Vale for now: Neutral Rates, "Symmetric", and EURGBP

I think there are a few interesting things happening that could make the summer quite exciting.

1) Talk of higher neutral rates is deafening. Dudley is entertaining a 3% r* in the US, even in Europe despite this slowdown in economic momentum, Coeure gave a fantastic speech (no surprise there) on the possibility of a reverse hysteresis type phenomena. Given this context, there are some interesting trades in the ER complex and EUR rates. In general, the market is clearing out short vol positions one by one. First US equity vol, then EM via USD, and next will be vol in EUR rates.

2) As I have been writing to a few people recently, there is an interesting dynamic going on between the ECB and Fed. Basically, given the Fed's desire to get to neutral in the face of this fiscal juice over the course of this year AND next, and an ECB still crushing global term premia, we are in the midst of a persistent flattening of the US yield curve. I wanted to suggest that as front month ECB implieds begin to steepen again after this softening of inflation, you could actually begin to see the US curve steepen. I had thought this could create a favorable dynamic for being short EURUSD or long USDCHF. The thought was, either the ECB continues this dove loop with its continental peers (Rix, NBP, etc) or they actually end up giving the Fed more scope to hike by beginning the process of allowing the forwards in the curve to start removing at least some of this term premia crush. Effectively, a term premia transfer from the steeper EUR curve into the US', especially as the ECB can ill afford the end of the Feds hiking cycle. The trade has worked, however, neither really has happened. Yes, the ECB still seems like the key central bank player in terms of dominos, but I believe this "either or" to quote Kierkegaard, can be expressed differently. Long EURGBP.

3) The reaction post the Fed's May policy statement was all about the usage of "symmetric." My first interpretation was, so what, Evans has been talking about this forever and even a likely 4 dots guy, Williams, has been talking about it in the context of his desire for price level targeting. So what's the big deal? I am now beginning to think the market reaction was actually more interesting then the usage of the word itself. Using it twice was purposeful, the Fed knows inflation will likely run above target in the coming months as one offs continue to drop out. Given where the yield curve is, and the desire of the board to have a balanced hiking cycle over the next couple years as fiscal keeps us decently above potential this year and next, this seems like an explicit attempt at steepening the curve. The problem is, the curve didn't steepen, in fact, we are back at the lows...... So what does this mean? The Fed showed their hand, and risk in equities and credit have ripped, which means it could be time for some bottom picking in EMFX.

Trades: Long ERZ9ERZ0, EURGBP, vol in bunds. Also, a no touch in USDMXN

Reverse hysteresis and forward guidance, steeper reds/greens and vol in rates

There are two key elements to this trade, first is the role of FX, second is this possibility of a reverse hysteresis in the face of a loss in near term economic momentum. The two are obviously interconnected so well look at it in one shot. Since the beginning of the year there has been a well documented loss in economic momentum in the Euro-Area. In my opinion there are a few key contributors to this. First, China clearly slowed, surveys, M1 and the LK index all point to a weaker first quarter. The balance of how much more softening regulators will allow, maybe not so much given the RRR cut, and the seasonal contributors related to the new year, is likely key. With that said, given EUR economic beta to the Chinese machine, a softer Q1 in places like Germany makes a lot of sense. External demand is still the key marginal driver of growth, China slowed and the EZ felt it. The other element is domestic factors. However, the ECB has been quick to come out talk about the temporary nature of the slowdown. Especially in inflation, we have seen people like Praet suggest it was temporary factors related to, the cold winter, timing of Easter, labor strikes and even the early innings of capacity constraints in the capital goods sector.

In my opinion this is where the opportunity lies, especially given the current backdrop. Praet's super core measure is running higher than current HICP readings. This means, stickier factors do seem to corroborate the ECB's stance that there are little signs of a material softening in domestic demand. Brent has ripped to almost 80 bucks, EURUSD is basically back at ECB staff macro estimates, and China is trying to re-up liquidity; all at a time that stickier components of inflation are largely behaving as expected. This could be why the market hasn't really budged on aggregate ECB hikes and has just pushed them further out the curve. Looking at Z9Z0 in Euribor is very interesting in this light, especially if FX signaling is such an important variable. ERZ9ERZ0 basically can't trade materially lower on further economic weakness and has a lot of upside to a mean reversion in CESI and the chances of a higher neutral rate (which I will get to). If the data will continue deteriorate as external demand does not pickup, EURUSD will continue on its path to 1.15 at a time oil has absolutely ripped, this means reds/greens have to take into account expected value of rising inflation. Or, this loss in momentum really is just "temporary", which seems to be the ECB's version of "transitory." This is what EUR duration also has to take into account, which makes me think Sintra type fireworks are coming to bunds and buxl as vol has gone to ridiculously low levels. If further econ n/t weakness is priced in FX, duration has to discount an increase in inflation expectations given oil and EUR moving at once. The asymmetry in shorting EUR FI looks pretty decent. This is all at a time scarcity may force a July decision the ECB may ideally want to avoid. Then there is the increased chances of reverse hysteresis kicking in and the limits of forward guidance which we can now get into.

The reverse hysteresis aspect is quite interesting and will play a key role in my FX idea below. Coeure in his speech last month noted that weighing hysteresis on general potential models has proved to be very tricky to flat out wrong in the post crisis world. What we are seeing more and more of is, potential just seems to move with cyclical fluctuations of aggregate demand. This means, in the post crisis world, we are too often confusing "scratches for scars." The ramifications of this for policy is quite interesting. Coeure of course only addresses it within context of current ECB stance, however, it does open door for some interesting hypotheticals especially in the current backdrop. What could happen is, as growth picks up again and inflation gets back closer to target, the market will have to take this idea much more seriously and likely add a lot more ECB hiking scope; maybe r* is more positive than we currently think......  The added part is, Draghi was asked about this in his most recent presser, and instead of entertaining a temporary overshoot in inflation, he opted for the higher neutral rate answer. If he wanted, that could of been an clever way to further the EUR sell-off and he didn't take it. All of this makes it hard for me to be EUR bearish, in fact, quite bullish in some crosses in spite of the steep fwd curve.

On forward guidance. The BIS did an interesting paper recently on forward guidance and the signal value of markets. Going through the references I saw a Coeure speech from last year that I slightly recalled. Given his recent stance and the worries he has re overextending the current forward guidance framework, it was interesting to go back. In that speech, he quotes an interesting Stein paper from 2015, on the time consistency problem with gradualism. The context of this for the ECB is of course on the current forward guidance stance acting as an anchor on rates vol. Constancio has explicitly said the biggest thing that scares him is a rates tantrum. The problem, as Stein notes is, a policy with the primary goal of controlling rates vol won't work over the long term, especially as their assessment of the progress of inflation evolves. Stein coins this as a problem with gradualist equilibria. Coeure is worried about the role it will play in a reaction function sense as the economic assessment evolves. Over the next few months, the ECB could not only be facing scarcity in PSPP, but also reaching the effective time limit in its goal to keep rates vol completely non existent through its current forward guidance framework. What's worth noting is, these things could very well end up happening at the same time.

EUR rates have to deal with inflation that can really only go one way from here at a time both the APP and current forward guidance framework seem to be closing in on their respective limits......
Summer fireworks are coming.

This all should mean EURGBP goes higher



Part of my issue in the last post was my lack of respect for geo-political events, especially in Russia and the Korean Peninsula. Given the fairly poor political dynamic in the Euro Area, it seemed like a good idea to use a cross who's political economy is just as shitty. Brexit is a soap opera that continues to weigh on UK sentiment, especially on the investment side, and the possibilities of an election being called this year are likely real. Of course, politics is not the reason why I like this long. If you recall, from last post, my -USTs+Gilts idea, it is quite similar. I am playing the chance that the respective equilibrium neutral rate is going in the opposite directions for these two economies. What seems to have happened is, sterling got two key things that have now changed. First, the BoE was able to establish a bid by convincing the market of a steeper SONIA curve through forward guidance. Watching short sterling implieds go from 90% to no May hike, puts a big dent in Carney's ability to  establish meaningful scope over the forecast period. The other element was the general tide of liquidity emanating from the Chinese fiscal expansion that fed the world in 2017. Now, survey sentiment is dropping rapidly, capacity is tight, inflation is falling faster than the BoE originally thought in November and Brexit refuses to leave the headlines. A cyclical change in expected potential does not look likely in the UK.

The other element of this trade, and what makes it in my opinion quite asymmetric, is the ECB-Fed dynamic I was talking about in the beginning. Basically, we are in a place where the ECB seems to be in control of how much Fed scope we can have given the effect of QE on term premia. What seems to have happened is, the loss in Euro-Area economic momentum pushed off ECB implieds further out the curve. In turn, we got a higher probability of a APP extension into next year. This creates a tricky dynamic for the Fed which is de facto relying on the ECB to get on with it to help get term premia off this crazy low level. So ECB implieds in whites go to zero, US yield curve forwards cant price any let off, and the relentless flattening continues as the Fed goes with the dots. So the question is, is this situation becoming quite binary and if so, how does EURGBP win either way.

The most likely situation to me is, contrary to current market pricing and sentiment, over the next few months, the ECB hiking cycle could actually be priced earlier than current the EONIA curve suggests with APP going through a more serious wind down. If that is the case, Euro should explode against sterling as the market dynamic of last summer looks set to return; doubting the BoE and a further deterioration in the political economy. However, lets say the other possibility, which is quite high in a probabilistic sense, occurs. The ECB has no let off as inflation remains subdued, the Fed keeps going and US 2s10s is 0 by year end. In that case, the market has to price the end of the Fed hiking cycle at a minimum and at max price a recession a lot more seriously as this will likely coincide with global growth that looks more like Q1 given that the ECB couldn't move. The UK economy, which is already at/near potential, likely is the first to go into recession and BoE has to cut, all while DFR is still stuck at -40bps, the ELB, and FX has to price it....... The other element of course is relative neutral rates as discussed above. In my estimation it seems likely that low potential in the UK is here to stay for now and the Euro Area economy may actually have a steeper hiking scope than is currently priced or expected. Given the asymmetry in my view, a 1y parity one touch, which currently trades for 13.5, makes a lot of sense. Given how steep EUR fwd curves, stuff in exotics is not that exciting, which may mean riding spot is the best option. However, I think given the power of these dynamics, this thing could really begin to move.

Back to the Fed

As said above, the Fed's communiqué from the May statement seemingly failed. The combination of adding emphasis to "symmetric" and having hawks like Mester come out and say gradualism should be the approach even in the face of overshoots in inflation from target suggests, the Fed is making a conscious effort to get the curve steeper. Fiscal is going to juice this year and next, and they want a balanced hiking cycle to keep it in check. However given current curvature, its hard for implieds to price much in scope given the fact the Fed wont move at inversion. Now, the Fed is really showing the market they're paying attention to the curve and seemingly cannot control it. This means, the market now knows the Fed will struggle to add scope to implieds even in the face of higher neutral rates and this massive fiscal boost. This effectively means a forced elongated stay at "policy is still accommodative" in a relative sense; risk assets have taken note of this as spoos have broken out. Given my opinion from last time is unchanged re the effect of fiscal and trade serving as the reverse QE, I am not bearish USD as the scope may exist, but it does mean I struggle to see how a swift 2014 type move could happen. If that is the case, some of the punishment in EM looks a bit overdone. Dollar Mex 6M 20 no touches trade for 25. The Fed will struggle to establish hiking scope until the ECB moves, this gives us time in the n/t for a swift move lower in USDMXN. This is the shortest time horizon trade, but the move could be quite swift. Expiration does encapsulate the July 1st elex, however given AMLO's 20pt lead in the polls, it looks like politics may only be tailwind. The other element is, NAFTA. Does Trump really want a two front negotiation while he deals with China, I doubt it. EM liquidity will begin normalize as public external balance sheets are not nearly as bad as '14. And given the above factors, MXN looks like it should be one of first beneficiary.

End on a longer term story, rebalancing in China 



What has really interested me over the past few weeks has been the relative strength of Asia FX given this broader rally in USD. Part of it is political given the promise of denuclearization of the peninsula, but there seems to be more. Another striking economic development this year was seeing China's current account go into deficit. Of course a lot of it was on more temporary factors such as, tourism related spending and a decent swing in the goods account. However, this move in the external account does seem to jive well with China's broader goal in getting consumption as a much higher percentage of GDP. In the face of this rather large move in the current account, a big compression in the front end spreads v US rates, USDCNH has not done all that much since the end of March.

Now we can look at this from the broader structural setup of the global economy. China in its quest to become a more consumer centric economy, at a time the US is trying to get manufacturing as a higher percentage of its output. The facilitator of this is a relative rebalancing in the exchange rate. To go along with this, China wants to issue for BRI in yuan. So someone has to finance this deficit through the capital account and contribute to the sprawling belt and road initiative; GPIF can do those things. It is very interesting that over the past year, in terms of JPY/Nikkei correlation, CNHJPY has better r^2 than USDJPY.

This relative rebalancing of output composition of the worlds two largest economies has wide ranging ramifications. First thing that comes to mind is term premia, as the recycling of Asia trade surplus' is slowed. This is why having a short yen element makes a lot of sense in this structure. So the way to play this longer developing story, which seems to have already begun, in a highly convex way is maybe through a 2y 20 one touch in CNHJPY. Fwd curve is very giving for betting on CNH strength, especially against yen. Which means, this relative economic rebalancing which will likely occur most through the exchange rate, you can own at 15:1 payout.

This will likely be my last post for a while, thanks for reading and for all of the engagement.

jonturek@gmail.com

Macro Is Back: Oil, USD/Asia FX, LOIS and TY/Gilts

Hope all is well. Markets have had a very interesting start to the year. Positioning has started the year kind of lopsided, despite sound reasoning. I don't think it is too contentious to say that given that fact there will be a pain trade in the next three months. I don't claim to know what it is, but to me, the cheapest way of expressing it is in a few USD crosses. Is USDJPY still going below 100, most likely and I continue to like that short from previous posts. The problem I am now grappling with is, what is going on in China? LK index shows GDP has come in, Asian trade data for Q1 has reflected that and housing prices look set to continue to fall. Yet, CNH remains pretty strong and imagine if we get a hedge bid from exporters, policy is accommodative and iron ore is near its highs as continued capacity cuts have been a big boost. So ya, I have no idea whats going on, but other than short USDJPY, you can balance out a book that I think over the next 3-6 months is decently convex in terms of narrative and fundamentals. Given this confusion, it makes sense to have "confusing" trade ideas. I think given near term potential for an acceleration in Chinese industrial sector deleveraging while we continue to see manufacturing upside in the US economy, I want to be long USD/Asian FX, short CHFJPY and synthetically long crude upside by being short USDRUB. USD is either dead, or we are due for a further technical bounce and Asia FX is the best r/r way of playing it as CBs there have effectively said this is as much strength that we are willing to tolerate. I have no idea if the USD is set for a reversal bid, but I do know USD/Asia vol is cheap given the current geo-political and economic backdrop. The same can be said for oil. I don't know if crude will trade choppy or not, but to me, given the current move in the US manufacturing sector, the right tail is being underestimated and RUB seems like a good expression, given their domestic cyclical uptick and very cheap ccy given improvements in terms of trade. Then finally, in all of my strangeness we get from the current widening in LOIS to being long TY/Gilts wideners. 

Hope you enjoy, and I look forward to all of the feedback. 

Oil upside in being short USDRUB

While the extended long positioning in crude is something to worry about, I still think the shadow of shale has blinded everybody's (IEA, EIA) vision about supply/demand dynamics. US has gotten to over 10mbd, its true, but the structure of the oil curve is sorta saying so what. The other 90% of global production is not keeping up with this pretty robust move in demand. Demand estimates seem soft if the US cycle has one last hoorah in it thanks the current policy stance. US makes up a fifth of global consumption and demand is at the highest its been since 2011. Despite this, the assumption is the right tail in oil is unreasonable given shale growth, effectively capping prices. But what if it disappoints, and pretty much every supply/demand dynamic is suggesting higher prices. Basically what I am thinking is, understated US demand and continued reduction in inventories may mean another big leg higher in crude, as we usually see at this stage of the economic cycle. What if oil trades to 80 bucks a barrel as IEA and EIA estimates of crude surplus' are off. As I said, the longs are overextended in crude and I am not playing for a few bucks of upside, especially into refinery maintenance season. A cheap way to play the right tail in crude is RUB. FX forwards continue to price a disaster and persistent weakness but to me, its a decent late cycle story. The combination of the return in domestic purchasing power as CBR easing cycle leads to pick up in private sector lending, means economic velocity should continue to trend higher. And, the CBR still has a lot to do with RUONIA up here given how low inflation is. An easing cycle in the middle of a broader cyclically led commodity rally should be RUB positive, and given the flexibility from cheap RUB (REER in mid 80s), they can win in price or volume, as we've seen in Wheat in the past 16 months. A 9M 48.50 USDRUB one touch trades for around 2.5. Which means you can effectively be long the right tail in crude at a 40:1 payout. 

Long USDKRW and USDTWD

My thoughts on USD are two fold as of now. First, The market has spent a lot of time focusing on the current account side of the currency, and not enough on monpol side. While we're all worried about twin deficits, the calendar '19 box in EDER is almost back to zero. To me, this means its time to look at structures in long USD/Asia. The combination of a technical bounce in USD and the possibility of worsening Chinese data means vol is too cheap. The reason I like USDKRW or USDTWD is the innate asymmetry, as the respective central banks have basically told you they will not really allow any further upside, we saw the BoK in there at 1050. The combination of a near term soft patch in Asia macro along with the current trade rhetoric from the White House, puts these mercantilist economies at risk. Recent JPY strength v ADXY ccy's is usually a decent indicator of pending ADXY weakness. Upside is pretty cheap and downside is well defined by CB intervention, like we saw with BoK at 1050 and following steepness in front end rates as 3s5s jumped to over 30bps. These crosses can bore you to death, but if it is at all possible for the  USD to get a meaningful reversal bid, it will manifest here.

USDTWD 6M Vol



There are a confluence of potential issues which make USD/Asia vol too cheap given problems mercantilists will face in the near term. First, of course is the potential for the further deleveraging in Chinese industrial economy, now that XI has been able to secure power for life. Recent PMI's were soft but the Chinese New Year probably had a hand in that. Second is, the recent White House rhetoric re trade, Korea and Taiwan fit the "cheater" bill, especially as Navarro and Lighthizer take on bigger roles. These econs are effectively just beta to the global business cycle as around 50% of their GDP is from exports. If the market is going to price trade war escalation, a good way to capture the short globalization theme is in being long USDKRW or USDTWD. Third, a Fed that hikes 4x this year while BoK sits on its hands, actually creating real carry. By being long USD/Asia you can be short globalization and long US economic outperformance v RoW, something that looks quite likely in the n/t, with effectively an implicit beta to broader long gamma. In these crosses you're long all of these potential near term narratives at a very well defined risk reward level. 

Short CHFJPY is Similar 

In a derivative sense, this is a similar structure to the ones above. The Euro Area economy lags the Asian business cycle and CHFJPY lags ECB implieds. Given the current commitment to forward guidance and the number one policy risk being a taper tantrum, according to Constancio, the EuroSwissy curve despite its recent compression, is likely still too steep. The point is, I can fade Euro Area STIRs, which have come in a lot, in this cross and get more JPY exposure all at once. I've made the case for JPY in the last three posts, specifically from a flows perspective, and the policy side changes are only beginning. Recent BoJ moves to me is Kuroda saying, we will do this on my terms, but at 1% inflation and an economy that is reliant on FI income flows, the current YCC range is too low. And if Draghi continues to whack ECB implieds following in the footsteps of his friends at the Riksbank (don't fight Ingves), and the BoJ moves closer to hiking YCC, a 3M 108 digi for 10 is a decent play. Basically, European CBs are in a dove loop where everyone waits for the ECB but Draghi and Constancio watch the Rix and CEE CBs whack hawkish pricing despite inflation being at/above target, and EZ core is still very low. Yes the recent Coeure paper, which was a tour de force, suggests given stock v flow, the GC should be less afraid of ending purchases and forward guidance will keep rates well anchored. With that said, given how low core HICP is, Draghi will likely punt that risk as BE's fall. Basically, being short this cross is long the BoJ making a significant move before the ECB. We know the ECB will have to make a language shift soon, but until we see a meaningful move in the Praet's super core measure, ERH0 thinking we will get positive EONIA before Draghi hands it over, still seems a bit aggressive. The chart looks bad and the JPY move is not done yet. Remember, the BoJ is still in a place where either the global economy continues to chug along and inflation forces them to move, or the Asian biz cycle is led lower by slower industrial activity in China and JPY lags a rally in rates. The BoJ has a massive effective short gamma position and the market is moving away from that, as the GOAT (PTJ) recently said, the last few years were a 5 standard deviation event. I don't mind betting the BoJ will be on the wrong side of the new paradigm markets are entering. 

End on LOIS, r*, Cash, and why the UST/Gilt Widening will Continue

My mentor told me that if I am going to write again soon, which I am grateful so many of you have reached out asking to me do so, that I should talk about the recent move in LOIS. I am not an expert on the intricacies of the LIBOR market, as will become clear, or the potential shift away from it. However, what has interested me is the fact despite a real tightening in USD funding, the dollar hasn't really budged even in cross currency basis swaps. So what has this move LOIS done other than juice ED$ shorts, as JPM estimates almost 50% of your pnl in short whites comes from this widening in basis. I hear, a popular narrative on the sellside is that the culprit is treasury bill issuance. This makes a lot of sense to me as public supply, especially as it has been in bills, crowds out private debt such as commercial paper (CP) and asset backed (ABCP). Fortunately, the academic literature on front end supply and the demand for safe assets is quite extensive. Much of this of course the case because of Jeremy Stein, and his quasi attempts at least in the literature to have the Fed's balance sheet replace bank debt for STSI (short term safe instruments) for the sake of financial stability, think of his Jackson Hole 2016 speech. "In particular, if the relationship between public and private short-term debt issuance is causal and robust, greater provision of public STSI by a central bank may result in smaller issuance of private STSI and lower levels of associated liquidity and maturity transformation, potentially improving financial stability"(Stein 2016, not JH speech). The merits of this argument I will not get into, but I think his work and subsequent papers on this topic have a lot of practical manifestations with whats going on today. As government budget deficits have come in and net issuance in the developed world has gone negative thanks to QE, the worry was that there was an insufficient amount of short term government debt in funding markets creating a "safety premia", which the ECB talked about in March of last year in a working paper (Golec Perotti 2017). Basically the combination of the ELB and the reduction in net bill supply led the market to substitute it with ABCP issuance as money demand is quite high; a substitute which has always scared central bankers. However, in the US, this is now reversing as the government issuance at the front end is increasing leading to much higher yields in tbills which will crowd out ABCP issuance to satiate this "money demand", even lower it. Adi Sunderam from Harvard has a great paper on this topic where effectively qualifies this "money demand" as a negative correlation to the tbill-OIS spread (Sunderam 2014). Effectively, increased tbill issuance means higher tbill-OIS spread and lower money demanded. This means the need for private sector debt substitutes logically falls. We also know from Stein's original paper that the lag of private sector issuance following an increase of tbill supply is usually in weeks not months. We also know, elasticity in bills to supply is the highest relative to other parts of the UST curve. Which is why it makes sense this blowout in basis and hints of slowing CP outstanding has happened so quickly. It is also important to remember that this is happening as reinvestment is slowing, reserves coming out. 

(January 2001 to July 2007, Sunderam 2014)

The question is, is this jam in LOIS just the market adjusting to this changing reality or is there real interbank lending stress. To me it looks like the former as there has been limited spillovers in XCCY and TED spreads. With that said, by boosting the US economy with this fiscal impulse at full employment, paradoxically, the broader fiscal policy has likely tightened financial conditions "forwards", so to speak, (I really make up nonsense sometimes). But really: first, the delta change in the short term funding space is becoming significant, the optionality of cash relative to asset valuations is probably the highest its been since the GFC, and third, fiscal may have mechanically raised r*. I know the latter will be quite contentious but to me, it seems possible even if the fiscal multiplier on output is low.

USD 5y1y - EUR 5y1y

Lets use the Bullard assumption from his presentation two weeks ago on how low r* is. He econometrically decomposes it as simply: labor productivity + labor force growth + desire for safe assets (negative number). So what is the case that recent fiscal measures have actually mechanically even if not explicitly (higher potential) raised r* via the third input. This is quite hypothetical and is backed by little empirical work, but is an interesting thought experiment even as the Laubach Williams model suggests r* has not really budged. 

The HQLA shortage has been well documented and is a side effect of Basel III and the actual shortage of government paper thanks to global QE. Basically a historic structural bid for gov't paper has been met by lower net issuance. The question is, to what extent does this new fiscal paradigm change that picture, if at all. Well, its likely through three channels. First, STSI demand, or the reduction in safety premia should occur thanks to over a quarter trillion of front issuance, just last week. From repatriation holiday effects, US companies needing to hold foreign earnings in money equivalents such as bills, can be lessened. Third, if trade wars escalate and the reserve status of USTs is further challenged, that removes, or at a minimum lessens, a key source of structural demand as surplus nations recycled in USDs. The point is, all of these fiscal knock ons suggest the possibility that third input in Bullard's r* deconstruction may be slightly less negative. Then there is the Fed's balance sheet part of the equation. In the beginning of 2017, the board did a model of how SOMA changes would effect term premia out until 2025, when the balance sheet is only expected to account for 15% of GDP. For the first few years, the balance sheet runoff was expected to account for a 40bps increase in term premia. Interestingly, Brainard speech from September of last year said, the rule of thumb is that the increase in term premia will lower the short neutral real interest rate. This is why Bullard famously last year suggested doing balance sheet instead of hikes. Anyway, what the Fed model did not anticipate is how this massive front end loaded supply of government paper would possibly outdo the effects of QT on term premia..... 

In sum of all; the US economy is running hot relative to potential, or r* is slightly rising. Either way, that means hikes are coming....... Kaplan used language recently which shouldn't be lost on the market, he said the Fed should get started on tightening policy. Having some long USD exposure (despite it being a POS) and short USTs makes some sense, as I will explain why I like USTs to continue to underperform Gilts. Being short ED$ is functionally a LIBOR call at this point. Ya I think the Fed could hike 5x by March '19, but will basis narrowing eventually crush me? I like the risk reward in playing Fed hikes better in having some USD exposure in asymmetric crosses and in being short TY/Gilts.

TY/Gilt widener

The best expression of this trade may in fact be in relative curve trades like in 2s5s, but I will keep it simple. Simply this is an economic divergence trade that will be enhanced by a BoE that looks poised to overstep. Firstly, I think that as the broader spillovers from China's recent credit expansion recede, we will begin to see which economies were swimming with the tide and which the tide was just carrying. Second, the BoE policy path screams for a flatter curve, especially if the right tail in oil plays, and non core price pressures remain elevated. So whats the BoE's play as we know the case for lower TY, everyone has that trade on. The UK economy looks like its chugging along, and since Carney took potential down so low, it is possible spare capacity has been taken out. So even as sterling effects from Brexit will drop out, in theory, core domestic pressures will slightly offset. As I've said in the past, Carney is not scared to move and since the summer, has been very committed to bringing inflation to target. However, what he really wants to do, and is doing with his forward guidance of combining "limited extent" while also suggesting that hikes could be earlier than is currently being discounted in OIS is, he is effectively hiking in spot and easing in the forwards. Which is quite elegant really. The problem is, PMIs are slipping, investment still sucks and city house prices are beginning to fall. Hiking twice this year will remove a healthy chunk of future growth potential which should be long end positive. Carney is thinking, lets juice sterling while we can and naturally ease (limited extent) once Brexit headwinds are more potent in the future (lower potential). It's not dumb, he was dealt a brutal card, but capacity constraints are duration +ve and the UK economy looks to have its fair share of them, especially if Brexit talks and the domestic political economy continue to deteriorate. 

Thanks for reading, thats all I got for now, email is still best way to reach out, jonturek@gmail.com

First of 2018

Well, it's a new year, and with it comes expectation for extensive shifts in DM central bank policy, which is exciting. As a whole, there are a few potential themes I am currently interested by. First, how sustainable are these effective ECB forward guidance pegs, especially if the Italian elections in March slow recent rhetoric from Nowotny and Couere down. I think there are some broader non EUR European crosses that play on this theme in a relatively outcome agonistic way. Second, there seems to be a paradigm shift in China, or one I am late to, and it has large ramifications for FX and rates. And finally, the dichotomy between improving economic fundamentals and worsening geo politics will make for some interesting trades in FX, as in some cases, the latter has been sorely under priced. I am usually scared of making calls in January, as it tends to be a month where consensus wins, but I did anyway.....

Heres to a great 2018 for Macro

FX Seems to be lagging this chart (ERZ8ERZ9 - EDZ8EDZ9)



While everyone is obsessed with rate diffs and historic wides in US 2s and schatz, reds/greens in STIRs have been widening in the other direction, and FX has clearly lagged them. It is clear that the market took Coeure's interview towards year end (Dec 30) as a tone change re APP and its sustainability given the transition of econ to expansion instead of recovery. In a forward guidance sense, "markets have to understand QE will not last forever", was very important. A key principle of the ECB's forward guidance in keeping curves repressed is using QE a curve anchorage mechanism in terms of pushing off the market pricing a DFR hike. Is that the inflection point here? I would guess Mario will wait until after March 4th before we get over excited. The spill over from this is obvious as other European economies tied to ECB forward guidance which warrant tightening in their respective policy rates, follow. As I've said before, without any structural shortages in USD funding, DXY is a one trick pony reliant on relative policy divergence. Now, given the markets allocation of future policy scope, with ERZ8ERZ9 15bps outside EDZ8EDZ9, the dollar will struggle. However, given the coming political event, I could see EURUSD taking out 1.20 in next few weeks and be back at 1.16 by end of Feb as crowded longs fret over FI being the most likely to build a coalition in Italy. With that said, being short EURUSD would not be my expression as I agree with Coeure, the European recovery has transitioned into an expansion and it has momentum.

BTP/Bund spread will make EUR longs nervous into March 4th



Interesting way to play Italian elections; short GBPSEK

My thinking is, I have no idea if M5S can build a coalition or not, nor how EU friendly will a FI coalition be, but these sort of political events do tend to narrow down the macro variables in a more binary fashion. Short sterling v stocky to me seems innately asymmetric going into the vote. There is an inflation report from the BoE in Feb, which does complicate this trade a little given my BoE view from prior notes. So keep previous short in short sterling whites, play steeper L H8M8. Back to the the election: From a bivariate reasoning perspective, its simple to see how this trade can work. If political risk rises, EUR sells off and ECB tones down APP shift speak. Now, in that case, SEK data for Q1 is going to be strong and EUR/GBP will likely sell off, BoE gets the luxury of taking foot off the pedal, but CPIF comfortably over 2, can Rix? I.e. the Rix peg to ECB forward guidance will likely have to give if Italian elections go to shit, given Kix weakness from end of last year, Q1 data should be quite strong. Ingves will test me on this one, but it seems to me if political risk in Europe rises, Ingves may have to ignore it while Carney would welcome it. The flip side is simple policy scope. Center right coalition in Italian parliament, EUR will do well, EONIA curve prices up hikes and Rix goes this year as ECB finally "lets" them. Yes, GBP will have lagging to do as EURGBP will selloff, however, Carney has already tried to talk down potential scope, and it is innately weak given mortgage resets. So, win/win? We could go back 11.15 given BoE rhetoric, but setup into end of March looks good for being short this cross.

Side note: fascinating BoE paper on mortgage market vulnerabilities using comp sci metrics, new form of economics. 

GBPSEK

Given Kix Move in Q3-Q4, Q1 data should be SEK +ve 



Its sorta hard to reconcile a pullback in EURUSD with being short USDSEK, but I think a divergence in data in Q1 should favor this cross being weaker. Given Italian elections, I am targeting a move to around 7.90 and then reevaluate. Core thinking is, US CPI comps are very tricky for the next two months, peaking in Jan at .31%, CPIF in SEK has ~4M Kix/PMI lag which should keep inflation elevated in Q1. USD already not getting much love and March implieds could be priced lower on weak n/t inflation numbers..... Data divergence narrative, especially in inflation, looks strong, a retest of recent low looks likely.

EURGBP, rhetoric divergence before March 4th

There is a strong possibility I am allocating to much attention to this Italian election, especially as I have no edge on the outcome. With that said, the precedent on ECB action into perceived political risk events has been a sure thing under Draghi. With everyone long EUR, on what cyclically is a worthy story, Draghi could enact some n/t dovish pain, while Carney is still dealing with 100bp inflation overshoot and negative real wage growth. If BTP/Bund spread picks up a bit, EUR will take notice. Couple this with the fact that Draghi has a 1.20 EUR and a political event at the same time; rhetoric could turn more dovish. With 3% inflation in the UK, that luxury does not exist. Back to .87 on EURGBP seems likely given CB rhetoric divergence for the next few weeks. Reds/greens, probably have to come back down to earth a bit, while BoE won't do much to allow implieds to move much lower.

Politics vs Economics, The former needs to be further priced in CEE's

Besides the potential shifts in monetary policy, I think the dichotomy between an improving global economy and deteriorating geo-political environment is very interesting. CEE's such as Poland and Hungary are first to come to mind.

EURPLN

Looking at the theme of effective ECB pegs, CEE's are an interesting case. As we all know, many of the CEE's are booming and policy is stuck effectively pegged to ECB forward guidance, so FX has been pricing it as rates can't adjust. Poland is a good example of this, everyone and their mother knows the NBP is behind the curve with wage growth over 7% and inflation at target. Paying long end rates would be a better way to play as despite political tension, econ has momentum. Consumption is booming and given wage growth and relatively low HH debt, it should continue.  However, what if a continued deterioration in the political situation in Poland continues....  I think FX has to price it. The EU triggered Article VII of Lisbon Treaty against Poland; Poland is a huge beneficiary of core EU transfer payments, FDI and exports, 30% go to France and Germany. A widening gap between the EU and Poland's PiS controlled government could meaningfully effect the perceived trajectory of the capital account, which would foster a decent reversal in EUR/PLN. There is a chasm building between east and west in Europe and FX is ignoring it, I could see that changing in the new year. 

Tax reform, NKY surge, and widening rate diffs; USDJPY stuck

Back to my favorite trade, as much of the themes I am thinking about can be boiled down to being short USDJPY. A break of the range would make me nervous, but think about it, rate diffs have blown out again, NKY is at 20yr highs and tax reform got through, and the cross is stuck. I have made the flows case a few times, but it really does seem to me, that Japan's balance of trade will improve at a time the investment side of the current account also does. Marginal room for them to be more long USD assets, especially if the spoos/blues model is questioned this year, not really there. Another perk of this trade, if the markets favorite trade, long disinflation breaks, you get vol exposure being short USDJPY. On the trade front, their biggest Asian trade competitor had its currency appreciate +10% vs the dollar in 2017, while JPY weakened.... This sets up a comparative advantage relative to KRW going into 2018. Also on the trade side, Japan machine orders are booming, i.e. if you want to be long Asia FX on rebirth global trade and strength in the business cycle, JPY has to lag it as 55% of their exports go to Asia. Market is pricing that JPY post YCC will follow rates and not comparable FX (ADXY), that could be reevaluated in 2018. Onto the BoJ. I have gone into the ramifications of Kuroda's November speech in Switzerland and how the BoJ ipso-facto established a put in the slope of the yield curve. They clearly now understand the feedback loop of the destruction of liability based biz on consumption, which means only place to go in curvature is steeper; even if they don't actually, the asymmetric scope is FX significant. Japan is growing at 1.5 despite a 1% decline in labor force, thats pretty good going. Given fiscal side, rates cant really move, so maybe the currency will do some of the tightening in 2018 like we saw in Europe in '17. The biggest risk to this trade in my view is a passive melt up in US equities and bonds, i.e. vol remaining on the floor. With that said, given exposure to pickup in Asian economic activity, this trade in my opinion can be sort of growth agnostic. O, and, 2s30s in JPY, steeper than US......

Paradigm Shift in China (ya, I could be a bit late)

While there are plenty to choose from, I think my biggest miss last year was missing the lagged effect of Chinese industrial activity, excess capacity reforms and fiscal impulse on the rest of the world, besides paying KRW rates on lag to copper, I missed legit everything else. And, all of these China positives coincided with a fairly broad USD sell-off and tame central banks, a perfect storm. To me, it looks like it could be another interesting year in China but in a different way. In short, China's transition from a mercantilist beast and further moves in belt road mean despite the move in current account, regulators will continue to keep CNH steady to strong.

The introduction of the CFETS basket was a key move in the PBOC's move to become a bit less USD reliant. These efforts will likely intensify in '18 as China would ideally like to finance belt road in Yuan, which sort of explains Xi's recent globalist push. The ramifications of a changing recycling model of USDs from the PBOC, or even China eventually fighting the US Treasury for excess Asian savings and reserves are a problem for USTs and USD. In general it seems, the combination of Trump potentially taking a more hawkish trade stance with China trying to take some reserve currency hegemony, to finance belt road in Yuan; the market will have to reprice the status quo of the UST reserve model. In a sense, this should be an easy test case as the reciprocal would present itself in an obvious way, i.e. PBOC says USDCNH needs to go back to 6.75.

The feeling, especially in academic circles is, with JGBs and Bunds at 0 and 40 respectively and a global savings glut, where can backend yields go, i.e. new normal for term premium (TP). Well, what if in a year of increased issuance and the FOMC reaching autopilot on SOMA, the UST reserve model is further questioned. CGBs yield 3.9, a fight for liquidity would hurt duration along with inflation ticking up after Q2. In a sense, this also plays into my USD/JPY short and why the post YCC correlation of 10Y yields and USD/JPY is breaking as GPIF pension money will have a new place to go. Mnuchin or Powell may not know it, but they will have to compete for Asian savings surplus' and reserves. The Fed is ahead of the curve on b/s as academics are stuck in a new normal for TP given global savings glut and shortage of HQLA's. Rates vol should pick up this year, paying long end USTs makes sense, as 30s should be above 3% on growth alone, let alone this change in supply/demand dynamics. The two biggest marginal buyers of duration, Fed and foreign $, are slowing/selling into increased issuance.....

I would leg into this given my inflation concerns in near term, strong comps for CPI until March number. In general, inflation in the US is a bit tricky given pick up in rental vacancies and what that will mean shelter component of CPI. However, normalization in one offs, pickup in goods thanks to consumption move in Q3-4 and USD weakness should be able to alleviate some OER weakness. And this is another reason why USDJPY is the way to play it, as it has so many outs. Worst of with USH8 is a fine idea but think of the outs for USDJPY in this scenario: if weakening UST supply/demand dynamics come at a time of weakening inflation, or inflation does move and makes Japanese holders uncomfortable in big USTs position. Basically unless rates vol stays on its ass and we steadily move higher in yields, short USDJPY should benefit if either variable is the marginal driver of yields in 2018.

A new CNH world or Beginning of Reversal?



PBOC has a knack for stepping at 6.45 to soften the blow. I think in general, PBOC reaction to strengthening CNH will tell us a lot about directionally where China is going,

Stronger Yuan, Inflationary

(Since 2008, Inputs YoY: REER, credit impulse, imports, m1)



I have been looking at creating an indicator for Chinese industrial activity and what it means in a global econ lag sense. I also wanted to involve FX, to me, Asia FX is one of the best global economic indicators. I could have been a bit less lazy and used a moving average so its a bit cleaner, but the gist is the same, DM world econ is in process of lagging renewal in Chinese industrial strength. China being the worlds most important marginal consumer, a strong currency likely means continued strength in world trade. China probably did double digits nominal growth last year into 19th NPC, which of course means econ should be a bit softer this year, so this indicator will be important as the credit impulse for this year is lower. Think as an offset you could have some 1050 knock ins in long USDKRW. Either CNH reverses higher or BOK will ramp up activity on weakening FX.

Does Buxl finally break.....



Interesting paradox for long end of German curve with EUR up here. The question is, does the long end discount the the thing that pushed EUR here (econ expansion), which has growing momentum, or does it discount what 1.20 means for future growth. The inability for Bunds to take out 50bps in yield and flattening in 2s10s, suggest the latter is meaningful, especially as it will likely take down staff macro forecasts for HICP at the ECB. To me, until Chinese economic activity meaningfully slows, the market will continue to try and get the back end off of this forward guidance curve anchorage. Germany is doing over 4% nominally and surveys are at record highs, coupled with rhetoric on APP changes turning more hawkish, long end should be under some pressure even if Italy dampens risk appetite and ECB tone.

All the best in 2018, email jonturek@gmail.com is best way to be in touch re questions/comments.