Rotating into lower risk long dollar trades

The dollar chart is no longer parabolic. It’s vertical.

This by itself is not an indicator, that we have to close the long dollar trade. My general feeling is “Why give up on a good trend, while it lasts?”

On January 1st, 2015 I posted that I had reduced my short Yen risk and focused on short Euro. My relatively conservative risk commitment at the beginning of the year allowed me to build a short Swiss (long USDCHF), after the SNB surprise action had sent the currency into the opposite of freefall.

But now both EURUSD and USDCHF trades have moved enough to be considered mature along with USDJPY. 

Even the secular dollar bulls, who are calling for EUR to go back to 0.80 and JPY to 150, have to admit that more than half on the move has already taken place.

When EURUSD was at 1.35, it was easy for to say “I will stay short no matter what. If it goes a few % against me, I will just wait it out.” Now there is a lot to lose from 1.05.

So, are you prepared to sit on your short EUR position, if it goes back to say 1.15? Maybe you are. But it is not crazy for even the greatest dollar bulls to think of some risk management. For some it means reducing positions, for some trailing stops. Personally, I prefer the former.

As I am taking some profits on EUR and CHF, my thoughts are turning to currencies that haven’t moved quite as much and still have space to catch up in the devaluation race.

You might have guessed what part of the world I am thinking of from the picture upfront. China, Taiwan, Australia, New Zealand, Korea, and so on.

Australia in fact has already moved a lot as well. But New Zealand, as I have written before, looks very expensive against its larger neighbor. So I have recently decided to swallow the negative carry pill and establish a small NZDUSD short.

China is the focus of raging debates and what is actually going on there is beyond the scope of this post.

I would like to have a better look at South Korea, which delivered a surprise rate cut last week, confirming its participation in the race to the bottom.

Indeed KRW has weakened somewhat against the US dollar. But the 10% retreat to the highs is not that substantial. If you substitute USD by the currency of their closer neighbor – JPY, you will see a very different picture (lower number means stronger KRW).

So we have a theme similar with China and New Zealand: the carry is not great (though closer to zero in the case of Korea), looks weaker relative to USD, but strong relative to some key counterparties.

I have to confess, I am not at all an expert on Korean economy. 

Rather than to analyze specific countries, I want to focus on the general theme. How much downside is really there in being short USDNZD, long USDCNY and USDKRW? 

Yes you might have to eat some negative carry, but are you worried about catastrophic appreciation of any of those currencies?

So now that we have (hopefully) booked some profits on easy positive carry trend trades in EUR, JPY, and CHF; is it worth to pay some carry in places where the downside is not that big?

I find it hard to imagine the world in which the broad dollar continues and the “catch-up” currencies do ont devalue as well.

Specter of negative rates is haunting global bond math

Extreme, even absurd-sounding scenarios. Don’t feel foolish for including them in your reasoning. Sometimes one has to ponder the extremes to reach the utmost clarity.

The last week’s Swiss Franc move reminded to us that no one is safe in the markets. I could gloat and say “Look at me: I was wrong way around, but I actually did well because of my good risk management and portfolio construction!”

But, rather I am saying “Whew…”

In the world of leveraged finance one may not honestly say “My portfolio cannot blow-up.” Rather I would hear “My portfolio will not blow-up, unless U.S Government declares a full default… China goes to war with Japan… aliens invade…”

In the spirit of considering all scenarios, let’s talk about the bond markets.

One of the arguments I heard recently from people who wanted to be short U.S. government bonds is “With 10-yr note yield sub 2%, how much more can they rally? The risk is skewed to the rate upside.”

I take an issue with this approach. Let’s consider the true extremes.

1. All rates going to infinity. An event approximated by full default or hyperinflation. All future cash flows become irrelevant. All bond prices, regardless of maturity, go to 0.

The downside for a par bond is 100 to 0. Regardless of coupon.

2. All rates go to 0. An event approximated by establishing gold standard and no term premium. All future cash flows have the same value as present cash. Every bond is worth it’s face value plus all future coupon payments.

The upside of par 2-yr note with 0.5% coupon 100 to 101. Not much compared to the downside of 0.

However, the upside of 30yr par bond with 2.5% coupon is 100 to 100 + 2.5*30 = 175. Not so skewed, is it? 

Another way to think of it: if you have a zero-coupon bond trading at 50, the risk symmetric with respect to these two scenarios (0 with infinity rates, 100 with 0 rates).

This counterintuitive distribution of risk, has to do with “bond convexity”. The convexity is caused by the fact that, as rates fall, the future gains and losses become more meaningful when discounted to the present. Thus those who bet on falling rates see the size of their position increase, as the market moves in their favor. The converse is true with betting on rising rates. These convexity effects increase dramatically as the maturity of the bond lengthens.

3. Rates go negative. Not possible, huh? Tell this to Euroland, Switzerland and Japan. So far the negative rates dominate only the portion of the yield curves within the 10yr mark and the convexity effects are subdued. But who can now deny the theoretical possibility of negative rates all across the curve?

Can future sovereign obligations become multi-fold more valuable, just by the virtue of being the future?

The U.S. Treasury curve seems in no such immediate danger. At least in nor much more danger than EURCHF floor was from being released.

However, the United States has a fundamental structural difference from European markets – the fixed prepayable mortgage market.

Imagine the prepayment and refinancing wave that would happen if the 30yr mortgages rates started to head towards 0. Below 0?

The mortgages originators will find themselves immensely short fixed income market and forced to keep buying, exarcurbating the move.

Now the dealers are not stupid (mostly), they are hedging (somewhat) not only their directional risk, but also the convexity. But are they really prepared for negative rates? The thing with derivatives: for every party there has to be a counterparty. So, no matter how you push the risk around, it remains in the system.

And when people are caught unprepared, things get funky. U.S. economy might not warrant negative rates, but can the runaway convexity move take us up there? Could we theoretically see bond futures rallying say, to 1000?

Those are not likely scenarios. And I am not saying that you cannot trade bonds on the short side. We are in the business of taking risk.

But don’t say that bond upside is limited. And if you blow-up by being short, do it with your eyes open.


Is Swiss Franc the new BIG SHORT?

The dust has not yet settled from the shocking SNB decision to release the 120 floor on EURCHF. Something I had considered possible, but unlikely. 

In rare move for a developed country Swiss Franc appreciated 15%-20% (depending on when you choose to look at the screen) against most currencies.

Now what? Let’s forget about money we made a lost or in today’s commotion. What is the BIG CURRENCY TRADE for the next few years?

USDJPY  (short Yen) 2010-2014 was the most profitable trade in my career. But it feels mostly done, the way I was thinking about it at conception. Now a new wave of traders who believe in a massively stronger dollar needs pick up the baton.

Short EUR has been another great trade for me. But where it stands today at 1.16, it is long way down from 1.40.

Is Swiss the new BIG SHORT?

I know little of Swiss politics, but clearly no one thinks that such drastic currency appreciation will be good for Swiss markets. But does it in itself mean that the currency has to correct?

I believe it does, but I don’t know when and how.

In 2010 when USDJPY was in the low 80’s, I had concluded that the levels were unsustainable. I hadn’t known what the mechanism of Yen depreciation would be. But I initiated the trade, believing that the economic forces would sort the market out. I could not have foreseen the dramatic political shift of 2012 and the Abenomics.

However, what I need to remind aspiring Swiss bears – it took two year of waiting and 5-6% of downside pain for the USDJPY trade to play out.

Are you ready for the pain and for the waiting?

As many people are pointing out, QE is not as easy implement in Switzerland as it was in Japan. There is not enough sovereign debt to buy. And as the world is becoming more dicey the flows into CHF might increase.

So how will the Franc be able to depreciate? 

I don’t know how, but I believe it will. My inclination is to think that eventually they will find a way to print their own currency and weaken it. And maybe they will even overshoot.

Just don’t ask me about the time horizon and the downside.

i am initiating long USDCHF (short Swiss), but I am doing it with considerable caution and preparedness for pain.

i’ll sleep on it before deciding how far to commit.