This is an excellent question: the decision about my USDCNH strategy, involved many parameters I use in my strategy. While I have been a China sceptic for a while, up to the end of 2014, I had considered betting against RMB to be a trade STRICTLY INFERIOR to bets against JPY and EUR, as described in Part III of http://tinyurl.com/q3sdqpo
In 2015 the dominance relationships changed, I may write about this in more detail but bets against stock market and currency no longer appeared to be dominated by other trades. On the other hand the was still the negative carry.
However, as dramatic appreciation of RMB didn’t appear to be likely any bet against it had a flavor of an option (whether it was actually an option or plain forward). In Part II I wrote why I try to be careful about using options. But the are situations like this one when an option strategy offers a very favorable risk-reward and hence may not be omitted. Such trades feel like a version of a “free lunch”.
As a result of this analysis, in the Spring of 2015, I have established options positions betting both against Chinese currency and equities,
Tomorrow’s FOMC will almost certainly bring in some excitement. While the prevailing opinion and market pricing seem to be no hike on Thursday, there is still a healthy degree of uncertainty priced in. Consequently:
The short end of interest rate curve will HAVE to move one way or another.
Be careful about trusting the odds of hiking calculated from Fed funds and Eurodollar futures. Correct pricing would incorporate various risk premiums and technicals which can muddy up result.
In the past, when I used to bet heavily of the FOMC outcomes, I tended to “favor” the “favorites”, i.e. I believed that whenever there was a more likely outcome the probability of it happening was EVEN HIGHER than projected, because the Fed didn’t like to rattle the market.
But now we have a new Fed and an unprecedented rates situation. I am not ruling out a hike with a dovish language. So I have no position on October Fed Funds futures.
The only meaningful bias I have with regards to the short-term Fed path is that the first hike is unlikely to be in December. There is the economic data lag I have been anecdotally observing over many years, but have no rigorous study to support with. I have noticed that periods of stock market correction and increased volatility tend to be followed with negative economic data surprises with a 2-3 month lag. And if the Fed don’t have in them to hike tomorrow, softer data this fall is unlikely push them over by December.
One can possibly play with the futures to express my view, but since the December hike probabilities are not placed that high, I see little edge there either.
So I falling back on my core strategy that I have expressed in my book “The Next Perfect Trade: A Magic Sword of Necessity” (now out on Amazon: ://tinyurl.com/q3sdqpo ):
I will see the forest behind the trees and I will not be afraid to enter.
I try to ignore the short-term volatility and stick to strategies which are not dependant on the exact Fed path.
There are two broad possibilities:
Fed never hikes and possibly goes to QE4. In this case being long UST’s will be earning excellent carry forever.
At some point the Fed hikes which is likely to cause curve flattening and stronger dollar, whenever that happens.
Long dollar and long bonds was the perfect trade of 2014. The two components were very nicely negatively correlated and were both grinding up overall, delivering an insane Sharpe Ratio (for those who care about Sharpe).
The correlation party is over in 2015. This year is a lot about positioning, so be prepared for every kind of counter-intuitive outcome.
Buy the rumor, sell the fact, and then buy the fact to fade the selling of the fact.
Don’t necessarily expect bonds (with the exception of the very short end) and equities to go up on the “hold” and “down” on the hike.
First, as I have pointed out many times already, at the beginning of a hiking cycle the long end interest rates have no clear correlation with the overnight policy.
Second, the idea of “dovish hike” or “hawkish hold” muddies up the issue quite a bit.
And positioning is what is likely to matter. If you do care to trade over the meeting – watch what will overextend before the FOMC meeting – it will be more likely go the opposite way afterwards, regardless of the outcome.
I have to be patient and cautious. While my strategic imperative is to still to be long both dollar and bonds, both positions may be hurt by a “hawkish hold”. Or not. Bonds are being beaten down into the Fed, which make me more bullish.
So my inclination with respect to predicting the FOMC is DON’T BOTHER. There will be better trading spots
Also, I recorded my newest interview with Raoul Pal on RealVisionTV (my first interview is available for free on its site using this link; for the latest one you’ll need to subscribe but I find its content invaluable so please take the step to sign up using promotion code “Alex”). It was an excellent chance to review the concepts I was pondering as I was writing the book over the last year, and apply them to the current turbulent markets.
There is no longer an easy equivalent of the logically irrefutable long dollar/long bond trade of 2014; however, chaos breeds opportunities. What does my current investing strategy dictate?
The approaching Federal Reserve meeting is the most contested one in years. In the past, I worked hard to predict the exact path of the Fed Funds, and I was not bad at it. But nowadays I often feel that there are bigger fish to fry.
Some people think they will tighten several times in a row and some people think they are not tightening in our market lifetime. Let’s accept this uncertainty and try to come with a portfolio which will work regardless.
Long-dated bonds were my beacon through this cycle. Again and again, I have been repeating the mantra:
No hike means bonds earn carry
Hike means stronger dollar, curve flattening and long bond rally
Another beacon of value in the times of stock market correction, may be cheap, established technology companies that are unburdened with excessive debt and have proven to be able to adjust to the change.
On the other hand, the world of currency trades has shifted from “slam dunks” to merely “good risk-reward propositions”. My significant bets on weaker euro, yen, Swiss Franc, and yuan, after the original surge, have meaningful downside.
Chinese currency devaluation is coming into focus. I am inclined to stay with the trade as I can’t imagine any other way to stem the tide of capital outflows.
I have to face that sitting here today having little conviction about the direction of the stock market or economic growth (both domestic and global). This doesn’t mean I can’t have a position.
In my book and in my recent interview, I explain how I rely on my understanding of causality chains between various asset classes, rather on predicting the market direction.
So don’t get flustered by volatility. Take a deep breath, and instead of aiming for the narrow target of precisely anticipating the price action, look for trades that will succeed even when your views are wrong.
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