Recap 2015-05-12: Update


A number of my longer term expectations were realized the past couple weeks. I have written at length about all these topics, so I’ll just be brief here:

  • Long dated EUR bonds will sell off despite the ECB QE program.
  • US 30y yields hit 3%, my long standing estimate of fair value
  • EU equities has significant exposure to EU duration
  • Risk Parity performance will wane sharply going forward
  • EUR is likely to bounce towards 1.15

To be fair, many of these are occurring somewhat later than I’d expected. I’m reminded of a quote by an MIT economist Rudiger Dornbusch: “In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.” Anyway, this seems like a good time to reassess the market picture for the second third of the year. Unlike my recent pieces, I don’t have an overarching theme here, so I’ll just present my thoughts on an itemized basis.

Yields are still well below fair value in Europe, but they’re not low enough that shorting is phenomenally attractive, especially if it’s adjusted for the likely volatility. The lack of liquidity that characterized this move up in yields the past few weeks is also likely to exacerbate moves on the way down. In addition, EU yields are now already higher than the levels prevailing just before the January ECB meeting, which suggests that the QE ‘surprise’ effect has already been removed from the price. Having said that, in my experience asset prices tend to fluctuate around fair value a bit like a pendulum. Given how far the mispricing has gone to the downside for yields, they may well overshoot more than expected to the upside. This applies to the US bond market as well. Movements in oil prices are likely to continue to play a role.

The duration risk in EU equities remains quite pertinent. While earnings expectations have finally picked up in a real way, there hasn’t been enough time for that growth to actually occur yet. Until that happens, I expect EU equity prices to continue to exhibit correlation to long dated EU bond prices.

The duration risk for US equities is lower, but another sizable backup in real yields from here could be problematic. Because US earnings are not expected to pickup until several quarters from now, that duration risk will be around for a while. Having said that, the long term charts continue to show the S&P in a bullish triangle formation that should be resolved by mid-June. The backdrop for US equities has been pretty difficult the past few quarters: a negative GDP print, a sharp drop in earnings expectations, a central bank that is discussing tightening, significant outperformance of foreign counterparts. Yet index prices have remained fairly resilient. With the waning of those headwinds, perhaps some more upside may be forthcoming. My macro models suggest that both expected EPS and PE will probably rise further through year end.

FTSE100 looks likely to underperform vs the US & Europe given valuation differences.

The USD correction is still ongoing. My 1.15 target on the EUR is the minimum – I wouldn’t be surprised to see it hit 1.20. There just isn’t a catalyst for further USD strength in the near term. The data has not bounced back like the Fed has expected yet, and until that happens for a sustained period of time, the FOMC will be on hold and hikes will continue to get pushed out. In aggregate, I wouldn’t be surprised if the USD rally didn’t resume until the fall.

I don’t know when the Fed’s going to hike – but I do think that it doesn’t matter that much with respect to long term asset prices. (I think that Fed hikes will be a positive for corporate profits, at least initially.) Much more important are the terminal level and the pace of hikes. Both have been revised lower (or slower) in the SEP, a trend that I think will continue. My best guess for the terminal rate is ~3.5%, give or take 50bps depending on economic momentum.

On Greece, I’ll just repeat what I’ve said before. I have no idea what will happen, but given that the market has had 5 years now to prepare for this, the probability that a Grexit or whatever affects the markets in a significant way is quite low.

On Oil, it seems like everyone who writes or talks about it has no idea. To be fair, I don’t have many ideas either. Production everywhere has surprised to the upside, so analysts have been bearish, yet prices are now up 13% for the year and near their highs for the year. Speculative positioning has turned from extremely short to only marginally short by my estimates. Thus, barring another shift in the marginal cost of production, one possibility is that we are near the middle of a new range here. The 1y, 1y fwd strip is currently at $65.

Recap 2015-04-30: ERP in the EU vs the US

I noted previously (3/5 to be exact) that one of the reasons I have been less bullish on EU equities over the longer run (as compared to the US) is that much of the move YTD has been due only to the excessively low EUR risk free rates. That was a factor that came into play yesterday, as both EU equities and fixed income sold off in tandem: (Eurostoxx in white, EUR 30y swap rates in orange and inverted)

A natural question following that is: why did EU equities get hit by higher yields this time, while US stocks escaped unscathed in 2013? A key reason is that Europe has a higher Equity Risk Premium than the US. A higher ERP that is entirely justified. Rather than expound on all the different potential reasons, many of which has been explored by others in the past, I’ll just list some bullet points:

  • Widely different economies and one central bank means that on a per country basis, policy is never optimal. See footnote 1.
  • The ECB’s mandate that ONLY encompasses the AVERAGE inflation, (which lags the economic cycle) across all the countries of the Eurozone, (which often have widely disparate data) means that the ECB is much more likely to act too late. This results in larger cyclical peaks and troughs and greater macro volatility, which typically results in higher risk premiums for longer dated, pro-cyclical assets. It is not an accident that they hiked in 2010… and eased in 2015. Both actions are likely to be categorized by historians as policy moves that were incorrect, IMO.
  • The combination of the Maastricht Treaty debt limitations and the ECB’s inflation-only mandate means that both fiscal AND monetary policy ability to support growth in a timely fashion is impaired.
  • Different politics, different laws and different courts of law means significant hurdles & friction for optimal capital deployment including M&A.
  • The amount of EUR debt held by EU insurance companies, and the rigidity of EU laws for insurers, restricts the portfolio rebalancing channel. I.e. it limits the ability of EU investors to move away from fixed income into equities. See footnote 2.

Readers will note that one implication of the ERP differential is that monetary policy in Europe has a more limited room to be effective on equities than in the US. My view is that we are basically at that limit already. By my estimates, a +10bp rise in the long term EU discount rate, without a change in the forward earnings estimates, would result in a ~1.6% decline in the Eurostoxx index, ceteris paribus.

Speaking of EU yields, I noted on 3/16 that the German yield curve matches up pretty well to the Japanese curve in 2002-03. That analog seems to be working pretty well YTD:

Having said that, I do think that this analog will only take us so far. The ECB has backed itself into a corner of sorts, and to turn in the towel after only 3 months would probably be seen within the institution as being very damaging for its credibility. IMO, the recent volatility has been the result of a combination of heavy issuance and speculative positioning, combined with poor liquidity conditions. (Which of course itself heavily exacerbated by QE) In aggregate, the price action in Buxl looks corrective. The downward trend in yields has been ongoing for years now – it will take time for the trend to reverse. But recent price action certainly suggests that this is the beginning of the end rather than the end of the beginning.

Speaking of corrective price action, I noted back on 3/23 that the 1.15 area is a likely corrective target for EUR. I think that is still the case. In fact, note that without an actual Fed hike, there are no obvious catalysts that are likely to push EURUSD to new lows. As a result, we should not be surprised to see the cross range bound over the next couple quarters.


1) Disparities in EU unemployment:

From JPM Private Bank:

2) Composition of EUR debt investors from Citi:

Recap 2015-04-22: My Take


The weak US data in 1Q has been unusually surprising. The Bloomberg measure of surprises, for example, is at the most negative level since the Lehman recession:

The drivers seem to be a result of both the data as well as the resilience of analyst estimates. Clearly, the US economy is feeling the front loaded effects of the move in oil and the dollar. However, analyst estimates has remained broadly sanguine, with many expecting a bounce back in 2Q. The chart below illustrates how despite the sharp drop off in 1Q growth estimates (white line) 2Q estimates has actually ticked up. (orange)

The wide spread consensus expectation of a strong rebound means that the data needs to hit expectations. And given where we are in 2Q, that needs to start happening soon.

Asset prices have already moved in response to the weak 1Q data. As economic surprises (orange) fell in late Dec and accelerated in Feb and March, treasury yields (white) fell, and equities (yellow) and the dollar (green) consolidated.

In other words, data over the next few weeks are likely to be quite important. If the recent string of data disappointments continue, analysts as well as the Fed are likely to need to reassess their growth projections. In particular, they are likely to need to reassess the impact of the dollar. The US economy is actually relatively closed, but its exposure to global trade has been increasing over the years, just like those of other DM countries. Dudley on Monday said that

While I am relatively optimistic about the growth outlook for 2015, I also must acknowledge that there are some significant downside risks. In particular, the roughly 15 percent appreciation of the exchange value of the dollar since mid-2014 is making U.S. exports more expensive and imports more competitive. My staff’s analysis concludes that an appreciation of this magnitude would, all else equal, reduce growth of real GDP by about 0.6 percentage point over this year. Some of the recent softness in indicators of manufacturing activity is likely a reflection of this development.

Given that US growth has been averaging 2.3%, the 0.6% figure is quite substantive. In addition, an upward revision of the ‘beta’ of the dollar on US growth is important because expectations for further dollar strength are widespread. Such a revision would thus have a compounded effect on expectations for US growth & monetary policy.

Furthermore, note that there is probably a reasonable basis for such a revision. All macro models use historical data as a basis for estimates. GMO recently published a white paper noting that domestic sales of EAFE (non-US developed market) country corporations have continued to fall since the recession, also that trend may have stabilized as of 2012:

In other words, it is quite possible that the continued globalization of corporate profits (which leads investment & hiring intentions) has not yet been fully incorporated into analyst models.

Having said that, however, most of the charts support analyst optimism. The S&P is in the middle of a textbook bullish wedge that looks likely to be resolved soon. The last such occurrence was a year ago:

US 30y yields’ downward momentum appears to be flagging, with yields unable to re-break support at 2.5%. Like the S&P chart, we are likely to get some sort of formation break soon, either up or down. There are some similarities to 2012 here also.

The Dollar is consolidating above long term support / resistance.

Finally, Gold appears to be consolidating before a push lower. If yields and the dollar move higher, such a move would not be surprising.

In fact, short gold may be one of the better proxies to express a short interest rate view. Since the curve is in contango, carry is positive. (rather than negative in most expressions) In addition, an end to global central bank easing is in sight. Finally, the sharp drop in commodity prices globally the past few quarters means the marginal cost of production has likely fallen dramatically.

Recap 2015-04-07: S&P Returns Decomposition


Trailing S&P returns has slowed sharply from the end of 2013. I thought it would be worthwhile to break down the sources and see if it there was anything worth extrapolating.

First, as most folks know, S&P price returns are driven by either an increase in earnings expectations, or an increase in the multiple of earnings that the market is willing to pay for those earnings. Bloomberg has a historical series of consensus expectations for EPS, so we can use that to back out the historical price change due to each part. Historically and unsurprisingly, the PE component has been much more volatile than the earnings component as a driver of prices:

What’s interesting here is the weakness in earnings growth since 2012, but especially in the past 6 months. That is, of course, the result of the combination of lower oil, a stronger dollar, and weaker growth globally. Unsurprisingly, the change in consensus estimated EPS can be reasonably approximated using economic data. The regression (subject to all the caveats on regression results) and consensus forecasts over the next few quarters all point to a decent bounce in EPS estimates by year end. Barring unexpected strength, however, EPS growth estimates are likely to remain below those from mid 2014:

That shouldn’t be too surprising… gradual revenue and productivity growth is the norm for corporate profits.

Outside of that, the trend of gradual PE expansion that has prevailed since mid-2012 has broadly continued, though at a slower pace than before. Looking forward, the tailwind from higher PE is likely to continue given where yields are and the credit backdrop. If anything, they are likely to pick up a bit from here given central bank policies the past quarter.


  • Wed: Japan Eco Watchers, Dudley Speaks, FOMC Minutes
  • Thu: BoE, US Jobless Claims,
  • Fri: Canada Employment
  • Mon: BoJ Minutes, China Trade Balance, AU NAB Business Confidence
  • Tue: US PPI, NFIB Survey
  • Wed:

Recap 2015-04-01: The EUR & Reserve Managers, the Outlook for Risk Parity


One of the most interesting and unprecedented decisions the ECB has made recently was not to conduct QE, but rather to cut interest rates into negative territory. While it is true that other countries have experimented with negative rates prior to the ECB, the ECB’s decision to apply a negative interest rate to the second largest reserve currency in the world was without precedent. That may well be one reason the market has been surprised by the extent of the move in the EUR over the past few quarters.

It seems that the release of the latest COFER data has shed some light on one reason why the move has been so quick: the reserve managers. Now, reserve managers tend to act as a market stabilizing force; they tend to want to keep their allocations to various currencies broadly stable, so if one currency appreciates sharply vs another, the reserve managers tend to sell the one that strengthened, while buying the one that weaked – at least over the short run. However, in 2H 2014, they seem to have stepped away from the EUR. From JPM:

The proportion invested in EUR assets declined significantly in Q4, to 22.2%, the lowest percentage since 2Q2002. Further, the decline experienced over the last year was the sharpest witnessed since the EUR’s inception. Prior to 2009 the allocation to EUR assets was on the rise. However, during the last four years this trend has reversed, with the allocation falling by roughly 1ppt per year…

Currency depreciation during the quarter caused passive declines for everything except the USD. However, reserve managers swam against the strong USD tide, concerned that FX movements were driving non-USD allocations below target. Net of currency effects, they were significant buyers of CHF and JPY, and moderate buyers of GBP, CAD and AUD. However, they allowed the weaker EUR to drive that allocation lower, pretty much unresisted. This reflects medium-term concerns regarding their prodigious exposure to the common currency.

Here is are a couple tables showing the data in more detail. The US, EU, Japan, and UK all conducted QE from 2008 to 2014, yet the share of FX reserves in USD only fell 0.9%, the share in Yen actually rose by 0.5%, but the share in the EUR declined by a full 4.0%, with about half of that move occurring in the second half of 2014.

Per FTA & Deutsche Bank,

The IMF data excludes two of the world’s largest holders of FX reserves, holding as many assets as the rest of the world’s central banks combined. It is precisely these holders that have the largest ongoing potential to sell Euros:

(1) The Middle East. The region currently holds 1 trillion dollars in official FX reserves and another 2.5 trillion via large sovereign wealth holdings. It just so happens that this region is also running very large fiscal deficits due to the collapse in oil revenues. The most natural source of financing for these countries is to run down reserves: there is little reason to increase government borrowing or aggressively cut back spending until the oil market price war reaches a conclusion. We estimate that Middle East oil producers are running a combined fiscal deficit of more than 200bn in 2015, and low-yielding European assets seem like the primary candidates of assets to be sold.*

(2) China. The country may be the world’s largest holder of FX reserves, but it is also running these down at the fastest pace in history. Assets are dropping at an annualized pace of around 200bn USD, driven by central bank intervention to accommodate large-scale capital outflows. In turn, these have been caused by a reversal in the structural CNY appreciation pressure that has been in place over the last two decades: increased corporate hedging activity, an unwind of speculative “hot money” inflows and hedging of outstanding portfolio exposures. All look likely to stay for this year and beyond.

In conclusion, it does not take an active re-allocation of central banks away from euro reserves to prompt capital outflows from Europe. The Middle East and China stand out as two regions that are likely to face ongoing pressures to run down reserves over the next few years, with low-yielding European reserves likely to be the main casualties of the post-EM and commodity boom trends.

In aggregate, the behavior of FX reserve managers may be one of the transmission mechanisms of negative rates in particular. That may be one reason the power of negative rates has been so surprising – something that central banks globally are likely to remember the next time they face output gaps.

Separately, Risk Parity has been a pretty popular strategy the past few years. There are many flavors, but the high sharpe ratio over the past few years has resulted in a number of new funds that follow the strategy. Unsurprisingly, future returns are unlikely to match that of the recent past. That because the main reason for the performance of the strategy has been the decline in the discount rate for all financial assets. With that discount rate broadly stable over the past couple years, the discount rate tailwind for Risk Parity has eased.

The chart below highlights the idea. I calculated a rolling 5yr annualized return for a 10% vol Risk Parity portfolio consisting of only S&P and US long bond futures. Against that, I charted the 5 year change in the 10yr TIPS real yield. The rationale is that the TIPS yield was a proxy for the discount rate. A decline in the discount rate should result in higher risk parity returns; a rise should conversely result in lower returns. I plotted the yield change with a lead of 3 years because it has historically taken time for the lower discount rate to become reflected in asset prices.

In aggregate, the data appears to support that rationale. Risk parity strategies did not particularly shine in the final years of the last decade, as the Fed’s hiking cycle raised discount rates. With the Fed nearing hiking again, it seems quite likely that we see a repeat of that. And if history is any guide, Risk Parity returns over the next 5 years are likely to fall quite sharply from those of recent memory.


  • Thu: US Jobless Claims, Yellen Speaks
  • Fri: US Employment
  • Mon: US Markit Services PMI, ISM Non-Mfg,
  • Tue: RBA, EU Services PMI,
  • Wed: Dudley Speaks, FOMC Minutes

Recap 2015-03-23: On the EUR


I’ve been very busy with some research projects the past week. I am optimistic that those efforts will bear fruit, but in the meantime, future updates will likely be intermittent. On the other hand, I will hopefully have a bit more to say when I do write.

Market action the past week has been quite interesting. I wrote a few weeks ago that there appears to be a large ‘duration squeeze’ following the ECB’s start of the QE program. I was too early in anticipating stabilization; it appears the squeeze is continuing. The chart below shows the US 30y Treasury yield vs the average 30y EUR sovereign yield. (the 4 largest countries)

What’s new over the past week is that for the first time this year, the yield differential has tightened. While that certainly does not mean that the duration squeeze is over, it does suggest that the intensity of the squeeze is slowing.

The other new item is that for the first time in several quarters, oil prices appear unable to break to substantive new lows. (oil in green below, EUR in white, 30y spread from chart above in orange, and the SPX vs Eurostoxx ratio in purple) This is pertinent because despite the fact that US oil imports have fallen dramatically, the world continues to run a USD to EUR trade balance via the OPEC countries, which tends to invoice in USD and spend in EUR. As a result, the EURUSD cross continues to exhibit decent correlation to oil.

The combination of a stabilization of both oil prices and yield differentials is notable in that they occurred in conjunction – the first time they had done so in recent months except for a few days at the end of January.

In addition, it is quite likely that the bulk of the move in both these factors is over. Obviously oil can’t fall another $50, and with the ECB QE broadly priced in, a further 100bp widening in the US-EU 30y yield spread is improbable.

Given that this backdrop is occurring in the context of a historically extreme move in the currency cross, (see my 2/13 note) there is a significant possibility of a continuation of this recent corrective move. I’ve noted that historical corrections in the EURUSD with this technical backdrop have been roughly 10 figures over the course of a couple months or so. The pace of the move this time suggests that the correction may be both stronger and shorter. We are only a couple weeks and 5 figures in so far; historical precedents suggest another few weeks and another 5 figures or so.

Such a move is likely to be quite pertinent for the US vs EU equity performance differential. A large part of the EU equity outperformance YTD has been pinned to the EUR, and EU equity overweights are currently extremely popular, according to surveys from both BAML and Barclays, among others.

Separately, some interesting points from Goldman on lower expected Neutral Rates:

  • Since reaching a local high in early 2014 after the ‘taper tantrum’ of 2013, our estimates for the neutral level of short rates have been falling both in the US and the Euro area. They are now around 3.25% in the US (on the latest available survey, taken in December 2014, they stood at 3.50%, while in June 2014 they were at 3.70%) and 2.5% in the Euro area. The gap in neutral rates estimates between the US and the Euro area is at the highest level post the global financial crisis.
  • By these metrics, the market’s estimate of neutral rates in the US is around 50bp lower than both the FOMC’s median longer-run federal funds rate and our US economists’ forecast.

To obtain a measure of term premium embedded in the curves, we subtract from the 5-year 5-year market yield the expectations of the 6-to-10 years short-term rates calculated as we described above. The latest numbers show that:

  • The term premium in the US is currently negative to the tune of around 70bp and is now at a historical low. For comparison, during 2012, it stood at around negative 50bp.
  • In the Euro area, the `blended’ term premium is at its historical minimum of negative 150bp.

My own estimate of the Neutral Rate is ~3% in the US and ~2% in Europe. As a result, I do not think yields are quite as mispriced as Goldman or the Fed, though still historically quite unusually low. The flow effects from the QE programs suggest that shorts should be placed at more extreme levels given that a full retracement is less likely.

Pretty funny:


  • EU Consumer Confidence improved to -3.7 vs -5.8 exp and -6.7 prev. This is the highest print since July 2007
  • US Existing Home Sales rose 1.2% MoM vs 1.7% exp
  • Tsipras has warned Angela Merkel that it will be “impossible” for Athens to service debt obligations due in the coming weeks if the EU fails to distribute any short-term financial assistance to the country. The warning, contained in a letter sent by Mr Tsipras to the German chancellor and obtained by the Financial Times, comes as concerns mount that Athens will struggle to make pension and wage payments at the end of this month and could run out of cash before the end of April.
  • the Syriza gov’t is ratcheting up an investigation into the head of the country’s statistics agency over charges he inflated Greece’s deficit figures to justify the current bailout. The action will likely draw the ire of troika officials who are demanding a politically neutral head of statistics to ensure accurate and transparent numbers. WSJ
  • 7.4% was the slowest expansion rate of the Chinese economy in 24 years according to Credit Suisse


  • Mon : Japan Markt PMI, China HSBC PMI
  • Tue: EU PMI, UKCPI, USCPI, US Markit PMI, New Home Sales
  • Wed: German IFO, US Durable Goods
  • Thu: German Consumer Confidence, EU Money Supply, UK Retail Sales, US Jobless Claims, US Markit Services PMI, Japan Jobless rate, CPI
  • Fri: UK House Prices

Recap 2015-03-16


Now that oil is back to making lows… are we likely to get a replace of Dec/Jan price action? In particular, are we likely to see the combination of widening credit spreads and falling bond yields? IMO, it’s possible but not probable. One reason why the effect of the decline in oil prices was so strong before was due to the speed of the decline. The pace of the decline was a multi-sigma event that was not priced into the risk premiums across markets. A similar decline from here would imply a $20 oil price – possible but not probable.

Separately, I was wondering how the ECB QE program compared to the first Japanese QE program back in 2002. I used the 2s30s curve as a point of comparison because front end EUR yields are negative now even as Japanese yields were not then. The price action analogue is clearly not meant to be compared literally, but may potentially be instructive as to how they may evolve going forward:

In any case, there isn’t much of a benefit to thinking too many moves ahead… just something to keep in mind.

Also, there has been a lot of press on “intelligent” portfolios recently. Most of these algorithms seem to be based primarily on some combination of historical price data rather than economic data. In particular, momentum seems to be an explicit part of the strategies involved. Now, momentum signals are successful when the trend to volatility ratio is strong. That is one major reason quant funds have performed well over the past several quarters – witness with trends across global fixed income, currency and equity markets over that time period. But what’s worth considering is that given the lower returned that are now priced into almost all asset prices here, future momentum to volatility ratios are likely to fall dramatically. As an example, consider an asset with a trend of zero, i.e. prices just exhibit volatility around its present level. It is likely that momentum based strategies are unlikely to perform especially well. It is probably not a coincidence that returns from momentum based strategies wane just as they become widely available.

Interesting Links:

Here is one very good reason not to use small email providers with security loopholes:


  • US Empire Mfg declined to 6.9 vs 8.0 exp and 7.8 prev
  • NAHB Housing Survey declined to 53 vs 56 exp and 55 prev


  • Tue: German ZEW, US Housing Starts
  • Wed: UK Employment, BoE Minutes, FOMC, NZ GDP
  • Thu: US Jobless Claims, Philly Fed
  • Fri: Quadruple Witching, Canada CPI, Retail Sales
  • Mon: US Existing Home Sales, EU Consumer Confidence, JapanMarkt PMI, China HSBC PMI