Entering the Kyle Bass US Yield Curve discussion…

I greatly enjoyed watching Raoul Pal’s latest interview with Kyle Bass, entitled “Tipping Point for China” on RealVisionTV. While my eagerness to hear the discussion was rooted in hearing Kyle’s current views on China, many other ideas and subjects surfaced as always happens during such talks.

In particular, the shape of yield curves in the developed markets caught my attention. Kyle was concerned about the supply shock of bonds which would be caused by the Fed unwinding its balance sheet and by the ECB tapering. This led him to expect higher long-dated interest rates and a curve steepening. Interestingly; Raoul emphatically agreed with the steepening bias, but his motivation was that he expected a deflationary rollover of the economy and an imminent easing in the front end.

I find myself unable to resist the temptation to wade into this debate. First and foremost, the US yield curve has been flattening, flattening, and then some more flattening. Why? Well, there are a few completely unambiguous lessons I have learned over my 20 years in the market, and one of them is that the hiking cycle equates to a flattening curve. Flattening starts before the market anticipates it; and flattening goes on for longer and deeper than one would expect. Flattening in every portion of the curve even where economically it doesn’t make sense. Flattening, period.

US 2s-10s vs FF, Jan 1999-Present


Raoul’s point is exactly the opposite side of this coin; easing means steepening. And you can easily see it on the charts above immediately after the orange-shaded boxes. I don’t have any proprietary way of estimating how soon the easing may come, but it tends to arrive sooner than expected, in fact, on average only a few months after the final hike of a cycle.

I am tempted to argue “this time is different”; current front-end rates are low enough that scope of a steepening rally may be limited by the zero rate (or small negative) bound. But this seems intellectually inconsistent after my flattening spiel.

Even assuming I accept that easing equates with steepening, until proven otherwise, I am left with the dichotomy between the observable fact of the current hiking cycle and the speculation about the future easing cycle.  

An even more complex dilemma that bond bulls, like myself, have to face is the specter of the QE/balance sheet unwind. Kyle brought up the supply shock worry that is expressed by many. In fact, there is an opinion out there that developed market sovereign debt is a huge bubble propped up by Central Bank purchases and is bound to implode in the near future. And while I generally disagree, I can’t deny the risk is real and material.

As I speak of the reasons why I hold a different conviction, I want to point out my arguments mostly pertain US Treasuries (“USTs”) and, to some extent, Japanese Government Bonds (“JGBs”), but probably less so to European sovereigns, which are idiosyncratic.

I. The secular total return bull market in USTs started decades ago and has not changed its shape, pattern, or velocity with the advent of QE and tapering.

US Long-Bond Futures (Total Return Chart)


II.The demand for USTs appear to be extremely elastic, making a supply shock unlikely. Furthermore, USTs are an asset and they don’t dictate the overall level of interest rates. At most, supply/demand can push swap spreads up and down. To illustrate the point, remember “the vanishing Treasury supply” in the Clinton Era.

Well, in the middle of all the repurchases, the 10 year rate peaked at 6.78% in 2000. Swap rates were even higher on a relative basis with the 10 year swap spread blowing out to 138bp four months later during the same year.

US 10yr Yields vs US 10yr Swap Spreads, January 1999 to December 2000


Meanwhile, all the debt expansion of the recent decade along with the tapering of QE didn’t stop rates from falling to the lows of 1.35% in 2016.  And swap rates overshot the downside with the spread touching -0.18% (negative!) in November, 2016.

Of course, there were other forces involved including an obvious negative correlation between economic growth and Treasury supply (Keynesian fiscal policy). Still, it is very hard to argue that UST supply drives US rates.

III. From an economic perspective, balance sheet (“B/S”) unwind is unequivocally bullish for USTs. A similar argument can be applied to a hawkish short-term rate policy; it achieves economic slowdown and lowers inflation expectations.  However, B/S unwind is even more positive because it accomplishes a tighter money supply without actually increasing the cost of carry for long-dated bonds. One could argue that the economic argument may not matter if there is simply more sellers than buyers, but for this, I would refer again to point II. Short-cycle gyration of the long bond prices can be quite vicious, but the economic gravity tends to win.

To summarize, a new easing cycle is something to deal with when it arrives and the supply shock is something worth fading, but not without peril.

Good luck,

Alex Gurevich

When can traders out-economize the economists?

When can traders out-economize the economists?

In both my public comments and investor correspondence, I have been consistently emphasizing the importance of separating expert opinions from layperson’s hunches. Applying this advice to myself, I try to rely on my strategic edge rather on my economic forecasts.

In fact, taking this point even further, I don’t rely on anyone’s economic forecasts.  But it is not because I consider the analysts who produced those views incompetent. Indeed, there are those with intellectual frameworks I highly respect. Still, for every well thought-out argument, there is an opposite one equally well-substantiated.

Current US economy and stock market bulls and bears are a great example; both camps have excellent charts, statistics, and qualitative opinions. When two experts I respect disagree so strongly, I have no choice but to believe the future is uncertain. And forecasts from either side have little value other than establishing a paradigm.

So are there times when traders can see something economists do not? The jury is still out on this one. I’m convinced more often than not that market professionals delude themselves by thinking their hunches regarding a particular unemployment number or inflation statistic have predictive power.

But I believe there is one area in which traders may have an edge: we tend to have a strong sense of momentum. While the analysts measure where things are, traders think in terms of where things are going. Thus, when a business cycle turns, traders may have a stronger strategic commitment to a nascent economic trend.

I will not use the cycle turning of 2007-2008 as an example – it was too unusual. But I remember well 2000-2001. The NASDAQ index started to collapse throughout 2000, while the Fed raised rates 100bp in the first half of the year and kept them flat at 6.5% for the remainder of the year.  Only towards the end of the year in 2000 did the Fed begin to initiate mild talk of a potential economic slowdown.  

NASDAQ vs FED Funds Target Rate, 2000 – 2003


To be sure, the central bank accepted recession being a real risk early in 2001 and started cutting rates aggressively. But not aggressively enough even though we in the trenches were quite sure that the dot.com bust was leading to the inevitable recession and a much deeper fall in interest rates. For the younger market participants, I will remind that the recession was not caused by September 11th. It was a virtual certainty months before. I even suspect that the terrorist attack, in fact, accelerated the recovery by forcing the Fed to ease even faster and by bringing stimulus into the economy.

I remember that sense of confidence: “blah blah blah, whatever the research says,” the rates are going down! Of course, for every time one could have been right this way and made a fortune, there could be several false starts; traders reading too much into a transitory data shift. I cannot prove or disprove the value of this momentum sense. I am just bringing it to your attention and judgment.

Why am I writing about this today? Over the last few weeks, my momentum sense started to tingle. The recent fall in oil prices and core inflation together with other incrementally soft data are beginning to signal the roll-over of the cycle and the bond markets are running with it. Meanwhile, the analysts are still vigorously debating.

Crude, US Surprise Index, Core PCE (y/y), June 2016 to present


To re-emphasize:  my bullish bond position is not contingent on this current perception but on my strategic framework which is independent of forecasts. The cycle does not have to end today, I can wait to make money tomorrow.

But I can’t help having a hunch – value or no value.

Good luck,

Not Forecasting 2017

Year end is a sweet time for bashing forecasters.  Many investors take a savage delight in pointing how comically off particular economists or analysts were on this or that price, or event, in 2016.  And then, without hesitation or irony, they proceed to read the forecasts for 2017.

Yogi Berra and others have said:
“It is difficult to make predictions, especially about the future.”

But instead of making light of forecasters, I will briefly discuss some limitations of using forecasts for trading.

There is a fundamental difference between analytical and strategic thinkers.

  • Analytical thinkers focus on facts and evidence; partitioning or breaking down information into mutually exclusive categories with a goal of generating a solution to a problem.
  • Strategic thinkers design systems of responses to various future situations, foreseen and unforeseen.

A great macro trader should at least be decent at one of those and a genius at the other.

I have always balked at questions such as “Where do you see the Euro at the end of the year?”  Somehow even trying to think in those terms annoys me. In my book (Chapter 7), I advise specifying one of two features for every trade: time horizon or price target.  Trying to do both seems too arrogant.

But forecasters are not stupid; they know the future is uncertain, but they are given a problem and need to come up with a number (e.g. GDP, exchange rate, election outcome, etc.). They are paid to deliver a prediction, and they do their best.

I.  The first and simplest forecasting problem is determining the difference between the Expected Value (EV) and the most likely outcome.

The most likely outcome is what I call the “Central Scenario” – the direction things are heading if everything plays out most or less as expected (it rarely does!).  

For example, a few months ago we could have correctly forecasted a single hike by the Federal Reserve that occurred in December.

The problem with the Central Scenario is it does not express in which direction the market is more likely to stray.  This problem has been a fundamental issue, for example, with the continuously mispriced interest rate curve.  For decades, both interest rate forwards and economists perpetually overestimated the average level of interest rates over any meaningful period.

For some charts and numbers, look up Chapters 2 and 3 of my book.

Over the last 40 years, short-term interest rates have exhibited a much stronger propensity to move dramatically lower than higher due to an exogenous event such as the Russian debt crisis, 9/11 or the Global Financial Crisis. To put it, in other words, there are surprise eases, but not surprise hikes.

It is not difficult to see how, over the long run, the outcome favors the bond bulls.  

It is important to understand that forecasters are likely to aim for what they think to be the Central Scenario as it maximizes their chances of actually being close to right.

By way of example, consider the extreme case of betting $1 on “tails” on a coin toss. The tail-ish economists will forecast a $1 gain, while the heads-ish ones a $1 loss, both hoping to be right more than 50% of the time. But those who forecast $0, have no chance to be right!

Critically, it is up to traders to understand the paradigm and maximize the value of their portfolios.

II. The more subtle and pernicious problem has to do with creating a variant forecast.

So far we haven’t considered the divergence between forecasts and market forwards. But for a trader, only a variant view is of any value. If there is no such divergence – there is no trade.

Now an analyst trying to forecast, say, the year-end level of EUR/USD would have to deal with multiple moving inputs such as equities, interest rates, and commodities, not to mention geopolitical variables. To derive a Central Scenario, the analyst will use what they think are the Central Scenarios for each of the inputs whether or not they are aligned with market forwards.

Therein lies an enormous logical fallacy that few traders in my experience escape: 

Unconsciously basing positions on a forecast for one asset class, which is relying on the divergent outcome of other asset classes.

Asset class interactions are discussed in Part III of my book, especially Chapters 11 and 12, but I will give just one example here.

At the beginning of 2016, there were a number of dollar bears (or at least skeptics). But when I dug deeper into their thinking, more often than not it turned out that their dollar view was predicated on the fact that the US economy was close to rolling over and the Fed was not likely to hike again or may even ease.

Yet, the market was predicting even more hiking than would actually happen for 2016. December Eurodollar futures ended the year far off the highs, but still higher than where it had started. And if one aligned with the earlier market forward, the dollar bearish view was unreasonable.

EDZ16 <Comdty>, 2016


I have written many times how long dollar and long bond trades have been strictly superior to their opposites.

Indeed, classic bond futures have played out exactly as predicted by markets for two consecutive years (i.e. no P/L on a total return basis), in the environment of very robust job data.

Classic Bond Futures, 2014-2016


Meanwhile, the dollar index (we are charting DXY price which is conservative as dollar also has positive carry) made substantial gains in both years.

DXY <Curncy>, 2014-2016


It is not that dollar bears were wrong. We have all been both right and wrong multiple times. Rather the point is they would have done better by going to the origin of their view and being long bonds.

Good luck and Happy New Year!

Flat Curves and Recessions

All too often I hear sentences like “The bond market and the stock market say opposite things about the economy” or “A flat curve means recession, so if you expect the curve to get flatter that means you are expecting an imminent recession”.

The purposes of this post are to dig a little deeper into the concepts of concurrencies and causality associated with the yield curve and to challenge some of the common assumptions embedded in the statements above.

While the “Freakonomics” crowd loves debunking confusion between correlation and causality, I will instead write in terms of the distinction between “causes” and “indicators” and, furthermore, between “leading” and “concurrent” indicators.

My strategy mostly deals with causes. In my book, I discuss how causal relationships between two market events can be characterized in terms of necessity and concurrency and how to trade based on such characterization.

By way of example, the Fed moving to tighter monetary policy has a clear causality relationship with a stronger dollar and a flatter US yield curve. As always, some would disagree even with this paradigm. But I am comfortable with this causality being if not as “certainty”, but an at least a “certain likelihood”. 

In my book, I have demonstrated how, in 2014, the stronger dollar was a concurrent necessity with respect to rising rates and thus a dominant trade. That meant by the time the Fed tightened, dollar would have to have strengthened but it might have (and did!) strengthened even without the tightening.

There are, however, highly correlated pairs of market events with a more obscure causality relationship. For example, up until 2016, USDJPY traded in high correlation with all risk assets, including not only the Nikkei but also the S&P 500. In my post, The Tale of Three Shorts, I have discussed some of the complexity there and even suggested that strong JPY trade may be a self-defeating chicken (a thesis yet to be verified). To put in simply, the correlation was obvious to me, but the causality wasn’t.

In such situations, I refer to events as “indicators” rather than “causes”. I have several times heard sentences like “weaker USDJPY spells trouble for stocks”. Such statements irked me as logically flawed, but the fallacy is not immediately obvious. Indeed, stocks tend to go down when JPY strengthens, don’t they?

This is where I introduce the notion of the concurrent indicator. If I look at my screen and see USDJPY up on the day and don’t look at anything else – what is my guess about the stock market? Of course, it’s more likely that the stocks are up. But why shouldn’t I look at anything else? I have a full screen of prices available.

My point is that USDJPY doesn’t convey any information about equities that I can’t see by looking at the equity screens. Yes, usually when USDJPY falls, S&P 500 trades lower as well, but if it did not go down there is no obvious ECONOMIC causality saying that it has to catch up. So, as I see it there is little predictive power to gain from divergence in this pair; what has happened, already happened. And with this mindset I was not at all shocked with the divergence of this year.

5Yr Chart of USDJPY (White) vs SPX (Yellow)


But what about the clearly statistically confirmed “leading” indicators? My contention here is that even those may not convey as much useful information as appears.

As you can guess, I am taking a swipe at the maxim that flat yield curves forecast recessions and steep yield curves forecast robust economic growth, which appears to be accepted by market participants almost without question.

The evidence is undoubtedly strong – flat curves indeed preceded all the recent recessions. But my question is, “does the curve convey any information about the possibility of a recession, we don’t have otherwise?”

Imagine that you have jumped from the roof of a high-rise. Falling past the 10th floor is a very reliable indicator of soon hitting the ground, but what new information does it contain?  Given that you jumped off consciously and are familiar with the law of gravity – none.

What if you fell while sleeping? Well, waking up to see the 10th-floor flash by is definitely good info. But returning the analogy to macro-trading, my assumption is that you are not asleep.

Then what if the law of gravity changes? In this case, the 10th floor may not even be a reliable leading indicator anymore.

Over the last few decades, we got used to certain patterns of the business/rates cycle. Events were happening in a certain order and over certain predictable time intervals:

1.       Rapid economic growth

2.       Tight labor market and inflationary pressure

3.       Rising rates

4.       Yield curve flattening

5.       Hiking cycle

6.       Bear stock market

7.       Rates fall

8.       Growth slows down

9.       Easing cycle

10.   Curve steepens

11.   Stock market rebounds

12.   Rapid economic growth

Notice, any of the events in this loop could be used as reliable leading indicators for any subsequent events. Assuming the loop persists.

As I have discussed in Chapter 4 of my book, historical patterns are important to study because they are more likely to repeat than not. But if we make an a priori assumption that this loop will just keep going on without alteration – we almost wouldn’t need to observe anything else – we would already know what happens next.

In that chapter, I gave an example of using interest rate momentum as a predictor of future stock market price action. That is, I showed a decent fit between the two-year backward looking change in the 10-year note yield and the two-year forward-looking change in S&P 500. In the loop above it would mean bullet point 7 (rates fall) is a leading indicator of 11 (stock market rebounds).

Backward-Looking Change in 10yr Yields vs Forward-Looking Change in S&P500 


Why is there good information in this pattern? My claim is that the information is there because there is CAUSALITY. Lower funding rates lead to improved corporate profits. And this simple paradigm lends extra strength to my pattern argument.

When, however, people make the assumption that 4 (yield curve flattening) predicts 8 (economic slowdown), their assumptions are not backed up by direct causality. This does not imply the indicator is wrong, but rather it makes it more fragile.

In the past decades, 4 (yield curve flattening) was typically associated with 5 (hiking cycle). However, as we have approached zero rates and entered the world of QE, the laws of gravity have changed. Curves in the developed world are flattening in the LOW rate environment and they are no longer backed by the causality of the increased funding cost.

The jury is out on whether in the new environment yield curves will reliably forecast the business cycle. My contention is that they are unlikely to carry any information not already familiar to an alert macro player.  For myself, I will stick to indicators resting on the simple and evident logic of causality.

The Tale of Three Shorts: Part I

Short JPY, CNH, and NZD are three currencies positions that have been prone to elicit doubt and second guessing recently.The great JPY short (long USDJPY) initiated as early as 2010 is much discussed in my book. Through 2015 it satisfied many characteristics of a superior trade. 

Short CNH (long USDCNH) and NZD were also added to the portfolio in early 2015. Several of my blog posts discuss the favorable risk-reward of those trades, especially USDCNH. 

The common theme between these three trades is that all of them were initiated based on very solid strategic considerations and had delivered excellent profitability until recently.  Over the past several months, all of them experienced a significant draw-down and/or a pickup in volatility. And all of them had experienced a meaningful challenge to the concept of their individual superiority.

Yet in all three cases, I have chosen to stay with the trades, albeit with differentiated risk exposures. In this piece I will discuss the various considerations that ultimately lead to this decision with regards to JPY.

Entering long USDJPY in the low 80’s and pyramiding it as the momentum built, I had established clear price targets; 110 in the event of a stable dollar and 120 to 125 in the event of much broader dollar strength. Price targets are to be respected and I dutifully took profits around the 120 level.  In fact, by the end of 2015 my exposure to USDJPY relative to the size of my portfolio was less than 15% of what it was at peak exposure. 

Whether it was correct to get flat or to run the residual position to see if the market would overshoot was, without the benefit of hindsight, neither here nor there. The true strategic question was what to do once the significant correction in USDJPY had occurred. 

20yr Chart of USDJPY

Based on the chart above, it is not clear whether the cyclical trend is sustained. As for the secular trend, it is more favorable for yen on a price basis and slightly more favorable for the dollar on a total return basis.

With respect to specific asset valuations, Chapter 1 of my book discusses the importance of a currency pendulum, which is propelled by economic gravity. Such gravity is often manifested by a central bank policy.

So is the recent change in USDJPY direction a sign that the pendulum has started to swing back the other way? It is important to remember that CB talk and incremental policy adjustments are more important in terms of changing sentiment than fundamental flows. 

Indeed, every speculator encouraged or discouraged by the BOJ, who sells USDJPY, is the speculator who later has to buy USDJPY. And since our time horizon is longer than that of virtually any other market player, the net long-term effect on our portfolio is minimal.

Spec JPY Positioning (CME, Non-Commercial Futures, >0 = Long JPY, Short USDJPY)

However, the actual policy does have an effect. A central bank is a monopolistic issuer of its own fiat currency. And continuous increase of supply is bound to make a product cheaper. 

The fact remains that the BOJ is continuing to buy assets and add liquidity and the FED is not. Furthermore, I see no imminent change to this situation.Thus, I find it hard to imagine that economic gravity would change against the dollar, unless the Federal Reserve policy were to change dramatically. Our long bond position should take care of such an eventuality.

For now, I regard the recent yen strength as a correction of a trend over-extension. Staying long USDJPY through such a correction has a logical implication. We are supposed to add to the position if it goes further down.

I try very hard to avoid the fallacy of trying to pick an exact “floor” for the price. If it went down to 108 there was no reason to be sure it couldn’t go to 106 (and it did!). But since our core thesis is based on policy, such price action should encourage us to increase the position rather than stop out. 

As one of the superiority tests for this trade, let us check if its opposite is a “self-defeating chicken” (strategic language from Part III of my book). We don’t know whether USDJPY has currently bottomed close to 105 or whether it could go to 103, 101, etc. But what we really care about in terms of portfolio risk management are much more extreme scenarios. For example, can USDJPY trade back to the lows of 2011? I think that is highly unlikely. Further JPY appreciation would elicit such a raging policy response from BOJ that the resulting pendulum forces may propel USDJPY to new highs. 

Some may disagree. There is an opinion that BOJ is powerless now to weaken their own currency. As I stated before, I am convinced that a CB can always devalue their fiat, as long as there is political will. People may argue if there is such a will at 110, but I assert that there WOULD BE such a will at 90. Thus as a sign of superiority USDJPY appears to have more upside than downside, as a large move to the downside creates a large opposing force.

Another superiority test is analyzing the historical pattern. What actually happens to USDJPY during US tightening cycles? This test comes back mildly encouraging. While having performed well through the 2004-2006 cycle; USDJPY fell sharply during the tightening of 1999 and started to riseonly at the last stage of the cycle in 2000.

But how can we can we tell, without the benefit of hindsight, where we are in the cycle? My preference is to remain agnostic about timing and to stick with what I know: eventually long USDJPY tends to win through the entire tightening cycle on a total return basis.  Not the strongest endorsement, but an endorsement nonetheless.

Lastly, comes the dominance test. Assuming that we like long USDJPY, we must check if there are any trades across asset classes which are strictly dominant; that is, they would perform in every case when USDJPY goes higher and possibly in some other cases?

The most natural candidate for such dominance is Nikkei. Will the Japanese stockmarket go up in every case when JPY weakens? Not entirely certain, but the likelihood is high. Furthermore, Nikkei has recently started to show signs of performing when the yen is merely stable, as opposed to falling. Dominance is not established, but suspected.

Conclusion: Long USDJPY is still an attractive trade with attributes of superiority, but it is at a risk of being dominated. Long Nikkei holds its own attraction to us (see my post from February 10th, 2016) and appears to be incrementally favored by the relationship of concurrent necessity.  Hence, USDJPY is a “hold” based on the policy support with modest tactical trading, while long Nikkei is an “accumulate” with an eye towards a significant position for the next great bull market.

Keep your minds open, and good luck!  

Is “Short RMB” Still the Fairest of Them All?

Before August of this year, the answer was a no-brainer.  Remember, our imperative is to buy low. I have written multiple times about the Chinese currency both before and after the August 11th devaluation.

My position had been clear – given the vol market’s extremely low probability on a devaluation, “Short RMB” was a mandatory, superior risk/reward bet, but not the kind of trade on which you would want to blow all of your capital. There was no ex-ante certainty of timing or magnitude.

Now that the second wave of the move is in progress, what am I doing? In markets like USDCNH, with expensive bid-offers, there is extra value in not “fidgeting” and just running my positions.  So I am sticking with my options, which are now deep-in-the-money and are essentially outright positions.

But that has been the case for a few months. Am I going to adjust my positions? My book The Next Perfect Trade discusses the currency pendulums in the first chapter. Normally, once a major trend has launched I would be piling in, as if possessed by macro demons, and not worrying at all about not getting the “cheapest level”.

I am, however, holding steady (while very substantial) positions, because long USDCNH is no longer a clearly “superior” trade according to my strategic language.

I still think it is a positive expectation trade: the devaluation is more likely to be equal or greater than projected by the market. But the question I am asking is, “are there more dominant trades out there?”

Let us disregard the scenario of re-appreciation of RMB as unlikely, and break down the market analysis into two scenarios for the next couple years:

  1. Relatively stable or slowly depreciating RMB
  2. Massive depreciation either because of the government’s loss of control or a radical policy decision

While long USDCNH looks good in light of Chapter 1 of my book (entitled “Trend”), it has problems with Chapter 2 (“Carry”). A slow depreciation may or may not catch up to the 3.4% devaluation priced in the 1yr forward. Many of us would agree that if Scenario 1 is a given, then the trade looks mediocre.

Scenario 2 is obviously great, but I seek trades that work in the broadest range of economic outcomes. In other words, are there trades that are as good in Scenario 1, but also hold up in Scenario 2?

I have two examples:

  • Long US bonds, a trade which I like for reasons I’ve written about ad nauseam; and
  • Long USDKRW, which while not clearly dominant, offers a nice diversification.

With positive carry in the bonds’ case and low carry in KRW case, we don’t have to worry about the velocity of RMB devaluation. Both trades are likely to get a tailwind from a lower Yuan, regardless of timing. And both trades have the potential to work even with stable RMB.

One caveat with KRW and has move quite a bit already, while not having the same overwhelming secular trend and superior risk profile as the bonds.

But both trades are set to do extremely well in Scenario 2, a catastrophic devaluation.

To summarize: While I like and will keep the USDCNH trade, I see a lack of clear dominance and am concerned over awkward liquidity. I prefer to focus my risk on long US bond futures and consider diversifying into USDKRW.

Good luck.

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

    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

    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