year-end opportunities in eurusd and Japan

Right now I'm quite short fixed income in the US and Japan - what you'd have called a risk-on position a year ago - and so selling eurusd looks like a good offsetting trade. We're just reaching a nice 5 year trend line, so it's possible to set quite a tight stop on the upside :

The situation in Turkey is a potential catalyst for a selloff in eurusd (you can imagine contagion into the Euro if things get out of control). There seems to be some end-of-year selling of dollars at the moment, and from a medium term perspective the economic strength is definitely clearer in the US than in the eurozone, so this looks like a good entry point for several reasons. Anyway, I'm selling it around here with a stop not too far above that trend line. We'll see if it holds. 

In Japan I'm switching from short yen to long Nikkei / short JGBs. I've just taken profit on some usdjpy as the trade now looks crowded and possibly overbought in the short term. I prefer owning high dividend Nikkei stocks. The trading companies are absurdly cheap (Marubeni, Mitsui and Sumitomo have forward p/es around 6.5 and dividend yields of 3.5%) and the megabanks aren't much more expensive. I'm reminded of the situation in the UK 3 years ago : retail investors bought boring, high dividend, low p/e stocks in their ISAs (tax free wrapper accounts) when they realised rates wouldn't rise for years and high inflation would penalise cash deposits. NISAs are the Japanese equivalent and have just started trading. If I was a Japanese pensioner sitting on a lot of cash and worried by rising inflation I'd want the safest, most boring high income stocks I could think of, preferably names I'd known for years, all held in a tax free account. Buying the trading companies in a NISA fits the bill perfectly. They've been outperforming the index recently, as you'd expect as the NISA deadline approaches. 

JGBs have no obvious reason to sell off since the BoJ keeps buying, but the chart looks terrible. The banks have been buying put options, which says a lot (the "stupid gaijin" trade), and everyone is talking about the BoJ increasing their purchases sometime next year, so that risk is partly in the price already. It certainly isn't yet a widely held position, and I think we could trade another 10-15bps higher quite easily. 

Fed to market : If you think we screwed up last time, just watch this...

It's interesting to compare the situation now with 2003/2004. If the drop in unemployment persists as it has for the last 3 years, we'll reach 6.3%, the level of peak unemployment in the dot com recession, around the end of next year :

How should eurodollars be priced if the Fed subsequently reacts exactly as it did last time ? Well, they made their final cut to 1% in Jun03 as unemployment peaked, kept rates on hold for a year and then hiked in a straight line by 425bps over the following 2 years. Like this :

Matching the two dates of identical 6.3% unemployment suggests rates stay at 0.25% till Jan16, then rise to 4.5% by Jan18. Allowing 30bp for the funds/Libor spread, that gives 95.20 (4.8%) for Dec17 euros. EDZ7 currently trades at 96.80, ie 160bps too high (interestingly that's exactly where I'd expect the next selloff in EDZ7 to stop from a technical perspective : down 200bps from 98.10 to 96.15 over last summer, a 100bp bounce to 97.15 this autumn and then another 200bps getting you to 95.20-ish. Funny coincidence.).

Of course, there are some differences :
- Fed Funds are 75bp lower now than in 2003 : easier policy now
- the Fed is saying they'll keep rates low for longer than Jan 2016 : easier policy
- the Fed has ~$4trn of bonds on its balance sheet : easier policy
- the stock market is at an all time high instead of recovering from a crash : easier financial conditions
- GT10 is 3% instead of 5% : easier financial conditions

One thing that isn't very different is inflation. Here's core cpi :



Inflation is actually higher today than in 2003, so real rates are even easier than nominal rates. In fact current 10yr break-evens are almost identical now to their levels in 2003 as well.

Obviously the Fed made a colossal mistake in 2003-2007. They kept rates too low for too long and inflated a monumental bubble which nearly destroyed everyone when it burst. So how can the current forward guidance, committing them to even lower real rates for even longer, be credible ? It all comes down to inflation I think. If the core cpi numbers turn as they did in late 2003, then the Fed will start hiking rates soon. Within a few weeks everyone will be dusting off charts like these and drawing the obvious conclusion that the steady-as-she-goes sequence of rate hikes from 2004-2006 is a better-than-best case scenario, and that to prevent the risk of bubbles they really ought to tighten even faster. Which all points to EDZ7 and its friends being 200bps or more lower than they are now. 95.20 on EDZ7 strikes me as a best-case scenario.

Personally I think there's a significant chance of this realisation dawning on the market in Q1, as we post stellar growth numbers and everyone races to upgrade their forecasts against the backdrop of tapering. Low delta puts on the golds are the obvious risk/return trade. Ideally equities will fail again here at 1810 on spx, giving a risk-off trade with a great risk/return to set against the rates trade. The combination could be the trade of the year if it lines up.

Nov update

		indexed NAV
	adjusted return
		100.00
Nov-12	17.8%	117.77
Dec-12	37.4%	161.78
Jan-13	38.1%	223.40
Feb-13	-3.3%	215.92
Mar-13	12.4%	242.62
Apr-13	30.2%	315.81
May-13	68.8%	533.08
Jun-13	36.9%	729.55
Jul-13	-12.6%	637.46
Aug-13	-1.7%	626.31
Sep-13	-9.6%	566.31
Oct-13	-4.9%	538.62
Nov-13	11.5%	600.41

Having drawn down from Jul to Oct (my own fault in Jul and Oct, and also due to the Fed's disgraceful behaviour in Sept) I was uncomfortably close to my stop by the end of Oct. I'm running a 30% drawdown from peak month end NAV, so I was 3.8% away at the end of Oct and running correspondingly smaller positions than in Jun. After Nov I'm back in the clear, so I can trade more freely without being constrained by the proximity of the stop. The easiest market has been fx, as the market looked into Q1 and saw a tighter Fed and a BoJ which is likely to undertake another round of easing :

Equities            2.7%        Nikkei longs (aka USDJPY) worked, offset by a small loss from long VIX

Commodities   0.4%        Short gold again, having been stopped on the same trade in Oct

Fxd income      0.0%        Gains in Aussie bills and short TYZ3 offset by losses from short JGBs

FX                    8.4%        Long USDJPY, GBPCHF and short AUDUSD and AUDNZD all worked

I should have made more in equities really : after payrolls it was clear that the hedge fund community needed to reduce the performance gap with equities to avoid some difficult investor conversations. The problem is that the taper is coming though. Never mind the data - the guard is changing at the Fed and QE is Bernanke's pet, not Yellen's. She's more interested in optimal control and convincing the market that rates will stay low for another 3 or 4 years. Anyway, QE's days seem numbered, and even if you believe that this year's equity rally - powered by  multiple expansion - has nothing to do with QE (I don't) then you don't want to find out the hard way that you might be wrong. After a great year, and with a major change in the monetary landscape coming, common sense suggests reducing equity positions. So being long stocks feels to me like picking up the last few pennies in front of the steamroller : 2% of upside vs 10% of downside. Not very attractive, so I left the equity market in the US alone in Nov.

Current thoughts (in brief):

I'm now short equities, but concerned I'm too early. Vol has picked up, and the 1810 highs should be met with selling from some over-excited longs from a couple of weeks ago. Maybe that will cap the upside now. If not, I'll respect the rally and cut.

FX still seems the easiest market in my opinion. I'm short AUD, JPY and CHF against GBP, USD and NZD (small for the latter). My risk-off hedge is long Aussie Dec14 bill futures, as before. More and more people are starting to suggest a final cut in 2014, but even without this the position still works. What's clear is that the hurdle for  rate hikes is higher than people thought a few months ago. I think rates aren't rising for a couple of years at least and AUDUSD probably heads towards its 0.82 low from 2010.

Fixed income. I like being short JGBs, for the first time in ages : real yields are negative in Japan and positive in the US, and the gap is the widest since 1998. That's triggered the second largest flows into Treasuries from Japan since they started collecting the data in 2000 - in other words, Japanese institutions are voting on JGBs with their feet. Everyone believes Abenomics will stutter in the spring and require more bond buying from the BoJ, so it only takes a few signs of durable success to make them question that assumption. That would push JGB yields a lot higher (ok, 15-20bps higher anyway). The negative carry isn't so bad, and positioning seems quite clean. Everyone's afraid to fight the BoJ, but there's always a level where it's the right idea.
Elsewhere I'm running a medium sized short in TYH4, as yields seem set to drift just north of 3% with a Jan taper. To an extent it's the same as the JGB trade though.

Oct update

		indexed NAV
	adjusted return
		100.00
Nov-12	17.8%	117.77
Dec-12	37.4%	161.78
Jan-13	38.1%	223.40
Feb-13	-3.3%	215.92
Mar-13	12.4%	242.62
Apr-13	30.2%	315.81
May-13	68.8%	533.08
Jun-13	36.9%	729.55
Jul-13	-12.6%	637.46
Aug-13	-1.7%	626.31
Sep-13	-9.6%	566.31
Oct-13	-4.9%	538.62

A very frustrating month here :

Equities               0.0%      Long Nikkei positions cancelling gains from S&P longs
Rates                   -1.8%     Shorts in US fixed income and small losses in Schatz & Bobl calls
Commodities      -1.3%     Stopped out of short gold at 1344, which turned a good trade into bad one
FX                       -1.8%    Stopped out of long USDJPY, short AUDUSD and long GBPCHF

Having sidestepped most of the US political noise I found it very hard to re-establish positions. Having had a large drawdown I'm running with much smaller positions and tighter stops. With hindsight, the positions should have been smaller still and the stops deeper : nearly all the trades I cut subsequently came good, so the lesson for November is to look for smaller positions on higher conviction trades.

Market outlook
US
October's first tier data (ISMs and payrolls) suggest that the real economy never believed the Washington pantomime. Perhaps Main Street is just as cynical as Wall street about the threats of US politicians. Either way, it's hard to see how Nov and Dec payrolls are going to be poor. That and the Fed's latest rhetoric (perpetually low rates should outweigh any taper) make me think that a Jan taper is most likely. I think the market basically "knows" this, but hasn't yet priced it in because we all got so badly hurt by the Fed's U-turn in Sept. Short gold, long the dollar (against AUD and JPY) and a small short in fixed income are all worth re-entering.

Japan
As things stand the impact of yen weakness on CPI will peak soon, but CPI is still a way from the BoJ's 2% target. Either Abe concedes defeat, or he makes another push to revive inflation. Defeat looks like political suicide, so my money is on another round of monetary stimulus. It's hard to buy more JGBs - they're already buying more than the annual net issuance - so the path of least resistance might be to buy more ETFs and equity index trackers. They'll be exploring the options for more easing at the same time that the Fed is talking its way to a Jan or Mar taper, so USDJPY

Sep update

Sep update

		indexed NAV
	monthly return
		100.00
Nov-12	17.8%	117.77
Dec-13	37.4%	161.78
Jan-13	38.1%	223.40
Feb-13	-3.3%	215.92
Mar-13	12.4%	242.62
Apr-13	30.2%	315.81
May-13	68.8%	533.08
Jun-13	36.9%	729.55
Jul-13	-12.6%	637.46
Aug-13	-1.7%	626.31
Sep-13	-9.6%	566.31

I feel like calling the US authorities and demanding my money back. I'd have put Summers for Fed chairman and an initial taper both as high probability outcomes, and obviously neither was. Having had a humiliating week in mid Sept, P&L preservation demanded a serious cut, so at least I've been largely on the sidelines during the current political fiasco in Washington.
I don't have a clear idea how to trade this situation - it's completely binary, driven by political egos and everything is correlated (so no good hedges that I can see). It beggars belief that the politicians will consciously drag us over the edge, but the gridlock and the dynamics in Washington are pushing that way. After all, everyone was aware of the risk of war in 1914 and no-one wanted it (well, maybe one did), but it still happened. I have some Schatz and Bobl calls 20-30bp OTM in case the unthinkable happens. The only long term position I'm keeping is long Japanese banks.

Things I'm watching with a view to enter when (if ?) the debt ceiling/shutdown is resolved :

Japan - people are starting to question Abenomics, which seems premature as you wouldn't expect it to be an easy straight line process. Offshore positions are being trimmed while domestic retail and institutional money are preparing for what could be the next leg (NISAs, GPIF asset re-allocation for example). BoJ seems to be talking down the JGB market and attempting to floor yields at 0.50, which sets up an interesting risk return there perhaps. I want to get the all clear from Washington first though.

Aussie - I'm out of the slowdown trade, as the data has bounced and housing seems to be following the NZ route.

UK - the recovery was looking great, until Osborne decided on a huge dose of adrenaline straight into the heart muscle (aka Help To Buy). Cue all 1 bed flats repricing to £600k. It seems unlikely to end happily. Being long GBP against CHF and AUD was a nice trade, but I'm now on the sidelines as explained.

USA - I'm concerned that everyone "knows" a default is unthinkable and that sanity will prevail. Markets are convinced that default is unthinkable, so they're not inclined to panic - but a market panic is the only tried and tested way to break a Washington logjam. So it's Catch 22, the downside being that if something goes wrong in this game of chicken then things fall apart extremely rapidly. Perhaps too rapidly for the authorities to react. The role of Treasuries as collateral seems to me the weakest link.

I'm out of the game till the odds are better.

insurance trade

Generally insurance trades are a waste of money, but the House Republicans seem determined to test that idea to destruction. It's a ninety-something percent probability that the debt ceiling is fixed by mid October, but if it isn't then it's nice to have protection. The best I can see is schatz and bobl calls expiring on Oct25th.

If the politicians screw up, the US could be in selective default soon after Oct 17th. That will raise a question mark against the eligibility of Treasuries as collateral for CSAs etc, and there'll be a mad scramble for every other government bond as banks and hedge funds try to get hold of replacement collateral. That points to Schatz and Bobl calls. Surprisingly the Nov calls (25th Oct expiry) are cheap : 0.01 for the Schatz 110.70 calls and 0.02 for Bobl 126.00 calls. If the unthinkable happens Schatz will trade to negative yields - we were there last year after all, so the precedent has been set - and these calls are in the money. Possible payout ratios could be 50:1 or higher, which seems a lot better than anything available in spx puts.

The real purpose is obviously to provide the backstop to buy equities if/when things are looking really ugly. We're not there yet though.

Aug update

Aug update

		indexed NAV
	adjusted return
		100.00
Nov-12	17.8%	117.77
Dec-13	37.4%	161.78
Jan-13	38.1%	223.40
Feb-13	-3.3%	215.92
Mar-13	12.4%	242.62
Apr-13	30.2%	315.81
May-13	68.8%	533.08
Jun-13	36.9%	729.55
Jul-13	-12.6%	637.46
Aug-13	-1.7%	626.31

Another frustrating month, especially in FX where I insisted on selling lows and buying highs again, but things seem to be picking up into September.

Ideas I like at the moment :

1. Long GBPCHF

People are getting used to the the idea that the eurozone isn't going to collapse (yet), but EURCHF is still at historically expensive levels. As CHF will lose more of its safe haven premium it makes it an attractive short against GBP. Obviously there's no net negative carry to speak of, and the chart looks good, as we're breaking out of a 3 or 4 year downtrend. The 1.40 level is good support provided eurozone breakup is off the table :




























It's really a doubly leveraged trade on eurozone recovery, as this is also one of the main reasons for the weakness of the UK economy since 2009. I prefer buying GBP to selling short sterling or gilts as the positioning seems cleaner and I don't want to incur the negative carry in the yield curve.


2. Resumption of the Abenomics trade

Japan still has some of the cheapest equities in the world, especially the megabanks. With very little fuss they offloaded a huge proportion of their JGBs on to the BoJ last quarter (almost half of them in the case of Sumitomo), and they're still on very cheap price/book ratios (0.75 for MUFG) and low p/es around 8-10. Just cheap then. Kuroda's commitment to further easing if the consumption tax slows the economy is important in underwriting the recovery, and USDJPY should be forced higher by rising US yields.


3. Aussie rates

The RBA may be taking a pause or done altogether, but either way the bill curve looks too steep. It's pricing 58bp between Z3 and Z4, and with all the PMIs in recession, retail sales growth stuck at zero and unemployment rising towards its 2009 peak that looks plain wrong. There are plenty of secondary reasons (mining capex cliff kicking in next year, some degree of fiscal restraint from the new govt and poor business confidence, eg the NAB survey). Further cuts next year aren't out of the question, but even without that this is my favourite slowdown trade. It's fighting the US rates headwind, but that's the reason for doing Z3/Z4 flatteners rather than just buying 3yr futures outright. It rolls down from 58bp in Dec to 31bp in Sep.


4. US yields

Last but not least, a Sept taper looks unavoidable now. The interesting question is, what next ? They've stuck so far to Bernanke's timetable (start tapering in Sept, finish by mid-2014), but the domestic data is turning out better than they expected, and the global data is far better. If anything that should bring the mid-2014 end date closer (and please don't suggest that Summers will stick to the schedule because he inherited it).*IF* they start with $10b in Sept, and pause in Oct to see the effects, then they have $75b to remove in at most 5 meetings. Alternatively they could start with $15b or $20b in Sept, or taper again in Oct. Any way you look at it, it's a more aggressive schedule than most people have been discussing, so it seems to me that when the market starts thinking about this on Sept 19th we'll have to sell off some more. Favourite trades here are short EDZ7 (still), covered puts in TYZ3 and FV/WN flatteners, ie 5/30s. And short some gold, just because it's had such a ridiculous squeeze.