Post April 19

Macro View

Here goes round two. Instead of focusing on macro themes, in this piece I am looking at ways to take advantage of the massive risk premia in markets right now, thanks to our friends in Paris. 

Geo-politics have a tendency to garner all of the headlines, but my macro view has not changed much since the last post. I continue to think inflation expectations overshot, which we have now seen in the March data in CPI in the US and HICP in Europe, as base effects took a firm hold. I continue to think the US economy is facing a negative GDP print in Q2 or Q3 of this year. Consumption is slowing as consumers face a third consecutive month of falling real wages with a FICA rise coming, bank lending has fallen off a cliff, velocity of money continues to make new lows, weakness in consumer credit is finally making headlines (delinquencies been rising since q3), and ISM is about to make a big turn lower (shown below). With that said, the market has already began to adjust to a slower growth paradigm, Atlanta Fed has GDP for Q1 at 0.5% and ff has barely 1.4 hikes in the curve for '17. So while I remain in the peak base effects and slowing US growth camp, I would not be adding to existing positions that express this view. Instead, I am looking at geo-political distortions, set on Europe and Italy in specific, case for buying BTPs below. The market has a funny approach to polls in this post fact world. If they show a benign outcome (Macron/Fillon), you can't trust the polls because look what happened with Brexit and Trump. However, if it shows the two volatile candidates gaining ground, perif spreads rip as the market cries about populism continuing its march through the developed world. Either way, only the removal of the uncertainty variable will allow markets to normalize.

First, A Quick Peruse Around Non Italy

2s look pricey relative to ff Curve

Front end seems to be assuming the Fed may get one more in and done for ’17. The problem is, the Fed seems to be getting rolled despite them saying, balance reduction could start this year. Well, under the ’14 Fed statement model and Bernanke’s Jan blog post, we are too close to the lower bound for the Fed to move on balance sheet. I am still not comfortable saying the Fed will shift to balance sheet instead of o/n rates this close to the lower bound, it's just inconsistent with Brainard speech from Feb which seems to have been adopted in March meeting. So, if the market is pricing in a bit over one hike for this year, then b/s is not happening and curve steepeners could go back to bed. I think the Fed needs to get the ball rolling on saving June odds, even just from an optionality perspective. Fed gets back in short end $ rates, pay 2’s or hedge long green ed$’s with front end shorts in ff, v7 is barely pricing in one hike by Oct expiration. The Fed’s policy path is being torn up, they’ll play around before the data fully rolls, pay front end until that happens, not in equivalent size to duration pos though. Would be nice to just put on a 2s10s flattener and hit the beach, but b/s ramifications from Fed getting June repriced should mean there is an effective put in the curve, think the Fed will use that to their advantage for the rest of this year. 


Could be a short in silver also, especially if reals rise. Longs are off the charts

Like Gold better anyway, its outperformance should reemerge (gold/silver cross)



Still a big fan of the India story and its positive effect on gold prices. 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 demonetization. Unlike the developed world, India is actualizing reforms instead of promising them. Will give gold a non STIRs driven boost over next few years. 


Was Chinese growth a false alarm...... Copper curve says yes




A few if so's....

1) back end $ rates should continue to rally (China M2 YoY)




2) US ISM will roll (ISM v iron ore)




3) KRW curve should flatten (2s10s v copper)




GBP curve, duration still looks ridiculous (15y15y v 5y5y inflation swap) 



Probably the thing that keeps me up at night the most, other than the Jets' inability to draft which should be on full display in eight days, is GBP rates. As DM inflation expectations have been repriced, UK 5y5y's remain above 3%. However, the market has priced in an assumption that I clearly missed, the GBP has bottomed and thus inflation expectations should be capped. Another aspect is that the market has realized the Forbes dissent reaction was overdone, Carney is going nowhere, which should favor a steeper curve. I reject the notion the bottom is in for GBP. Tradeable side is weak, ca deficit around 4.5%, rate differentials are also weak around 110 bps inside the $ curve. So, the GBP will rally because May is calling an early election and just ignore its weak balance of payments and dovish BoE? Fade it. Once the GBP is faded, what I like to call the "pound put" is back in play. As the GBP starts to fall again, even on weaker domestic data, the market is forced to price in an inflationary knock on effect in the rates curve. So as the domestic economy weakens and ccy weakens, rates cant follow through in the back end due to this inflation premium, i.e. your "pound put." I am watching a return to 80 bps in 10s, then reevaluate, until then continue to pay GBP rates as a long duration hedge and worthy inflationary fundamentals. 


Can OPEC keep the market happy in the front (m7-m9)

The Saudis clearly want the market to be happy in spot. Obvious reasons for this as we approach local Aramco bond offering and IPO. While the market from my perspective looks to be fully supplied, recent EIA reports show inventory draws are beginning, could be seasonal. The question for me is, for how much longer can the Saudi’s keep everyone in spot happy with US production over 9 mbd and growing? Curve shows, not so much longer....There is also a massive practical difference between now and ’14, US exports have gone parabolic. Market share will play a factor in OPEC extension and time spreads are telling you they will be a big one, especially if Asian demand slows. The market will also have to deal with the possibility of OPEC disappointing, in terms of guidance or action in May. Oil doesn't look like an obvious long to me. 

Case for BTPs

What has become clearer to me in watching in g10 rates is that the best short cases on a credit basis, are actually the very reason to be receiving. Think this is the case in BTPs now. As I noted in the March 22 post, Italy faces a maturity wall over the next 3 years. I.e there is nowhere for the ECB to go in terms of b/s. I bet Draghi fulfills, "whatever it takes". Buy 7y BTP at 1.5%

7y BTP v 10y OAT/Bund

The bet is simple, until Draghi gives over the reigns to Weidmann in '19, Italian rates are capped, creating a decently convex play in the Italian curve. Obviously there is a gaping left tail that comes from Le Pen risk in France. I will not pretend that I have an edge on her chances, but I do think the markets paranoia about her actually winning is what has made BTPs very attractive, especially as z7-z8 spreads in ER have already taken ECB depo hike odds this year to the floor. However, owning BTPs outright into an event, ex ante, that I have no edge on, is not for me. I am looking at some eur/jpy hedges, despite the high cost of vol. Japan is the biggest funders of OATs and BTF's in France, which makes me favor that cross.

Hedge left tail in EUR/JPY

Knock in makes sense as I really only wanna own the thing unless sh*t hits the fan. In Le Pen win scenario, eur/jpy breaks 112 with ease, people dont realize how much the Japanese bought into the bund+ theory with regard to OAT's. Having an out of the money barrier should bring the cost down a bit, its a bit pricey but its not a horrible way to hedge.

 

I have always been amused by the argument that "QE doesn't work." While in a sense its true, Japan's been doing it for ten years at they're still in deflation, US has not had a 3% GDP year since pre crisis and in Europe headline unemployment is still around 10%. However, the question is, what defines "working"? Draghi's QE is meant to solve the problem below, not an abstract relative ideal of having 90's level GDP growth.

"The aim of the wise is not to secure pleasure, but to avoid pain." - Aristotle  

In 10s we have seen over 120 bps of tightening since late summer, not a sustainable trend unless something in Europe breaks. Gov interest pmts have been steady over the past decade between, 4-5%, despite a 35% jump in debt/GDP and a material slowdown in nominal growth. This has been Draghis plan all along. Put up the euros, monetize the curve and let budget deficits narrow without seeing much change in govt outlays (social stability). As there is no escape velocity in DM, spending 4-5% of GDP on interest payments is unsustainable.

Mario's plan

*Assumptions: primary deficit balances and interest payments remains stable at 135%. BTP yields stay in range, maturity profile is constant and nominal GDP is stable at around 2%. (credit to @gmactrading for showing me this)

Interest payments as % of GDP

2017: 3.31 * 1.35 = 4.46%

2018: 2.97 * 1.35 = 4%

2019: 2.73 * 1.35 = 3.68%

Without the current yield environment and what will likely be below trend growth, Italy is crushed under its almost 800B euro in obligations over the next three years. However, if real BTPs are left at zero or negative, Italy will be in the 3% range for interest pmts by the time Draghi leaves the ECB in 2019.

It's do or die for Draghi and Italy (I bet he does)

Someone needs to finance it.....
(Italy net budget balance in orange, budget def %GDP in white)

Vol in red ER is cheap if you want to hedge hawkish Buba 

3m erz8 100.125p (post June ECB meeting expiration) v German PMI

Despite making the case that Draghi is going nowhere, guidance could tilt hawkish in the June ECB meeting as the hawks will be clamoring for a shift from inflation to growth. On the HICP front, post Easter tends to receive a seasonal boost, obviously oil factions are waning but market maybe underestimating the possibility of inflation in core going back to 1%. I don’t buy it, but its cheap. Part of the reason I dont see ECB action this year is, where can they go? If they do depo instead of taper, curve flattens and their precarious banking situation comes back to the forefront. Taper is not really an option given the above need for periphery funding. I think Mario will let it run until Weidmann takes over in '19. 

German 2s10s v Deutsche Bank

Update from March 22 post and position sum up

Been a few weeks since the last post and markets have been rewarding receiving rates and fading growth. Despite recent gains, I would keep, rec MXN 1y1y, back end USTs and Bunds, JPY 10y10y, and CAD 2y2y. I would take off flatteners in euribor (erz8-z9) as ECB has been repriced post March inflation figures. NZD 1y1y, CPI could overshoot and market has taken off any chances of RBNZ hikes for this year. Also taking off flattener in edu7-edz7. Still good options in ed$, but I want to push out, think flattener in u7-z9 still will work despite recent gains. Steepeners in gilts curve continues to weigh as 2s10s back below 100 bps, but I am staying with it as it is natural hedge to long duration bias (expounded upon above). Paying AUD curve has also struggled as iron ore has taken it on the chin, to me, cant see RBA cutting this year so if China is to rebound mid year, paying the front end remains a decent hedge. Now, looking to rec 7y BTPs with a EUR/JPY hedge and short 2s in USTs. 


Thanks for reading