. Keen readers may notice I almost never make a call on stocks, stock sectors, or egads….single name stocks--but it is tough for a trader to walk away from a couple of days in and around a hospital without thinking that there is a lot of capital and profit sloshing around in that place. Since I was disconnected from markets much of last week I’m going to circle back to the widening in LIBOR/OIS spreads that has continued unabated since I wrote about it a few weeks ago. I'm sure this has been to the erm...consternation of more than a few traders like our good friend here: Actual footage of a macro trader reacting to the latest LIBOR fixingsJPM published this chart showing that the current 3mo libor/ois spread is at its widest post-crisis level. That’s amazing, given nobody has really noticed outside of this small sector of the fixed income market. Even the 2016 money market reform move made some headlines in the financial media, even if it didn’t penetrate the white hot din of the US election media coverage. Sure, there have been a few articles in bloomberg and the WSJ that have highlighted the move higher in LIBOR, what might be driving it and what it might mean for the regular Joe. Quite honestly, with a little time away from it, I think the coverage has overcomplicated the issue. What I think the market is missing is that this really is a plain vanilla credit story. What makes it different is the magnitude of the move, one driven by the confluence of competing supply and demand factors. Yes, there are many factors that are driving this move, but I think they can be simplified into only two or three. The first, and arguably most important, is the US tax reform. This incentivized US corporate treasurers to start repatriating foreign-domiciled assets, much of which was invested in short-term corporate debt. And yeah, that matters! What I think has been slightly deceptive in the media coverage of this move is that it has been sold as “having nothing to do with credit,” or that credit hasn't been a driver because various other basis trades (3s6s, xccy basis, etc.) aren't moving much. That’s only partially true, especially when you look at this chart: Put another way, since the beginning of February you’ve lost all of the spread tightening move since June of last year. This chart also highlights that the weakening of markets in general might also be at play here--an overall weakening of credit markets has caused a re-pricing of the entire credit complex...including commercial paper, bank funding and thus LIBOR. The second factor is commercial paper. Treasurers are pretty smart people--and most of them have a guy that is sitting in front of a bloomberg terminal all day thinking about how he can fund the company’s working capital 5bps cheaper for a few months. When these guys figured out the tax reform was for real and, later--that there would be an acceleration in t-bill supply because of the bipartisan spending agreement struck in early January, those treasurers wasted no time in tapping the market. Commercial paper outstanding accelerated throughout Q4 and picked up at an even faster pace in January. This acted as a sponge for money market cash......Which left the market dry as a bone when the US government dramatically accelerated t-bill issuance in February, increasing the amount of bills outstanding from roughly $2trn to $2.2trn. You can see how these trends impacted the market by looking at this chart:LIBOR and commercial paper rates underperformed OIS starting in December, but flattened out in January. Similarly, 3m t-bill rates and OIS followed each other very closely until the t-bill issuance accelerated sharply in February. At that point all bets were off--with CP rates and t-bill rates widening amid weakening credit markets and an decrease in dollar funding supply, LIBOR started to underperform everything, since panel banks saw that issuance concessions were back and weaker panelists probably had to pay up to get deals done. The rest, as they say, is history. Where does the market stand now? Pretty nervous, to say the least. 3mo/3mo forward (June fra/ois) blew out to new wides last week, and the 6m3m (Sept fra/ois) is again skulking around the 40 level.  This seems like the capitulation move here--L/OIS over 50….money market investors are going to look at that and say this is where we can step in, and there is already some evidence this is happening. I continue to believe that the market will stabilize in the low-mid 30s and we’ll see a return of a more normal looking upward sloping term structure. But when? That’s the big question I guess--however you look to structure this trade, it will be worth considering how much carry and resilience it built into the trade.

08 марта, 08:02

CAD and NAFTA Risk: Show Me The Money

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Part of the genesis of this blog is to provide a historical record of trade ideas, and just as important, the justification behind them. And looking back now, it appears I like to talk about CAD, which is strange since I really never traded it all that often. The loonie has gotten kicked around the past month or so, ending in this brilliant Twitter post: Every currency should be represented by some kind of animal so we can have more of this. Then the super-quants chimed in...Jens Nordvig’s Exante Data posted this today:  That got the wheels turning….first, is CAD really underperforming, and if so, is it underperforming because of amorphous residual factors that one could call collective “NAFTA risk” rather than more discernible ones? Let’s go to the facts. First, if we look at a pack of commodity currencies over the past year, CAD falls nicely in the middle of the range. On a shorter time scale, the underperformance is more apparent. Since the beginning of the year CAD can’t get out of its own way...but it really started to trade ugly around the end of January.  This is where the “NAFTA risk” story breaks down. No chance MXN is at the top of this performance table if the risk of a NAFTA blow up were increasing. Indeed, as I highlighted last week, if anything MXN is arguably pricing in significant political risks as well--leading me to assume there is little if any NAFTA risk priced into either MXN or CAD. So where does that leave CAD? I can’t compete with the sentient machine learning models at Exante Data, but I can come up with a crude regression model of my own, which is like comparing a Bugatti to a go-cart built with scavenged lawn mower parts.  Borrowing from some inputs and ideas in the JP Morgan model, I modeled up CAD against oil, 1y1y CAD-USD rate spreads, and S&P vol.  The takeaway I get from this is that the blowup in vol and the pullback in equity risk has taken significant air out of the tires for CAD...the model value for CAD rose from 1.24 to 1.32 in a short period of time...and spot was slow to catch up. When it got moving, traders didn’t waste any time in gunning it towards 1.30. But was it just the equity selloff at work? Turns out the data played a part too--this chart is the Barclays economic data surprise indexes for the US and Canada. The Canadian index craters throughout February, while the US index chops around a more narrow range. When combined with higher equity (and currency) vol and lower stock prices, it’s a clear trigger for traders that had done well holding long CAD positions throughout 2017 to hit the exits.Similarly, in the rates space, there was some change in pricing the BoC hiking cycle but nothing earth-shattering. On January 25, this is what was priced in. a y/e 2018 rate of 1.84%. Today that rate is 1.74%. Does 10bps in the front end equate to a 4-5% underperformance in the currency relative to other commodity currencies? That sounds a bit much to me, but it points to the overall trend that the weakness in the currency is being driven by a reversal in short-term economic indicators rather than the “residual”--NAFTA risk, political risk, or the risk Justin Trudeau is in fact the spawn of Fidel Castro.  Did the Trump tariff news play a role here? Doesn’t look like it to me--the bulk of the underperformance was prior to that, but ya never know. It would be reasonable to use that as the explanatory variable to support underperformance relative to MXN, but the data isn’t there to support that. Currency trading is about much more than interest rate spreads and current account deficits. At its most basic level, it is about the relative rate of return in different economies….and in this case when the short-vol/equity momentum finally broke down (at least in its previous iteration), it signaled a break in potential growth rates in Canada, and combined with some additional macro-prudential measures to soften the real estate market, it took a good deal of the shine out of CAD.   Bottom line, when you look at a mean-reversion in what had been a very strong run of economic data, the underperformance relative to MXN, and a regression analysis that makes the recent weakness in CAD look more in line with the fundamentals--there isn’t as much to panic about. What’s next for CAD? It seems like the market is on to something here, and there is good evidence that the business cycle is looking rather tired, despite a strong print from the Ivey PMI earlier this week. That said, my gut says the market seems to have gotten a bit offside here, pushing CAD too much relative to the underlying drivers. Despite the naysayers I think the weak USD trade is intact, so I’m inclined to catch the knife here and sell usd/cad, but just can’t get too excited about it so long as it continues to screen marginally rich on my regression model and the model inputs continue to point towards a weaker currency. [email protected]

03 марта, 00:13

Why is LIBOR Moving Higher?

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Indeed, volatility is back. BTD may not be dead, and as I have mentioned here, I’m not convinced the bull market is dead and spoos are heading back to 2000 (yet). However, the systematic gamma sellers have taken a serious beating--and one that doesn’t seem to want to let up.   Beyond a couple of bullet point sized comments, I’ll again leave it to the peanut gallery to advance the discussion on where markets are going in the next couple of weeks. My take on the steel tariff move by Trump is that it is not a game changer for the economy at large but was designed by the administration’s trade negotiators as a tactic to make them look more serious in negotiations with China and NAFTA.  A lot of people ask me, “As a bond trader, what do you do?”  Well ok, I guess nobody has ever asked me that. If fact, I find that most friends and family are pretty happy to not know what I do at all.  But in the US fixed income world, one of the big asset classes is LIBOR spreads. These trades can take on all kinds of forms, where you can bet on (or hedge) the spread between LIBOR and OIS, LIBOR and Treasury rates, or the individual components of LIBOR (1mo vs. 3mo, or 3mo vs. 6mo fixings, etc.). The people looking to hedge are often banks with various tenors of floating loans they want to match up, or asset managers that want to switch their liabilities from one benchmark (say, LIBOR) to another (like OIS).Theoretically, LIBOR rates are the rate at which banks lend to each other, but nobody really does that any more. Today this rate is often set by bankers with an algorithm that takes into account various credit-driven short-term funding markets like repo, commercial paper and cross currency swaps. When credit tightens up, bank balance sheets contract, and/or capital leaves the market at large, these rates move higher relative to OIS, which is and overnight rate indexed to the fed funds rate that is more or less controlled by FOMC policy.   If the market is really scared--to the point where there is some question about the viability of the banks that are holding all of this credit risk and collateral for clients, LIBOR blows out to extreme levels. This is what happened in 2008-2009 and 2011-2012 during the GFC and European sovereign debt crisis. More prosaic spread widenings have occurred recently around the taper tantrum, China deval in 2015 and early 2016, and Brexit in 2016.By contrast, these spreads contract when the market believes there will be more money to lend, which drives down interest rates. This is exactly what happened after Trump’s victory in the US election. After years or tightening balance sheets in reaction to Dodd-Frank regulations and a variety of Basel II reforms designed to increase bank capital, banks had less free capital to lend. When Trump won, his pronouncements about cutting regulations were seen as freeing up capital for banks to start lending again.“Risk on” and tightening credit spreads didn’t hurt either. In mid-2017, the spot 3mo LIBOR/OIS spread went from the mid-30s to the teens, while forward spreads fell by 10-15bps too. (Source: JP Morgan data; note: I used a 5-day MVA here to make the chart less noisy)This trend reversed in style starting in December, when LIBOR fixings started to trend higher, taking all of the forward basis levels up with it. What happened?The answer lies in deep in the plumbing of the financial system. Back in December, two big things happened to impact short term funding markets: Trump and congress passed the tax reform bill. This gave many corporations with dollar assets offshore the incentive to repatriate those dollars and use them for share buybacks, dividends or M&A. The loss of that supply of dollars to lend out caused lending rates to increase, In the same tax reform, and in the subsequent budget deal with Democrats, the US decided to borrow more money. A lot more money. This will cause a big increase in t-bill supply, which will have the end effect of crowding out private borrowing--or at least causing the demand curve to shift to the right, also leading to higher borrowing rates.  For most of 2017, 3mo t-bill rates had been stable around 10bps tighter than OIS. Since the budget deal, that spread has moved 10-12bps wider. LIBOR has moved even wider, essentially taking in the impact of both the t-bill supply and the corporate foreign earnings repatriation. We’ve seen the impact in commercial paper and repo rates as well: (Source: JP Morgan data)We’ve seen cross currency basis (the deviation between covered interest rate parity and where one can borrow or lend in USD in currency forward markets) has tightened as well, although not dramatically. The sum impact of these factors means LIBOR fixings are moving higher not because of any stress to the banking system, but because there is a greater shortage of USD funding, and fears of greater supply are forcing treasuries to cheapen.In the end, I see the funding factor (offshore profit repatriation) and the supply factor (more t-bills) each having widened short-term funding rates by roughly 10bps--other measures that indicate pure (or more pure, anyway) expressions of bank credit risk (like 3mo/6mo LIBOR basis) are showing very little movement, despite the pullback in equity markets the past few weeks. That tells me this move is all about USD supply and t-bill issuance. Where do these markets go from here? Here is a cleaner look at the LIBOR/ois forward markets relative to “spot”:Put another way, the market is pricing a significant tightening in the LIBOR/OIS spread one year forward. 1y1y LIBOR/OIS is trading 5-8bps higher than it was for most of 2017. (Note also here that the market was set up for part of this move--presumably the offshore profits repatriation, but was caught with its pants down in the budget deal.)  That order of magnitude looks about right to me--clearly hedge funds stepped into this trade in size this week. From these levels, I would look to pay forwards 2-3 years out  vs. receiving front-end FRA/OIS (the short-term version of this trade in eurodollars), on the idea that 1) inversions in this curve are very rare, 2) there is no sign of credit stress, 3) short-term funding can subside, but 4) the long-term fiscal impact of the t-bill supply will likely be ongoing, and maybe worsen if the economy slows down and/or if credit markets weaken. If you made it this far, you are either a basis junkie or you win the medal for getting through Professor MacroShawn’s Funding Markets 101 class. Either way, kick back with a Friday afternoon happy hour beverage of your choice. You deserve it.Have a good weekend! [email protected]

01 марта, 18:43

Major Europe FX Pairs On The Precipice.....The CTA Nightmare To Continue

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As the dust settles from the saber-rattling equities move of  ~11% (shocking to some), many CTA's are attempting to lick their wounds and regroup for a profitable rest of the year.As they proceed down this path, there are a few other trend-following trades that are on the precipice of reverse and could prove to be obstacles to these funds' Pnls.I believe we are near a meaningful reversal in the dollar versus developed Europe, namely EUR, GBP, and CHF. How did we get here? Well, back in 2017 I was a proponent for the major European currencies. I spoke extensively about GBP based on rate differentials here, as well as  EUR in a few posts here and here. Although were drivers in the currencies above, just as importantly was the dollar move that materialized after that time.It was around this time last year.  Trump went around saying he wanted a weaker dollar. We had headlines like this: Trump says the dollar is "too strong" -- good luck weakening itWell, it turned out that he actually had pretty good "luck", since that turned out to be a major top in the dollar.Where are we now?Today, it seems that the unrelenting move in EUR and GBP has promoted participants to pile in on the long side for a number of reasons that could be broadly grouped together as the following:1) Prospect of renormalization in monetary policies of non-US countries2) Shifts in reserve policies in non-US countries3) Higher beta to global growth in non-US countriesThis line of reasoning and speculative FX market positioning has stretched so much that participants have hypothesized that things like interest rate differentials no longer work!Yes, interest rate differentials as a signal for trading currencies go through prolonged periods of "working" and "not working" (my friend Goofy Man from a large macro hedge fund noted that 2004-2006 was a period when interest rate differentials did not "work").However, we are at a point where I think the markets have over-anticipated and other fundamental factors beneath the surface of price action can trigger a reversal.First, let's talk about rate differentials.2yr notes in the US, UK, and Germany.2yr swap rates in USD and CHF IRS.Clearly, we see that rate differential in nominal terms has been stretched. In addition, FX cares even more about real rate differentials, which roughly reflect the same pattern, but could serve to explain why this phenomenon has failed to impact things until now.Next, let's talk about policy.When we look at some of these other central banks, we hear a somewhat similar, yet importantly different tone.ECB:As late as last week, the ECB stated that it was too early to review policy and that the latest it would even consider revisiting policy would be sometime "early this year".As with most central banks, the surprise the world and rip rates mantra no longer exists and what we have in place these days is the announce, announce, and announce until finally ticking rates up at the slowest possible pace. So reasonable to say, the market has over-anticipated a bit here.They've also expressed their intent on not targeting the exchange rate.BOE:We know they came out last month and stated that they could be moving on policy changes more swiftly than previously thought  (This was what I was looking for last year). There was a nice pop for GBP on the news. Now that the cat's out of the bag, we need to think about what they might do going forward.As our very own Macro Man has documented, the BOE's flip-floppy nature, so that could be a risk.Tying that to the price action - we have seen that GBP topped out right around that announcement. Not exactly a good harbinger for GBPUSD.With that said, it is still important to keep in mind that trade-weighted GBP still looks cheap.SNB:The SNB has not shown clear signs of tapering yet. Not only that, they are trying to invest in stocks (sign of the times in 2018). Thus, the appreciation of CHF versus the dollar is probably not sustainable.The Fed:Lastly, thinking about the dollar leg.We had the latest Fed minutes last week and Powell speak recently. They have made it abundantly evident that the Fed will do it's best to maintain it's attempt to continue its pace of hiking.Breakevens have slowly started building a head of steam. There are enough stories delineating the tax cuts. I've detailed some of Trump's Fed choices in the past here. It is clear that we are starting to get a hawkish Fed. Shawn has recently put up details regarding some evidence of J-Powell's intents.Finally, there's my favorite indicator - Jay Powell's height - he's over 6 foot!!And a picture is worth a thousand words:Finally, let's talk about Donald Trump who seemingly always does his best (whether intentionally or unintentionally) to keep things interesting.Unlike this time last year, he and Steve Mnuchin has come out and said that they want the dollar stronger from these levels.Here and here, etc.Ironically, the market once again fails to pay attention to the most important man in America as he explicitly states his goals and intent (look, no mystery here).With this combination of reasons in mind, I now turn to the dollar chart (using DXY as a proxy - which is mainly composed of EUR, JPY, GBP, and CHF)Looks pretty clear to me that it is looking for a bottom. From this one should be able to construct clear entry and stop levels to either take profits if you've been riding the trend or to get into a speculative long position.This has been such a persistent move for G10 currencies, it will be hard to see CTA's getting out of the way of this one.And for the rest of us, good huntin'.

28 февраля, 23:01

Powell's First Dance with Congress: Hawkish.

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I guess I’m not much of a Fed watcher. There’s something I don’t like about the Kremlinology aspect of parsing a Fed governors words. Sell side economists, financial media, and no small amount of fin-twitter opine on every speech as if it is potentially a game changer for monetary policy, rates, and the value of the dollar. However, when you have a new chairman of the Fed, it pays to sit down and listen to the guy for his first speech in front of congress, because he is going to bring his own style to the proceedings--and ya never know….maybe some new substance. So this passage stood out: “In gauging the appropriate path for monetary policy over the next few years, the FOMC will continue to strike a balance between avoiding an overheated economy and bringing PCE price inflation to 2 percent on a sustained basis.” I can’t remember the last time a Fed chairman used the words “overheated economy”, and the unequivocal statement that they will manage monetary policy is such a way to avoid it. What is more peculiar about this statement is not just the hawkish implications--but the clear implication that the level of PCE price inflation is potentially mutually exclusive from an overheated economy. When you consider that in the context of a dual mandate--it illustrates what I think is a big trend in central banks around the world since the financial crisis: There is a stealth mandate to maintain financial stability, or at the very least an implicit one embedded in the stated mandate of all central banks. What does that mean for the hiking cycle, and for rates at large? Clearly it is hawkish. It is also argues that Powell is looking at: 1) an economy at full employment, 2) inflation somewhat convincingly, but not conclusively, ticking higher, 3) higher commodity prices ( mandate is HEADLINE inflation, not core...so this matters, even if they don’t say so), but also importantly 4) a government that is bound and determined to borrow and spend money like a drunken sailor on leave, 5a) financial conditions at increasingly easy levels,  5b) credit growth starting to tick up, and 5c) financial markets showing some signs of froth, reaching for risk, etc. Add those factors to a Federal Reserve that has the institutional memory of a financial system that exploded at the end of a three year hiking cycle, despite modest upticks in inflation, and you can paint a picture of a chairman that might look to be more aggressive in reigning in excess than his predecessors--even if the past several years of central bank policy history seem to imply that monetary authorities shouldn’t pump the brakes too fast as economies recover and financial markets recapitalize. Which leads us back to what we all really care about, WIPI. What Is Priced In?The Powell testimony put paid to the front end again….but took levels pretty much in line with “the dots”: 75bps this year….yes three hikes, on the screws with what was in the December SEP. But the cycle peters out after that, with roughly 30bps priced in for 2019. Here is a mockup of the impact from Powell’s speech, using 3m OIS rates at various forward tenors.   More simply, the front end 3m rates were far more stable than the 3m rates one year, two years and five years in the future. It’s a bear steepener in the front end--but consistent with the type of policy shifts that can put a bid into the long bond--higher front rates amid stable long-term flows. And looking at the outright levels of those 3m forward rates, the levels five years out-somewhat consistent with where the market’s estimation of a “neutral rate” might be-- are only just now reaching that seemed sorta normal-ish between 2011 and 2014. Bottom line, the market isn’t counting on a bear steepening in the front end relative to the belly of the curve, but the combination of fiscal stimulus, high commodity prices and a hawkish FOMC chairman might just do it---and shepherding the curve slowly but surely in that in that direction might be the best way for Powell to let some air out of this balloon global central banks inflated over the past decade. 2y/5y OIS is sitting at 25bps--unless Powell moves decisively towards four hikes this year, the market might shift towards higher rates later rather than sooner...especially if it is appearing that wages are taking more time to accelerate than many seem to expect.  Yeah, I know….US economic data is already starting to tail off...commodities have seemed to find a level here...and yes, maybe there is something to the impact of higher rates on the housing market. And I believe the most convincing argument in favor of lower rates from these levels is the unwavering commitment of the ECB and BoJ to keep rates right where they are. Suddenly nearly 3% in dollars doesn’t sound so bad. As such I don’t think the long bond is going to far.  But when the long-term neutral ex-ante real rate is at 50bps, there is still room for that to move higher.  Why did I use OIS rates here? I wanted a clean picture of Fed-implied policy rates since LIBOR and swap spreads have undergone some big policy-driven changes over the past couple of months...who said US rates are boring!! Stay tuned for more on that subject on Friday. [email protected]

27 февраля, 20:00

Is This Peak AMLO?

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Fear not, macro audience. TMM2 has posts in the hopper about US front end swap spreads and CTA's flailing about in FX crosses....but for now humor me and put up with another post on the Mexican election. I want to give you folks a quick walk through the details of how I will be thinking about the Mexican presidential election in 2018, and my admittedly cursory attempt to model the market’s implied probability of a victory for Andres Manuel Lopez Obrador--AMLO. First, let’s look back at the US election in in the summer of 2016, which was a similar stage to where Mexico is now. Before the conventions in July, Hillary led by 5-8 points. According to the folks at fivethirtyeight.com and most prediction markets (this chart is from my old friends at the Iowa Electronic Market), this translated into a 70-75% probability of Hillary winning the election. Now, let’s turn our attention to the polls in Mexico. AMLO leads the competition by a similar margin to where Hillary was in July 2016--all data and charts here from the people at Oraculus. Thanks to @horaciocoutino for the excellent data visualizationIn their brilliant poll of polls rendition, AMLO leads by 8 points, with the lower bound of the 90% confidence interval of 35% (the numbers in brackets), while the upper bound of Anaya’s confidence interval is 33%.Where does that leave the implied probability of an AMLO victory? Just looking at this polling data, one might say it is pretty close to 70-75%, just as it was for Hillary in July 2016. The race seems more likely to tighten from here, rather than AMLO running away with it. First, support for the PAN candidate in polling data cratered last September with Margarita Zavala broke with the party to run as an independent. But Anaya has started to recover as he is now looking like the #1 “anti-AMLO” candidate. If he continues to run a “clean” campaign and performs well in the debates, one can envision him converging towards the 40% levels of support generic PAN candidates were receiving in mid-2017.  That’s not a done deal--Zavala has gained some support lately and continues to troll Anaya on Twitter--but right now it looks like the path of least resistance.Meanwhile, AMLO has had a very good run. He has consolidated the support of his base and made some inroads to the middle class that was lukewarm at best during his previous campaigns. So far, he has won the battle to re-cast himself as a kinder, gentler, cuddly version of AMLO.  Where does he go from here? I believe AMLO will gain more support as a second choice from “strategic voting” than he has in the past, but he is still a divisive figure. It is tough to believe this chart is going to continue to trend higher towards 50%. Are we at Peak AMLO? Peak implies a summit and decent--I’d lean towards “Plateau AMLO”, even though it doesn’t have near the same ring to it--and it is certainly plausible that he hits some landmines between now and July 1. As the front runner and an outsider, he’ll be the target of an unstoppable barrage of negative ads, media coverage and opposition camaigning. Bottom line, there is a good probability that Anaya and AMLO will converge around the 35-40% neighborhood and battle for victory right down to the wire. To make a sporting metaphor, AMLO won game 1 of the seven game series...but there are still six games to go. Now, what does the market think? I pulled some data from CDS markets to estimate a market-implied probability of an AMLO victory. First, I looked at 5y Mex CDS vs. a basket of EM credits--Colombia, Indonesia, Peru and China--similar credits--the former two with a higher correlation to oil prices, with the latter two more dependent on some combination of global manufacturing demand, metals prices and market sentiment. These two charts show Mex CDS has dramatically underperformed since August 2017 when one could argue Mex political and trade policy risk was priced for perfection. Comparing Mex CDS to a basket of US BBB industrials gives you similar results (LHS = CDS spread, RHS = spread of bbb industrials to mex): Mex has underperformed by roughly 15-20bps since summer. That’s a good approximation of the upside if AMLO were to lose--an Anaya victory would mean not only a business-friendly government in Los Pinos for the next six years, but the delta on a successful renegotiation of NAFTA would go dramatically higher. By contrast, an AMLO victory would cause CDS to widen no more than 40bps where it would be to South Africa--which has been outperforming everything since the ANC finally managed to drag Zuma out of office and the reform-minded Cyril Ramaphosa took over.  A more realistic estimate of where CDS would settle would split the difference at 20bp wider to today’s levels. If this back of the envelope stuff were right, including carry/roll, the market’s implied probability of an AMLO victory is between 47% and 62%. That feels a little low to me, but not dramatically so. Now that the parties have settled on their candidates and they have staked out broad platforms, the real race will start with all of the political blood sport we have come to expect from modern day political races. One only has to think back to the French election last April, where Macron took advantage of the corruption and ineptitude of the policial class to come out of nowhere and win. I don’t see either of the independent candidates primed to pull that off, but it shows how much uncertainty has to be priced into these bianary events. No doubt that as the election machine fires up, realized volatility will increase and there will be more tradable opportunities.Perhaps there’s a more clear trade in MXN, which has also dramatically underperformed and now has juicy carry over 7%? More on that next week.

17 февраля, 00:34

The US Economy: So Good It's Bad

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This is why I try not to look at markets more than once a day. Just as I opine in the comments section, ringing the metaphorical “all clear” siren that there’s nothing but air between here from 17.5 to 13 in the VIX….it pops back up to 21. ….and equities roll over, sort of...spoos aren’t playing dead. At least not yet. Prior misgivings about the long-term health of the market notwithstanding, it is tough for me to see how this isn’t anything less than a beach ball held underwater. Gamma driven mineshaft drops notwithstanding, we’ll just go ahead and call this a 50% retracement. Will equity indices drive higher? The burden of proof is on the bear camp again. Looks like a grind higher towards the 2800 level, maybe there valuation anxiety rises again and we get some chop. I don’t like calling copper the world’s economic barameter, but I do think it strips out some of the noise in other asset classes. Earlier this month it fell roughly 5% from the low 3.20s to mid 3.00s. The beach ball has resurfaced….resume normal service. China. The one market with a decent reversal today is USD:I think EUR got a little over its skis above 1.25--but not expecting a change in trend here. I continue to prefer EMFX and EM local rates.Now, while there isn't much to throw sand in the gears for risk assets in the short-term, I've been clarifying why I think the glory days for US equity returns are behind us. I also mentioned in the comments that yesterday I sat in on a speech by Jim Paulsen, the ex-Wells Capital strategist that made a name for himself as the Minneapolis answer to Warren Buffett, regularly appearing on CNBC with folksy witticisms about the market. I found his outlook pretty insightful--I’ve summarized his views below,  along with some graphs I hijacked from his deck, interspersed with my own commentary.   First and foremost was the broadening of the economic recovery. I’d argue this really started back in 2015, when oil prices crashed but employment stayed strong-- and suddenly regular Americans had more money in their pockets. The data hasn’t been updated for 2017 but it is solidly higher with the trend intact.Yet, contrary to all history, and the very fabric of this country--the US consumer hasn’t levered up!  There is plenty of runway for increases in areas like retail sales or home prices given the broad household balance sheet strength. Similarly, despite fears about massive issuance by US the corporate sector amid low rates and equity buybacks, Corporate debt relative to profits is far from overstretched levels. Put another way...every dollar of the issuance avalanche (more or less) has been backed by an increase in profits. Is that a risk factor when profits eventually fall in a recession? Sure, but there’s little sign we’re there yet. Earnings are also picking up. This is far from breaking news, but what I find fascinating is the trend.  There’s little doubt we’re now at full employment--one can make a strong argument that wages have found a new, higher trend level. Which leads me to again look at US inflation breakevens. 5y breaks have risen to around 2%.... Yeah, I get it, it’s an oil trade. But it isn’t always. Looking farther back in history--not even ancient history--shows the 5y breaks/oil correlation doesn’t have to move in lockstep. If US producers indeed gun production amid higher prices in the next few months, breaks can move back towards the 1.80s but given the heavy volume in oil forward contracts that has come from US producers selling forward production, I think that’s not a big risk--or at least a two-sided one along with the potential for higher global demand to continue driving commodity prices higher. Given the supply side of the economy at full capacity and the government throwing fiscal fuel on the fire...a lot of fiscal fuel...i think 5y breaks can move towards 2.30%. Remember this would still be well inside of the new trend of 2.5-2.8% for wage increases. Here’s a reminder of what the US government is doing. Spending a ton of borrowed money is the only way to ring in a new era of bipartisanship. .Indeed, on current evidence rates have to go higher--or at the very least, nominal rates need to continue to cheapen, even if the fed sticks to the low r* script.  What about stocks? What I really liked about Paulsen’s presentation was his efforts to bring some objectivity to equity valuations. In these two charts he breaks down annualized equity returns based on that month’s unemployment rate and by the ratio of price/earnings-to-U/E (a dubious number, sure, so take it with a grain of salt). Bottom line here is that it will take a lot...and I mean a lot...of game changers to drive and outperformance in equity returns from here.    The Jeremy Grantham Fan Club, to which I count myself a member (although with the healthy cynicism of James Montier), will recognize the guts of the analysis here. Another way Paulsen looked at it was to look at six month annualized equity returns given certain buckets of the Citi economic surprise index. That index came into the year around 80 and while it has fallen back in recent weeks, the outlook after January’s equity melt-up isn’t good. Unless the economy finds a miraculous way to outperform the high expectations already baked in, equity returns are going to be low, with downside risks. It’s the white goose walking merrily along, ignorant of the fact it is being stalked by a black swan and a gaggle of grey ones.* Maybe one of the grey swans strikes--higher inflation, higher rates, lower equity valuations, or a simple slowdown in the economy-- but no shock. But as I've highlighted before, the market is ever more susceptible to the unexpected black swan. Put another way, the economy is good….it’s bad. If bond yields are heading higher and US equities are fully valued, where should you put your money? Again like Grantham….and me!....the answer is emerging markets. Commodity prices and the value of the dollar are generally good proxies for the performance of emerging markets assets.  Industrial commodities like aluminum and copper have been on a tear lately--and while EM equities have done very well since bottoming in 2016, their relative performance--especially beta-weighted--has been just ok. I’ll save a few more charts on what I believe shows better equity valuations, growth capacity, and real rates in EM...you get the picture. Compra! Shawn [email protected]*If you have the photoshop skills to turn that white goose gold, please get in touch with TMM management immediately.

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15 февраля, 22:54

Clean It Up in the Comments Section, Folks

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Re-posting this from the comments section in the previous post. I've taken a libertarian approach to the comments, but we're implementing a zero tolerance policy from here on out. ----------------Ok listen up Buy Stocks and the rest of you: per IPA's point above, I've spent precious time going through this comment thread and deleting anything that is 1) aggressive towards other users, 2) vulgar, INCLUDING using curse words with asterisks, 3) just generally disrespectful, or anything you wouldn't say in good nature if we were all shooting the breeze about markets over pints in a pub.I'm going to give you my Dad speech here--I thought you were old enough to handle the responsibility of an open forum but you've proven me wrong. I'm going to wield the ax accordingly for the foreseeable future.If you want to blast people, go to zerohedge. The people that come to this blog are here *because* they don't want to be a part of that.For me, I contribute to this blog *because* of the discourse in the comments section with bright people. I wouldn't spend the time writing this stuff if I were just shouting into a canyon. Please show a little respect to me and the others in this forum by keeping it respectful.

13 февраля, 22:27

The Short-Vol Trade: Someone Forgot to Turn Off the Machine

Equity markets took a standing-8 count over the weekend and came out swinging on Monday, bouncing roughly 1.5% off the lows from Friday’s close, and a solid 4-5% off the spike bottom lows around lunchtime. Friday’s headlines were notable given the change in sentiment--a correction!  To again quote Matt Levine at Bloomberg….”there you go. All you’re stock prices are correct now.” The rest of the financial media howled in unison. It wasn’t a contrarian green light, but it was close. Buyers had a few strong points in support:On the technical side, there’s little doubt a significant portion of the price action last week was driven by some combination of forced selling, negative convexity, liquidity seizures, and outright panic.  Fundamentally, no change, and notably cheaper valuations:still strong global growth, A weak USDStrong commodity pricesFiscal stimulus in the USA new Fed chair that has pledged fealty to the credit-addict that gave him the jobMoreover, central banks that recognize the fragility of the beast they birthedIt adds up to a decent opportunity to buy...if you didn’t get run over making the same call at some point last week. I’ll let y’all duke it out in the comment section on that one. It is the last point that has been bothering me all week. An astoundingly quiescent market, followed by higher rates and a modest risk-off move in stocks, contributed to a MOAB move in vol, gamma and the VIX. Usually when something like this happens--and it is supposed to happen periodically--vol everywhere spikes higher, FTQ assets appreciate, and the system rebalances itself. What is not supposed to happen is something like this: So what’s going on? There’s been no shortage of media coverage on the blowup of short vol ETNs like XIV. But as I highlighted last week, these products are--or were anyway--$2-4bn in notional value in a market that is many, many times that size. The real iceberg beneath the surface is the short-vol trade writ large. The short-vol trade goes by a few different names--last October, in an article highlighting the depths of the short-vol monster, Chris Cole at Artemis Capital Management illustrated it as a pyramid: Cole called this the Ouroboros, the mythical greek snake that devours itself by eating its own tail. “Volatility as an asset class, both explicitly and implicitly, has been commoditized via financial engineering as an alternative form of yield….A long dated short option position receives an upfront yield for exposure to being short volatility, gamma, interest rates, and correlations. Many popular institutional investment strategies bear many, if not all, of these risks even if they are not explicitly shorting options….Lower volatility begets lower volatility, rewarding strategies that systematically bet on market stability so they can make even bigger bets on that stability. Investors assume increasingly higher levels of risk betting on the status quo for yields that look attractive only in comparison to bad alternatives.”Put another way, as the avalanche of monetary stimulus compressed risk and pushed down expected returns, Wall Street needed a new asset class to sell in the search for yield. Pension funds needed to maintain high returns, and were ready to listen to the sales pitch for volatility as an asset class.  Let's look back a couple of years for some examples of how this was sold to investors. Pimco led the charge in 2012 with this article entitled, “The Volatility Risk Premium.” “We conclude that the risk-return tradeoff for volatility strategies compares favorably to those of traditional investments such and equities and bonds and that the strategies exhibit relatively low correlations to equity risk.” Ooh, now you have my attention, says Joe Capital-Allocator at XYZ Pension Fund, tell me more.  All too happy to oblige, Pimco continues: Well there it is...implied vol is typically higher than realized vol. Real MIT rocket science PhD type of stuff. There is a good rationale and justification for that “premium” that is not unlike an insurance premium. Though I wouldn’t call it that, since realized and implied volatility really don’t a relationship other than one that is backward looking, there is a “price” there. What’s the right price? Think back to 2012--in the article The Pimco authors concluded, “given the economic rationale for the existence of a volatility risk premium, and the supportive supply-demand situation that emerged following the 2008 financial crisis, we believe an allocation to volatility strategies could enhance portfolio efficiency.” I’ll bet they did….but they were right! Back in 2012, there were no shortage of Black Swan disciples of Roubini and Taleb pitching and building tail risk products and funds. The memories of the GFC were still fresh, and the wounds were still healing. If that weren’t enough, the entire European project nearly imploded on itself, giving more ammunition to those that believed the financial system was on a steep descent into (further) chaos. It comes back to recency bias...The demand for volatility was high. The short-vol trade was born to provide the supply...and fees!....to support it....and yield-hungry institutional investors ate it up.  It was a good trade if you had a long-term time horizon and didn’t think the world was about to end.The trouble is, someone forgot to turn off the machine. By 2015, Nomura was pitching a product they called the eVRP--the Equity Volatility Risk Premium-- all backed by a Nomura index that followed this kind of thing. As prices rose, financial engineering took over for thematic simplicity.    Now, this wasn’t just a diversifier, it was some sexy stuff! Check out these charts: The volatility risk premium has been a great trade compared to “long only”The best time to sell for is when vol is lowThe equity vol risk premium is better than ya know, other stuffAll the cool kids are doing itSo three years on from the Pimco article, when there was a tasty volatility premium thanks to the back-to-back existential crises in global markets, Nomura is pushing the same trade, only in the form of their esoteric eVRP product rather than the more straightforward Pimco strategies of 2012. And of course, Nomura has the data to back it up, and your friendly salesman has just the right product for your long-term risk bucket. This is the Ouroboros. Just like the housing/credit bubble in the mid-00s, the financial system doesn’t know how to stop. Just because there was a rich volatility premium in 2012, doesn’t mean it is perpetually and always going to exist. In fact...quite the opposite. As markets calmed, the trade worked….and more money flowed into it. Supply and demand swung the opposite direction, but nobody ever turned off the machine. The snake latched on to its own tail, compressing vols, perpetuating BTD, which compressed vols, which juiced returns. Lather, rinse, repeat. And wait for the bonus checks to roll in. How can you identify when this trade is overdone? You can probably point to your own examples, but these two charts sum it up: You’re telling me there’s an equity volatility premium….even as equity vol its generational lows?That can only be because you’re looking at realized vol still below implied vol. That’s what you call a “premium”? Then in fixed income….monetary authorities are finally hiking rates and decreasing or stopping asset purchases….and you think you can capture a “premium” for volatility above realized when implieds (as proxied here by 1m/10y USD swap vols) are THIS far below the long-term average?  (I trimmed this chart back to the lows in January before the spike in the last two weeks to illustrate the point, but the current level stands just above 80)As Cole said in the “Alchemy of Risk” article...as the short-vol sales machine perpetuated itself, it gave birth to a reflexive process: “What we think we know about volatility is all wrong….Modern Portfolio theory conceives volatility as an external measurement of intrinsic risk of an asset….this highly flawed concept, widely taught in MBA and financial engineering programs, preceives volatility as an exogenous measurement of risk, ignoring its role as both a source of excess returns and as a direct influencer on risk itself. To this extent, portfolio theory evaluates volatility the same way a sports commentator see hits, strikeouts, or shots on goal. The problem is volatility isn’t just keeping score, but is massively affecting the outcome of the game itself in real time. Volatility is now a player on the field. “That’s what has changed...Pimco and Nomura built their analysis on a history where volatility was a measure. Now it is a player. It has a price. What once was rich is now obscenely expensive. Yet for these guys it all comes back to returns--more specifically risk-adjusted returns.   How did the Nomura guys fair at selling volatility? This is the stated performance of their “eVRP” product as of January 25: 12-month excess return of 4716 basis points! A 1yr sharpe ratio of 3.74! As Kevin Muir at MacroTourist said back in November in a post on the same subject, “Hedge fund managers do terrible unspeakable things for Sharpe Ratios of 2.5 to 3. Indeed...and pension fund investors are no different. Moreover, that 5-yr Sharpe of 1.28 is pretty spicy too when compared to the Sharpe on long-only equity returns skulking on either side of .5. Now, fast forward to last Thursday:Oh dear. Our precious short-vol baby vaporized that 1yr excess return in only two weeks! And those Sharpe ratios went from heavenly to downright ordinary, and I’ll hazard a guess that these figures aren’t including the tasty fees that your pension fund paid their friendly neighborhood bank or hedge fund for managing this risk over the past few years. It started as a good trade...but as the money rolled in, they just couldn't turn the machine off. And so it begins, where the top of Cole’s short-vol pyramid has gotten wiped out--the $60-$100bn in explicitly short-vol funds that were betting on pension fund overwriting, “risk premiums”, or just whacking bids in the VIX. While these funds may not have blown up in style like XIV, they have been mortally wounded by the combination of a landmine in their performance record and the demonstrable gap in liquidity for their strategies. The universal risk management strategies like VaR de-risking like those discussed by Polemic in his weekend posts will play a big role too. Nevertheless, for short-vol the sales pitch is dead--these strategies won’t go away overnight but they will die a slow death. In the short-term, vol will subside--but the next chapter hasn’t been written yet. What does the future hold for the more subtle short vol strategies--like “volatility control” and risk parity? That might depend on faith in the system, the continued negative correlation of equities and fixed income products, and the ability of leveraged corporations to continue servicing their debt in the event of a shock to the system or a material slowdown in global growth.  And don’t forget this….liquidity is now such that this short-gamma trainwreck may not be so easily contained within equity markets when we inevitably encounter a genuine exogenous shock to the system.

09 февраля, 16:00

Musings On Mexico's Presidential Election--A Market Waiting for Tomorrow

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This July, these five characters will be vying to be the next president of Mexico. The one on the far left--in the picture and the political spectrum--is Andres Manuel Lopez Obrador, or AMLO.  He leads most polls, but the campaign is still in the early stages. From left to right: AMLO (Morena), El Gato en Saco (PRI), Flaca (Ind), El Joven (PAN), and mi guarura (Ind) Thanks to his two runner-up showings in 2006 and 2012, the market has convinced itself AMLO’s populist campaign won’t sustain itself and one of the other candidates will emerge victorious by uniting mainstream voters.  I believe political undercurrents and the polling data indicates otherwise, and current market optimism presents an attractive opportunity to sell MXN or buy MXN vol. First, a quick primer on Mexican politics. The current president is Enrique Peña Nieto, or EPN. He is a member of PRI, a party that has run the government for most of the past eighty years. His presidency has been a disaster. Growth and wages have stagnated, inflation has spiked higher, and the peso has been decimated. People are frustrated with high rates of crime, and dramatically higher energy prices, despite the promises cheaper gasoline and propane following the passage of reforms in 2014. Corruption has been a big issue too, as allegations have dogged the administration since its early days, as well as PRI governors throughout the country. This has left behind the stench of systematic sleeze, both within PRI and throughout all of the nation’s political parties. Do you really believe Mexico was the only big Latin country to be spared the public works bribe-fest led by Odebrecht? Maybe…..But it seems like a bit of a long shot.  People aren’t buying it. EPN and PRI have led his administration to unheard of levels of unpopularity in Mexico; only 26% of people approve of EPN’s government. Here is a chart of the approval ratings for this stage in time of last five administrations...none of them come even close to the vitriol generated by the current government. Source: Mitofsky Group poll, December 2017And lest you think this is a “class warfare” thing, look at this chart. EPN approval rating by group: Source: Mitofsky Group poll, December 2017This chart says….men, women, rich, poor, uneducated, educated, young, old….they are all united by one thing: a hate EPN.Well, a hate for two things. EPN and Trump.People are fed up. All of ‘em. This isn’t 2006. It is going to be a “throw the bums out” type of election. No doubt about it, AMLO is a divisive name. He is your standard-issue leftist, and talks about import substitution, national pride, how to revive rural economies, and promises to roll back market-friendly energy reforms, amid a broad “power to the people” theme. Financial markets panicked in 2006 when it looked like he might win, and there has been no signs that his rhetoric has softened in the intervening twelve years. AMLO will run against PRI’s Jose Antonio Meade, and Ricardo Anaya, the leader of the center-right PAN, as well as a couple of independent candidates who have yet to show any signs of life. Meade is perhaps one of the weirdest candidates I have seen from an establishment party in any country. He’s not even a member of the party. He’s a life long bureaucrat, with high marks for basic competency, but has never run for office at any level. In contrast to any other PRI politician, he’s clean as a whistle--but has the all the election campaign charisma of an old house cat.  AMLO leads early polls by between 3 and 12 points. But financial markets are desperate to believe Meade will somehow find a way. A brilliant illustration of this fact came last week, when I stumbled across this gem in a tweet by Bloomberg journalist Eric Martin: Now, let’s take a look at a recent poll for a national newspaper by polling firm Buendia & Laredo: Regardless of the candidate you are planning to vote for, with what you know or have heard, who is the candidate most likely to win the election of President of the Republic?Source: Buendia & Laredo poll for El Universal, January 29, 2018Put another way, actual voters believe AMLO will win by a near 2-to-1 margin. There’s a 46% gap between the proportion of actual voters that believe Meade will win, and the business elites in the Santander poll. Before we look at how that may manifest itself in a trade, let’s look deeper into the polling numbers. Presidential preference--AMLO leads PAN’s Anaya by 6 points, but a whopping 16 points over Meade. Source: Buendia & Laredo poll for El Universal, January 29, 2018Alright you say, but as the election approaches, will  center and right-wing voters unite under an “Anyone but AMLO” flag?  That appears unlikely. First, both Meade and Anaya will have their own problems uniting their constituencies. More importantly,  AMLO is way more popular among supporters of the other two main candidates than they are among his supporters. In a hypothetical two-way race between AMLO and Anaya, AMLO’s support rises from 32% to 46%, while Anaya’s rises from 26% to 38%. Source: Buendia & Laredo poll for El Universal, January 29, 2018The outlook in a two-way race against PRI’s Meade is even more in AMLO’s favor. AMLO’s support goes from 32% to an outright majority--55%. While Meade’s support rises from 16% to a pathetic 26%. Source: Buendia & Laredo poll for El Universal, January 29, 2018Another prevailing belief about AMLO is that he has a “toxic brand” among centrist voters, owing to his long history of leftist politics and his decision to dispute the results of the 2006 election. But again this ignores the data--AMLO is BY FAR the most popular politician in the race! What is your opinion of...Source: El Financiero poll, February 6, 2018Maybe there is some chance that Meade can unite the party and take advantage of the PRI “machine” to bring in the middle class and get out the vote in the rural south and northeast. But it is tough to see how, given his personal unpopularity and these numbers: Source: Mitofsky Group poll, January 17, 201859% of people say they would never vote for PRI--a number that has risen materially since Meade’s nomination in November.  With these numbers, Meade might struggle to beat The Donald in a head-to-head race.Can Anaya and the Frente por Mexico left/right alliance cobble together a coalition to defeat AMLO? Sure, it could happen, especially as the campaign picks up speed and gets into debates where he could excel. As of now, the metrics aren’t suggesting Anaya is gaining any traction, and the machiavellian break between him the Calderonistas led by former PAN first lady Margarita Zavala will continue haunt him so long as she continues her independent bid. By refusing to make peace with Zavala, Anaya signaled to many voters he is just another career politician, exactly the type of figure that many Mexicans claim they are sick and tired of. Given there is no runoff, Anaya could cobble together 30-35% of the vote between independents, PAN, PRD and dissident PRI voters and hope Morena’s lack of financial resources, campaign experience and “GOTV” machinery dilute AMLO’s electoral performance despite his broad appeal. Even if that happens, it won’t be pretty, and there will be plenty of volatility along the way.       Putting it all together: The Anti-PRI/anti-corruption vote is going to be significantAMLO is popular, and a likely second choice candidate by many non-supportersMeade will have enough trouble uniting PRI, say nothing of the country, behind his campaign,Anaya, same thing, but with marginally better chancesThere is little chance of any change in sentiment towards PRI, or a material change in economic fortunes to favor establishment candidates at this stage of the raceThe base case should look for an AMLO victory in July. So what’s the trade? First, politics matter. Another undercurrent in this fantastical EMFX market may be the belief that this is a “kinder, gentler” AMLO and EM investors aren’t that worried about him blowing up the market-friendly system. But just looking at recent history in Argentina, Brazil, South Africa, or even Chile, where equity and FX markets rallied hard after Piñera’s victory in December, and you can’t ignore the power of politics in EM. The result of this election will move the market. The easy answer is just to buy USD/MXN and be done with it. You won’t get much argument from me on that one, especially after MXN was swept along with the USD fire sale over the past three months. Nobody is making big country-level decisions (ARS and ZAR being notable exceptions). All macro, all the time. Flows. Source: JP MorganNow, over the past week as US equity markets cracked, volaitlity spiked, and short-gamma funds started washing up dead on the beach, high-beta EMFX has been quiet….a little too quiet. You could do a lot worse than to overlay a short MXN position in a risky portfolio. If you’re too squeamish--or too bullish on EM, I guess-- to buy USD/MXN outright, the currencies in the chart above would be high-carry candidates from the long side. FX volatility presents an opportunity as well. This is the chart for 3m atm volatility in USD/MXN and USD/BRL--which I included as a “control”--going back to the stone ages in 2010. Today’s level around 12% isn’t too bad at all historically--and certainly seems cheap flat to BRL.  Source: JP MorganSimilarly, 3m riskies are flat to BRL and not looking expensive at all. Keep in mind both of these trades give you protection against a global short-gamma freakout or Trump drone-striking NAFTA too. Source: JP MorganIndeed, the 3mo option expiries only give you protection until early May. If you prefer a full six months of protection to get past the election on July 1, those levels look pretty spicy. The 3mo, 3mo fwd atm vol is 17%, which you see in the chart above is higher than most any non-crisis data point. Similarly, the 3mo, 3mo fwd 25d RR is 5.3%, which is higher than anything this decade outside the European debt crisis. Those levels may pay off, but look overdone relative to spot 3mo volatility. Moreover, while the 3mo vols only take you into early May, the fireworks will likely already be in the air by that time, especially if AMLO has consolidated a significant lead and his rivals appear incapable of staging a comeback. This chart from a Barclays piece last week shows how MXN started to depreciate around this time in the 2006 cycle, when AMLO-risk was particularly acute: Source: Bloomberg, BarclaysAnd while that underperformance in MXN in 2006 was triggered by AMLO jumping to the lead in the polls, the peso continued to weaken throughout the campaign, even though it was a tight race right to the end. Source: Wikipedia, BarclaysFast-forward back to 2018, and the spec market is still stubbornly long MXN--expect that to change, soon. Bottom line, three factors set up an attractive trade here: A big disconnect between political expectations in financial markets and realityStrong signs the market is remembering the divisive, undisciplined AMLO of 2006, and ignoring his broad popularity combined with the utter disgust for the establishment, A currency that has been pushed along by a macro tailwind, ignoring the local scene,A vol market that is mis-pricing the timing for a panic--or at least giving you good odds to bet on a shock sooner rather than later. So take your pick--buy USD/MXN outright if you think the USD selloff is overwrought, sell MXN vs. an EMFX for a market neutral position, or buy vol to provide some upside for a relatively quick realization that AMLO is likely to be the next president of Mexico. [email protected]

08 февраля, 18:31

XIV Post-Mortem: We Honor the Dead

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I’m tempted to leave sorting through the short-vol/XIV wreckage to the rest of the financial blogosphere. I mean look, we’ve all been around the block--as Matt Levine at Bloomberg said, it isn’t that complicated, you bought a product that was short something, that something went up 100%. Your equity is wiped out. Thanks for playing, we have some lovely parting gifts for you.This isn't shadenfreude.  I take no joy in the destruction. I simply find it amazing that someone with a ton of firepower figured out exactly how and when to crush the world’s most liquid market at just the right time, and in just the right way to trigger a massive vol puke. It was like a boxing match where there is little action for nine rounds, then one guy takes a punch, hesitates momentarily, and then gets clobbered by a vicious, match-ending combo.Congratulations on your squeeze, whoever you are. It was a thing of beauty, and I’m sure there was champagne and steaks for all when the XIV-enemy was vanquished and victory was declared.  Just don't fool yourself into thinking you're creating any real value.Meanwhile in risk-parity land, there were more than a few nervous managing directors as the financial media swarmed around the idea that robots triggered the meltdown. Just to be on the safe side, Bridgewater and AQR  put out a joint press release  were quoted in a WSJ article today in defense of risk-parity. “It is definitely not driving global asset prices. It just sits there like a turtle,” Bridgewater CIO Bob Price said. “We have done pretty much no trading in risk parity” Cliff Asness of AQR said.I’m sure that’s true, but it highlights how this was an orchestrated squeeze rather than a real crisis. Spoos may have taken a big dump, but market liquidity backstopped the selloff once strong hands figured out what was going on. So AQR and Bridgewater didn’t have to do anything--they just let their models keep doing their thing. They had little to fear from outflows or any type of financing squeeze for their leveraged positions. They won’t be so fortunate when this type of event happens in the midst of a real liquidity crisis that strangles financing capacity.What happens next--there are a few points short term: The quant folks at JP Morgan think this shock to systematic trading/short vol “asset class” will generate as much as $100bn in outflows from these strategies. I don’t think that has a macro impact other than to leave less of an offer for vol when the market stress subsides. That means lower asset values and wider credit spreads at the margin, but not dramatically so. Second, I agree there is likely still a residual hedge to be unwound for whoever is wearing the position that Credit Suisse dumped on them when the market went berserk earlier this week. They will find a way to parcel it out over time--that’s what these guys do.The mentality--or flows-- to make money from short gamma and/or tighter ranges within a rising, low-vol, risk-on market isn’t dead.   I continue to believe this event won’t permanently break the market, but I do believe it could be remembered as the event where we should all have known quant strats and yield-chasing have gone too far. It reminds me of mid-2007, when Northern Rock blew up.  I remember a prominent newsletter author saying at the time that the market had to give up a big whale….and Northern Rock was it. Well, the market had to give up a big whale alright, but it wasn’t Northern Rock.XIV is far from a whale--heck, it isn’t even a Northern Rock. XIV is more like a small trout some big bank or hedge fund just pulled out of a river. This market isn’t out of kerosene quite [email protected]

05 февраля, 23:58

We Interrupt Normal Programming for....Vol!

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Alright, so at some point in the next few weeks, we’re going to be able to start analyzing markets again without simply writing off the most recent price action to bubble-mania, bitcoin flows, stock-and-trade momentum, or any other fanciful unintelligible metric of your choice. Let's go to the facts:The Treasury curve is bull steepening, indicating there isn’t much of a change in long-term sentiment, but a modest re-pricing of short-medium term expectations for the hiking cycle. More to the point, there hasn’t been a big bounce back, FTQ flow, or simply a material reversal in UST term yields. Look, there’s another 30bps to go in UST 10yr before we get to where we started the year. And I repeat, the long bond at 3% and a 30yr fixed mortgage at 4.25% won't bring the economy to a screeching halt. Sticking with rates...credit markets aren’t showing any stress either--HY is down less than 1% for the day, and IG credit indices are something like 4bps wider on the day. Color me unimpressed with this state of panic--not two years ago that type of vol was just another day at the office. And looking at another of our favourite markets,  the USD is far from reversing...in fact we’ve just now given up a week’s worth of gains in DXY.  Not much to speak of here, until we start looking at the 1.20 level in EUR, or taking out 112 in JPY. Similarly, if I were to do something reckless like use usd/mxn as a proxy for global EM currency risk appetite, it is clear there is a long way to go to reverse out recent gains: Meanwhile, more prosaic markets--yet those linked to global demand and the manufacturing cycle, have been stable, nearly boring. Take a look at the copper chart, which has lulled traders to sleep, despite “accelerating global growth” being the talk of the town: At this point, it appears we’ve burned off the 5-6% outperformance in the US equity market...a market that nearly the whole world said was some combination of illusionary, a “melt-up”, driven by January retail flows, or simply nuts...all with relatively little collateral damage.So what’s going on? Can this degree of vol really be isolated to such a deep, liquid market? Let’s take a look at the chart that ties it all together….frequent commenters know what’s coming next: That’s the VIX, going out today above the magic 30 level, higher than only one other data point in the past five years, which was right after the Chinese destructo-deval of August 2016. Put another way, this measure would indicate we're at levels to suggest widespread panic, blood in the streets, and margin departments gang-pressing Park Avenue passers-by into temporary service. Now stop and think about just how complacent this market has become, just how much money has flowed into short vol, or gasp, levered short vol, how pension funds now think short vol is a high-yielding asset class, and how there is just a ton of traders that have gotten fat and happy collecting short gamma nickels. The gamma check has come due...never send for whom the bell tolls; it tolls for thee. With the S&P looking set to close at late December support levels, the overarching message is there isn’t a genuine change in macro sentiment, but rather a reversal in a market that had simply gone too far, too fast dependent on an avalanche of money, momentum and hope. I don’t want to use the term “healthy correction”, especially in a market that was high on financial amphetamines rather than "healthy" to begin with.  Yet there is little evidence to suggest this selloff is global in nature but is instead blowing off the exuberance of the past couple of months. Will it continue? I’m skeptical the party is over--I see no reason to change my optimistic view of foreign assets....but the sordid short volatility tale may just be getting going.