In my last post I signaled the possible market confusion about the Fed’s dovishness. For sake of clarity, I voluntarily skipped an important development going on within the Fed’s policy framework – the switch from a focus on tapering bond purchases to a focus on thresholds of forward guidance.
Ahead of the Fed minutes tomorrow, this switch deserves some explanations for three reasons: 1/ it is probably the main reason why the market got confused about Fed’s dovishness; 2/ the market has started being sensitive to this switch as can be seen in the correlation break between the 2Y USD and the 10Y USD; 3/ the reliance on forward guidance involves some risks for the Fed as controlling indirectly money market expectations is very different from controlling directly the 10Y yields – as the BoE experience has shown recently.
1/ In Fedspeak, tapering is not tightening.
In virtually every newspaper last week you could read that Yellen had been dovish, the main reason being cited was that she said that the output gap was such that accommodative monetary conditions were necessary for a long time. Many concluded that tapering will be pushed back. But the Fed has been clear for a very long time that tapering – the end of bond purchases – would not affect monetary conditions. In other words, in Fedspeak, ending purchases will keep monetary conditions as accommodative as before. That will just stop them from becoming more accommodative. So when Yellen or Dudley yesterday, are saying that the size of the output gap, or low inflation should be met with accommodative conditions, it does not mean at all that tapering is going to be pushed back. That’s a key source of confusion I think.
2/ 2Y – 10Y correlation break indicates that the switch in tools has started.
That being said, when one looks at a chart of 2Y and 10Y USD yields (below), it is clear that the two maturities have been pricing something different (NB. I voluntarily take 2Y Swaps vs 10Y Govies to take what I consider to be a more accurate picture of Fed expectations vs Financing conditions in the Bond market). One can notice that since end October, the 2Y has fallen, while the 10Y was rising (red arrows in the upper panel). This is a rare occurrence, as the curve tends to bull flatten (lower yields , with the 10Y going faster down) or bear steepen (higher yields with the 2Y going faster up).
That has occurred because the Fed has two main policy tools – it’s bond purchases (QE) with which it impacts directly the 10Y yields, and the forward guidance and its thresholds (when will rate hikes start) with which it tries to impact the money market curve and also indirectly the long term rates (which are an aggregation of expectations of forward short term rates and a risk premium).
The thing is, because QE is seen as having high risks, tapering needs to take place. But because the Fed doesn’t want long term yields to spiral higher, it might be trying to “compensate” by being dovish in terms of forward guidance. That is why we are seeing a higher 10Y, and simultaneously a lower 2Y.s why the Fed message has seemed so confused. But actually, attempting to differentiate between these two tools is the very reason why forward guidance (see QE4) was created.
The divergence in yields was triggered by the debate on thresholds. At the start of the month, two major papers were published by the Fed research discussing the possibility of lowering the unemployment threshold or adding an inflation threshold, one by English and the other by Wilcox. I must confess I didn’t read them, but from discussions I had, I tend to think that it is more likely that the Fed would add an inflation threshold, rather than move the unemployment threshold (which would tend to be more risky in terms of credibility).
Another factor that has helped the divergence between 2Y and 10Y in that period was the drop in inflation. Inflation has surprised on the downside and even without a formal inflation threshold it has mechanically pushed back expectations about the first rate hikes.
In any case, around this time window, the high frequency correlation between the 2Y and 10Y (10 day, in return) moved from 80% to about 40%, showing clearly how the two Fed tools were affected by a different message. The thing is, since then, the correlation has resumed which can be a good thing as long as market expectations about economic growth remain in line with the Fed’s scenario.
3/ But there are risks in the switch.
First, if you accept that what primarily matters for the economy is the ability to control the level of the 10Y yield and the 30Y MBS, then it is rather obvious that it is a risky move because the “forward guidance” tool is much less accurate. With QE, the Fed was directly buying bonds, while with Forward Guidance it is going to affect the long term yields only indirectly through the money market part of the curve.
Second, if for some supply / demand reasons, bond holders don’t want to buy more bonds (I think of EM central banks in particular – China and Japan), bonds will selloff whatever happens to the 2Y. The advantage with QE was that the Fed could directly affect the supply / demand balance and prevent a selloff, something that can’t be done with forward guidance. In that sense, forward guidance can work (in terms of impact on the 10Y) only in a context of stability of the bond market’s suppy / demand.
Third, the BoE’s experience with forward guidance has been a complete fiasco so far. In the sense that the rate market has reacted in “black or white” to economic news, by that I mean that the 2Y and 10Y GBP didn’t suggest any differentiation between end of QE and start of rate hikes. All good data were pushing both yields higher (see chart). And the correlation between the two yields is at a high.
That makes sense in a way because at the end of the day forward guidance is data dependent, so what really matters are market expectations about the economy. The thresholds are a framework, but the actual Policy moves will depend on your economic forecasts! Worse in terms of precedent, the market was proven right in its economic forecasts and it is the BoE which last week modified its expectations of first rate hikes and moved them forward by 18 months! (ok admittedly the Fed has a better forecasting track record…).
Recently the Fed has had two messages for two different tools – QE and forward guidance. That might have been a source of confusion for some investors.
At the same time, the correlation break between the 2Y and the 10Y might prove transitory as it was driven by temporary factors: 1/ the current debate on integrating an inflation threshold or lowering the current unemployment threshold, and 2/ a downside surprise on inflation. Once these factors are over (priced in), better data might tend to push all yields higher once again just like in the UK, because in the end what matters are data and economic forecasts. If so, relying on forward guidance would mean more difficulty for the Fed to control the 10Y yield, putting the valuation of many financial assets at risks.
Tomorrow’s minutes are likely to be very instructive, watch the reaction of the 2Y-10Y!
Market’s misunderstanding about the Fed’s message has been a great trading edge over the last 5 months. With the market’s reaction to Yellen’s confirmation hearing, I wonder whether a new confusion – and trading opportunity – is not appearing. Indeed I see absolutely nothing new in terms of tapering odds and timing in her testimony, it is just pure policy continuity.
First, I want to apologize to my regular readers for not writing for quite a while… I am the happy father of a second child so sleepless nights have had a direct impact on my propensity to write. As I kept following markets astutely in that period, I will write a few stuffs in the coming weeks to catch up on what I think are the biggest developments. But for now, let’s discuss the global view and the biggest factor affecting it – the Fed’s tapering…
Coming back on the history of tapering:
In March already the debate about the timing of QE’s end started. At the time I wrote “the debate about the timing of QE ends should last. If that is the case, 10YUSD could rise further and break the 2% threshold for good, then it would affect all valuation metrics, in particular, it could have consequences for corporate bonds, EM bonds currencies and equities and DM equities”.
In May, Bernanke confirmed that the “exit” was coming, but the market thought –wrongly – that it was a communication mistake from the Fed. I thought at the time that “importantly, and contrary to many, I don’t think the Fed is surprised or scared by the market moves. I think it had exactly the reaction it hoped for. Delaying it too much would have been a mistake.”
Then, finally starting in July, Bernanke clearly suggested that the relative stability of the 10Y yield was a key pre-condition for tapering to take place, but again as I wrote at the time, nobody noticed. I noted that the Fed’s core assumption was that “thanks to the forward guidance and clear indication that there will not be any faster rate hikes, then 10Y yields should stay where they were initially”. [Admittedly, following discussions with my ex-colleague Olivier K, I oversimplified here; and should have written that the Fed expected only a limited rise – rather than no rise at all]. What is even more astounding is that I wrote that “Bernanke replied frankly as usual, and he said that indeed he and other members of the FOMC now had doubts about that core assumption, notably following the recent rise in yields (that was last month). Yes, it is amazing. And amusingly that went totally unnoticed and unreported (to my knowledge).”.
Recent swings in tapering expectations:
All that to say, that when after the summer, you could see the chart below, it was the single most important piece of data you could see. And there was zero doubt that the Fed would be much more dovish than what the market expected. Despite that, the market was very very surprised on September 18, showing how far the misunderstanding had run.
The chart clearly showed that the sharp unwanted rise in 30Y mortgage rates had triggered a collapse in refinancing, which would surely impact the most important pillar of the US economic recovery – that is the housing market. At that time there was a clear trading edge for investors as Fed’s dovishness / later tapering was highly likely. And indeed the Fed’s delayed tapering has been the key driver of the equity rally.
I must say that the most striking comment came from a Fed watcher I respect a lot at Pimco who wrote that he was surprised that the Fed had talked about “tightening of financial conditions” in the Sept communique, when stocks were at some record highs! Didn’t he realize that the 10Y yields and Mortgage yields were the two most important tools for the Fed?
Yellen’s confirmation hearing:
That brings me to another trading edge. I realized at the end of Bernanke’s conference on September 18 (when tapering was supposed to be announced – in other words, at the most important policy event of the last five years) that there were only 5000 people still logged onto the Fed web site to listen to his answers. When you compare that with the number of Bloomberg terminals (310 000?) you can easily understand how most investors don’t know much about the thought process of the most important policy maker on the planet. Most just take for granted what their average reporter / analyst has understood or heard from someone else.
And finally that brings me to Yellen’s speech. When you look at the market’s reaction to yesterday’s hearing, it is as if there were some new information, or even a policy turn. But Yellen has been key in the framing of most of what Bernanke has been doing for years now. I see nothing but continuity in her speech and in her answers. Why would anything she said yesterday indicate that tapering is going to be delayed further? For instance she is the main architect of the “forward guidance” as I exposed already last year. She also already gave her view – which is the Fed’s official view – on “search for yield behaviors” a long time ago. If anything, the only thing that I find interesting is a confirmation of the doubts that Bernanke signaled about the Fed’s core assumption (see above – the stock or flow debate). Indeed, according to the FT she confirmed that the recent rise in rates had caused the Fed to “ask ourselves whether or not that could potentially derail what we were trying to achieve”.
More important, it is sure that Bernanke and Yellen have been preparing for the transition for at least several months. Yellen certainly had an important role both in the decision to push back the tapering (as financial conditions had tightened too much), but also in the wording of the latest Fed communique which intentionally withdrew the reference to tighter financial conditions, signaling that Tapering could finally occur before year end – despite the fiscal cliff fight.
Where does this leaves us?
That leaves us simply where we were after the latest FOMC. Like the Fed we need to watch the data to have a view on Tapering’s timing. And data have not sent a clear and consistent message, so we are in transition…
On one side we have the latest Non-Farm Payrolls which have been very good, we have the last FOMC communique that got rid of the “financial condition” mention, and we have spreading global growth. On the other side, we have US cyclical data that have been marginally disappointing (ISM new orders down to 56.1 in Oct from a top of 60.5 in Aug; GDP growth showing weakening consumption and excessive inventory buildup, Conference Board Consumer confidence down to 71.2 from 79.7), and concerns on housing (pending home sales slowing down to 3 years low at +1.1% y/y from +2.9%y/y). Plus the effects of the Debt ceiling fight unclear (from a statistical and growth point of view).
The slight breakdown in price action between the Bond market and equities (in blue below) might be a confirmation of that transition thesis. Don’t get me wrong, if DATA end up supporting a tapering delay then I reckon that it would legitimate (from a macro standpoint) a continuation of the equity rally. And that would likely be signaled by a Tnote rally, to new highs, maybe 130 / 131 are the obvious targets. But for that we need first to see more evidence from the data.
To conclude, Yellen was probably very much involved in the last FOMC’s communique where the “tighter financial condition” mention was deliberately suppressed. So again, like the Fed, we are left watching DATA to decide on the timing of tapering. And data have not sent a clear and consistent message in the last few weeks. That means that there is no particular trading edge currently (from a macro / policy standpoint) in staying in the market’s current trends.
Of course one might argue that the traditional year-end trend is currently gathering momentum so this is not a time to get out. That’s a possibility, but one should be aware that the rally has lost one of its key macro drivers (contrary to the last two months), and consequently if data fail to disappoint, another “alleged surprise” by the Fed might end the party all of a sudden at the worst possible time in the year. A risk reward tactic suggests waiting for a clearer turn in data. In the meantime we and the Fed are in transition.
For some reason, just like last month, the market seems to be focused on the wrong questions. It completely misses the key monetary policy debate about how QE works – is it the stock of bond purchases or the flow of bond purchases that matters for monetary policy conditions? This is the key of the Fed’s exit. After his last speech, Bernanke himself recognized that he had doubts about the Fed’s core assumption. A few quick thoughts on that issue ahead of Bernanke speech today and next week’s semi-annual monetary policy meeting before Congress.
The market is focused on the timing and extent of Fed tapering. Will it take place? When? How much? Bernanke has been relatively clear on these questions. It is going to happen soon, unless financial conditions deteriorate significantly (read equities drop, or 10Y yields rise too sharply). So why wonder? Particularly now that US equities have decided not to fight the Fed and have actually given the Fed its vote of confidence (=> stronger growth, and no rate hikes is bull for equities… for now at least).
So for the market the more important question is one that has been THE core assumption of the Fed’s QE program, and has actually been a key reason for the adoption of forward guidance. The question is whether QE is working on monetary conditions, through the total stock of bond purchased by the Fed – as is the Fed’s core assumption, or whether it is the flow of bond purchases that matter?
If it is the stock that matters, as the Fed believes, then stopping the purchases should keep the monetary conditions unchanged – very accommodative. The only change is that there would be no faster accommodation. But in no way would there be a tightening of monetary conditions. In this case, thanks to the forward guidance and clear indication that there will not be any faster rate hikes, then 10Y yields should stay where they were initially.
If it is the flow of purchases that matters, then tapering would mean a tightening of monetary conditions… And the Fed’s Exit would be much more complicated… (In a way in that case, the risk is that it could be condemned to buy bonds for much longer, with the risks of bubbles that it carries)
What is interesting is that after his speech last month, an FT journalist (Harding if I remember well) asked precisely that question to Bernanke. And Bernanke replied frankly as usual, and he said that indeed he and other members of the FOMC now had doubts about that core assumption, notably following the recent rise in yields (that was last month). Yes, it is amazing. And amusingly that went totally unnoticed and unreported (to my knowledge).
Any precisions from Bernanke about the “doubts” he has on the Fed’s core assumption (the stock effect) would be greatly appreciated, but I doubt there will be some at this stage as that would bring a lot of volatility. In the longer term this question will certainly have to be treated. And I must say that I tend to think that it is the marginal change of monetary conditions that matters, so would tend to vote for the “flow assumption”.
I think Bernanke is very likely to stay within the framework of his main assumption (it is the stock of bonds that matters) and will not speak about these “doubts” (be ready for a big move if he does).
Instead he will strongly emphasize the dichotomy between QE tapering on one side, and on the other side, forward guidance and the next rate hike cycle. In other words, the message is likely to be - in this perfect framework, tapering doesn’t tighten monetary conditions so 10Y yields should have barely moved as the timing of rate hikes hasn’t changed (as forward guidance indicates).
If he chooses to communicate that way, it could bring quite a lot of relief to the bond markets (only in the short term), so for once tactically catching a falling knife (Tnote) could make sense here…
Is it already over? Have we reached the capitulation point? That’s really the key question that everyone has in mind in terms of short term outlook, particularly people who were short (as I have advised :-) ), so here are a few indicators I am looking at.
The initial panic reaction when fear was most intense lasted about three days, before seeing the first rebound since yesterday evening. That’s a decent move, and I think it could last a bit further after a one day conso. That would be a good point to take profit. There are two things that could easily stop the move, 1/ some reinsuring words from the Fed (we had maybe some preliminary attempts at doing so yesterday with Fisher, Kocherlakota and Dudley all sounding upset by the markets’ reaction), or 2/ a reversal in the bond market. But I don’t see these as very likely in the coming week (the Fed would lose in credibility, while bonds broke some major levels and there is significant US issuance this week).
So the key in the short term is going to be how long forced liquidation continue. Some big names have apparently made large losses, and are probably not alone given the verticality of the recent moves. The redemptions at credit ETFs also generated a rare mismatch (sometimes quite large) between ETF prices and the underlying credit bonds… Leverage is a key reason for forced selling, and leverage was high, so that could go on a bit. Interestingly, some indicators of financial stress are worsening, look at the OIS/Libor USD spread below… it rose back to some levels not seen for a while. The banks are rightly more cautious in their short term lending… a counterparty closure can happen so quickly. It is something important to monitor.
In terms of longer term outlook, as I have been saying in my two last posts, what matters is that investors’ assumptions are being adjusted. And in that respect, the Fed’s move was a major inflection point. It is amazing to see how the Fed’s impact on global liquidity is instantly spreading. For instance, as an illustration, I just heard a story of a large European airport issuing a 7yr bond. Last Wednesday it was supposed to be issued at Swap+70bp, then on Friday the talk was +100bp, on Monday it was +125bp, and finally the final price decided today is Swap +170bp. The 7Yr EUR swap has risen by 25bp in one week. So the airport is going to pay +125bp more just because of the Fed, to be clear, that is 3.38% instead of 2.12%… not a marginal change!
Of course, valuations are going to be affected as well. The risk premium concept is based on the 10Yr, so the 100bp rise is affecting all asset classes… Equities, EM… The volatility has also risen, which will affect also valuation and risk exposure. Maybe more important Policy uncertainty has significantly changed. Many investors believed in QE infinity, now even if they’re not seeing rate hikes, at least there is a major uncertainty about what the Fed will do. That’s a big change. That means that macro and fundamentals are going to become more important drivers once things normalize.
More interesting as a sign of global contagion, we are seeing some signs that could suggest that reduced USD liquidity is already being felt. (I will write shortly about the “impossible trinity” to explain how USD liquidity has been leaking into EM Asia during QE because of Asian FX policies). Look at the 2Y cross currency basis swaps in USD vs JPY, or in USD vs KRW. Clearly someone needs dollars in Asia… Maybe it’s due to a domestic factor that I am not aware of, so I stay cautious, but maybe it is due to the Fed’s policy shift… In any case it clearly suggests that there is an increased willingness to pay a large spread to get USD funding. Is it the start of a dollar shortage because of shifting Fed Policy ? (That would hit particularly badly EM Asia). Clearly Temasek (Singapore’s SWF) is very worried about that.
Capitulation is usually signaled by sharp vertical down-moves, with new lows, in high volumes. Last Thursday on the S&P could qualify but that was not the lows, and there were Option expiries which blurred the picture. Star equity performers (JPM and Home Depot for instance) are rebounding nicely which is encouraging. Some for some EM currencies that initially got hit, they have stabilized (USD/TWD or USD/MXN). So overall in terms of market internals the signals are not too conclusive to slightly bullish.
Conclusion: Indicators of contagion (Cross currency basis swaps) and of financial stress (OIS/BOR spreads) are more relevant to me in the current context. USD scarcity, but also reluctance to lend because of fear of a financial accident would be major accelerators of the down move. That’s not what I am expecting so far, but things that bear watching particularly for the summer. Tactically in the short term, I would advise to wait a bit more before taking profits, and reassessing the situation ahead of the key data at the start of July (ISM, NFP). Tapering expectations are going to be highly data dépendent…
Finally it is FOMC’s day, the market is soon going to resume moving – up or down… I have already given my preferred play last week – the bearish scenario, mostly based on the trending potential of squeezed assets. But Current Accounts are also worth having a look at to help in trade selection, or simply to realize how much the EM and Commodity miracles have changed in the last two years.
The press has well covered the current squeeze in credit markets (here and here). Retail investors are over-loaded with credit and bond ETFs, while banks have sharply reduced their market making / risk taking capacities… so that there is little liquidity left, particularly in times of rush to the exits. Exactly the kind of situation we should be looking for, so shorting US credit markets would be a good bearish vehicle if Bernanke fails to reinsure markets.
The other asset class where investors are over-exposed is EM markets. When considering things globally, having a look at current accounts is always very instructive, and here one can see quickly that things have changed significantly over the last one or two years. For readers not used to this concept, a current account has to be understood in two ways (I am simplifying of course). One, it tells you whether a country is benefiting or contributing to the Rest of the World’s (RoW) demand. For instance, the US with its deficit has been helping the rest of the World’s GDP grow, thanks to its very strong domestic demand. While, on the contrary Germany has been benefiting from the RoW demand. Second, it tells you whether a country needs capital from the RoW or whether it exports some. Japan and China for instance have been exporting capital for years. That’s important because a country with a large CA deficit is very vulnerable in times of reduced market confidence and outflows (as we could see in coming semesters).
First let’s have a global look. Global imbalances are back, the horizontal conic shape is back, showing an ever more imbalanced world – that’s too bad because that situation strongly contributed to the 2007 crisis because of excess global savings. On the deficit side there is still the US, and on the surplus side China, Germany and Japan and the Oil exporters. Not such a surprising situation when Europe is in recession and China is going through its structural rebalancing. Again, most hopes go to the US consumer.
Let’s go into more details, which is relevant for a local / RV analysis. There are important shifts going on. Look at Brazil and India… two of the star BRIC group. Brazil shifted from a minor CA surplus to a big deficit. That’s what happens when you try to boost consumption, while your China centered commodity exports fall. Same for India, from a flat CA, it is moving quickly into increasing deficits. Growth collapse because of bad policies (see my last post) and budget issues are likely central in that move. Also interesting, the G10 commodity exporters – Australia and Canada – they have shifted from flat current accounts to fast increasing deficits… again like for Brazil, it is a case of strong domestic demand and falling exports.
Now let’s have a look at the shifts in more details, in this second graph. Let’s start with the BRICS. India and Brazil are now well into negative territories, at about -5% and -2.5 % of GDP. And Russia also saw a sharp drop of its surplus. Where is the BRIC’s miracle? We saw above the G10 commodity exporters Australia and Canada – not nice either, between -5% and -3.5%… not exactly what is supposed to happen within a booming commodity exporter, whose currencies have been heavily accumulated by SWF, CBs and Wealth Managers. Admittedly, BRL, INR, and AUD have already well corrected, but the CA shifts are impressive. It could definitely push these currencies much lower.
Let’s have a look at a third group now from EM Asia – Honk Kong, Thailand, and Indonesia. Like China, their CA surpluses have sharply dropped. I have not yet checked in details at the reasons for these drops, but I am pretty sure that the consumption boom in Thailand, and the rebalancing to domestic consumption models in countries like Hong Kong and Singapore are important factors. For Thailand which remains an export led economy it is quite worrying. The worst is Indonesia, once a booming export economy that had the chance of being also a commodity exporter. It’s CA has shifted from a surplus to a large deficit.
Actually, in the case of Indonesia the CA deficit is now as large as during the 1998 Asian crisis (see the chart below), that’s amazing. In the case of India it is even worse. And everywhere the downtrends of deterioration over the last 2 years are surprisingly sharp… the world we had in mind one year ago has really changed with the shift in China’s growth model. (I have voluntarily hidden the years after 2012, because the IMF tends to consider that CA will adjust to balance, and hence the current trends are less clear).
Without considering an Asian Crisis scenario (EM sovereign debt are now mostly in local currencies rather than dollars, EM FX reserves are overall very high, EM debt are much longer term than in the past), some investors are nonetheless rightly worried about EM vulnerabilities in the context of peaking QE. EM Corporate debts for instance have increased significantly and have remained in dollar. Global investors’ massive exposure to EM also matter, particularly if it is trough ETF (just like in the case of Credit). The JPY drop is a worsening factor as it is affecting all of EM asia’s competitiveness – just like before the 1998’s crisis. So CA deficits are a key discriminating factor.
To conclude: 1/ The world has changed with China’s policy shift. The commodity markets have priced it in H1 2013, but the EM markets have probably just started the process. 2/ From a trading perspective, for those that envision to trade the bearish case, the CA factor suggests that the most vulnerable currencies are AUD, BRL, INR, IDR, CAD and THB, against USD of course.
It is amazing how the world can change in a few weeks… To be more accurate I should say that I remain amazed, after 15 years spent analyzing the markets, by how long the markets can get carried away by some weak assumptions… and then adjust all of a sudden.
Actually this behavioral bias of riding a theme / trend far beyond its value has increased in the last few years, thus generating frequent divergences between prices and macro realities (be it from the perspective of data or likely policy changes). In other words the market is now more prone to be trendy but less intelligent in macro terms. That’s important to realize because like in Poker, Trading has a lot to do with maximizing the consequences of other people’s mistakes, so one has to know the weaknesses of other investors.
To give an illustration, equity markets have long been known for their weak understanding of macro risks. The example I like most is the crazy behavior of US Stocks in H2 2007, when despite the Funding / Banking / Financial / Mortgage crisis that had started in May / June 2007 and sent all assets into full panic mode, the SPX500 was still making new highs in Oct 2007. To me that can be explained by the fact 1/ that – contrary to other markets – there are mostly long only investors on equities, and that 2/ equity analysts (bottom up or top down) tend to simply take the last ISM trend (often lagging) as an input to their valuation models.
Likewise, SWF / Wealth manager can also be very dumb by continuing to focus on structural macro factors that have recently become irrelevant. That has been the case with the AUD’s inability to drop between July 2012 and April 2013 (despite the correction of commodities and rates), and then start its collapse all of sudden… once it was clear that the flows of mining investments had disappeared.
That brings me to CTAs. Over the last two years I had lots of discussions with traders and HF managers about the way the market action was changing. I am not talking about the change in drivers (policy), but how the prices react. Most of my contacts agreed that 1/ markets increasingly tend to overshoot once a trend start (there is more momentum feeding on itself), 2/ as a consequence price increasingly tend to diverge from macro drivers / risks once a theme appears (see the sharp USD/JPY rise to the sky…), 3/ short term price action has changed with more abrupt corrections (short term stops triggered) and immediate recovery.
I have always suspected that CTAs (and HFT for point 3/) were a major reason behind these changes. And over the last 3 weeks, we had good indications that it is indeed the case. Actually, what really surprised me is that I thought the star CTAs had some sort of macro discretionary inputs in their risk sizing decisions… But apparently they have none.
Indeed, have a look at the performance of the major CTAs over the last few weeks, it is rather shocking. According to the FT here and there, they had an average perf since the start of year of 5% to 8%, and lost it all and turned negative to -2% on average in just 2 or 3 weeks! That’s huge. They all lost 8% in one month, and that was their profit for the year!!! How can that happen? And what were the trades? Bond longs primarily and USDJPY longs… Come on? Is it a joke ? They hadn’t heard about the risks of a Fed Exit ? I wrote about that as early as March 11!!! As a reminder here is what I wrote… « is the market going to shift from structural complacency to reservations on the level of long term yields? It is surely what the sharp move in the 10Y USD on Friday suggests. […] All are indicators that we might be about to shift to a new regime. […] So the debate about the timing of QE ends should last. If that is the case, 10YUSD could rise further and break the 2% threshold for good, then it would affect all valuation metrics, in particular, it could have consequences for corporate bonds, EM bonds currencies and equities and DM equities.”
And here I am not talking about small funds, but the big stars like Bluetrend or Man. So assuming that the reported performances and trades of these major CTAs are true, that means that they don’t take into account at all the macro policy debates to adjust their models. If that is the case, one can easily understand why markets trends increasingly tend to overshoot once the momentum starts, and why prices can so easily diverge from macro drivers. In terms of trading tactics that suggests that more than ever one has to invest early in a macro theme, and then get out early, or shift from a structural to tactical (shorter term) tactic within the trend. Additionally, one has to try to take advantage of the massive and quick unwinding waves that occur regularly. In other words, again like in Poker, patience (right opportunities), selectivity (odds), flexibility (trading style adjustment) are key.
That brings me to the changes in macro perceptions – ie. What the market suddenly realized:
* The Fed exit debate is alive and well (as I suspected in March). I have a few things to say on that. 1/ I suspect that the Fed’s concern about “search for yield” was more important in Bernanke’s decision to confirm the Exit than it was publicly expressed. See for instance Stein’s or Yellen’s speeches, or the latest BIS quarterly review. After all Rwanda (still involved in conflicts) managed to borrow below 7% while Apple borrowed on 30yr at 3.9% (investors are already loosing 10% upfront). The Fed had to stress-test the market in some way to bring it back to reality. All markets understood the message except so far US equities… watch out for a possible break if the Fed doesn’t water down his message next week. So importantly, and contrary to many, I don’t think the Fed is surprised or scared by the market moves. I think it had exactly the reaction it hoped for. Delaying it too much would have been a mistake. 2/ That being said, Fed Funds futures already are at 0.36% in Dec14 and 0.51% in April15 (in other words 100% of a 25 bp hike priced in). That’s decent, and might stabilize somewhat – remember we are talking about rate hikes here, not QE tapering… So indeed maybe position unwinding has already pushed the rate market toward overshooting levels.
* Those who expected the QE ocean to continue indefinitely as the BOJ and the ECB were about to take the relay from the Fed were disappointed:
* Abenomics seriousness and success can ultimately only be judged through the structural reforms efforts (the third arrow) – see my post on JPY in February. From that standpoint, the announcements (or lack of it) made last week by Abe were quite disappointing, because they lacked substance and looked like vague promises. Of course it has always been rather obvious that no serious structural reforms will be announced before the general elections but why would JPY shorts have cared about that? Moreover – and more important for global markets – the BOJ refused to react to the recent rise in JGB yields and JPY… Maybe China’s recent assertiveness about JPY weakness was a factor here. So position unwindings continue for now. All that being said, I must recognize that the improvement in data in Japan is genuine, and of particular importance I note the recent rise in wages. Let’s see what sort of structural reforms are announced…
* Draghi’s big bazooka turned out to be a water pistol (I read that on a blog and fankly couldn’t resist reusing it – it is so accurate). Many who had hoped to see an ECB QE through the SME lending scheme were disappointed. Moreover the LTRO programs because of their impact on the ECB balance sheet always had been assimilated by the market as QE (à la FED, BOJ or BOE), but apparently Draghi strongly disagrees.
* China’s authorities smartly continue to focus on internal rebalancing rather than use palliative to support growth. In the process growth continues to disappoint. Commodities have now acknowledged the policy shift, but many stocks remain in denial (look LVMH close to its highs for instance…). This article on urbanization by The Economist is a must read to understand what China has to do and how hard it will be. This one from the FT also shows the political threat poised to the Chinese authority by the Hukou system in a world of social media. We will know this year whether China is going to be a new miracle thanks to a smart and courageous policy shift (towards internal consumption), or whether it is going to be a failure and just another bursting bubble. (By the way in terms of policy failure – read this on India and this on Brazil and you will understand why INR and BRL have dropped so much and can go much lower).
* Finally a word on Europe and France. There, market denial is still obvious despite the recent 10Y OAT rise from 1.66% to 2.25%. I have written enough about data, the real estate bubble or the political situation. BUT there is one thing I saw about the unfolding political crisis that really shocked me. The documentary here is a must see – unfortunately only in French. It is a prime time program on French TV on the whereabouts of the Cahuzac affair. Basically it says that 1/ the government covered the affair for 4 months, 2/ for 10 years the successive governments have refused to investigate on the account and even sacked some tax inspectors who started investigating, 3/ the Swiss banker personally knows 10 major political personalities with accounts in Switzerland, 4/ both the left and right parties knew about the accounts but covered it, 5/ tax inspectors suggest that it is implicitly forbidden to investigate on any political personality. To conclude, in a France that is in the deepest economic crisis for a long time, with ever more popular far right party, the documentary suggests that there is a dangerous collusion between the high administration, the press and political parties (see my last post). Frankly it’s worrying to say the least. Let’s see how long long OATs resist…
To conclude, the position adjustment to the reality of policy risks is now well advanced. Despite that, I think there is still value in going with it at this stage (short EM FX vs USD, short Commo, long JPY, short S&P500). The main reason for that is that positions based on the QE eternity concept are massive after five years of QE. Moreover, the US equity markets are still resisting. And I note that Shcomp (China A shares) and Ibex35 (Spain) just broke some key levels… In terms of timing, it might be better to wait for next week’s FOMC, the market is likely to expect soothing words from Bernanke. But as I said above, if Bernanke is happy with the recent decline in the “search for yield” behavior and fails to reinsure, the corrections will resume. Otherwise, one will have to wait further for an entry point.