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.
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
