In my book the “The Next Perfect Trade – the Magic Sword of Necessity”, which is now available on ebookit and amazon, I take the reader step-by-step through the process of selecting trades that are aided by market tailwinds. Broadening your range of success is the focus of my portfolio approach.
Also, I recorded my newest interview with Raoul Pal on RealVisionTV (my first interview is available for free on its site using this link; for the latest one you’ll need to subscribe but I find its content invaluable so please take the step to sign up using promotion code “Alex”). It was an excellent chance to review the concepts I was pondering as I was writing the book over the last year, and apply them to the current turbulent markets.
There is no longer an easy equivalent of the logically irrefutable long dollar/long bond trade of 2014; however, chaos breeds opportunities. What does my current investing strategy dictate?
The approaching Federal Reserve meeting is the most contested one in years. In the past, I worked hard to predict the exact path of the Fed Funds, and I was not bad at it. But nowadays I often feel that there are bigger fish to fry.
Some people think they will tighten several times in a row and some people think they are not tightening in our market lifetime. Let’s accept this uncertainty and try to come with a portfolio which will work regardless.
Long-dated bonds were my beacon through this cycle. Again and again, I have been repeating the mantra:
No hike means bonds earn carry
Hike means stronger dollar, curve flattening and long bond rally
Another beacon of value in the times of stock market correction, may be cheap, established technology companies that are unburdened with excessive debt and have proven to be able to adjust to the change.
On the other hand, the world of currency trades has shifted from “slam dunks” to merely “good risk-reward propositions”. My significant bets on weaker euro, yen, Swiss Franc, and yuan, after the original surge, have meaningful downside.
Chinese currency devaluation is coming into focus. I am inclined to stay with the trade as I can’t imagine any other way to stem the tide of capital outflows.
I have to face that sitting here today having little conviction about the direction of the stock market or economic growth (both domestic and global). This doesn’t mean I can’t have a position.
In my book and in my recent interview, I explain how I rely on my understanding of causality chains between various asset classes, rather on predicting the market direction.
So don’t get flustered by volatility. Take a deep breath, and instead of aiming for the narrow target of precisely anticipating the price action, look for trades that will succeed even when your views are wrong.
The generic assumption is that any government agency is out-of-touch and ineffectual. There may be a truth to that, but it doesn’t mean that the individuals in charge are not actually trying to do their best. Neither should we assume that they are all stupid.
With the next Federal Reserve meeting coming up this week, it is worth reviewing the Central Bank’s dilemma.
Investors can be divided into three main camps:
Economy is fine. Inflation pressures are rising. The Fed should and will hike soon.
We are heading into recession. Deflation pressures are rising. The Fed will not hike anytime soon.
We are heading into recession. Deflation pressures are rising. The Fed will hike soon and make things worse.
It is important to understand that each of those camps has strong arguments and statistics to back their position. Anyone with an open mind should be wary of being completely convinced when so there are so many strong counter-arguments.
As my readers know, I have critiqued Bernanke’s Fed before and I am a bigger fan of Janet Yellen. But whoever the chairperson is, the occusation of being an out-of-touch academic hangs over their head.
Now, as a former academic I can tell you: intelligent people are aware of the differences between models and reality, regardless of their theoretical background. They are aware of the risk of being out-of-touch and are trying with all their not inconsiderable resources not to be.
Now let’s assume that Yellen is familiar with all of the current schools of thought and is not completely convinced by any of them. What is the safest course?
If the Fed followed the hawkish docrine and hiked as early as June, they would have risked the runaway dollar strength and destabilization of global economy, which would eventually backfire domestically.
On the other hand, pushing the hiking cycle indefinitely has its own risks. Arguably, ZIRP can lead to a dangerous rise of leverage and price distortions. In the recent months, as the market had started expecting a more dovish Fed, the long bonds actually collapsed. It is hard to be sure how much of it was just positioning and how much the erosion of the central bank’s credibility, but the consequences could be counterproductive for the economy.
Thus the current procrastinating stance of the Fed:
“We will hike sometime soon, honestly. Just not today.”
One could argue that their information is not likely to become much more conclusive soon. But such indecisiveness may paradoxically be the most benevolent course:
The pace of the dollar rise stays under control
Rate expectation are kept away from zero to prevent a complete party in the short-end
So is it possible that the Fed is actually smarter than we think? That they are doing there best to guide their boat between Scylla and Charybdis?
Should we expect more of the same: “just not today?”
It has been a fun weekend. Between the escalation of Greek crisis and the surprise liquidity measures in China, it was as if the market never closed.
When considering market significance of a geopolitical event, it is important to distinguish between
The actual economic effect
The immediate impact on market players
In the case of the on-going Greek debt crisis and the potential so-called “Grexit”, remember that Greek economy commands only about 2% of the Eurozone GDP. Whether Greece muddles through or exits, the long-term economic impact should be moderate.
Two points that have been made by multiple people:
Greece exit might create a blueprint for an exit by other countries on the periphery, such as Portugal or even Spain.
Eurozone might be actually economically better off and the euro incrementally stronger without Greece.
What concerns me now though, is whether whatever happens in Greece may trigger a market panic or even a new crisis. There I encounter the “positioning” conundrum.
Paradoxically, it is easier to describe what would happen to the markets in the aftermath of a completely unanticipated and destructive event such as 9/11. We would expect a sharp equities sell-off, a flight to U.S. Treasuries and to defensive currencies such as dollar, swiss franc, and yen. The reason is that if market players are not positioned for this particular event, it is easy to guess what they would do.
But when an event was in the making for five years, the prediction is much harder. The “buy the rumor, sell the fact” paradigm comes into play. If we assume that most of speculative money was already positioned defensively with respect to Greece, any resolution may come as a relief.
But let’s go to the next level. If the speculators anticipate the post-resolution relief rally in Greek bonds and stocks, they may actually not be positoned defensively.
You know that I know that you know…
A parallel begs to be drawn with the Russian crisis of 1998. Russia didn’t default exactly overnight. But market players were anticipating either default or devaluation of ruble, not both. Caught by surprise, over-leveraged hedge funds folded like dominos, liquidating all positions, good or bad. Everything, from swap spreads to implied equity vol to municipal bonds went into a crisis mode.
So the question we have to ask ourselves is not just what exactly going to happen to Greece, but how is the “fast money” positioned.
Greek banks are not opening on Monday.
Stock market is likely not opening.
Virtually nothing should surprise us on Monday morning. Not a huge market commotion, not a relief rally, and not even business as usual.
Generally I am a fan of the concept that “crisis doesn’t happen on schedule”. We have learned it after the Y2K. And we knew in advance, about all the deadline for Greece and the dates for Brussels summit.
As I write this on sunday afternoon in California, the euro is down moderately (1.5-2%) and US Bonds are rallying quite a bit. My usual intuition would be not to get overexcited and stay with my core positions without adding anything. Which happen to short euro and long bonds as all my readers know.
If anything my bias would have been to expect for things to calm down and pull back to normal on Monday.
However, for me China is the enormous extra variable in this equation. I have tweeted earlier that extraordinary measures taken by the PBOC over this weekend indicate to me that might more problems there than it looks from the outside. Indeed, the correction in the stock indices like SHCOMP which are still tremendously up on the year is hardly a disaster by itself. But the aggressive central bank’s response may instill further doubt rather than inspire confidence.
But beware of contagion! Risk aversion in Europe may spill into Asia and converse. And when it comes to positioning in China – I have a feeling – the majority market players expect the government to be able to back-stop any crisis.
This type of confidence has been a path to disaster over and over again in the course of history.
My readers know me as a general global growth and economy bull. I don’t cry “crisis” often. But the confluence of events over last few days is making me view risks as highly elevated.
Diversified portfolios perform well during a hiking cycle – a simple and undeniable observation in a recent Fortune article by Joshua Brown @reformedbroker.
The points made in this post elicit my response, as they touch upon the core of my own strategy. I offer not a rebuttal, but rather a discussion of nuance on some of those points.
Point 1. Success of diversified portfolios during tightening cycles over the last forty years. I believe this is mostly a function of the overall secular bull market in stocks AND bonds. Given the short-term negative correlation between equities and fixed income, the diversified portfolio of stock and bonds has been performing extremely well in the idiosyncratic environment of the last few decades.
Point 2. Bonds don’t do too badly during a hiking cycle. Very true. I have observed this historical pattern and it has been at the heart of my bond bullish strategy over the last two years. The fact is, bond investors are usually well compensated for the anticipation of tightening and major surprises tend to arrive on the side of lower rates.
Point 3. Stocks do well during a hiking cycle. Can we agree with that? Here is how S&P500 performed relative to the Fed Funds target during the last two tightening cycles.
As you can see, in both cases the stock market rally continued throughout the cycle and, in one case, even beyond the end of tightening. Both of those rallies, incidentally, were followed by major bear market.
I don’t argue agianst the statement “stocks tend to go up, as the Fed hikes”, but I wouldn’t translate it into the statement “the Fed is about to hike, thus it is good to own stocks”. This would be confusing concurrency with causality. Indeed, the correct causality statement would be “absent a major inflation threat, the Fed continues hiking only for as long as stocks go up”.
Hence, if we have a GIVEN knowledge that the hiking cycle will go on and on, it is reasonable to assume that stocks will be performing. But with this knowledge we can do many other trades, such as short eurodollar futures or five-year notes, or long the dollar.
As we don’t know when the hiking cycle will end, we also don’t know when the bull market in stocks will turn.
Interestingly, this observation doesn’t undermine the credentials of a diversified portfolio. Indeed, this is exactly how it works: the end of hiking and the bond rally cushion us against a possible stock setback, when the economy turns.
US Government Bonds market has been one of the best games in town over the last couple of years. Especially, if you adjust for the currency. Indeed, though the yields of Japanese and European bonds have declined (priced rose) more than those of Treasuries, the currencies of the respective countries have declined against the dollar. Thus international investors would have done better staying in US Bonds.
When what is supposed to be the safest investment of the world also outperforms most world’s risky markets, it is bound to draw attention from new ranks of investors.
As one of the most vocal “bond and dollar bulls”, I’ve been getting a number of questions regarding the interest rates markets both directly from my friends and via social media.
A long-time friend with a solid academic background asked a particularly interesting set of questions about trading Treasury Futures. In this post I will give our dialog almost verbatim, as I think it might be helpful to some novice traders and even contain some elements useful for more experienced ones. I will also insert some helpful questions and answers from my blog.
To preface the dialog I want to point out a few things.
Treasury futures might be awkward to trade for small investors as the unit contract has a $100,000 notional.
The actual mechanics of those futures (with convergence factors and cheapest-to-deliver) is rather complex. This post is not meant to teach this mechanics.
The advantages of trading Treasury futures are the price transparency and the level field. Through futures we can all enjoy the same economics of funding and carry, as any big bank, without hidden costs.
Finally, keep in mind, everything below is discussion points and not trade recommendations.
Email I
Could I again ask for your help with (hopefully, rather basic) questions about fixed-income trading? I am learning to trade treasury futures, and my questions are about the underlying math.
Q: The first question is about the cheapest-to-deliver bonds for futures contracts. Am I right in my understanding that, when yields are below 6%, the cheapest-to-deliver bonds are the shortest duration bonds (among those allowed by the contract spec)? For example, the cheapest-to-deliver bonds for the classic T-Bond futures would be 15-year bonds, the cheapest-to-deliver for the 10-Year T-Note futures would be 6.5-year bonds, and so on? If I am actually wrong, how do I figure out the cheapest-to-deliver bonds for each contract?
A: First, I want to be sure you understand modified duration – it appears that you do.
Duration = – d price / d yield
Modified Duration = Duration / Dirty Price
When the prevailing yields are (like now) way below 6%, the cheapest-to-deliver is usually the shortest maturity allowable bond. But what really matters is modified duration, so in rare cases, a slightly longer bond with much higher coupon could have a shorter modified duration and be cheaper to deliver. Current cheapest-to-deliver for every contract can be looked up.
Q: The second question is about durations. How can I figure out the duration for a specific futures contract? For example, would it be right to assume that classic T-Bond futures are roughly equivalent to a 15-year bond with 6% coupon, and thus have duration of about 11 years?
A: In this rate environment the futures contract will essentially trade with cheapest-to-deliver (adjusted by the conversion factor). There will be some small technical factors, like the carry between the spot date and the delivery date, but they are not significant. However, it is incorrect to assume bond futures will always trade like a 15-year bond. In fact, currently they trade more like 20-year bond, because there do not exist any bonds with 15-19 year maturity. Those would have been the 30-year bonds issued during the Clinton era, when the long bonds were temporarily discontinued.
Q: Suppose I expect yields to rise (over the next few weeks or months), and I would like to take a position that bets on the rise of yields. Would it be reasonable to get a spread between 5-year and 10-year T-Note futures, that is, to sell short 10-years and buy an equal amount of 5-years? Are there better ways to bet on the rise of interest rates?
A: Betting on rising yields has been a bad idea over the last 30 years and probably still is. Google “One Chart To Rule Them All” – my twitter post appears on the first page. Check it out.
Typically selling one thing and buying another just increases the amount things that can go wrong, so I almost never recommend such strategy to express a simple directional view. If you have a view on a specific forward portion of the yield curve, this could be a correct trade to express it.
Relative direction of interest rates is rather tricky. If the Fed were to start tightening soon, 5-year futures could go down, while 10-year futures not move at all. You could lose money, despite possibly having a correct view. Of course, the opposite could happen and you could make money on both sides.
Overall I would need to know your reasoning behind the bet to have an opinion whether the strategy is appropriate.
Email II
I have two follow-up questions.
Q: You mentioned that the cheapest-to-deliver for every contract may be looked up. Could you let me know where? Probably a trivial question, but I could not find these data.
A: To look up Cheapest-to-Deliver and risk ratios:
Q: You indicated that using a spread (buying one thing and selling another) is unnecessarily complex. Is there a simpler/better way to bet on rising yields? (The first thing that comes to mind is simply shorting, say, 10-Years, but I am concerned that doing so would be “swimming against the tide”, since I would be effectively paying the coupon on the shorted bonds.)
[From my blog
Q: When you say Long Bonds will carry if the Fed stays put, could you explain in simple terms what you mean ?
A: By carry I mean the difference between the yield on a bond and the rate at which a leveraged trader can borrow money overnight, using the bond as a collateral. In the current rate environment this borrowing (funding) rate for treasury bonds is virtually zero. If the Fed were to start raising rates, the funding cost would go up, making the carry trade less profitable.]
A: Getting a “free lunch” is not easy. When you do 5/10 spread, it might appear you are avoiding the negative carry, but actually you aren’t. The 5 year forward 5 year rate slides down rapidly as it goes to 4 year forward. The nature of betting against the bond market typically leads to negative carry.
Q: Also, here is an explanation of my reasoning behind my bet on the rising yields. I realize that my reasoning is naive–I am just learning the treasuries–but it may help you understand where my questions are coming from.
I expect that yields will rise at least a little–maybe by something between 0.25 and 0.40–in the next few months, and that, if they fall, they will not fall below the Jan. 30 minimum, and not for long. (From your email, I understood that you feel far less “bullish” about the rates–which is depressing. I really hate when they are that low.)
Given that expectation, I was trying to figure out some position that would allow me to bet on rising yields without “swimming against the tide”, i.e. without simply taking a short position and paying coupon on it.
First, I drastically reduced the duration of my bond portfolio, from about 12 years to about 5. This change was done in my positions in bond mutual funds and actual treasury bonds (not in treasury futures, which I have never traded before). Now, I am trying to to a similar thing with futures, mostly for thepurpose of learning how to use them, with small positions. I first considered doing a spread between Ultra T-Bond and Classic T-Bond, but even a single-contract position turned out too large for me (in terms of potential losses and margin requirements), so instead I am looking at a spread between 10-Year and 5-Year.
A: First – terminology: being bullish on rates means expecting rates to go DOWN (price language as opposed to funding language). So I am actually bullish, but only on the long-dated rates – I have no opinion on the short end.
[ From my blog
Q: Won’t Long Bonds fall if the Fed hikes rates ?
A: Over the last decade we have found out that the Fed cannot reliably control long-term interest rates with their overnight rate policy. In fact, when the Fed tightens, the market starts projecting lower inflation and slower economic growth for years in the future. Thus, long-dated rates often don’t move or move lower early in a hiking cycle.]
If you go deep to the reason why you want to make this bet, you might find ways to do this, without swimming against the tide – this is what Part III of my book is about.
For example,
If you think the inflation is going to be high, you might want to buy gold.
If you think the economy is going to do well – you can buy an established stock such as IBM with good dividend, so you will betting on strong economy and earning carry.
Finally, if you already have a preference for higher rates – remember by actually betting on higher rates, you are doubling down.
Image: ‘Fit to Fight: Combatives Course teaches Airmen the basics [Image 2 of 3]’ Photo by Senior Airman Tong Duong via DVIDSHUB
Ms. Yellen got her reputation for being a dove in the years following the Great Recession, when it was correct to be a dove. That is not an evidence of her dovishness, but rather of her intelligence.
Nowadays we are at true crossroads. I have discussed in my previous posts, how there is an abundance of solid arguments for both sides of the interest policy debate.
Fixed income analysts, allocators and traders are racking their brains to decipher the central bank rhetoric and the Hodge-podge of confusing data. They are on the sacred quest for the date of the first hike. I can hear them mumbling their prayer: “June, September, September, June, December, no June, no June, maybe September, no September…”
I am no stranger to such soul-searching. My career started with trading interest rate derivatives in the late 90’s. In fact, I used to make markets on basis swaps (the swaps between various floating rates, such as LIBOR, commercial paper, or prime). Such products required me to focus on very short-term rates.
With my recent posts, I weighed into the 2015 rates hike debate. I have been inclined to believe that the Fed was on the course to raise rates this year and the burden of proof was on the doves. But I have never had a date pinned in my mind.
The recent unemployment report, however, was unquestionably weak. On Friday, I was one the people, whose attention was drawn to the continuing downtrend in the participation rate.
It is hard to get too excited about the falling unemployment rate, when the participation rate is only accelerating on its millennium downtrend. There are different ways to interpret this phenomena.
I think that lower participation rate reflects the trend towards labor redundancy, about which I wrote in my recent post on March 22nd. The economy needs less and less human input to march forward, so people are getting pushed out from the labor market.
Those long-term considerations combined with recent headline weakness, could by themselves shake any hawkish conviction. But even before the April 3rd release, the sentiment had been shifting towards greater uncertainty and confusion.
I am throwing in the towel. I don’t know what the Fed will do and Janet Yellen doesn’t know either. What is more important, she is not afraid to say so.
I am not a fan of the Central Bank policy of predictability and gradualism. On occasion, it felt that Greenspan and Bernanke were more compelled to hold hands of Wall Street traders than to protect the actual economy.
Indeed, financial media has a tendency to portray high volatility and low liquidity as a negative course of events. Critiques of the Quantitative Easing, for example, often point out that the program might reduce liquidity in the sovereign bond market. I could never understand it: given the huge budgetary and macroeconomic impact of the QE, are we really so worried about some traders being hurt by the bond volatility?
Many would agree with me that long period of low volatility and apparently unlimited liquidity lead to over-leveraging by risk takers.
In this case, is it not reasonable to deduce that the measured and predictable Fed was among the culprits of the recent financial crisis and the Great Depression?
My recent critique of @benbernanke on Twitter caused a surge of disagreement and debate. The general feeling was that were lucky to have him as a chairman during the crisis. My opinion is that things couldn’t have gone much worse.
Admittedly, I am biased. I got hurt badly in August 2007 by betting on the Fed responding to the freeze-up in financial markets much more vigorously. I couldn’t imagine (and still can’t) that Bernanke’s response to the unfolding catastrophe would be slow slow and lackluster.
Do you see LIBOR going up in August and September? Do you see that the Fed barely managed to get it down by the end of the year?
I see this as egregious a failure, as Greenspan’s infamous 50bps hike in May 2000 in the middle of the unfolding collapse of the internet bubble.
Am I now asking the Fed for a bailout? No, the Central Bank has no obligation to bail out my portfolio. There shouldn’t be too concerned if their actions blow up a few traders and help disproportionately a few others.
But when a systemic crisis unfolds, it is beneficial for the Fed to move with decisiveness of Alexander the Great and not to worry about timely signaling and methodical approach.
This is the problem with academics running the Fed: there are afraid to be wrong and act prematurely, so they collect the preponderance of evidence before acting. Traders have no such compunctions.
You see the financial system freeze? Cut right away, don’t talk, just cut! You find out your actions were excessive: tighten back. Nobody was ever able to explain to me what was wrong with the Fed being dynamic and flexible.
I hope that Ms. Yellen will bring us a more dynamic Fed and a higher interest rate volatility. Instead of the Fed pushing forward on a preset course with bull-headed certainty, I’d rather have a factitious collection of central bankers as confused and befuddled, as the rest of us, by the conflicting stories.
Let’s allow the possibility that the Fed knows about the dollar, the unemployment, the globalization, the U3, the U6, the commodity prices, and even the economic singularity. And they don’t know either what the should do or what they will do.
I don’t claim to be a better economist than Ben Bernanke. In fact, I respect his intelligence and scholarship greatly. Now that he has started blogging, I think he is on a short-list to be the most influential financial blogger in the world.
The same is true about Janet Yellen: I am sure she knows everything I do and more about the economy and inflation.
What I am trying to be, is a better trader. So let’s trade circles around the Central Bank.
With intelligent, but unpredictable Fed, and complex economic story, is it really worth committing our capital to pinpoint the “lift-off” date for the rate cycle?
My strategy over the last couple of years was consistent with remaining agnostic about the first hike. I have summarized it in a tweet last year:
Long bonds are perfect:
Fed hikes – they rally.
Fed holds – they carry.
So I will stay the course and keep away from bets on the short end of the yield curve.
I am also staying long dollar, because I think the dollar will benefit whenever the hiking cycle will start, and especially so, if the rates will go up much more than I expect.
This is how I hope to circumvent Yellen’s dilemma and survive whatever course she takes.
Inflationary apocalypse or deflationary apocalypse? Which way is the United States heading?
Both doves and hawks have their arguments, and their statistics, and their indicators.
Those, who pay attention to strong dollar and headline inflation, argue that a rates hike by the Fed would be a terrible mistake, pushing the country into recession and the negative yields hell experienced by Europe and Japan.
Those, who view the improving labor market as an undeniable indicator of imminent wage pressure and inflationary spiral, consider the Fed to be way behind the curve.
If we take one side of this debate, let’s not call the other side stupid. They have their points. Let’s also not automatically assume that the Fed is stupid. Janet Yellen’s carefully hedged language from the last policy meeting and the press conference reflects that she is aware of the complexity of this puzzle.
As a sideline, I think the Fed is often forced to be somewhat disingenuous, because “we have no idea what’s going on, so we’ll just try to wing it”, might not go over well with the public. They are forced to appear to have an opinion, when I believe they have none (in the very least no consensus opinion).
Having said that, the markets are made of people who think they recognize something that others don’t. So let me respectfully share some of the things I think I recognize.
There is a common problem in partisan politics that tends to surface in financial markets debates. Opinions get packaged.
I would not be the first one to point out that there is no particular reason why, if a person is for tighter financial regulations, they should be also be pro- choice, anti- death penalty, pro- marriage equality, pro- gun control and so on. I don’t think that the majority of people package their opinions for political expedience. Rather, I suspect, they are unconsciously programmed to bundle their views according to a template laid out by our political history and media dialog.
Traders have no political reason to package their views, at least no rational reason. Yet decades of observing the economy and the markets have taught us to associate:
Stock rally with wage pressure
Economic growth with inflation
Corporate profits growth with expansion
Government bonds rally with recession
Deflation with stagnation
Flat yield curves with economic pessimism
Low commodity prices with economic slowdown
I could go through many such pairs. Needless to say, those relationships went a little haywire in the last few years. In the very least, we have a strong stock market with decent economy accompanied by lackluster wage growth and very low interest rates.
I feel that market players are choosing between roughly three packages:
1. Stocks are grossly overvalued, We are heading towards a deflationary disaster. Rates are going down.
2. Stock market is reasonably valued. The economy is in a cyclical expansion. Rates are going up.
3. The Fed is far behind the curve. The inflation is about to get out of control, the expansion will stifled by rising rates.
As I have stated above, all of those positions have historical precedents and cyclical arguments to back them up.
My own SECULAR view, however, unpackages those positions.
I am very bullish on long-dated US Government Bonds, but I am also cautiously bullish on stocks. I think there are risks on the near horizon, China slowdown being an obvious one.
But I recognize the following secular trends:
Global labor redundancy
Lack of wage pressure
Global disinflation
Global explosive economic growth
Explosive growth in corporate profits
In fact, I allow the possibility of us heading into the future where deflation and negative rates (as a price for safe dynamic liquidity) will be a norm. And despite disinflation, I believe that future trillionaires are already born.
Clearly, the burden of proof is on me. I have to make an argument that “this time is different”. And usually “this time is different” story has an ending “well, it turned out to be just like the last time”.
The disinflationary jobless growth scenario hinges on the interpretation of globalization and automatization. And history so far has shown that when progress eliminates one kind of jobs it creates others.
I think this history is no longer applicable. People were speaking of accelerating science and technology for centuries. But up until the recent decades they mere moving and accelerating at the pace set by human intelligence.
We were designing new tools, but those tools were requiring humans to manufacture and operate them. The more complex the tools were, the more highly trained the humans were required to be. And with tools humans were able to make more impact thus, in fact, maintaining demand for their labor in the exponentially growing economy.
It is still mostly true. Computers aid our thinking and research, but the bulk of changes and innovation is driven by human creativity. Yet the balance is shifting.
Singularitarians (such as Ray Kurzweil) believe that we are on the brink of explosive self-acceleration led by computers designing better computers, which design better computers even faster, and rapidly surpassing every aspect of human intelligence.
Singularitarian philosophy is migrating out of the province of science fiction writers into the mainstream, and can no longer be ignored by long horizon investors.
I don’t know when we will be uploading our minds or merging them with artificial intelligence.
But I do see that we are shifting into the world where more and more able-bodied competent adults do not have sufficiently marketable skills.
And those of us who are still doing well, say trading, shouldn’t get too comfortable. The algos are breathing hot on our heels.
I want to be clear. My core strategy over the last couple of years – long dollar, long bonds, long stocks – is not predicated on any conviction about “economic singularity”. Rather, I am following market patterns and trends that I currently observing. And questioning some old economic paradigms doesn’t equate to disregarding historical market patterns (such as strong performance of the long end of the curve in the tightening environment).
In fact, my portfolio strategy does not require an over-arching philosophy. But the idea of economic singularity allows me to have a clear and consistent theory of unfolding events.
I can be positive on stock market without being scared of valuations
I can be long bonds without fear of job growth
I can anticipate the Fed tightening without conjuring an imminent global depression
And even when I contemplate the possibility of catastrophic China collapse, I can see light on the other end of the tunnel
The Fed doesn’t have have the luxury of including the singularity into their discourse. They have to appear serious and academic.
There has been a lot of talk about the bubbles lately. Stocks are a bubble or bonds are a bubble. Dollar is a bubble or all other currencies are a bubble. Bitcoins are a bubble or fiat currencies are a bubble. Start-ups are a bubble or established companies are a bubble. The list goes on.
All I know: the only thing worse than going bust buying into a bubble is going bust selling into a bubble.
For the purposes of this post I am going to assume that you, the reader, have a way to identify a bubble.
By identifying a bubble, in some specific security or in a market, I mean knowing with complete certainty that at some point in the future this security will trade at 50% of its current price.
Knowing some like this with certainty is a tall order. But I will give you this. There are instances of obvious bubbles/dislocations, and though the financial world is probabilistic, at some point you have to go with your own reasoning.
What I will not give you, is the knowledge of the timing of the said bubble bursting and the timing of this 50% price decline occurring.
Now let’s look back at the tech bubble of 1999-2000.
The NASDAQ peaked out at over 5,000 in March 2000 only to fall later to close to 1,000. One could argue that the bubble had been already identifiable when NASDAQ reached, say, 3,000 in 1999. Certainly, it subsequently corrected by more than 50%.
So who is a worse trader – the one who bought it at 3,000 or the one who sold it short at 3,000?
I don’t know the fate of a bull: it depends on the stop-loss strategy. But I do know the fate of the bear, and it is grim.
This is the problem of all short-selling strategies. You think a company as overvalued at $100 and set a target price of $50. But what if it goes to $150 before it goes down? Are you actually going to hold the position?
The answer might be “yes” for some people. Such people usually don’t survive in the world of leverage finance – your capital, your credit lines will eventually get exhausted and your investors will flee.
Of course, you can limit your downside by expressing your bearish bets via options. But this is a treacherous path as well. Downside options tend to be expensive and decay rapidly. The view might be correct, but your timing might be off, and the options will drain your capital before paying off.
All of us want to be John Paulson, who made something like $20bln betting against subprime mortgages. My hat is off to him and his team for their excellent research and unwavering commitment.
But even the people who correctly anticipated the mortgage crisis, didn’t have an easy time of timing the collapse or finding the correct strategy to take advantage of the bubble. For every John Paulson, there are a lot bear skeletons littering financial thoroughfares.
Am I telling you that there is no way to take advantage of recognizing a bubble?
No. There is one sure way.
SIT IT OUT.
If you know that stocks will collapse below current levels, stay flat! By the virtue of being in cash, you guarantee yourself a great buying opportunity (like in 2002 or 2009) with no risk of being squeezed.
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.
I prefer to focus on what the Federal Reserve WILL do, instead of what it SHOULD do. A lot of time is spent debating the latter, while what will make money for us, is understanding the former.
This post is designed to communicate some ideas about trading U.S. markets in the tightening and pre-tightening environments – something the younger traders might have not experienced. But first I want to make a case why Fed’s raising rates this year is a likely scenario.
The opinions on what is necessary for the economics are clearly divided. And I am not the one to resolve this debate.
The projection of rates going up sometime in the middle of 2015 dates all the way back to 2013. Since then the market gyrated, but continued to inexorably creep to this target date. September-2016 Eurodollar contract is good proxy for the tightening schedule anticipation:
While this contract has being going nowhere, the 2-yr swap rate, which indicates where we are on this consistent schedule, is steadily creeping up:
The Fed knows this. And they are not speaking otherwise. I think they are OK with this schedule. Low inflation and strong dollar notwithstanding.
Let me be clear. I do not propose betting heavily on the tightening, especially on a particular schedule. There are a lot of uncertainties in the world – a lot can go wrong in the next few months and deter the Fed.
My point is that the current course is set and the burden of proof is on the contrarians. In this context last Friday’s job report is especially important. Usually, I don’t put much weight on a single economic indicator, but this strong release came at a critical juncture. It took away a major opportunity for the Fed to diverge from expectations by claiming weaker economy or job market.
I think we should brace for the tightening to come and enjoy the ride.
Here are some lessons I have learned from the last two tightening cycles:
1. Yield curve flattening will start earlier than you think and will be more vicious than you think.
UNDER NO CIRCUMSTANCES EXPECT HAWKISH FED TO CAUSE LONG END TO SELL OFF.
This understanding allowed me to load up on the bonds in the end of 2013 (not as an allocation, but as a leveraged trade). If the Fed stood pat, I would be receiving the carry indefinitely, but when they started leaning towards hiking – I knew the long end would be supported.
2. No matter how much the curve flattens or inverts, the reality will be even more extreme than its anticipation.
In 2006, someone told me that the easing of a cycle takes place on average only 9 MONTHS after the last tightening of the previous cycle. This sounded like complete nonsense. How stupid the Fed should be to tighten only to have to ease nine months later?
Well, let’s remember the hikes of May 2000 and June 2006. I don’t have to tell you what happened shortly after. Notice how short the “flat tops” of the Fed Funds target rate were.
So remember:
TIGHTENING LEADS TO EASING AND THE MARKETS WILL ANTICIPATE THIS TO AN EXTENT.
3. There is a lot of talk of how long (albeit lackluster) this expansion has been and for long we were in the equities’ bull market.
Well all this time we did not have hikes. The last two times:
TIGHTENING WAS FOLLOWED BY RECESSIONS.
So anticipate the stock market and the economy to roll over 2-3 years from the beginning of the tightening cycle. Given the unique current circumstances (dollar appreciation, China slowdown, European woes) those things might happen sooner.
So check the lines securing your portfolio. These are different seas.
