My first go of a blog. Honestly idea came from someone I follow on twitter as a way of sharing personal market thoughts in an informal setting. Written on a plane ride to Israel so excuse grammar related mistakes. Comments are encouraged and welcome. My general macro framework right now is two things 1) we are at peak base effects and oil prices are declining 2) US econ should print a neg GDP print in Q2 or 3. (can go over model assumptions on request) With that said here are few things I’m looking at.
MXN trade is now in rates
Sent this out a few weeks ago, but since MXN has rallied so much, makes sense to make the transfer to rates now. MXN curve still needs market to rip out the 65 bps in ff curve, as Fed beta is extreme for Banxico. Given my macro take, especially on the U.S., hard to see the Fed getting 2 more in. Receive MXN curve as fx pushes down inflation and Fed pushes up fx. Since vol is cheap can hedge in usd/mxn puts. More detailed case below.
(from a feb 15 email)
⁃ Key to the thesis is the U.S. not Mexico. Not really on the radar, but I think we print a negative GDP quarter in the U.S., probably Q3 (my model). Mexican econ is famously correlated with 80% of their exports, U.S. bound. So any U.S. economic weakness creates a two fold move in Mexican rates. First, Fed backs off and dollar-mex sells off. Second, MXN curve is priced for 50 bps by themselves and whatever the Fed does over the course of this year. A U.S. negative GDP print sends Banxico into cut mode. Given the respective OIS curves, it seems that the best risk reward in playing US econ weakness is not in the U.S. but in receiving Mexican rates. Does the Fed cut 100 bps, no, but Banxico very well could.
⁃ Inflation is running hot but most of it is fx driven (CA def -3.3%) and weak yoy comps. Gasoline and refined petroleum is the biggest import (6% of total) and oil was 26 bucks this time last year. The fx side is tricky with Trump, but yield differentials remain a buffer, and a Fed that is lighter on hikes (I expect), stabilization in the Peso will occur. This should move headline inflation back towards 3% (Banxico target), but as I said, very current account driven. Internal consumption numbers including food, which was 125 bps lighter in Jan, do not point to inflation remaining hot if exchange rate gets under control.
- Given the move in latam yields, MXN shouldnt behave like a funder. Brazilian and Colombian inflation are in free fall, with aggressive easing from those two countries, real yields in Mex are in line. And on a PPP basis, ccy is cheapest it has been in 5yrs.
- US FDI was falling pre trump, $3 billon since '15. Of course a 40% reduction in FDI is a risk as that it is how they fund their current account deficit. Still feel given massive labor comparative advantage, FDI will “survive.” Pick up in Remittances, 2% of GDP, will also be a money supply story as Mexicans in US use 2017 as a year to “prepare."
- FX reserves are light at $167b, especially as percentage of external debt, so Carstens is a bit hamstrung and that is probably why he is being so aggressive with rate increases. Hes still scared Fed will move +3x, in mid year that will calm itself. So he probably goes again 25 bps in March, following the Fed.
Base effects in inflation peaked in Feb (WTI YoY%)
Data will break the u7-z7 range in ed$s
Big ed$ level, looks ripe for the break, don’t think fed speak is enough to overrule pending data, but we shall see. big gap to fill if the market goes to 50 bps in ff curve. UST's should follow breaking through 2.32 support in coming weeks. C&I bank lending slowdown, utilization rates, negative real wages and disposable income, slowing velocity of money supply and worsening credit card writeoffs, draw a picture of a neg GDP print. Likely q2 or 3.
Shorting gilts looks like the best way to hedge fading inflation
Distinction in UK inflation is fx due to massive current account deficit. Input cost push may wane, but feedback loop makes it hard for exchange rate to remain stable. BoE likely on hold with wage pressure soft, GBP rallies will be faded. W/o GBP rally, nominals will struggle to reprice elevated inflation expectations. GBP range will remain in check as 1.18ish range means rates sell off and interest rate diffs will eventually support it. Given 5y5y, CPI, and a cost curve that is 70% imported, inflation adjusted gilts seem to be the most expensive sov rates in g10. Fade that through steepners or swaps (15y15y) as BoE will go purposefully behind the curve. Hawkish Forbes is gone in June and her dissent is not as meaningful to me.
JGB curve a bit ahead of themselves, 10y10y 120 bps over cash
Have to think Chinese credit creation is unsustainable and with rate diffs going lower DM, BoJ is not going anywhere. Now with Kuroda looking more likely to get another 5 year term, this trend will reverse. Think the perception that the BoJ is at max is flawed. Same logic dictated they were at table max 3 years ago. Not sure I would play the back end in cash or in swaps, just a general observation that backdrop which fostered the perception of a taper seems unfounded if Chinese credit growth slows and the fickle Yen rallies back to par, which to me looks pretty likely. But, owning Yen is somewhat of an extension of rates and gold, which I like a bit better.
CAD curve lagging crude
A bother some chart at the face, despite CAD curves beta to the Fed, secular debt backdrop, housing bubble and now falling crude should have flattened the CAD curve. Think receiving CAD makes sense. Oil could hang onto this risk range into Q2 as the Saudi’s and their local Aramco IPO gives them every incentive to do so. However, oil looks to be in structural in trouble until LIBOR rises and shuts off shale financing. As OPEC has learned price IS irrelevant. BoC going nowhere, retail sales will fade as structural debt levels make it hard to see sustained consumption growth.
Paying AUD curve hedges China upside
Prevailing consensus is that the RBA is on the sidelines for eternity as secular variables such as private, HH, debt/DI all remain at nosebleed levels and a housing bubble on par with Canada’s. To add to that, wage growth has slowed and employment participation rates have worsened in recent weeks. However, to me, AUD curve looks more levered to Iron ore, since Iron ore also has beta to the DM curves that I want to rec, paying the AUD curve seems like a decent hedge. Hard to gauge China’s supply side reforms but if they are limiting iron ore prod while continuing with around current levels of steel demand, RBA will be looking at very different econ in the coming months.
Another fact that plays into paying AUD rates is what makes gold interesting, strong India and "improving" China supply side. In India, there has been massive reforms put into effect over the last few years. Digital ID system, the reform of the tax system, and now demonetisation. Gold works in a strong India environment.
Bobls and Euribor seem China driven (China PMI)
Kind of always had the feeling that “reflation” was China thing, its almost that simple. Of course oil is the price factor, but also a China derivative to an extent, what gave the OPEC cuts legitimacy was a pickup in demand, which was thought to be unlikely given that China was playing the contango in storage. Selling Bobls and having Euribor steepenrs has been a trade missed despite its carry. With that said, ECB could hike rates in depo and continue to have their stealth bailout of perif until Draghi steps aside in ’19. Hikes and no taper should flatten German curve. Further, if China rolls, bobls are dramatically underpriced, compounded by EU vol that may play out. Still think flatteners in Bunds or rec bobls make sense. Consensus smart money is levered short bunds, levered because of inflation overshoot. Feels transitory to me and fundamentals (if priced in Deutsche Marks’s) give them a strong base, like an 8% current account surplus. Still like tsy’s more as the China variable is proving difficult for me to price (money supply distorted by cap controls). If credit growth in China slows, as Shibor and rate increases in the MLF indicate, bunds have more China beta and will outperform treasuries. At the end of the day, the thing leading Mario is China/oil, as it has for Yellen as well, even if they don’t know it. Fading bunds selloff gives you both of these inputs.
Draghi wont let Italy face this wall alone, issuer limit extension a cometh.
Why MYR lagging EMFX
Was my favorite fx short in the depths of December, as I did not see a stable resolution to dollar funding markets so felt like I needed some long dollar exposure, but didnt turst sustainability of rate diffs. As fra-ois has come in and xccy’s have tightened, the need for dollar exposure has come down. However, it seems that the decline of Treasury cash balances has eased dollar funding for now, post debt ceiling this could change, worth watching for dollar bears. As I think rates are headed lower, strong dollar thesis lacks luster. Think g3 policy divergence was a large driver in Dec, and the tradable side is still weak even with recent current account data. However, still think MYR has room for continued relative weakness.
- exports to china =8% of gdp and natural spill over with high beta correlation to CNH. If dollar does go higher (dont think so) market will always first punish currencies with poor fx reserve adequacy (assumptions are made based off of IMF standard measures)
- Since 2013, MYR's fx reserves have gone from 45 to 33%.
- As a percentage of short term external debt, MYR's fx reserves are where Thailand was in '96, only 1.2% coverage ratio. For context, stronger ratios include Russia and Brazil which are +6.5%.
- Fx reserves as a percentage of risk weighted liabilities ( exports, short term debt, medium to long term debt liabilities, broad money). The IMF says a ratio of 125% shows adequate reserves, MYR is at 110% while every other Asia EM is over the benchmark. (See below for another adequacy perspective)
- 50% of local bonds are foreign owned. Capital flight, could be swift in event of Chinese deval, which will worsen the outcome for MYR. Will be tough to defend currency in this event as external debt to fx reserves is 187%.
- Currency weakness will accelerate as current account surplus continues to narrow. CA was +6% in 2012, it is now half of that as of Q3. Exports declined -8.6% in Oct. Shows how levered MYR is to China, 30% of exports go to China, Singapore, Thailand. This is leading to considerable domestic weakness as PMI's are showing contraction with last month's at 49.4. Keep in mind, this is happening while Global PMI's have soared.
RBNZ looks to be on hold, TWI kiwi puts them in a difficult position, inflation seems pretty stable at 1.3%, and retail related consumption seems to be trending lower. Decent beta to the RBA, but it looks like the curve overshot.
Copper move seems largely supply driven (CLP inv)
I am skeptical the copper move is much more than supply disruptions in Chile and Indonesia. Divergence in CLP confirms that point. CLP could be another attractive short with CB cutting and copper likely moving lower in Q2 with Chinese SOE investment slowing.
As one of my macro heros, Russell Clark would say: "your fund is long bonds." But in my case (no fund just sharing), with some idiosyncrasy. Pay long end GBP and some front end AUD, as a hedge to possibilities that China’s supply side and capacity reforms are legit and gilts offer strong relative value as a short, given inflation overshoot has an fx lever there.
Sum
- back end UST's, US econ neg GDP print coming in Q2 or 3 (FICA raise goes into effect)
- rec 1y1y MXN
- pay long end gilts or curve steepners
- rec bunds or flatten curve vs paying AUD 2y2y (carry problems hurt this concept)
Thanks for reading
Thanks for reading
