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
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.
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.
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:
Relatively stable or slowly depreciating RMB
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.
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
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.
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.
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
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.
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