Mid-Year Recap & Outlook

Having been away from the markets for a while, it’s probably a good chance to review my expectations vs how things have played out. That will offer a nice segue to my outlook for 2H, after which I will conclude with an analysis of my trade ideas for this year to date.

Economy / Rates

The ECB surprised last week as expected. Though the action was appropriate, I think it won’t do much. The main problem with Europe is a combination of unbalanced labor costs, and over-levered banks & sovereigns. The end of the AQR may be a bigger catalyst than this ECB move, which is very likely to be the last of this cycle. Forcing the European banks to recapitalize may actually have a much bigger impact for growth that this latest rate cut, or even a QE program. Nevertheless, the decrease in periphery spreads vs Germany is a positive, and likely to persist, although I am not sure how much more they will tighten.

In addition, the recent concerns over EU inflation are likely to abate over the coming months. The most recent inflation prints, when broken down, reveals that inflation in Non Energy Goods, Energy, and Foods are already at zero. The only category that is not at zero (in fact well above it) is services, in which inflation has been very sticky. So there is at the very least a strong likelihood that the negative momentum in inflation will slow substantially.

In the US, I continue to expect that 2s30s will flatten over time beyond what is priced in by the forwards. (Though the price action today was U-G-L-Y!) The front end is still pricing in only a minimal risk premium to the risk of an earlier hike, while the back end is discounting inflation & growth expectations that are too high given the secular backdrop. This view seems to be working. The FOMC SEP dots rose for 2015 and 2016, while the longer term dots fell. Note that since the FOMC started publishing the SEP in Jan 2012, the average FOMC estimate of the long term Fed Funds rate has fallen 42.5bps, which equates to an average decrease of 4.25bps per quarter. Also worth noting is how the front end consistently prices in lower yields than the FOMC dots for 2015 and 2016, even though the dots have been moving here. I think the apparent ‘complacency’ has the Fed as well as the BoE worried. Note that Yellen said the word ‘uncertainty’ many times, a point that was also noted in a WSJ/Hilsengrath note published the next day, which may have been a leak. I think that may be due to the fact that since a short position has negative carry, shorts may need some additional risk premium (as compared to longs) to enter positions for a catalyst that is so far away. An ECB with an easing bias may also be having a sizable effect. Thus – there is a chance that, outside upside economic surprises, the repricing of the front end higher does not occur until 2015. Finally, there is the potential turn in USDCNY. The stoppage / slowing in PBoC buying – likely in the front end or belly – may help this thesis.

Carney’s comments were something of a bombshell. There aren’t many other ways for central bank heads to signal that front end yields are too low. However, based on the minutes, it seems that a main reason for Carney’s comments is worries over the risk premium priced in at the front end. I don’t have a strong view on UK rates here, pending data and additional commentary from BoE members, but I do think that the spread between UK yields and EU yields could revisit their highs, which are a ways from here. The secular growth & inflation backdrops seem supportive of such a move.

I think the BoJ is done easing. I think the hurdle for another ease is higher than the market believes, and that Japanese yields will turn higher sometime either late this year or early next year. However, I also think that growth will be tepid.

Australian money market rates look broadly reasonable. Assistant RBA governor Christopher Kent recently noted that “The unemployment rate is expected to remain elevated… declining from later in 2015 when we anticipate GDP growth to be picking up to an above-trend pace.” The generalized take away is that the RBA is currently not anticipating tightening until 2H 2015 or later, which is roughly consistent with what the Aussie money market pricing in. The more interesting part of the AU rates curve is the longer end, which is well below historical levels, but also should price in the possibility of a growth accident in China / EM. The recent minutes also suggest some frustration on the part of the RBA that the growth rebound hasn’t been stronger. In conjunction with the fact 10y that Australia yields are well above most other DM’s, sponsorship of the Australian long end may continue.

In contrast, the RBNZ has continued to hike, and the current pace would put the policy rate differential between the two countries beyond historical wides. Whether that will actually occur is anyone’s guess, of course, but it seems that the RBNZ’s hikes so far are more driven by macro-prudential concerns rather than worries over inflation. 2y survey based inflation expectations are at just 2.3%, hardly a worrying level.

I expect the Chinese economy to continue to slow as they continue to rebalance. The easing conducted via both FX and rates over the past few weeks suggests that policy makers are aware of the downside tail risks and are anxious to contain them. Nevertheless, the main problem remains that of an unbalanced and unsustainable economic model that will take quite some time to change.

Equities

Since I expect that the ECB cut is itself ineffective for growth, I continue to think that broader EU equity trends will remain intact, at least for now. That means that German equities are likely to outperform French equities. The popular EU vs US trade is likely to continue to fizzle. Once the AQR is over, however, it will be important to reassess. One especially interesting data point is that consensus EPS estimates for the Eurostoxx 50 is now rising on a 3m basis for the first time since mid 2011, although EPS growth remains well below that of the US.

The S&P continues to do well. I think we will continue to grind higher, with a risk of a substantial rally in 4Q, as the Fed’s QE program ends. I think there are a great number of investors who continue to believe that QE is supporting the equity market, and that they will have to throw in the towel when that hypothesis is proven false. Note also that 4Q is the start of the most bullish 4 quarters of the presidential election cycle.

However, I am getting nervous about EM equities here. The bounce in risk assets and currencies seem to have emboldened the central banks there, and positioning is now no longer short. The much discussed problems there have not been resolved, and the risk premium has narrowed significantly. I think it is prudent to consider taking chips off the table.

FX

On EUR vs USD, the debate now seems to be when the cross will re-couple with rate differentials. Perhaps the better question to ask is when will flows become a weaker driver? More specifically, I’m referring to flows that are not likely to be currency hedged. So we’re talking about private equity type & central bank type flows rather than fixed income type flows. My perspective there is that as long as European banks ability & willingness to extend credit remains tight, those flows will likely continue. While I completely agree with the consensus view that over the long run, EURUSD should trade weaker, I think there is a strong chance that it needs to either trade higher or stabilize at these levels first, until the European Banks are done recapitalizing. Note also that higher oil prices is a positive for the cross, although it is less of a positive now than in the past.

The lack of additional BoJ easing may not mean the end of the USDJPY trade. Demographics ensure a continuation of the decline in the current account balance. But to the extent that the consensus remains quite convinced of additional QE, there is a substantial risk of disappointment.

USDCAD is likely to continue to rally. The Canadian economy continues to face the effects of an overvalued exchange rate, which is likely to be resolved either via net investment outflows in the near term, or net carry driven outflows once we get closer to the first hike date.

Commodities

The risk premium that has been built in oil prices over the past few months seems to be justified now, given what has been going on in Iraq and elsewhere in the Mid-East. And unlike Ukraine, the geopolitical risk premium here seems likely to persist. Note that the oil market is also discounting this – the back end (5y fwds) is up $10/bbl since early this year, and at the highest level since Feb 2013.

My 2014 Trade Ideas – Marking to Market (from inception on Dec 13, 2013 to yesterday’s close)

Long S&P via LT calls

Entry: 16.66

Last: 25.85

PL: +55.2%

Closing vs keeping: Definitely keeping this one. The thesis is working and there really isn’t a compelling reason to take profits yet.

Long DAX vs CAC

PL: -4.3%

Closing vs keeping: Keeping. The optimism around an EU growth rebound has been coming at the expense of German equities. So even though DAX EPS continues to outpace those of their EU counterparts, the DAX has not been able to outperform. This is a dichotomy that is likely resolve itself, but the timing remains uncertain. Possibilities include another round of austerity in France, or a swing in the political picture.

Short TSX60 vs S&P 500, currency unhedged

PL: -2.6%

Closing or keeping: Keeping. This is the most disappointing trade to date, although fortunately the loss isn’t massive. I think my original analysis still holds, but things are taking a fair bit longer to play out than I expected. (A problem common for equity bets) My best guess is that the combination of higher US yields vis-à-vis Canada and the quick move in the FX rate in 1H have temporarily supported Canadian equity performance. With both those trends seemingly played out, this trade may have a better chance of working, although higher geopolitics-driven oil prices may provide a further offset in 2H. We’ll see.

Long EU 5y vs US 5y

Entry: differential of 5y rates 6m fwd = 1.967-1.342 = 62.5bps

Last: differential of spot 5y swap rates = 1.747-0.676 = 107.1bps

PL: +44.6bps

Closing vs keeping: Closing. The forwards are discounting a rising spread, and the differential at the 5y point is now on par with the differential at the 30y point. Furthermore, the catalysts have shrunk from two potential sources (either the ECB cuts or the Fed turns more hawkish) to just one. This trade has had a great run, but it’s probably time to cash in.

Long 2y Italy (or Spain)

Entry: 1.44%

Last: 0.63%

PL: including coupon & rolldown, +211bps

Closing vs keeping: This is a close call. On the one hand, the spread vs Germany has tightened massively, to levels that arguably will appear too tight by the end of the business cycle. On the other hand, you are still getting paid to lend at a rate well above swaps. However, the expected information ratio of the trade from these levels are below 1 so I’m closing it.

Conclusion

My hit rate was only 3 for 5, which is a bit below my bogey. But given that there were fewer trades this year, also the fact that the winners made much more on a risk adjusted basis that the losers, I’m not too unhappy about it. Unfortunately, given the back drop, there are not a lot of trades to replace the ones I’ve taken off. Lower volatility = fewer opportunities, and if there are fewer opportunities, there should be less trading.

There seems to be a lot of articles on the low volatility. As I’ve noted before, I don’t think this should be especially surprising. The business, central bank, and credit cycles are all supportive of low vols at present, and will continue to be supportive for some time yet. Central bankers are starting to get concerned about housing prices in some of the smaller countries, and the macro-prudential measures are likely to have an impact, given the dependence of housing transactions on the banking system. The credit markets, however, are much less dependent, and the most likely candidate for overheating. I fully expect some sort of flash crash type accident to occur in the credit markets once liquidity starts getting tighter. Note that the relationship between spreads and leverage has broken down. The last time this happened was in the mid 80’s, which ended with the junk bond bubble collapse and the savings and loan crisis. Caveat Emptor!

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