Trades for 2Q11

In no particular order, grouped by asset class:

Risk Premiums have increased too far for what is likely to be only a short term hit to global growth.

  • Short S&P Variance swaps. If you didn’t initiate in December, you can get pretty much the same levels now. I see a pretty decent realized PnL YTD: 12.1% realized vol (75d vol in purple below) vs a sale at 26.4%. Over roughly 4 months that is (26.4 – 12.1) / 3 = ~4.8 vol points.
     

    To recap – this opportunity is there because of the misalignment of incentives at real money funds. I.E. pension managers don’t mind paying premiums if it doesn’t come out of their own pockets in order to make sure they keep their jobs. Herd mentality helps.

  • EEM vs EAFE. With ECB hikes coming, and a big unwind, this trade is likely to work in 2Q after a bad 1Q. Relative valuation has improved a bit, and EM’s higher growth + a reduction in the global risk premium should help drive this trade higher.
     

Global rates have rallied too far for what will likely be only a minor hit to growth. Where to position for hikes?

  • Au 3s10s flattener. Carry is only ~8bps a year in swaps space, less than 1 hike is priced in through year end. Simple chart of the curve vs real RBA rate suggests curve should be ~30bps flatter. Even if term premiums at the front end mean reverts this trade should work:
     
  • Short Dec11 Short Sterling. Model suggests a very high probability of hikes, (chart below) and entry levels are the best they’ve been all year. 3 hikes are priced in so far, and the BoE will likely feel much more comfortable with hikes given that the ECB is hiking. The commodities driven inflation pass through will have a particularly sharp impact over the next few months. Gilts also look cheap.
     
  • Short US 5yr. There is simply too little term premium priced in. Using an OIS strip where the Fed starts hiking in June 2013 yields a ‘fair’ 5yr yield of 1.95%, vs the 2.0% level it is trading now. The level doesn’t make sense unless you think QE3 is going to happen. Seasonals are also negative through mid June. This trade should be converted to a 2s5s flattener once that curve touches 154.

FX is likely to continue to react to relative shifts in CB policy and long term portfolio flows

  • EURUSD – Buy. The ECB hikes and higher oil prices can drive a big trend until the Fed responds. Regression using weekly levels has a correlation of 78% over the past 5 years, and they all suggest short term upside. The PIGS are always a wildcard but things look manageable at the moment. Seasonality is also positive until July. Finally, despite the worries about the PIGS, net portfolio flows has remained positive for the EUR so far, suggesting that a secular move out of EUR isn’t a worry.
     
  • USDCAD – Tactically sell puts and begin to initiate long term calls. The cross is very expensive vs PPP – in fact it is near the most expensive levels in 2 decades.
     

    As a result, Canada’s trade surplus vs US has been reduced sharply – to levels not seen since the late 90’s:

    BoC hikes are widely expected, but perhaps over done. The expensiveness of the cross is having a real impact on the Canadian economy. It is likely that Canada is beginning to suffer a form of Dutch Disease, whereby high energy prices strengthen the currency and render Canada’s other exports much less competitive. The chart below shows the 5yr growth in employment across different Canadian sectors. It is evident that the strongest employment growth are in sectors related to energy development: construction, mining/oil/gas, and finance. It is also evident that Canada’s other export sectors of manufacturing and Agriculture has suffered.

    Interestingly, speculators have been decent at calling turns in CADUSD. The below chart shows how a moving average of net speculative positioning diverged vs the cross, a divergence which last occurred in early 2008 and before that in 2Q 2006 – both instances of which saw multi figure reversals.

    This all suggests that a long term play on a USDCAD reversal is in order.

  • NZDUSD – Buy. The cross is now just above the levels prevailing during the Christchurch earthquake, even as growth and hikes going forward is likely to accelerate.
    ANOVA shows that over the past 5 years AUDUSD has had a much stronger impact on this cross than AUDNZD – and AUDUSD is now 10 figures higher. And finally, speculative positioning are at levels which have historically lead sharp rallies:
     
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5 thoughts on “Trades for 2Q11

      1. yeah, so much for canada’s attempts to have a “diversified” economy; its basically a play on the pillars of a developing world- energy and credit. not sure what the valuations looks like but given your EUR positive view, selling cad/nok might be a good proposition. mutterings that given growth trajectory norges bank not so worried about its currency appreciating whereas canadian manufacturers must be jumping up and down, eh.

  1. is your BoE model basically a taylor rule structure? other than inflation not sure what is driving it to diverge. (and it does a very nice job predicting! so of course curious what’s in it.)

    while i’d agree there’s a burgeoning inflation problem in the UK, growth and employment are still very weak and fiscal stimuli are fading. feels a lot like the US generally, and given MPC has waited this long i’d guess they’re more likely to follow the Fed than the ECB through this cycle.

    1. Yup, basically a taylor rule plus a confidence measure.

      I’m sympathetic to the view that the MPC will follow Newton’s 1st law. But the BoE’s problems are a lot worse than the Fed’s. I think the MPC may want to do what the Fed is doing, but the appearance of 2nd round effects may force them to act. I see several potential catalysts, the most likely of which is probably a potential upward revision of 1Q GDP, or catchup jump in 2Q GDP growth

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