Considering the news that come from China regarding huge capital outflows and shrinking reserves, do you think it might affect your long bond strategy? At some point liquidity issues in the market and the sheer volume of the bonds China is selling can affect yields, especially the long term yields. I see China the biggest danger to the world economy, especially if they decide hard to devalue.

Chinese problems make me more confident of my bullish bond view. A slowdown and especially devaluation are very deflationary for the USA. I am not concerned too much about bond liquidation from China. My sense is that some of it is going on already and is priced into the market. Furthermore, while their portfolio of US securities is very extensive, the duration of that portfolio is not that high. Most of their holdings, to the best of my knowledge, are in the short end. 

Alex Japan and Europe are both in the process of QE but USD EUR and USD JPY are going nowhere, so is the QE already baked into the prices? What could be the catalyst for the next leg down and what is the risk that either of them actually rise?

I am not sure if QE can be fully baked in, because the actual buying is a material force that continues to push the currency down. Beginning of a hikng cycle in US could be the catalyst for the next leg down, while a position squeeze reamins the biggest upside risk. 

Is the Federal Reserve procrastinating?

The generic assumption is that any government agency is out-of-touch and ineffectual. There may be a truth to that, but it doesn’t mean that the individuals in charge are not actually trying to do their best. Neither should we assume that they are all stupid.

With the next Federal Reserve meeting coming up this week, it is worth reviewing the Central Bank’s dilemma.

Investors can be divided into three main camps:

  • Economy is fine. Inflation pressures are rising. The Fed should and will hike soon.
  • We are heading into recession. Deflation pressures are rising. The Fed will not hike anytime soon.
  • We are heading into recession. Deflation pressures are rising. The Fed will hike soon and make things worse.
  • As I have written before, I have my own small camp:  “Economy is fine (at least in the USA) AND deflation pressures are rising”. See my post from March 22nd, 2015

    It is important to understand that each of those camps has strong arguments and statistics to back their position. Anyone with an open mind should be wary of being completely convinced when so there are so many strong counter-arguments.

    As my readers know, I have critiqued Bernanke’s Fed before and I am a bigger fan of Janet Yellen. But whoever the chairperson is, the occusation of being an out-of-touch academic hangs over their head.

    Now, as a former academic I can tell you: intelligent people are aware of the differences between models and reality, regardless of their theoretical background. They are aware of the risk of being out-of-touch and are trying with all their not inconsiderable resources not to be.

    Now let’s assume that Yellen is familiar with all of the current schools of thought and is not completely convinced by any of them. What is the safest course?

    If the Fed followed the hawkish docrine and hiked as early as June, they would have risked the runaway dollar strength and destabilization of global economy, which would eventually backfire domestically.

    On the other hand, pushing the hiking cycle indefinitely has its own risks. Arguably, ZIRP can lead to a dangerous rise of leverage and price distortions. In the recent months, as the market had started expecting a more dovish Fed, the long bonds actually collapsed. It is hard to be sure how much of it was just positioning and how much the erosion of the central bank’s credibility, but the consequences could be counterproductive for the economy.

    Thus the current procrastinating stance of the Fed:

    “We will hike sometime soon, honestly. Just not today.”

    One could argue that their information is not likely to become much more conclusive soon. But such indecisiveness may paradoxically be the most benevolent course:

    • The pace of the dollar rise stays under control
    • Rate expectation are kept away from zero to prevent a complete party in the short-end

    So is it possible that the Fed is actually smarter than we think? That they are doing there best to guide their boat between Scylla and Charybdis?

    Should we expect more of the same: “just not today?”

    Image “Between Scylla and Charybdis” by Cea.

    Currency values amidst the commotion

    As the Greco-Chinese drama unfolds in its ebbs and flows, strategic clarity is paramount. First, let’s separate opinions from facts.

    • It is still completely unknown whether there will be any material economic fallout from the Greece crisis (see my post from June 28th
    • It is safe to assume that there will be a global deflationary shock wave resulting from Chinese stock market crash and trading freeze-up. Hard to imagine recent events to have no effect on consumption and investment. Recent fall in commodity prices is an example.

    In this post I will go over a few world currencies and their connection to the recent events.


    • Facts: US job market appears to be steadily improving. The Fed exited the QE program and is contemplating a timeline for tightening.
    • Opinions widely differ and how well the economy is actually doing and whether there is any imminent inflation threat.
    • Currency: Long dollar continues to be the theme as it is favored by the policy divergence and spiraling pressure on the Emerging Market and falling commodity prices.


  • Facts: The economic performance appears improving, but there is no immediate threat of inflation. Greek crisis postpones any possibility of slowing down the QE.
  • Opinions differ on the full outcome and impact of the Greek debacle.
  • Currency: Short EURUSD remains my core position. The QE is in progress regardless of the Greek outcome. And any rebound in the Eurozone economy is not necessarily currency positive as I’ve written on May 3, 2015. 
  • China:

  • Facts: The economy has slowed down from its earlier tremendous pace and needs to work out some imbalances. The stock market is going through a massive correction and extreme volatility.
  • Opinions differ on how sound the overall economy is and on the necessity of the RMB devaluation.
  • Currency: Outright and options bets may offer a positive risk-reward as the potential for significant devaluation appeares underpriced. But there is no certainty of success and high likelihood of getting the timing wrong. Betting on the currency requires a strong China view.
  • Japan:

    • Facts: The inflation target is still not achieved and the economy is still struggling to accelerate. The QE is in progress and current government and central bank are extremely committed to achieving their inflation targets.
    • Opinions differ about the country’s economic future.
    • Currency: As short-term panic typically cause a flight to JPY as one of the “safe haven” currencies, I see any dips in USDJPY as an opportunity to build long USDJPY position. Indeed, Chinese slowdown is deflationary, and of all the central banks BOJ has the prime political mandate and tools to fight deflation. So the market’s tendency to strengthen the yen during stock market dips is completely counter-economic and a good entry opportunity.  


  • Facts: The economy is experiencing headwind from the China slowdown and falling commodity prices.
  • Opinions differ on whether the currency has reached an attractive valuation after the recent plunge.
  • Currency: Any bets the AUD have a strong component of expressing opinion on Chinese economic growth.
  • Emerging market:

  • Facts: Producer countries are suffering from falling commodity prices. The broad dollar strength is putting pressure on all dollar-funded carry trades.
  • Opinions differ on whether countries like Brazil or Turkey now represent value.
  • Currency strategy: I believe caution is still in order when investing in EM as the trend is abysmal, but if your portfolio is overall crisis resistant, some bottom-fishing may be in order.
  • South Korea:

    • Facts: Japanese currency weakness and Chinese slowdown are both deflationary for their neighbor.
    • Opinions differ of the overall economic health and debt problems.
    • Currency: I think KRW is on one-way train and this train is not going North. The current environment seems to offer very low chance of significant KRW appreciation. I am in favor of long USDKRW.

    To summarize: long dollar vs. USD, JPY, and KRW seems to be a good risk-reward proposition regardless of the crisis outcome.

    Image: “Money changer” by calamur

    Chart source: Yahoo! Finance