participants, remembering the impact of Brexit, have their focus on France this
weekend. The last thing I want to do is add into the
mix my futile hunches regarding the probabilities of various winning candidate
permutations. Furthermore, wI won’t even speculate how the market will react to
any particular second round match-up.
The purpose of
this note is to discuss a rare, tactical conviction over this weekend.
Staying COMPLETELY AGNOSTIC as to whether the election outcome will be taken as
Eurozone positive or negative, consider USDCHF.
The outcome is
perceived as negative; fueling French EU exit fears (‘disenfrancising’) and
risk-off trades such short USDJPY, short equities, and long US Treasury bonds
are expected to benefit. EURUSD is likely to fall and underperform CHF.
However, given the close linkages, CHF is likely to be dragged down by the EUR
and, unlike JPY, underperform the US dollar. So, in this scenario, we expect
USDCHF to gain.
The outcome is
perceived as positive; risk-on trades, such as long equities, are expected to
benefit. US and European risk-free rates are likely to trade higher. EUR
will likely outperform CHF and possibly by a lot, as Swiss interest rates are
more pinned, and USD will rally against safe harbor currencies such as JPY and
CHF. So, in this scenario, we expect USDCHF to appreciate.
goes up, or USDCHF goes up.
important to underscore that when I talk of tactical conviction, I don’t mean
“I am positive that this
trade will make money,” rather I mean “I am convinced that this is a positive expectation
finicky, and even with the logic above I can assign no higher than 60% chance
of being correct.
And we I am fully prepared to be completely wrong.
Hence, I am purposefully posting at the end of the trading day not to entice the reader to
follow our trade, but to share and “timestamp” my thinking, which typically
applies to the long investment horizon, but in this unique case may have a
over two solid weeks after the election, the markets have been relentlessly
pricing in the success of “Trumponomics.”
To be clear, we mean “success” in a purely non-partisan manner. It just means the President-Elect would accomplish what he says he is going to
accomplish, whether that might be good or bad in an individual’s view.
Furthermore, we discuss economic causality only to the extent it affects
financial markets, or more precisely, how it defines superiority and dominance
relationships between specific trades.
that in mind, let’s start untangling Trumponomics with its flagship item:
infrastructure stimulus. Long on the Democrats’ agenda, the package of $500bln
to $1tln is now expected to pass through the Republican Congress. Without
offering our amateur political analysis, we point out that this may or may not
“expected,” we mean the price action in:
Industrial commodities; and
if the stimulus were to pass, all else being equal, it would provide a tailwind to all of the above. But, the
magnitude of the move thus far has already been substantial enough to make us
question if betting against the stimulus is taking on a characteristic of an “Even If” trade discussed in Chapter 13 of The
Next Perfect Trade. The argument being that there are occasions when the
market pricing is so skewed towards one outcome, that betting on the opposite
outcome may make money even if
the most expected event comes to pass.
recent price action in pertinent markets:
US Equities: 1m Historical
5Year US Inflation Breakeven: 1m
let’s shift the discussion to the Federal Reserve. Should the stimulus pass,
the Fed would consider the rising inflation expectations justified, based on
the triple impact of:
Rising commodity prices;
Tightening labor markets; and
Wealth effect from the stock market.
the Fed was well on track to tighten imminently regardless of the election
outcome, so in this case the EVEN IF trade points us in the direction aligned
with Trumponomics. There have been debates on whether the current Federal
Reserve is too tight or too easy. We elected to stay on the sidelines but
consistently highlighted that the Fed is indubitably hawkish relative to other DM central banks.
Trump criticized Yellen during the campaign, we are not sure how much of that
was purely political rhetoric, and what he would rather she do or not do. What
we know is that Ms. Yellen is likely to stay on for the remainder of her term
and to pursue her policy framework. As for what
comes after, we would posit that the President-Elect has a good understanding
of debt and interest rates; he would likely “push” for a policy that would
neither stifle the economy through excessive hikes nor allow inflation
expectations to run away leading to a catastrophic steepening of the borrowing
pointed to the limitations of the curve shape as a leading indicator in our
Curves & Recessions, from September 28th, but steepening is
often viewed as a good thing as it is associated with periods of solid economic
growth. On the other hand, as the United
States has a considerable current account deficit, higher rates are net
negative for the wealth of the nation (more interest going to foreigners), and
this is something Trump may be aware of.
we see no reason for the new administration to nudge the Fed to one extreme or
another, so ‘business as usual’ is our best guess.
What Does This Mean for The
US dollar (USD) has strengthened a lot on the back of Trumponomics. This price
action is consistent with the notion of a
reasonably vigilant Fed, which would raise REAL interest rates in response to
higher inflation expectations.
USD: 1m Historical (DXY)
re-price of the markets notwithstanding; we continue to maintain that
stronger dollar is a concurrent necessity with
respect to higher interest rates. In other words, if US rates stay where
they are or move higher, the USD should continue to perform well on a total
return basis. For those who feel that the dollar rally has gone too far, we would refer to our post
from March of this year and point out that given the rates differentials,
the current 10-year forwards in EURUSD,
USDJPY, and USDCHF are 1.3150, 84.00, and 0.7500, respectively.
we have long noted, ECB, BOJ, and SNB do not have to ease further to weaken
their currencies; all they have to do is to hold steady and let the Fed lift
dollar bears base their view on the implicit necessity of the US rates playing
out much lower than currently projected. Our logic then dictates that betting
on lower rates is the dominant trade.
Talk About the Transmission Mechanisms
rates and stronger dollar traditionally are seen as a recipe for a deflationary
an aside, we acknowledge the point of view that in a stronger final demand
environment, higher rates may, in fact,
be inflationary as they increase the production costs. We, however, stick with
the simple perspective that real rates are “the cost of money.” And if the cost rises, well then money
becomes more expensive, i.e. deflation. Of course, a further nuance may
be possible arguing that higher rates are mostly deflationary for asset prices,
not consumer goods – a theory well supported by the fact that recent low rates
have helped asset prices much more than wages.
are acknowledging those arguments to emphasize serious uncertainties and
complexities in the rates mechanism, but we will stick to the simple
observation that “too high rates” typically lead to a collapse in the stock market, which is often followed by an economic slowdown.
have long argued for the negative predictive power of interest rates and that
perpetually upward sloping and steep
yield curves, provide a tailwind for the secular bond bull market.
dollar rise should be even less controversial, as it incrementally leads to
weaker exports and lower imports prices.
on an “all else being equal” basis, the recent shift to higher rates and stronger
dollar equates to a tightening monetary condition and should lead to lower
inflation expectations, a flatter yield curve,
and lower equity prices.
transmission mechanism is challenged by
the market’s acceptance of the Trumponomics. The higher rates would be offset by the stimulus and the impact to trade from a higher
dollar by import taxes. Tariffs being another “may or may not happen”
proposition. We will not even go into
the risk of a global slowdown caused by potential
is sufficient to say that the tightening of economic conditions is present here
and now, and stimulus and tariffs are
something that might happen in the future and just might have the expected
you may guess, we continue to argue for
our portfolio strategy; a combination of long US bonds and long US dollar
against DM currencies.
addressing bonds, it is important to
mention the credit risk which may increase
with Trump’s potential expansion of the budget deficit and his rhetoric,
however unlikely, regarding a “workout” on the US debt.
Long-dated bonds have cheapened significantly
over the last few days on an asset swap basis, some of them approaching the
level of Libor + 60 bps. Some have viewed that relationship as mathematically impossible
and attribute it purely to technicals related to the Dodd-Frank limitations of
balance sheet and foreign CB selling.
we wrote in a blog post a year ago, it is not exactly as simple as that.
setting technicals aside, the only economic justification for the current levels is the pricing of at least 100bps of credit risk. This, in itself, implies something like 80
cents on the dollar workout on long-dated
bonds, which in our view is extremely conservative.
is no doubt that the Trump victory has introduced more uncertainty into the
rates environment, but we are well compensated
for this. For example, while we would
rather be long bonds with Clinton than with Trump at the same level, we prefer
to be long bonds with Trump for an extra 100 bps.
finally, for what it’s worth, both the magnitude and velocity of the recent
correction are entirely consistent with
multiple, recent corrections including:
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
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.
Like the old Soviet Regime, certain market regimes seem to be entrenched so thoroughly, that it is impossible to visualize any mechanism, by which they can be dislodged. But the Soviet Union fell and did so in a fashion few could have foreseen.
Until only a few years ago, Japan appeared to be caught in the never-ending purgatory of deflation, sagging growth and capital markets, and meaningless reform promises. In 2012, the current account surplus was not scheduled to elapse for a few more years, and the market flows, according to strategists, continued to support the yen. And then the sudden collapse of DPJ and Abenomics. You know the story.
And you also know the story of the Swiss Franc. First it was immovably pegged at a too weak 1.20 exchange rate to the euro. Then the immovable and indestructible peg suddenly evanesced. The franc briefly rallied above parity, which was way too strong. It appeared that the SNB had no means to control the currency appreciation. Until they did. And guess what? EURCHF drifted to somewhere in between 1.00 and 1.20. Probably where it should have been to begin with.
You probably can see where I am going with that. If general economic principles and historical patterns dictate that something has to happen, it probably will. Even if you see no possible mechanism to drive the transition.
I reviewed a book by John Mauldin and Worth Wray A Great Leap Forward?
I conceded that both China bulls and bears were making strong points. And with regards to currency I was giving heed to both those who said that a massive devaluation was inevitable and those who pointed out the imminent deval was neither necessary nor in the interest of the government.
There were few precedents to establish how price and credit overextensions unwind in tightly controlled communist/capitalist markets.
Personally though, I leaned to the bearish case for both equities and currency, based on the historical pattern for countries with credit growth excesses. Until proven wrong, I had to assume that the “what” of the equities correction and currency deval, even if I didn’t know the “how”.
And given that I ALWAYS put my money where my mouth is, my strategy did not permit me not to trade accordingly.
It was not cheap and my timing was not perfect. And today it is too early to celebrate victory: all my gains are reversible.
Now what? Do I stick to my guns and expect more of the same?
If you were wondering why I haven’t posted any anything extensive on the RMB devaluation thus far (I suspect you have better things to do than to wonder why I don’t post): I had relatively little to contribute to the discussion. I don’t have a clear idea why they did what they did and what their long-term plan is.
So in the absence of such insights, I have to stick the fundamental principle which drove the China trade, as well as other examples above:
Unsustainable will not be sustained.
If you see a major dislocation what have to bet on it eventually being rectified, even if you fail to understand the mechanism of the shift.
One of the reasons I prefer simple directional trades is because the “what” of the market is often easier to discern than the “how”.
And with the respect to China, if (and that’s a big if) you believe that the major dislocations are still there, it is reasonable to assume that they won’t be fixed by a 5% currency move. And so, regardless of what the authorities may have in mind, the odds are skewed towards further devaluation.
Chart source: Yahoo! Finance
Image: The Unstoppable Wave by Theophilos Papadopoulos
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.
The dollar chart is no longer parabolic. It’s vertical.
This by itself is not an indicator, that we have to close the long dollar trade. My general feeling is “Why give up on a good trend, while it lasts?”
On January 1st, 2015 I posted that I had reduced my short Yen risk and focused on short Euro. My relatively conservative risk commitment at the beginning of the year allowed me to build a short Swiss (long USDCHF), after the SNB surprise action had sent the currency into the opposite of freefall.
But now both EURUSD and USDCHF trades have moved enough to be considered mature along with USDJPY.
Even the secular dollar bulls, who are calling for EUR to go back to 0.80 and JPY to 150, have to admit that more than half on the move has already taken place.
When EURUSD was at 1.35, it was easy for to say “I will stay short no matter what. If it goes a few % against me, I will just wait it out.” Now there is a lot to lose from 1.05.
So, are you prepared to sit on your short EUR position, if it goes back to say 1.15? Maybe you are. But it is not crazy for even the greatest dollar bulls to think of some risk management. For some it means reducing positions, for some trailing stops. Personally, I prefer the former.
As I am taking some profits on EUR and CHF, my thoughts are turning to currencies that haven’t moved quite as much and still have space to catch up in the devaluation race.
You might have guessed what part of the world I am thinking of from the picture upfront. China, Taiwan, Australia, New Zealand, Korea, and so on.
Australia in fact has already moved a lot as well. But New Zealand, as I have written before, looks very expensive against its larger neighbor. So I have recently decided to swallow the negative carry pill and establish a small NZDUSD short.
China is the focus of raging debates and what is actually going on there is beyond the scope of this post.
I would like to have a better look at South Korea, which delivered a surprise rate cut last week, confirming its participation in the race to the bottom.
Indeed KRW has weakened somewhat against the US dollar. But the 10% retreat to the highs is not that substantial. If you substitute USD by the currency of their closer neighbor – JPY, you will see a very different picture (lower number means stronger KRW).
So we have a theme similar with China and New Zealand: the carry is not great (though closer to zero in the case of Korea), looks weaker relative to USD, but strong relative to some key counterparties.
I have to confess, I am not at all an expert on Korean economy.
Rather than to analyze specific countries, I want to focus on the general theme. How much downside is really there in being short USDNZD, long USDCNY and USDKRW?
Yes you might have to eat some negative carry, but are you worried about catastrophic appreciation of any of those currencies?
So now that we have (hopefully) booked some profits on easy positive carry trend trades in EUR, JPY, and CHF; is it worth to pay some carry in places where the downside is not that big?
I find it hard to imagine the world in which the broad dollar continues and the “catch-up” currencies do ont devalue as well.
Extreme, even absurd-sounding scenarios. Don’t feel foolish for including them in your reasoning. Sometimes one has to ponder the extremes to reach the utmost clarity.
The last week’s Swiss Franc move reminded to us that no one is safe in the markets. I could gloat and say “Look at me: I was wrong way around, but I actually did well because of my good risk management and portfolio construction!”
But, rather I am saying “Whew…”
In the world of leveraged finance one may not honestly say “My portfolio cannot blow-up.” Rather I would hear “My portfolio will not blow-up, unless U.S Government declares a full default… China goes to war with Japan… aliens invade…”
In the spirit of considering all scenarios, let’s talk about the bond markets.
One of the arguments I heard recently from people who wanted to be short U.S. government bonds is “With 10-yr note yield sub 2%, how much more can they rally? The risk is skewed to the rate upside.”
I take an issue with this approach. Let’s consider the true extremes.
1. All rates going to infinity. An event approximated by full default or hyperinflation. All future cash flows become irrelevant. All bond prices, regardless of maturity, go to 0.
The downside for a par bond is 100 to 0. Regardless of coupon.
2. All rates go to 0. An event approximated by establishing gold standard and no term premium. All future cash flows have the same value as present cash. Every bond is worth it’s face value plus all future coupon payments.
The upside of par 2-yr note with 0.5% coupon 100 to 101. Not much compared to the downside of 0.
However, the upside of 30yr par bond with 2.5% coupon is 100 to 100 + 2.5*30 = 175. Not so skewed, is it?
Another way to think of it: if you have a zero-coupon bond trading at 50, the risk symmetric with respect to these two scenarios (0 with infinity rates, 100 with 0 rates).
This counterintuitive distribution of risk, has to do with “bond convexity”. The convexity is caused by the fact that, as rates fall, the future gains and losses become more meaningful when discounted to the present. Thus those who bet on falling rates see the size of their position increase, as the market moves in their favor. The converse is true with betting on rising rates. These convexity effects increase dramatically as the maturity of the bond lengthens.
3. Rates go negative. Not possible, huh? Tell this to Euroland, Switzerland and Japan. So far the negative rates dominate only the portion of the yield curves within the 10yr mark and the convexity effects are subdued. But who can now deny the theoretical possibility of negative rates all across the curve?
Can future sovereign obligations become multi-fold more valuable, just by the virtue of being the future?
The U.S. Treasury curve seems in no such immediate danger. At least in nor much more danger than EURCHF floor was from being released.
However, the United States has a fundamental structural difference from European markets – the fixed prepayable mortgage market.
Imagine the prepayment and refinancing wave that would happen if the 30yr mortgages rates started to head towards 0. Below 0?
The mortgages originators will find themselves immensely short fixed income market and forced to keep buying, exarcurbating the move.
Now the dealers are not stupid (mostly), they are hedging (somewhat) not only their directional risk, but also the convexity. But are they really prepared for negative rates? The thing with derivatives: for every party there has to be a counterparty. So, no matter how you push the risk around, it remains in the system.
And when people are caught unprepared, things get funky. U.S. economy might not warrant negative rates, but can the runaway convexity move take us up there? Could we theoretically see bond futures rallying say, to 1000?
Those are not likely scenarios. And I am not saying that you cannot trade bonds on the short side. We are in the business of taking risk.
But don’t say that bond upside is limited. And if you blow-up by being short, do it with your eyes open.
The dust has not yet settled from the shocking SNB decision to release the 120 floor on EURCHF. Something I had considered possible, but unlikely.
In rare move for a developed country Swiss Franc appreciated 15%-20% (depending on when you choose to look at the screen) against most currencies.
Now what? Let’s forget about money we made a lost or in today’s commotion. What is the BIG CURRENCY TRADE for the next few years?
USDJPY (short Yen) 2010-2014 was the most profitable trade in my career. But it feels mostly done, the way I was thinking about it at conception. Now a new wave of traders who believe in a massively stronger dollar needs pick up the baton.
Short EUR has been another great trade for me. But where it stands today at 1.16, it is long way down from 1.40.
Is Swiss the new BIG SHORT?
I know little of Swiss politics, but clearly no one thinks that such drastic currency appreciation will be good for Swiss markets. But does it in itself mean that the currency has to correct?
I believe it does, but I don’t know when and how.
In 2010 when USDJPY was in the low 80’s, I had concluded that the levels were unsustainable. I hadn’t known what the mechanism of Yen depreciation would be. But I initiated the trade, believing that the economic forces would sort the market out. I could not have foreseen the dramatic political shift of 2012 and the Abenomics.
However, what I need to remind aspiring Swiss bears – it took two year of waiting and 5-6% of downside pain for the USDJPY trade to play out.
Are you ready for the pain and for the waiting?
As many people are pointing out, QE is not as easy implement in Switzerland as it was in Japan. There is not enough sovereign debt to buy. And as the world is becoming more dicey the flows into CHF might increase.
So how will the Franc be able to depreciate?
I don’t know how, but I believe it will. My inclination is to think that eventually they will find a way to print their own currency and weaken it. And maybe they will even overshoot.
Just don’t ask me about the time horizon and the downside.
i am initiating long USDCHF (short Swiss), but I am doing it with considerable caution and preparedness for pain.
i’ll sleep on it before deciding how far to commit.
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