Trades for 1Q11

People are putting out their 2011 trades / outlooks so here is a list of my own. Sorted by conviction. I tried to keep it short – feedback welcome.

Sell S&P 1yr Variance swaps

  • Forward vol is very high, probably because the pension fund managers are buying long term S&P puts so they can keep their job next time the market crashes. Take advantage. The S&P is not going to average 1.65% of volatility a day over the next year. I see indicative 1yr bids @ 26.4 and 2yr bids @ 30.0. As a reference realized vol over the past 12m is 17.8, or 1.1% per day. Had you done this trade a year ago you would’ve made 10 vol points.
  • Risks: a global bank goes under

Buy Fed Fund futures or OIS, for 1Q12

  • They are pricing Fed hikes, but it’s not going to happen. Potential profit / vol isn’t great on this trade, but the probability adjusted return vs risk of loss is very good. 1st full hike is priced in for Fed 2012.
  • Note that this is good in a book with a pro-cyclical tilt in that it could dampen portfolio volatility.
  • Risks: Better than expected US data over the next quarter could send yields sharply higher as people panic that the Fed will halt QE2 early.

Buy EEM vs EAFE

  • Pretty straightforward. For those worried that EEM will sharply underperform in a risk aversion event, look @ the ratio between April to August. This trade has the additional benefit of having a low correlation to the S&P.
  • Risks: higher EM inflation drives profit taking, like in mid 2006

Buy FCX or copper outright

  • Basically an EM inflation play. Fundamentals are good, macro trends are in its favor. The curve has gotten quite backwardated over the past 4 months, and looks set to continue.
  • Risks: Cyclical risks, Chinese growth stumbles

Buy USDJPY

  • Yes, rate differentials aren’t going to change, but the negative seasonality is neutralized by year end, and PPP as well as rate based regressions suggest 3-4 figures of upside. Outright is probably better than via options due high premium vs drift.
  • Risks: a bit of a crowded trade, higher Japanese inflation.

Buy the Dow

  • Very cheap vs fixed income, dividend attractive, entering 3rd year of presidential election cycle, low risk of recession, (somewhat explicit) Fed put, strong technicals.
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7 thoughts on “Trades for 1Q11

  1. Hah – that trade is definitely going to be choppy…
    Having said that I feel like people are broadly expecting better data out of the US. Since peaking at 37 a month ago, Citi’s surprise index has come off to 21. Also, barring year end balance sheet effects and MBS hedging, I don’t think treasury yields are going to move appreciably higher in the next couple months. The biggest uncertainty is probably the direction of core inflation – driven by OER.
    Also, speculator positioning at the front end is at the lowest level in months.

  2. I’ve been thinking about your EEM vs. EAFE idea. It seems to me, just buying EEM outright has better risk/reward ratio than spreading. Spread with EAFE gives certain protection against risk-off event in Europe or Japan, but lowers returns significantly. And if the risk-off event comes from other source (especially, the EMs), it’s quite likely that you’d still be forced to get out of the trade.

    1. I think you’re right about the reward, but I’m not sure about the ratio vs risk. The list includes short variance and long the Dow, so I was looking for something that wasn’t as correlated to equities performance. If you look at the ratio between EEM and EAFE, you can see how the ratio performed quite well all through the risk off period in the middle of the year.

      1. Well, I looked at the trade separately from other trades in your list. If you’re already long Dow and short variance it does make sense to buy the spread instead of EM outright.

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