USDCHF – A French Election Trade

participants, remembering the impact of Brexit, have their focus on France this
weekend. The last thing I want to do is add into the
mix my futile hunches regarding the probabilities of various winning candidate
permutations. Furthermore, wI won’t even speculate how the market will react to
any particular second round match-up.

The purpose of
this note is to discuss a rare, tactical conviction over this weekend.
Staying COMPLETELY AGNOSTIC as to whether the election outcome will be taken as
Eurozone positive or negative, consider USDCHF. 

Scenario I
The outcome is
perceived as negative; fueling French EU exit fears (‘disenfrancising’) and
risk-off trades such short USDJPY, short equities, and long US Treasury bonds
are expected to benefit. EURUSD is likely to fall and underperform CHF.
However, given the close linkages, CHF is likely to be dragged down by the EUR
and, unlike JPY, underperform the US dollar. So, in this scenario, we expect
USDCHF to gain.

Scenario II
The outcome is
perceived as positive; risk-on trades, such as long equities, are expected to
benefit. US and European risk-free rates are likely to trade higher.  EUR
will likely outperform CHF and possibly by a lot, as Swiss interest rates are
more pinned, and USD will rally against safe harbor currencies such as JPY and
CHF. So, in this scenario, we expect USDCHF to appreciate.

re-cap, USDCHF
goes up, or USDCHF goes up.

It is
important to underscore that when I talk of tactical conviction, I don’t mean
“I am positive that this
trade will make money,” rather I mean “I am convinced that this is a positive expectation

Markets are
finicky, and even with the logic above I can assign no higher than 60% chance
of being correct.

And we I am fully prepared to be completely wrong.

Hence, I am purposefully posting at the end of the trading day not to entice the reader to
follow our trade, but to share and “timestamp” my thinking, which typically
applies to the long investment horizon, but in this unique case may have a
short-term value.

Good luck this

Priced To Perfection?


over two solid weeks after the election, the markets have been relentlessly
pricing in the success of “Trumponomics.”
To be clear, we mean “success” in a purely non-partisan manner. It just means the President-Elect would accomplish what he says he is going to
accomplish, whether that might be good or bad in an individual’s view.
Furthermore, we discuss economic causality only to the extent it affects
financial markets, or more precisely, how it defines superiority and dominance
relationships between specific trades.

that in mind, let’s start untangling Trumponomics with its flagship item:
infrastructure stimulus. Long on the Democrats’ agenda, the package of $500bln
to $1tln is now expected to pass through the Republican Congress. Without
offering our amateur political analysis, we point out that this may or may not

“expected,” we mean the price action in:

  • Equities;
  • Industrial commodities; and
  • Inflation break-evens.

if the stimulus were to pass, all else being equal, it would provide a tailwind to all of the above. But, the
magnitude of the move thus far has already been substantial enough to make us
question if betting against the stimulus is taking on a characteristic of an “Even If” trade discussed in Chapter 13 of The
Next Perfect Trade
. The argument being that there are occasions when the
market pricing is so skewed towards one outcome, that betting on the opposite
outcome may make money even if
the most expected event comes to pass.  

recent price action in pertinent markets:

US Equities: 1m Historical


1m Historical


5Year US Inflation Breakeven: 1m



let’s shift the discussion to the Federal Reserve. Should the stimulus pass,
the Fed would consider the rising inflation expectations justified, based on
the triple impact of:

  • Rising commodity prices;
  • Tightening labor markets; and
  • Wealth effect from the stock market.

the Fed was well on track to tighten imminently regardless of the election
outcome, so in this case the EVEN IF trade points us in the direction aligned
with Trumponomics. There have been debates on whether the current Federal
Reserve is too tight or too easy. We elected to stay on the sidelines but
consistently highlighted that the Fed is indubitably hawkish relative to other DM central banks.

Trump criticized Yellen during the campaign, we are not sure how much of that
was purely political rhetoric, and what he would rather she do or not do. What
we know is that Ms. Yellen is likely to stay on for the remainder of her term
and to pursue her policy framework. As for what
comes after, we would posit that the President-Elect has a good understanding
of debt and interest rates; he would likely “push” for a policy that would
neither stifle the economy through excessive hikes nor allow inflation
expectations to run away leading to a catastrophic steepening of the borrowing

pointed to the limitations of the curve shape as a leading indicator in our
post, Flat
Curves & Recessions
, from September 28th, but steepening is
often viewed as a good thing as it is associated with periods of solid economic
growth. On the other hand, as the United
States has a considerable current account deficit, higher rates are net
negative for the wealth of the nation (more interest going to foreigners), and
this is something Trump may be aware of.

we see no reason for the new administration to nudge the Fed to one extreme or
another, so ‘business as usual’ is our best guess.

What Does This Mean for The

US dollar (USD) has strengthened a lot on the back of Trumponomics. This price
action is consistent with the notion of a
reasonably vigilant Fed, which would raise REAL interest rates in response to
higher inflation expectations.

USD: 1m Historical (DXY)


re-price of the markets notwithstanding; we continue to maintain that
stronger dollar is a concurrent necessity with
respect to higher interest rates. In other words, if US rates stay where
they are or move higher, the USD should continue to perform well on a total
return basis. For those who feel that the dollar rally has gone too far, we would refer to our post
from March of this year
and point out that given the rates differentials,
the current 10-year forwards in EURUSD,
USDJPY, and USDCHF are 1.3150, 84.00, and 0.7500, respectively.

we have long noted, ECB, BOJ, and SNB do not have to ease further to weaken
their currencies; all they have to do is to hold steady and let the Fed lift

dollar bears base their view on the implicit necessity of the US rates playing
out much lower than currently projected. Our logic then dictates that betting
on lower rates is the dominant trade.

Talk About the Transmission Mechanisms

rates and stronger dollar traditionally are seen as a recipe for a deflationary

an aside, we acknowledge the point of view that in a stronger final demand
environment, higher rates may, in fact,
be inflationary as they increase the production costs. We, however, stick with
the simple perspective that real rates are “the cost of money.” And if the cost rises, well then money
becomes more expensive, i.e. deflation. Of course, a further nuance may
be possible arguing that higher rates are mostly deflationary for asset prices,
not consumer goods – a theory well supported by the fact that recent low rates
have helped asset prices much more than wages.

are acknowledging those arguments to emphasize serious uncertainties and
complexities in the rates mechanism, but we will stick to the simple
observation that “too high rates” typically lead to a collapse in the stock market, which is often followed by an economic slowdown.  

have long argued for the negative predictive power of interest rates and that
perpetually upward sloping and steep
yield curves, provide a tailwind for the secular bond bull market.

dollar rise should be even less controversial, as it incrementally leads to
weaker exports and lower imports prices.

on an “all else being equal” basis, the recent shift to higher rates and stronger
dollar equates to a tightening monetary condition and should lead to lower
inflation expectations, a flatter yield curve,
and lower equity prices.

transmission mechanism is challenged by
the market’s acceptance of the Trumponomics. The higher rates would be offset by the stimulus and the impact to trade from a higher
dollar by import taxes. Tariffs being another “may or may not happen”
proposition.  We will not even go into
the risk of a global slowdown caused by potential
trade wars.

is sufficient to say that the tightening of economic conditions is present here
and now, and stimulus and tariffs are
something that might happen in the future and just might have the expected

you may guess, we continue to argue for
our portfolio strategy; a combination of long US bonds and long US dollar
against DM currencies.

addressing bonds, it is important to
mention the credit risk which may increase
with Trump’s potential expansion of the budget deficit and his rhetoric,
however unlikely, regarding a “workout” on the US debt.

Long-dated bonds have cheapened significantly
over the last few days on an asset swap basis, some of them approaching the
level of Libor + 60 bps. Some have viewed that relationship as mathematically impossible
and attribute it purely to technicals related to the Dodd-Frank limitations of
balance sheet and foreign CB selling.

we wrote in a blog post a year ago, it is not exactly as simple as that.  

setting technicals aside, the only economic justification for the current levels is the pricing of at least 100bps of credit risk. This, in itself, implies something like 80
cents on the dollar workout on long-dated
bonds, which in our view is extremely conservative.

is no doubt that the Trump victory has introduced more uncertainty into the
rates environment, but we are well compensated
for this.  For example, while we would
rather be long bonds with Clinton than with Trump at the same level, we prefer
to be long bonds with Trump for an extra 100 bps.

finally, for what it’s worth, both the magnitude and velocity of the recent
correction are entirely consistent with
multiple, recent corrections including:

Long-Bond Futures: Corrections of 1994,
‘00, ‘02, ’06, ’09, ’11, ’13, ’15, ‘16


For now,
the One Chart still rules them all.


EURUSD Parity Magnet

What is the target on the short EURUSD
position? Are all the dollar bulls just looking at the charts? Or are they
throwing out targets at random: “Parity”, “Post-inception
low”, and so on?

They are many ways to look at the “fair
value” of a currency exchange. There are static approaches such as PPP
(purchasing power parity) and dynamic models involving interest rate
differentials, trade, and who knows what other factors.

George Soros emphasized in “The
Alchemy of Finance
” that any “equilibrium” value is elusive.  I, in turn, have likened developed world
currency pairs to a pendulum in Chapter 1 of ”The
Next Perfect Trade
“. However, in contemplating a pendulum it is useful
to know where the "bottom”, or the neutral position, is.  

First, any “value” principle may
apply to a market price only at some point in the future. The present price is
what it is. Do not confuse this with an endorsement of EMT (Efficient Market
Theory). We make money by finding value in projected market forwards. But
current price is a reality. And denying reality, as Buddhism teaches, only
causes stress.

So how would I estimate the long-horizon
neutral point? It would be hard to do if EURUSD were in a secular trend but,
fortunately for this exercise, it is not.

EUR: Since March, 31, 1975 (average 1.1930)


So why don’t we just assume a simple mean-reversion
and take the average: 1.1930.

Of course, one might argue that
post-inception data is more relevant.

EUR: Since Jan 1, 1999 (average 1.2176)


The average here is 1.2176?

Or, maybe let’s just say 1.20. Imprecise?
Yes, but who is more precise?

Wait, if I am thinking of 1.20 as a neutral
point, why am I still short at 1.12? I could just say: remember the pendulum.
The cyclical trend is intact; it is still swinging. But in this post I am
focusing on a complimentary approach.

We are in an unusual place with interest rate
differential being very high and policy divergence favoring the dollar.  How do we account for the idiosyncrasy of the
current environment?

I suggest avoiding it by looking ten years
forward. On this time horizon any economic predictions are virtually
meaningless. Those who think that the current situation is bound to persist in
ten years, think ten years back. That’s all I have to say.

So instead of challenging the reality of the
current exchange rate I challenge the ten year forward which as I am writing
this is around 1.33; well above the historical average.

EUR and 10 yr EUR (FX): from 2013 to present


Notice that due to the widening rates
differential, despite a much lower spot, the ten year forward is not far from
where it was three years ago. And guess what spot price would have brought the
forward to the average given current rates environment? PARITY. Hence,
parity is not bad as far as shorter-term magnets go.

So am I planning to hold the trade for ten
years for an uncertain 10% gain?

As written in my book, such a value pull (or
carry if you wish) provides an extra wind in my sails. But this is where other
considerations such as pendulum pattern or secular skepticism in the Euroland
come into play.

Once I estimate my neutral point as 1.20, I
look at the 10 yr forward and expect it to swing through this point by at least
another 10%. Thus if I am correct I can hope for a 20% move on a horizon much
shorter than ten years.

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” 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

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

    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.

    Federal Reserve: Will Two Wrongs Make a Right?

    Comical failure – this is how I would describe the quest for 2% inflation by the developed world central banks.

    So what is the Fed thinking, as it is gearing up to tighten?

    In my post on February 8th and during my appearance on Wharton Business Radio @BizRadio111 on February 13th, I have argued that imminent tightening is the most likely scenario. I have focused on what the Fed will do.

    Now I find myself drawn into the discussion of what the Fed should do. This question might be less important for short horizon trading, but it bears a lot of weight when you consider long-term policy implications.

    Is the Fed too easy? Should we worry about inflation and asset bubbles?

    Is the Fed too tight? Should we worry about deflation and recession?

    Or are we in a perfect balance leading into a perpetual Goldilocks scenario?

    Essentially, the Fed is trying to achieve maximum prosperity (whatever that means), while maintaining price stability.

    The developed world somehow has accepted that price stability means 2% inflation. If we regard this notion as a starting axiom (or as a religious dogma), I believe the Fed is wrong.

    Indeed, I see little indication that we are heading towards 2% inflation in a tightening environment. The USA has made a decent progress on growth and employment. But does this guarantee inflation?

    I am not arguing against the fact that wage pressure could be inflationary. I am just not sure that there is a causality between economic growth and wage pressure. There certainly has been some concurrence of those things in the 20th century. But now we don’t see this concurrence. Why should we assume the causality?

    My opinion is that labor having negotiating power was an idiosyncratic 20th century phenomena. Technology and globalization are leading to deep labor redundancy and increasing power of dynamic capital.

    But even if I am wrong, and there is some wage pressure looming on the horizon, do we not have some serious offsetting factors? Rising dollar? Pull-back in commodity prices? Deflationary threat from China slowdown?

    I am not alone in being “inflation skeptic”. And most people, who think this way, conclude that The Federal Reserve is about to make a mistake.

    However, my own argument is making me see the other side. If I believe in unlimited technology-driven growth and labor redundancy, why should I believe in the 2% inflation target?

    And is deflation really so corrosive? It was in Japan, but that was a different century. The risk of deflation is that people and businesses will wait to buy goods hoping to get a better deal in the future.

    Are you waiting a few years for I-Phone 12? No, enough of us are buying any new tech as soon as it hits the market. Even if we know it will be 10 times cheaper and better in a couple of years.

    The technology cost overall has dropped below the threshold when the utility of having always outweighs the utility of waiting

    One might argue: technology is not the whole economy. Well, some other areas of economy (like housing market!) could use a bubble control on occasion.

    I do not have a firm conviction, but I have a strong suspicion: 21st century economy has capacity to grow without inflation. And in such robust growth environment the fiscal problems can be solved without resorting to inflating out of debt. 

    In this case there is a possibility that 1.6% inflation in the USA a sign of significant overheating. In this case the Fed does need to raise rates!

    But what about the dollar strength? One could go both ways on this. Dollar has momentum, but it is not extremely strong by historical measures.

    And The United States might be now in the unique position of strength, warranting even further currency appreciation.

    I do think the Fed will raise rates. And I do think we will slide into a new recession thereafter. But I am not sure the future recession will be the fault of the central bank.

    It is possible that making two wrong assumption (wage pressure and 2% target), the Fed will stumble into the new price-stability.

    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.