Review of Trade Ideas for 2014

My original thoughts from a year ago are at the bottom. Trades are marked from the close on Dec 13, 2013. In retrospect, my biggest misses this year were the moves in the Yen and in Oil, both of which occurred late in the year. The long DAX vs CAC idea was a small loser. I actually think that given what happened in Ukraine, and given the German dependence on Russian gas, the trade did pretty well.

Long S&P via SPY Dec 2015 175 strike calls: +111%

Open: 16.66

Last: 35.2

Long DAX vs CAC: -1.1%

Short TSX60 vs S&P 500, currency unhedged: +9.8%

Long EU 5y vs US 5y: +67bps

5y Swap Rate Spread, 1y Forward at Opening: 0.625%

5y Swap Rate Spread, Spot: 1.303%

Long 2y Italy (or Spain): +2.8%

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Trade Ideas for 2014

As always, comments & feedback are welcome.

Themes:

  • Yields remain low, but what is different now is that expected macro volatility is also low, after major shocks over the past few years. As a result, we are likely to enter the part of the cycle where leverage starts to build and credit quality begins to deteriorate. This is a trend that really only just started this year and has a fair bit of room to run. As people begin to get more comfortable using leverage, the riskiest assets usually perform the best. Low macro and asset vol means consensus trades are more likely to work because the probability of a sharp change in the consensus is lower. Given these conditions, risk asset prices should not be just ‘fair’ – they should be ‘rich.’
  • Both ILBE as well as realized inflation is very low, which is likely to contain any aggressive CB tightening, which appears to be a major investor concern at the moment.
  • The lack of macro volatility as well as fairly stable central bank policies mean that opportunities for good macro bets is also likely to diminish.
  • The low potential growth in DM is not due to ‘damage’ but due to falling labor force growth. It is here to stay, which suggests that asset prices will price in lower returns over the long run, which is another way of saying that asset prices can drift higher even if the expected income stream stays stable.

Trades:

Long S&P via LT (>= 2y) calls

  • Vol is very low, and so is time decay.
  • Risk premium is likely to compress (meaning PE is likely to rise) during this part of the cycle

Long DAX vs CAC

  • France just hasn’t done enough to normalize its productivity-adjusted labor costs vs Germany.
  • CAC is quite a bit more expensive than the DAX on forward earnings metrics relative to history.

Short TSX60 vs S&P 500, currency unhedged

  • Problems facing Canada include an overly strong exchange rate (still just 10% from all time highs vs USD) and falling energy exports to the US courtesy of fracking.

Long EU 5y vs US 5y

  • This one is SO popular it’s almost embarrassing to include it here. But the economics behind it is pretty solid, although the list of possible catalyst is murky and the carry is unpleasant. Unemployment in the US has been declining for 4 years, where as EU unemployment may have just peaked and is unlikely to decline quickly anytime soon. As a result, it is really just a question of when the Fed will tighten first.
  • Potential catalysts include a series of strong US payroll prints or some kind of growth accident in Europe that leads the ECB to take further measures.

Long 2y Italy (or Spain)

  • These are still ~100bps over Germany and France. The ECB probably won’t be in a position to tighten until that spread compresses significantly further. In fact, they have implied as much when noting the fragmentation of EUR money markets. Furthermore, rolldown is ~20bps a quarter.
  • The risk of yet another shock so soon after the last one is less likely. Historical vol looks high but with somewhat better data, that is likely to decline. For comparison purposes, 5y EUR financial CDS is trading at ~100bps also. Politics remain a risk, but with a current account in surplus, this is less likely to affect shorter term Italian yields. Another good sign is that the correlation between short term yields and economic data has flipped– i.e. weaker data is now correlated with lower yields.
  • A recent comment by ECB members Praet and Coeure suggested that there could be a risk weighting for sovereign debt on bank balance sheets. If so, that would have the dual impact of forcing some sales of periphery debt by periphery banks as well as reducing their Tier 1 capital. Given that the Eurozone is just starting to exit a recession, such a change seems unwarranted and is more likely to be phased in over time – especially since the ECB is still operating under an ‘easing bias.’ (NB: Draghi reportedly said last night that the ECB will NOT unilaterally assign risk weights for banks’ holdings of government debt: "This is not the task for us or for now. This is the global task that will be discussed by the Basel Committee (on banking supervision) at the proper time".) But it is certainly a risk given the ECB’s history of giving EUR risk takers the shaft.

Trade Ideas for 2013

Readers, please feel free to share your thoughts. Opposing viewpoints are particularly appreciated.

Themes:

  • Pessimism for 1Q growth due to high fiscal multiplier on austerity measures, optimism for 2H 2013 as a result of low inventories, better bank lending as a result of completing Basel 3 requirements, continued strength in US housing, and falling commodities inflation. Peak fiscal drag globally is also likely to hit next year, and asset prices are likely to look ahead of that. Unfortunately, this view is also very consensus, which points to the risk of the opposite happening.
  • Low economic volatility in 2H2013. The reason is that we’ve had so many shocks and tremors over the past few years that most short term imbalances have already been shaken out. So in aggregate, there is likely to be less economic volatility next year, which probably means that the range for financial asset returns will also be narrow. Near zero interest rates means there will be little funding pressure, which favors carry. As a result, default rates can remain low. Carry will likely be an important source of return, as the lack of economic volatility suggests that market timing based returns may be weak. Note that implicitly, this means global macro strategies / ideas are likely to continue to exhibit lower returns.
  • Bifurcated growth globally. Though short term imbalances have mostly been resolved, longer term imbalances continue to remain substantial, and need to be resolved. And the likely lower level of macro volatility may be favorable for these types of bets.
  • The global High Grade Credit shortage is worsening. Treasury & MBS supply is falling. So risk for High Grade yields is rangebound to lower. Consensus expectations for DM government bonds also look too low. There is a growing shortage of high grade credit, and demand is very sticky due to institutional constraints on real money managers. Despite articles to the contrary, demand is likely to increase, as this chart from JPM shows:
  • Consensus expectations for equity returns globally look almost universally too optimistic. With peak margins and low nominal GDP growth, a double digit return on equities requires a 1x increase in the PE multiple. This does not appear to be likely given the DM demographic shift toward retirees, who favor debt. The chart above points to a continued decrease in P/E, although share buybacks will probably mitigate that somewhat. As a result, junior credit appears to be a more attractive way to express pro-cyclical views.
  • Japanese voters want deflation. It has been said that inflation is a political decision. So in Japan, many market participants believe that the political will to force the BoJ to print will result in inflation. However, this view does not take into account the fact that the majority of Japanese voters are elderly who are living off of savings and/or fixed pensions, which means they don’t want inflation! Inflation may be a political decision, but Japanese voters have already decided that one – they want deflation – a condition they’ve been fine with for over a decade now.

Long EU High Yield

  • With funding costs not far above the rate of inflation, many high yield companies can continue operating for an extended period of time. That means there is a much higher probability that they can avoid default.
  • With the EU in a late stage recession, this is the best part of the business cycle for this asset class.
  • Low macro volatility is also favorable for this asset class
  • US HY should also do well, albeit returns will be lower

Long Dax vs Eurostoxx 50

  • The German Economy has 2 advantages vs the rest of the EMU: cheaper labor costs per unit of out put, and cheaper funding costs. Both are in the process of reverting, but due to institutional rigidity, the timeline for that is measured in years, if not decades. These structural advantages are likely to be a key differentiator and are not priced in. The Dax is actually trading at the cheapest levels vs the Eurostoxx in many years.
  • The main arguments against this trade is that the Eurostoxx earnings are coming off of depressed levels, but are likely to bounce as a result of ECB easing and a better fiscal backdrop. That is probably true, but to a large extent, also priced in. Fiscal consolidation in a low growth environment almost always takes longer than expected to play out, and European banks continue to delever. Trends in relative export performance, or relative deposit growth across EMU countries all continue to widen. The variant perception here is that this is NOT a typical post recession recovery, which most EMU equity managers appear to expect. It is much more of a Japan-like recovery, as long term imbalances have much more room to improve.

Long US Tech Sector vs S&P 500. (Nasdaq 100 is a rough proxy)

  • Tech sector remains a relatively high growth area in a low growth world. The massive institutional overweight in Tech was unwound over the past 3 months, but the fundamental story still sound. As a result of the unwind, the Tech sector is trading at the cheapest level vs the index in recent memory.
  • Recent Tech earnings likely curtailed by fiscal cliff uncertainties. A rebound in capex following the end of the cliff will likely lead to a bounce regardless of if there is a recession or not.

Short AS51 (Australia) vs S&P 500, currency unhedged

  • The Australian currency is very overvalued – something the RBA governor has explained well. This means competitiveness is low, and growth is likely to slow.
  • Commodity super cycle over, but mining investment is 8% of Australia GDP vs 2% in 2005. Risk is another super stimulus in China, but it appears the leadership there understands the need for rebalancing. Even if growth in China is maintained in the high single digits, mining capex in Australia will decline, which will necessitate rebalancing and lower growth & earnings.

Short Nikkei vs S&P, currency hedged

  • This idea may be the most anti-consensus trade here, so I will elaborate a bit further. The consensus expectation seems to be that Shinzo Abe, who has already failed once as Prime Minister, (Resigning after 1 year) will be able to bring both growth AND inflation to Japan, despite multi decade trends to the contrary. Despite many years of QE that has failed to increase growth, Abe is campaigning on the idea that more QE by the BoJ will increase growth and inflation. Even if this is achieved, an increase in nominal bond yields would be a massive hit to the Japanese financial sector, which is laden with JGBs. An increase of 10y bond yields from 70bps to even 1.5% would drive 10y JGB prices from 101 to 94. With the election in a couple weeks, much of the optimism may be near local extremes.
  • More QE will NOT result in more profits. QE impact on stock prices is limited, as we have seen with Japan over the past decade, and in the US since QE infinity was announced in Sept. Remember that Japan has tried a massive QE program before. From late 1999 to early 2002, the BoJ balance sheet doubled, (+70Trn Yen) which increased M1 growth to a peak rate of 33% by early 2002. During this time, the Nikkei declined 36% even as the yen weakened 28% vs the USD.
  • A weaker currency would certainly help earnings, but < 1/3rd of Nikkei revenue comes from overseas. So even IF the BoJ is successful at creating inflation & weakening the currency, it’s not clear if that will be sufficient to allow the Nikkei to outperform. Also Yen shorts at the highest level since July 2007.
  • The consensus view seems unanimous in loving the Nikkei and hating the Yen. That’s usually a good sign to go the other way. Here is the chart of the S&P vs the Nikkei over the past 4 years. Maybe this long term trend is over, but it still looks like a correction to me:

Long US Homebuilders vs S&P 500

  • The tailwind for homebuilders in certain sections of this country is substantial. While we will not come close to seeing the boom levels of 2005/2006, the market is still discounting very modest growth in that sector. The price ratio, despite increasing 50% from just over a year ago, remains at levels last seen in mid 2007 and before that early 2002. It will take a 150% rally from here for the ratio to get to the 2005 highs.
  • I wasn’t smart enough to think of a way to really mitigate the beta component of this trade. The SPX beta is ~1.5 right now, but has ranged from 1 to 2.5. And using the S&P to beta hedge actually hasn’t been very useful for improving risk adjusted returns because this is a cyclical product. A simple 1:1 ratio should serve to mitigate the volatility, but an outright long position also looks reasonable.

Receive US 5y inflation 1y forward

  • Market is pricing in inflation of 1.35% over the next 12m, but an average rate of 2.5% over the next 6 years. If you do a 1y5y forward by receiving 6y inflation and paying 1y inflation, you can receive 5y inflation starting in 1y at an implied rate of 2.71%, which incidentally is also the highest print for the 5y inflation swap over the past 4 years, and also a high level even during the 2007-2008 period.
  • With continued high unemployment and a declining energy trade balance, US inflation is highly likely to remain subdued over the next few years. Since the recession ended in June 2009, realized inflation has been just 2.1% annually.

Short BAZ3 vs Long EDZ5

  • No hikes are priced in, even though the BoC expects hikes by 3Q next year Carney became more hawkish in the last BoC statement, noting in particular the housing bubble. Though he is moving on, the rest of the staff will likely continue his policies
  • Long EDU5 will mitigate risk on/off, and carries positively in case no hikes or cuts happen.
  • Canadian Inflation pressures likely to become evident by 2Q.

Short AUD/CAD

  • This is mainly an expression of AUD bearishness. The cross is very, very rich by most valuation metrics.
  • Mining capex in Australia is in the process of peaking. The trade balance has been negative for almost a year, and is worsening. The only reason the cross hasn’t traded lower already is because of inflows into Australian government bonds. But some more cuts by the RBA could change that.
  • CAD is used as the long leg because of its procyclical correlation and also because BoC is the only CB that hasn’t eased this year.

Score Card for 2012 Trade Ideas

Before looking ahead to next year, it probably makes sense to see how last year’s ideas did. So without further ado: (spot levels used unless otherwise declared)

Price at Price at
Trade 12/14/11 11/23/12 Change Profitable?
Buy Short Term SIFI US Bank Debt (Proxy is equal wgt 5y CDS) 276.48 132.17 -144.31 Y
Buy an ATMF 3y1y USD Receiver (on 100mm Notional) $253,411 $1,031,412 $778,001 Y
Long Gold (GLD) 152.89 169.61 10.9% Y
Long Brent Crude (Jan 2013 Future) 101.41 111.38 9.8% Y
Sell EURSEK 9.083 8.594 -5.4% Y
Long EURCHF 1.238 1.204 -2.7% N
Long Nasdaq 100 vs Dow Jones Industrials 0.189 0.203 7.4% Y
Long S&P 500 vs Eurostoxx 50, FX Hedged 0.549 0.551 0.3% Y
Short Consumer Discretionary vs Staples (-XLY / +XLP) 1.209 1.322 9.4% N
Buy Agency REITS (NLY & AGNC. Including dividends) 1 1.1613 16.1% Y
Total Trades 10
Profitable 8
Not Profitable 2
Hit Rate 80%

Long term readers know that my ‘bogey’ is a hit rate of around 2/3rds, so by those standards, last year’s results were passable. However, a caveat there is that this year’s price action was very pro-cyclical, partially as a result of market pricing at the end of last year, and partially as a result of monetary easing. As a result, any portfolio with a pro-cyclical tilt wound up doing well. That is not likely to be the case for 2013.

Finally, the size of the consumer discretionary outperformance vs staples was surprising to me. Part of the explanation there is the strength in the home improvement sector, while another was relative starting valuations. Media companies also performed strongly, possibly with help from the election cycle. If readers have additional thoughts on that topic, please feel free to share.

Trades & Rationale reprinted from 12/13/2011:

Buy Short Term USD SIFI US Bank debt

  • Recent Fed stress tests suggest that the Fed is very concerned about solvency. They do not want to let any of the SIFI banks go under again. Worst case scenario is probably the GSE conservatorship model, whereby equity holders get wiped.
  • Short term yields on senior unsecured obligations are consistent with super junk levels. For example, a Merrill Aug 2012 issue is trading at a yield to maturity of 5%.
  • US banks are in good shape from a liquidity perspective. There is almost no use of the Fed’s discount window, suggesting that liquidity remains plentiful. This is important because ultimately, it is a liquidity problem that causes large banks to go under.

Buy an ATMF 3y1y USD Receiver

  • The US is going to slowdown, and headline Inflation is likely to peak soon
  • Fed will do more QE. Implicitly this pushes back expectations for the date of the first hike.
  • K = 1.72%, 2y1y = 1.03%. If vol and fwd curves are unchanged in 1yr, you’re up 50% on the premium.

Long Gold

  • Real rates globally are likely to remain low for an extended period. The Fed is likely to embark on another round of QE. Almost every major CB in the world is easing policy. Most developed market currencies have negative real rates
  • Stockpiles of crude oil and grains are at very low levels, increasing the likelihood of a supply shock
  • The biggest risk is a disorderly deleveraging of the EU banking system. However, given recent ECB actions, arguably this risk has been sharply reduced.

Long Brent Crude

  • OECD supplies are very tight. The lesson from 2008 is that tight supplies can induce rallies despite an upcoming recession
  • Futures strip is very backwardated as a result of tight supplies, which has historically been very positive for returns.
  • An EU recession is less damaging for Oil demand than a US recession due to lower elasticity of demand. Meanwhile, US vehicle sales have been surprising on the upside

Sell EURSEK

  • The Swedish current account is actually broadly uncorrelated to EURSEK levels. Historically, the swing factor has been portfolio flows. As a result of the EU crisis, this should continue to support SEK.
  • Historically, Swedish banks have had large EUR liabilities. This contributed to the massive move in EURSEK following Lehman. However, since then much of the exposure has been reduced, meaning the currency is less exposed to EU contractions
  • Carry is 2% annualized, for now

Long EURCHF

  • Recent Swiss data has been horrible. Mfg PMI has declined to 44.8. CPI is now at -0.5% YoY. The SNB is likely to react by resetting the EURCHF floor higher, since it is the only tool left.

Long Nasdaq 100 vs Dow Jones Industrials Avg

  • Relative valuation is very skewed. There is a large amount of flight to quality premium priced into the DJIA which is likely to unwind either via a stabilization of the stress in the EU or over time via Nasdaq’s higher earnings growth
  • In a slow or no growth environment, growth stocks are likely to outperform

Long S&P 500 vs Eurostoxx50, FX hedged

  • US growth will exceed EU growth relative to expectations. Specifically, consensus expectations have not adjusted sufficiently for the upcoming EU recession.

Short Consumer Discretionary vs Consumer Staples

  • US slowdown + low savings rate => discretionary spending will fall.

Buy agency REITS like NLY or AGNC

  • 15% dividend yield is sustainable given current low levels of leverage due to the wide spread between current coupon and swaps
  • An MBS focused QE program will yield a sharp improvement in book value
  • NLY currently trading at just 1x book. Over the past decade, this is the bottom end of the valuation range. Buying at 1x book has been good entry points.

Trade Ideas for 2012

As always, comments & thoughts are welcome. In the interests of keeping this brief, I didn’t include detailed data behind some of the ideas, but I may discuss them in future updates.

Outlook:

The current bout of deleveraging is likely to continue. The tightening in credit over the past few months will accelerate the contraction we are already seeing in the Eurozone, and will likely last at least through 1H 2012.

Also accelerating this process is likely further downgrades of sovereign EU debt, which will increase the amount of capital that has to be held against them. Finally, the upcoming EU recession will cause EU budget deficits to be worse than forecast as the ‘automatic stabilizers’ like unemployment benefits kick in. The additional issuance of debt will also exacerbate the deleveraging process. However, I do not think the EMU will break up in a disorderly way, barring a revolution in Greece. I think the societal and legal constraints are much stronger than some market participants think.

In the US, the situation looks better, but only on a relative basis, thanks to super easy monetary policy and a resilient consumer. However, the US is now the only major country which is growing more than expected, and the big question is how long the US can remain decoupled. Forward looking items that are growth negative include:

· likely fiscal contraction, if not much near term at the federal level then a continuation at the state and local level

· low savings rates, which suggests there isn’t much room left for increasing consumption. This is the key factor since consumer spending remains 2/3rds of GDP. Note that historically, declines in the savings rate (white) has proceeded declines in retail sales (orange) and recessions.

· the US economic surprise index is near all time highs, which suggests that this recent series of positive data surprises may be ending soon. Historically, these episodes have coincided with short term tops in US equities as well.

I expect US growth, as reflected by ISM prints, to peak in the next few months before grinding lower. The likely slowdown in the US will probably induce another round of QE.

This suggests that the market environment over the next quarter will continue be choppy and challenging. As a result, I am putting out some ideas for all of 2012 rather than just 1Q.

Trades:

Buy Short Term USD SIFI US Bank debt

  • Recent Fed stress tests suggest that the Fed is very concerned about solvency. They do not want to let any of the SIFI banks go under again. Worst case scenario is probably the GSE conservatorship model, whereby equity holders get wiped.
  • Short term yields on senior unsecured obligations are consistent with super junk levels. For example, a Merrill Aug 2012 issue is trading at a yield to maturity of 5%.
  • US banks are in good shape from a liquidity perspective. There is almost no use of the Fed’s discount window, suggesting that liquidity remains plentiful. This is important because ultimately, it is a liquidity problem that causes large banks to go under.

Buy an ATMF 3y1y USD Receiver

  • The US is going to slowdown, and headline Inflation is likely to peak soon
  • Fed will do more QE. Implicitly this pushes back expectations for the date of the first hike.
  • K = 1.72%, 2y1y = 1.03%. If vol and fwd curves are unchanged in 1yr, you’re up 50% on the premium.

Long Gold

  • Real rates globally are likely to remain low for an extended period. The Fed is likely to embark on another round of QE. Almost every major CB in the world is easing policy. Most developed market currencies have negative real rates
  • Stockpiles of crude oil and grains are at very low levels, increasing the likelihood of a supply shock
  • The biggest risk is a disorderly deleveraging of the EU banking system. However, given recent ECB actions, arguably this risk has been sharply reduced.

Long Brent Crude

  • OECD supplies are very tight. The lesson from 2008 is that tight supplies can induce rallies despite an upcoming recession
  • Futures strip is very backwardated as a result of tight supplies, which has historically been very positive for returns.
  • An EU recession is less damaging for Oil demand than a US recession due to lower elasticity of demand. Meanwhile, US vehicle sales have been surprising on the upside

Sell EURSEK

  • The Swedish current account is actually broadly uncorrelated to EURSEK levels. Historically, the swing factor has been portfolio flows. As a result of the EU crisis, this should continue to support SEK.
  • Historically, Swedish banks have had large EUR liabilities. This contributed to the massive move in EURSEK following Lehman. However, since then much of the exposure has been reduced, meaning the currency is less exposed to EU contractions
  • Carry is 2% annualized, for now

Long EURCHF

  • Recent Swiss data has been horrible. Mfg PMI has declined to 44.8. CPI is now at -0.5% YoY. The SNB is likely to react by resetting the EURCHF floor higher, since it is the only tool left.

Long Nasdaq 100 vs Dow Jones Industrials Avg

  • Relative valuation is very skewed. There is a large amount of flight to quality premium priced into the DJIA which is likely to unwind either via a stabilization of the stress in the EU or over time via Nasdaq’s higher earnings growth
  • In a slow or no growth environment, growth stocks are likely to outperform

Long S&P 500 vs Eurostoxx50, FX hedged

  • US growth will exceed EU growth relative to expectations. Specifically, consensus expectations have not adjusted sufficiently for the upcoming EU recession.

Short Consumer Discretionary vs Consumer Staples

  • US slowdown + low savings rate => discretionary spending will fall.

Buy agency REITS like NLY or AGNC

  • 15% dividend yield is sustainable given current low levels of leverage due to the wide spread between current coupon and swaps
  • An MBS focused QE program will yield a sharp improvement in book value
  • NLY currently trading at just 1x book. Over the past decade, this is the bottom end of the valuation range. Buying at 1x book has been good entry points.

Trades for 3Q11

In no particular order, grouped by asset class:

NB: this is probably the hardest quarterly trade ideas list so far this year, stemming from the lack of clarity regarding near term macro direction. Obviously, if Greece blows up, all bets are off. I aimed for brevity – readers are welcome to challenge or question any of the ideas.

Stay Short S&P Variance Swaps

  • Implied Vol remains too high. 2yr realized vol is 16.1% and 1yr realized is 13.9% vs 1y variance swap at 25% and 9m variance swap at 24.1%. As the US is not going into a recession, this remains a good risk reward bet.
  • Model estimates suggest that the VIX can decline below 14.

Long Dax vs IBEX, equal Euro weighted

  • Relative growth differential is not adequately priced in. Austerity measures in the periphery will have a bigger impact on growth than expected, and growth will be weaker for longer than expected.
  • Germany will be less affected by higher rates / lower credit than Spain

Long Nasdaq 100 vs S&P, equal dollar weighted

  • Relative growth differential is not adequately priced in. On a forward basis, the Nasdaq is very cheap vs the S&P.
  • Nasdaq Index earnings continue to grow faster than S&P earnings
  • Long term trend has been upward for 5 years and looks set to continue after a pause:

Buy US 10-year Future August 125+/126/127 Call Tree for flat

  • Cheap bet that yields are not far from a floor. High print from the rolling 10y future over the past 12m is 128.
  • Matures on 7/22

Sell 5y Treasury Future

  • Net supply set to turn sharply bearish. (See comments from 6/24)
  • Data surprises set to revert to the mean
  • Insufficient Term Premium in the curve. There are different ways to measure this, but the first Fed hike is now priced for Nov 2012.

Sell USDCNY 12m Fwd

  • The NDF has rallied over the past month based on fears of a hard landing in China. Only a 1.2% appreciation is now priced in for the next 12m, the smallest amount since last May/June:
  • While I agree that China’s economy is in an investment bubble, it is not yet at the tipping point when the government is losing control. Sufficient liquidity can yet be unleashed to offset hard landing risks, so the slowdown is unlikely to be bad enough for China to devalue. This is probably a story for the next global recession.
  • Going into a presidential election year in the US, there will likely be increased political pressure on China for the appreciation to continue

Buy USDJPY

  • Proxy on US 3yr swaps. As yields can’t get much lower, USDJPY probably has limited downside.
  • Higher relative 2yr real yields is also positive:

Q2 Trades Recap:

Trades are assumed to be initiated at the close of 3/21 with zero transaction costs.

  1. Short S&P Variance Swaps: Sold vol at 26.4 vs realized of 12.3. Net profit of 14.1 vol pts over the past 3 months.
  2. Long EEM vs EAFE, proxied by EEM and EFA: Net profit of 3%.
  3. AUD 3s10s Flattener: after being profitable over most of the quarter, this week’s sell off in AUD rates drove this trade to a 6bp loss
  4. Short Dec11 Short Sterling: BoE did not hike, and now people are talking about another round of QE. 42bp loss
  5. Long US 5yr Future: I sent out recommendations to take profit in early April. Profit of 1pt + 4/32nds
  6. Long EURUSD: Profit of 1%, although it was up almost 5% at one point
  7. Long CAD puts: I didn’t specify strikes and maturity, but pretty much any combination would’ve resulted in a loss
  8. Long NZDUSD: Profit of 11%

Success Rate: 63%.

Eh. In retrospect, I should’ve avoided the CAD puts and remembered to recommend taking profits on the AUD flattener.

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: