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.
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.
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.
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
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
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
