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.


Journey of Cash

A fascinating debate about equity valuations and the validity of lofty bond prices rages on. Some macro thinkers such as @MarkYusko, while not exactly calling top of the stock market, recommend building a substantial cash position. Their strategy is to wait in order to take advantage of an eventual, inevitable bursting of the equity bubble.

I do not intend to contribute an opinion to whether equities are currently a bubble or not; in fact, I have no opinion to contribute. But assuming some reasonable concern over valuations, cash appears aligned with my own recommendations in Chapter 5 of my book. In that chapter I propose sitting out the bubbles rather than trying to aggressively time them. This strategy avoids the risk of blowing up either on the short or on the long side.

However, it is important to understand that line of reasoning is predicated on the assumption that “cash” is actually SAFE.

For an individual cash has two separate, though interwoven aspects: cash is a means to pay for one’s lifestyle and it is a financial asset.

Those financially less secure will require the safety of cash to meet their immediate needs such as rent or food. If they are fortunate to have some savings they may be concerned that cash may fail to keep up with inflationary pressure, but if they live paycheck to paycheck they must count on the wage inflation.

For the purposes of this post, however, I am using the term ‘cash’ from the perspective of a money manager whose central objective is absolute performance. For such a manager, cash is purely a financial asset.

Managers tend to think of cash as “safe”. They lean on the thinking that when benchmarked to cash, cash will never deliver a negative return which is important both psychologically and in terms of calculating incentive fees. But such benchmarking is somewhat arbitrary: for example if you are benchmarked to gold your safest asset is gold and when you are benchmarked to S&P 500 your safest asset is…And so on.

The very concept of a “risky” asset comes from benchmarking.

While the concept of over/underperformance vs. a benchmark is relative to the choice of benchmark, the absolute performance is unambiguous. And by absolute I mean absolute – weighted by the performance of your base currency. That is a Euro-based asset manager who delivered a 10% return in 2014 still underperformed USD cash on that year. Notice that as incentive fees are calculated in base currency, most money manager wouldn’t currency-weigh their performance.

But if you are a truly global money manager you can think of cash as unsafe in three different ways:

  1. You have base currency risk
  2. You have benchmark risk, i.e. if you are supposed to track a stock index and you stay in cash – well you know what bad things may happen…
  3. You may underperform competitors in terms of returns in base currency

In summary, as a global manager, I view cash as an asset as risky as all others. My goal is absolute performance. While long-only managers can only make a decision to hold or not to hold cash, I have the option to be short or long cash like any other asset.

Indeed, using leverage to go long another financial asset is equivalent to going short cash, while going short an asset is equivalent to going leveraged long cash.

Having established our view of cash as a highly speculative investment, let’s look at how it is has performed.

USD cash was a good place to be invested early in 2008. The dollar index bottomed out in March 2008 and surged over the next year to make a cyclical top in March 2009 – the same month the stock market made its bottom. Over that year, dollar cash beat all stock markets, most commodities, most other currencies, most risky bonds. It only underperformed Treasuries – as one might have expected.


A bubble had formed. Yes the greatest bubble of this millennium (so far) was not Internet-2000, Sunprime-2006 or Bitcoin-2014.

It was Cash-2009.

Panicked, trading chickens who had piled into this cash bubble were brutally punished as recovering asset prices left them behind. How do I know that? Well, somebody had to be my counterparty.

Much of my success in subsequent years was due to recognizing this bubble and following my advice to sit it out. No, I didn’t go short cash. I just rotated my money out of it into the “safe haven” of stocks.

After an initial rebound, I got an additional tailwind as the Fed started to pound on cash by the wave of supply provided by multiple QEs.

Between 2010 and 2014 I gradually realized that the other CB’s will have to follow suit and destroy the value of their own cash. Now it was time to short foreign cash. The One Trade was born.

My version of it was not to be just long Treasuries, but to build leverage funding them in low (and now negative) yielding DM currencies.

The continuing success of that trade has been nothing short of magical.

But, now the question is whether the trade has gone too far and the cash has actually become too cheap?  The question more ambiguous as to whether I mean dollar or RoW cash. Much of the recent underperformance of USD-based mangers can be explained by the fact that they are benchmarked to strongly performing asset: USD.

Thus far my answer was to be slightly less net short cash, i.e. book some profits but still run the core position. Why am I being so stubborn, despite the lofty asset valuations?

When I think of cash as an asset (or even as a commodity?) there is practically no limit to how cheap you can get it by producing more and more of it. And that is what the BoJs and the ECBs of the world have been doing without any sign of stopping so far.

So is their no risk to being long bonds vs. cash? Theoretically there is. Going back to the duality of cash we have discussed earlier, cash can cheapen in two different ways:

  • Against real goods and services
  • Against financial assets

So far we are only seeing the latter in DM. The former is called inflation and when it arrives some financial assets may do even worse than cash. Paradoxically, in the event of an inflation scare, cash is historically the place to be as the DM CBs tend to protect it by raising rates and keeping its total return positive. Negative real interest rates are typically a product of a deflationary environment.

My central thesis is that secular automatization and globalization still channel excess cash into the asset rather than goods prices. But cyclical inflationary forces are not to be disregarded out of hand.

The case for cash is not proven, but it needs to be heard.

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

    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” 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: :// ):

    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