Central Banks Teach 2015 Trading Lesson

Arguably, the three biggest Central Bank (“CB”) driven surprises so far this year:

  • January 15, 2015 –  SNB de-pegged the Swiss Franc, causing catastrophic revaluation.
  • August 11, 2015 –  PBoC suddenly devalued the RMB; a historic change in stance.
  • December 3rd, 2015 –  ECB dealt a disappointment to the doves causing a massive rebound in the Euro, as well as Euroland yields.
  • The three events listed above were particularly educational for me, as each CB action and marketresponse had its own unique impact on the portfolio given three different positioning environments:

    • SNB –    No significant CHF positioning into the moveo 
    • PBoC –  Large, specific CNH positioning in anticipation of the move
    • ECB –   Large portfolio positions and substantial risk exposure

    The market shocks I observed and their corresponding impact on my portfolio all rang strong truth towhat I have discussed in detail in Chapter 10, “Portfolio Paralysis”, of my book, The Next Perfect Trade:

    Huge optionality lies in having unencumbered capital.

    I have described Portfolio Paralysis as the instance when you cannot take advantage of a sudden market dislocation because your capital is already tied up in existing positions.

    Aware of my previous tendencies to be overconfident and stretch positions enough to become vulnerable to portfolio paralysis, I had introduced a discipline of limiting exposure during the “good times”, when everything seems to be going my way.  Hence when the market suddenly turns I can take advantage of the dislocation and increase positions, rather than being forced to cut.

    My long bonds, long dollar, long stocks portfolio had been tremendously productive through 2014 and into the first quarter of 2015. Correspondingly, I exercised some caution proceeding further into the year. Retrospectively, it was still not enough caution.

    One could make an argument that I was sized correctly because I survived the vicious correction in the second quarter and was even able to incrementally add risk. Yet by June 2015, the drawdown put me uncomfortably close to the edge of the cliff. In action movies, heroes repeatedly dodge bullets or cars by a millimeter, narrowly slip under the drop-down gates or deftly defuse bombs with only seconds remaining.  I posit that in markets, as in real-life action sequences, such circumstances are a sign of failure to be in the position in the first place rather than success in getting out.  In other words, if you teeter too often on the edge – you are bound to fall off sooner or later.

    How does this lesson relate to the three central bank surprises?

    Going into the ECB meeting, I considered myself not to be overextended. Having said that, an important tenet of my strategy is not to reduce my core positions ahead of important data releases or policy meetings.  My rationale is that if markets were to gap in my favor, I would irrevocably lose a portion of my profits. Alternatively, if the markets were to gap against me, I would still expect to recover the money given that my long-term view is likely to be correct.

    So, I took some profits on the favorable Euro move in November 2015 and was not losing any sleep over the ECB. The result, however, is self-evident:  EVERY position in the portfolio was hit, causing a multi-standard deviation loss (not that I believe in the Bell Curve probabilities). December 3rd turned out to be the single worst trading day of my career in percentage terms.  Yet, it was nowhere near the most painful or stressful day.  

    In fact, I started the day at an all-time High-Water Mark with a decent amount of profits locked up. While the move was ferocious in total drawdown terms, my portfolio was under much less pressure than during the second quarter compression and other tough spots in my career.  I was able to judge this time that the ECB-related contagion and sell-off in the US Treasury Bonds was largely position driven and likely to be short-lived.  I not only held on to all my positions, but also was marginally able to increase my long bonds exposure. Even so, it felt and still feels a little too close for comfort. Importantly, caution precluded me from SIGNIFICANT increase in positions, and therefore, I didn’t really take advantage of the volatility.

    Now, I am not so arrogant to believe that I should make money on every instance of a violent market move. All you can hope for as an experienced trader is that the aggregate of your first buy/sell reactions puts you slightly ahead of the game over your career. A long-term trader faces a tradeoff: keep your position larger to profit more on the underlying trend and risk portfolio paralysis OR decrease risk size to have “dry powder” when the market dislocates.

    There is no exact criterion for the right level of risk. But consider this: I was spot on with China,anticipating both the equities sell-off and the currency devaluation. Fearing a short-squeeze, I expressed my views via options with the intention to hold them into expiration. But options entail additional risks of failure discussed in Chapter 9, “Adding Unnecessary Complexity”, of The Next Perfect Trade. As Chinese markets were recently progressing in my direction, I explained in my October 5th blogpost, complete success was far from certain.  Indeed, due to imperfect timing and time decay on the options I have only managed to break-even on the equity trades. The currency options are deep in the black, but as I have written, the battle is far from over.

    Finally, the CHF de-pegging in January caught me completely by surprise.  In fact, in December 2014 I wrote about initiating a short CHFMXN position. However, my exposure to CHF had been sufficiently small and overall performance sufficiently good, that on January 15th, I experienced no hint of portfolio paralysis.  I was able to think clearly and take advantage of the panic by selling CHF. This is what I wrote on that day. By diving into the unexpected dislocation, the trade turned out to be one of my best money-makers, both in absolute terms and in terms of the ROC in 2015.

    Hence, the lesson of 2015 taught by Central Banks:

    During extreme market events, a clear head and free capital may often trump correct, but unwieldy positioning.

    Good Luck with the Fed this week.

    Image: A New Japanese 7th Grade Classroom by Angie Harms

    In the financial world, we often hear that when the equity market lose on a day the the yields on the bonds go lower. As if the participants are running to the fixed income for security when there is volatility in the equity market. So my question is that how is it possible on a day to day basis, e.g. if I am a fund manager who is long equities and expecting volatility I get rid of the long position and buy bonds or vice versa. How would this strategy be profitable in the long run?

    Generally, the process is more slow and complex. I discuss much of it in The Next Perfect Trade. One market modality to consider is: when stocks go down, we can incrementally expect a slower economy and, thus, lower bond yields. Fund managers don’t necessarily rebalance on the daily basis, but fast money speculators create price action.

    Bitcoin on RealVision

    Recent bitcoin volatility has left many people scratching their heads. Is the cryptocurrency heading the way on the new “universal gold” or the way of beanie babies?


    As my readers, know I am cautiously curious. Like some, I think it worthwhile to allocate a small portion of your portfolio to the bitcoin, in the event it explodes 1000-fold.

    Dan Morehead, a huge bitcoin enthusiast, will not argue it is by any means a safe investment. For myself, I see multiple vulnerabilities:

    Government crackdown

    Public loss of faith/interest

    Competing cryptocurrencies

    Encryption-breaking algorithms 

    But we are not talking about Treasury bonds here, rather it is a “Pascal’s Wager” – modest investment with a potentially infinite payout. 

    However, the same logic could have been applied to beanie babies. 

    What distinguishes cryptocurrencies and blockchain technology, so that many experienced financial industry professionals such as Dan Morehead, Ex-Head of Macro Trading at Tiger Management and now CEO of Bitcoin investment firm Pantera, and my former senior colleague, Blythe Masters, throw their lot in with this new wave?

    Today in RealVIsionTV, Dan Morehead interviews Wences Casares, the Founder of Xapo and a bitcoin pioneer. This conversation is certain to bring some insights.

    Here the teaser https://teaser.realvisiontv.com/146689832

    To sign up a free trial for www.realvisiontv.com and view the whole interview, use the code FREETRIAL. If you decide to go on with a paid subscription use ALEX1 for discount.

    Good luck in the changing world!

    Chart source: coinbase

    Is a December Hike Another Step Towards NIRP?

    Economic bears welcome the imminent hike with grim glee. Now they can be certain that the Fed will not fail to push the economy into a recession.

    Meanwhile, economic bulls and policy hawks point out that signs of reviving wage pressure suggest the Fed is well behind the curve.

    The question I ask myself is not “which of those of factions are correct?” but “how should I position my portfolio given the growing dichotomy between the two camps?” If the skeptics of green shoots are correct and we are about to fall into some deflationary hell, I should do very well with my long bonds.

    So, for the purpose of challenging my market position, let’s side with employment bulls.  What will it take to lose money on being long US bond futures? Not for tomorrow, but on a 2-to-5 year horizon?

    Clearly, if the fed hikes once or twice and NEVER goes again, the bonds will be cheap – you can earn 3%yield and fund at 0.50%. The point being that despite a likely volatile market-to-market, over the long-run, the economics has to win – the carry will just accrue. Chapters two and three of my book, The Next Perfect Trade, discuss such carry and value considerations in detail.

    Barring US sovereign default concerns, to put pressure on profitability of bonds bought with 3% yield, the overnight rate would have to go above 3% AT SOME POINT. But what else will have to happen in this case?

    Along with long US bonds, I am also long the US dollar. I have discussed the interplay between those two trades multiple times. I consider this combination in 2014 to have been one the two greatest macro trades (a “perfect trade”) in all history of markets. But I also wrote in 2015 the position was not looking quite so easy. Indeed, in the months following the completion of the book the strategy has meandered, making a trader rely on tactical skills to deliver any profit.

    As of today, the long dollar trade is getting crowded in the anticipation of the policy “lift-off”. So it is not inconceivable that the original hike is already priced in and one or two hikes will not really move the needle.

    But what about going all the way to 3% while the other major CBs are still easing?  One may argue that hiking cycles in the past have not always coincided with broad dollar strengthening. But in this particular environment, I have trouble imaging the dollar not continuing its uptrend in the event of such a dramatic hiking cycle.

    It is important to remember that US is not an export economy and a strong domestic currency may at first be only a very moderate drag on the GDP.  Thus a cyclical recession might not be imminent.

    However, certain things are likely in a strong dollar environment:

    Suppressed commodity prices

    • Labor outsourcing 
    • Emerging markets debt troubles 
    • Chinese currency decoupling and devaluation 
    • Deflationary shocks coming from overseas

    None of those things make me think of an inflationary spiral.
    The historical pattern of the last few decades has been a fairly regular alternation of easing and tightening cycles with each easing cycle pushing rates into a lower and lower territory.

    As I have mentioned, I am agnostic about the current strength of the US economy and I am not trying to argue that we are about to enter a recession. But I do assume that a recession will happen sometime in the next few years, and most likely soon after the end on the tightening cycle, as the historical pattern indicates.

    In the event of significant rise in interest rates I don’t expect a break in the secular disinflation cycle; in fact, I expect the next easing wave to take us into the negative rates territory (NIRP). Hence, when David Schawel (@DavidSchawel) conducted a poll on the Fed Funds rate three years from now – I called for negative one percent (-1.00%).  Not that I have any conviction about this level or timing; I just think it is at least as likely as any other outcome.

    So with the Fed getting ready to move, I am getting more constructive again about the long US dollar/long US bonds. I see two longer-term scenarios.

    1. One and done. Massive gains on the bonds. Dollar unclear, but still supported by policy divergence.
    2. Protracted tightening. Gains on the dollar. Possible pull-back on bonds, mitigated by curve flattening. Eventually, massive gains when the easing cycle plays out.

    In the interim, one can expect all sorts of short-term market-to-market volatility, which may be the price to be paid for the high likelihood of longer-term success.

    Image: Ruth Hartnup Beware of red men dive bombing off cliffs

    Inverted Swap Spreads – “Not  Apples-to-Apples”

    Today’s market participants are thoroughly puzzled by the recently
    renewed inversion of swap spreads;  in
    other words, by the fact that the yield on the long-dated US Treasury notes and
    bonds is higher than the corresponding interbank swap rate for the same

    US 10yr Swap Spreads over
    past 5yrs


    Several portfolio managers, financial journalists and market
    spectators are calling this inversion completely
    illogical, and even mathematically impossible.
    And usually they site this as evidence of a broken financial system.

    Indeed, it seems to make little sense that
    the swap curve which is based on LIBOR (London Interbank Offered Rate) would
    reflect a lower lending rate than the full faith and credit of the US

    From a market perspective, those who follow me know that I am big
    fan of US bonds and that I think they are currently cheap on both an absolute
    basis as well as relative to swaps.  But
    in the interest of intellectual honesty, I must concede that the inversion of
    swap spreads is NOT mathematically meaningless.

    Allow me to share an observation I made in my very early days
    after entering the swap market in 1997. 

    The popular “swap spread” is not a
    spread between apples and apples.

    In fact, the spread
    compares two completely different types of financial instruments.

    • A bond, which is an asset, is a security which represents
      term lending of cash to the government and includes all associated risks.
    • A swap, which is a derivative as opposed to an asset,
      represents a bet on a string of three- month interbank lending rates which
      includes no principal risk.

    In other words, the swap spread does not compare ‘term lending
    to the government’ with ‘term inter-bank lending’
    . If you doubt it, see
    where a bank can borrow money for ten years – I can assure you the rate would be higher than that of a ten year US Treasury.

    So, we are comparing term lending to the government with a
    projection of a rolling short-term interbank lending rate. And if the interbank
    market breaks down, the payers of Libor will be nailed for a period of days, quarters,
    etc, but will not risk the whole principal investment like the bond holders.

    Importantly, the way to
    think of the inversion of the swap spreads is not a mathematical break-down,
    but rather a spike in the term premium.  The
    situation we are witnessing today is not new to debt-laden, developed
    countries, such as Japan.  

    Japanese 10yr Swap Spreads
    Since 1998


    That said, we can still perform a “carry” or
    “terminal value” analysis of the trade of being long bonds vs. paying
    interest rate swaps, similar to the examples I discussed in Chapters Two and
    Three in my book The
    Next Perfect Trade

    Mathematically, we are comparing three month LIBOR with the
    rolling funding rate for Treasuries; the rate at which you can borrow money if
    you offer your bonds as collateral.  Note: in the unlikely event of imminent
    default, the funding rate will go to virtually infinity.

    While most of us are not actually afraid of a US default, we
    cannot secure the funding rate that would guarantee arbitrage profits.
    Banks can likely secure the funding, but they are limited in their ability to
    take additional market risk or expand their balance sheets.

    In summary, the swap spread inversion is not mathematically
    impossible and does not indicate a collapse of the financial system.  And, betting on its normalization is a good,
    but not riskless trade.

    Image: Apples to apples to apples by Artful Magpie

    Hi Alex, Firstly I’d like to congratulate to your book its the best I’ve ever read. After I read the book I got really interested in your approach. I’d be very grateful if you could give us a little insight about the background you use to get an economic view. Do you use the regular leading indicators like ISM, UMCSI etc and you mentioned you read lot of research. Are they public? Keep it up and all the best for your new fund.

    Thank you for your support and encouragement – it means a lot. I will much appreciate Amazon reviews and “spreading the word” in any other ways.

    I definitely follow major economic releases such is GDP, CPI, ISM, NFP, and so on. I am trying to focus on the broad concept of “what is going on”, rather on a very deep detailed analysis of numbers. I rely on my personal and social media network to point me towards any interesting unorthodox pieces of research, which can help me to evolve my paradigm.

    Good luck in your endeavors!

    China Strategy Overview

    I’ve been somewhat prematurely congratulated on the success of my China strategy. Indeed, I have been vocally sceptic this year about Chinese stock market and currency. And given that I ALWAYS put my money where mouth is, it is natural for my followers to assume that I making “fortunes untold” on those trades.

    The reality is that the trades I have been involved in this year have been, while profitable thus far, were by no means “slam-dunks” and may yet end being in the red.

    The readers of my book “The Next Perfect Trade” http://tinyurl.com/q3sdqpo have pointed out that the long USDCNH trade, for example, may not meet some of my criteria for a superior trade.

    My book had been mostly completed before China came into focus. In this post, by popular demand, I will outline my approach to trading RMB and $FXI in the light of my broader strategies.

    As far back as 2006, I have started to suspect that Chinese economy was a giant Ponzi Scheme destined for a collapse far more devastating than what happened to Japan in the 80’s.

    To be clear: I don’t produce my own economic research, all I can do is listen to people and side with those who make more sense.

    However, for years I have stayed out of betting against China, because I couldn’t formulate any bearish strategy that would fit my criteria. I’ve written before how difficult, in general, it is to be short a stock market and as for the currency – the appreciation trend had been overwhelming.

    I have mentioned in my book that if you can’t a find a good trade to express a view, you may want to question the view. So despite, having a wrong view for almost a decade, I have escaped much damage by failing to find a trade fitting into my strategy.

    By 2013-2014 the China troubles appeared more imminent to some experts, but my eyes were turned elsewhere. I saw tremendous value in being long dollar vs. yen and, later, vs’ euro. But my strongest conviction was in the long end of the US Treasuries curve, where I had a disproportionate risk concentration by the beginning of 2014.

    According to my strategic language (which I explain in detail in my book) being long USDCNY  (betting on RMB devaluation) was, while attractive on its own, a strictly inferior trade with respect to other positions in my portfolio.

    For the currency devaluation to occur, at least one, if not both of the following conditions had to be concurrently satisfied:

    • Broad dollar strength
    • Dramatic weakening of Chinese economy

    My portfolio was already directly aligned with the first condition; and a massive Chinese slowdown was likely to affect the global risk appetite and cause a flight to the US bonds. Thus, in 2014, the currency bet was redundant to my portfolio and I stayed out.

    In 2015, the game had changed: the dollar had already rallied and so had the bonds, making those bets no longer as superior. I was increasingly convinced by the arguments for the necessity of the Chinese credit cycle unwind. (I will omit the discussion of idiosyncratic pros and cons  – I have written on the subject enough and for further information read “A Great Leap Forward?” by John Mauldin and Worth Wray.)

    Yet I was waiting for another shoe to drop: the stock market. I thought Chinese stocks screaming up would give the government a good excuse not to devalue. Yet without devaluation the equity bonanza was likely to end in tears.

    So I got involved in two very uncharacteristic trades: long USDCNH (offshore bet against RMB; at this point it appears I might have done better with USDCNY) and short FXI (Hong Kong listed Chinese large cap). I chose to bet against the dollar expressed ETF, because I was hoping for an additional benefit in the event of currency devaluation.

    But Chinese stocks were rallying and I had no intention to be wiped out by shorting into the bubble (I’ve written about this too). So my only “option” was to buy puts, illiquid and expensive as they were. And as the market continued to rally another 25% since I started, I kept adding more puts, but I was beginning experience pain.

    Why would I get involved in buying options and in betting against a currency with positive carry? I have cautioned against both of those things in my book. There are times though when the risk-reward appears so skewed, that it is beginning to have the flavor of a “free lunch”. I decided that the opportunity was too great, and in the absence of the ability to structure a “no-lose” trade, I had to risk some fixed amount of capital.

    Initiate the positions and run them to the bitter end. No hedging, no whining.

    Not only my long dollar/long bonds came under pressure in Q2 of 2015, but the capital committed to bets against China was grinding away. Fortunately, I had been positioned with enough caution to keep all the trades.

    Needless to say in Q3 things got much better.

    But I want to emphasize that my entry points were not perfect and the trades are far from complete with my portfolio still leaking carry and decay. In fact, the extreme scenarios, I have been hoping for, HAVE NOT yet materialized.

    The equity trade I think will be over soon one way or another. But I still see no way out of further currency devaluation, and I will continue to pay carry to stay in the trade. With the full understanding that the whole strategy may yet end up being a loser.

    Chart Source: Yahoo! Finance

    Image: Terracotta Army by Tom Wachtel

    Hi Alex… Great book. Wanted your take on USDCNH short. Shorting this pair has a negative carry but has strong macro fundamentals behind it. In your framework, would you take this kind of trade? Thanks

    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,

    There Will Be Better Trading Spots Than Tomorrow

    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 this post, I will not argue with the approximate odds offered by the market. We all know the pros and cons. As a sidenote, the best pro I’ve seen is “the avalanche patrol argument” http://markdow.tumblr.com/post/116263207105/the-federal-reserve-on-avalanche-patrol by @mark_dow.

    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:

    1. Fed never hikes and possibly goes to QE4. In this case being long UST’s will be earning excellent carry forever.
    2. 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

    Image: la libertad tiene un precio by marta … maduixaaaa