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.

What is "Gradualism", JPY and Oil/Copper Ratio

Now that I am back in school, finding Bloomberg time is not as easy, in turn, my economic outlook has not been assisted by the mighty workbench. There is probably a negative psychological term for this sort of dependency, but I do not want my posts to limited to times when I have Bloomberg access. Thus, this post is chart lite. However, I still think there are a lot of interesting themes to discuss in macro as we head into the new year. While it could be as simple as taking GS' 2018 trade ideas and putting on the opposite positions, I think there are other interesting macro trades to be had over the next few months. I want to continue looking at short USDJPY from last post, the path of rate hikes for the FOMC over the next few months, why whites in short sterling rates look rich, the oil/copper ratio and the FX lags of a potential mean reversion. Despite the lack of charts, I hope you still enjoy and I look forward to the conversations to follow.

Gradualism and JPY

Despite the Fed hitting their dots for this year and achieving a shift in SOMA policy, the market is still pricing in an underwhelming Fed in ed$ for 2018. The question is, given the cyclical pickup we have seen, especially in the global economy, surely 1.5 hikes in ed$ is too few and the Fed is behind the curve... I think this prevailing logic is flawed for a number of reasons as it ignores some key subtleties. First, comparing the current hiking cycle to other post Volcker moves in an absolute sense is incredibly misleading. What I think many at the Fed have missed is, gradualism is a relative term, not an absolute one. 3 hikes in '17 may equal 7 hikes in '05. The Fed knows this of course, or it would not keep lowering r*, however they may be underestimating it's extent and the flatness in reds/greens and even golds is trying to remind them. In a prior post, I showed a chart of Wu-Xia shadow rate for fed funds since Volcker; despite its flaws, it makes a powerful point that this hiking cycle has been pretty normal, I know wild. In a shadow sense we have done 300bps including the pending December hike, and now real rates are positive. Hiking cycles should be compared to the neutral rate of interest not nominal bps in the FFTR. So, oil's rally, NYFRB new UIG inflation indicator, and financial conditions all suggest the Fed should be able to hit its dots of 3 again next year, yet the market is skeptical and by extension the USD is on the offer again. A few things to keep an eye on and why the market will continue to sell the Fed's 2018 dots and likely until inflation numbers turn meaningfully higher after February of next year. 

1) As we said, policy may be more restrictive than many think (remember monpol operates on a lag). In 2018, the economy will deal with a positive real rate and a Fed accelerating its SOMA run off, reaching autopilot of $50B a month in September and the lag effect of three hikes in 2017. It should not surprise us that EDU8EDU9 is 20bps with the Fed unprinting $600B over that time horizon and the unknown effects from a change in the liability side of the b/s. If the market won't allocate the Fed potential policy scope, 2s5s near cycle lows, the USD will continue to be on the offer. Also, the Fed is going to force the Treasury to fight for liquidity with a budget deficit over 3% of GDP. This position is a bit of a doom loop as more funding means higher rates which means either larger external debt position and further deterioration of current account, or move higher in savings rate i.e. TSY crowding out. This is why "paradoxically", I do not like duration in USTs but still like JPY. The US doesn't do domestic saving, so deficits are financed by a large external debt position and the Fed's balance sheet. Well, one marginal buyer is stepping back, do foreign savers fill that void as so many think given relative rates in JPY and EUR, I am not so sure. And if not, rates will adjust to attract savers, which will effect consumption. Not ideal. My question is what attracts new foreign $$$ into USTs? 10y JGBs or Bunds are not going much lower than this, i.e. the 200bp relative pick up is likely at a peak. So, in a sense, I should like curve steepners? Well, despite carry and roll, I do not, I like being short USD/JPY as it plays on both potential directions of curvature. If the curve is to steepen on a slower Fed combined with weak fundamentals in duration i.e. positive net supply, then USD will likely be offered. If the curve continues to flatten and the Fed's policy scope is priced in a limited fashion, USD/JPY goes lower as well. 



2) One of the biggest consensus out there in macro is, either the curve will steepen or it is a faulty indicator given G4 QE crushing term premia along with increased bill issuance (brilliance of TBAC). I am very sympathetic to the latter argument as I advocated that being a key cause before Brainard's paper in July. 2s30s below 100bps, 2s10s headed to 50, all seem odd given the synchronized pickup in global growth. If there is something markets have taught me, especially in macro is, univariate thinking will kill you, and with everyone thinking G4 QE has killed the YC signal, I would be more cautious. I am not in the recession camp, domestic growth in the US is still pretty good and consumption has hung on much longer than I expected. However, the YC could ALSO be telling us, the Fed has actually been far more aggressive than they or much of the market believes, and two, the Fed is AHEAD of any cyclical inflationary pickup. So ya, the ECB has and will continue to take duration out of the US YC, but what I am saying is, that it is not only the variable at play.

3) As we know, the biggest variable that could upset this paradigm other than a change in ECB policy is inflation. Given the backdrop in commodities, especially WTI, the expectation is for inflation to turn up into the possibility of a March hike, with implieds around 50%. The question is, will core CPI move higher as one offs such as telecom comes off, it is possible, but progress may be slow and that will give the doves increased voice, despite a hawkish tilt in the Fed board coming in '18. As you may recall, post the OPEC run up of Q4 last year, crude put in a big delta move which has now created a very difficult comp for CPI in the coming months. For example, the January y/y comp for CPI will be 0.31%. This comp headwind will likely peak in March and then be quite favorable, but until then, the inflation worriers will continue to be puzzled by below target PCE. Maybe next time we can look at Bernanke's temp price targeting regime, which seems to be gathering steam at the FOMC, with Williams and Evans the most recent to push it.  So despite the positive backdrop of the commods rally, inevitable reversal in declines such as telecom, used cars, medical care,  increase in core goods from USD selloff, core CPI will likely remain low going into Powell's first potential hike. However, the stage looks to be set for an inflationary move post Q1 2018. 

USDJPY Par Looks to be in the Cards

The trade for me continues to be short USDJPY. The Fed take above is USD negative plus the fact that macro has used this cross as a positive carry way to be short duration on an expected pickup in inflation, and thus, longs in USDJPY are very stretched. A potential FX theme I could see occurring over the next few months is a favoring of current account surplus' (c/a) over carry. Despite this cyclical pickup, curves are super flat, i.e no expected policy scope for G10 central banks, so global econ does ok and FX gets rewarded by natural flow. A flat ed$ curve should be very positive for JPY as its fundamentals, c/a, PPP and REER make it super cheap. And in my opinion, given structure of Japans c/a, the BoJ knows JPY is super cheap, which means banking on a BoJ put in USDJPY could be dangerous. There is recent precedent for the BoJ letting the JPY move higher, in 2015, at similar REER levels, Kuroda said the Yen is already very weak and is unlikely to depreciate further. Onto Japan's net foreign investment position. We already know FX adjusted carry in USTs has largely gone, forcing JPY accounts to get carry naked. Foreign assets owned by JPY accounts have gone up over 50% over the past five years and is now close to 8.8T USD, JPY accounts have created a massive long exposure to the US. So there may be limited scope for a further marginal increase in the net foreign investment position. First, given the move in global asset prices, especially in US equities, the net income balance, which already a big boon to the current account, should only expand in the coming months. This is a fundamental problem with CBs driving investment outflow, CHF will likely have this problem as well. JPY foreign investment looks like it will not be able to keep up with the income balance, meaning the c/a will only expand. Another point, which has arguably come up on recently, is the end of policy divergence. It is getting some attention now, but Kuroda's November 13th speech in Zurich was very interesting.....While he was quite positive on the prospects for inflation to finally pickup given a lack of capacity (good luck with that), his take on QQE and YCC's effect on the sentiment channel via long term rates was eye opening. "An excessive decline in long-term and super-long-term interest rates may give rise to concerns about the rates of return on insurance and pension products, which may have a negative impact on the economy through a deterioration in people's sentiment." Kuroda's mention of the reversal rate also makes it seem this is the lowest and flattest curve he will tolerate. Does all of this mean that Kuroda will move up the YCC target in 10s, not necessarily but it does create a powerful FX narrative going into "The Banks Review" at the end of January with 5s10s likely steepening. JPY could gravitate towards this in the coming weeks. Remember, all of these positives are happening with market super long USDJPY...... Another thing is, I am not sure a move to 105 or 100 has to coincide with a downturn in global growth, but one would of course help. 

Did the Market Misread Carney, Again?

Going into the BoE November hike, I sort of found myself in the consensus. GBP twi is now fine and CPI will lag lower, also the fact that such senior MPC members were against it in Ramsden and Cunliffe, I felt Carney would go one time just to show the market he could, in case Brexit turns south. And this is how the market interpreted it, reading a lot into the "limited extent" language with regard to future hikes in the forward guidance. Now I am not so sure the market got it right. For context, I have liked GBP v JPY/CHF/USD since July as I thought Carney had to lag that EUR/GBP move given inflation was already 100bps above target. Now, despite my inclination that the BoE could hike earlier than expected, I would rather express that view with puts in short sterling rates, not GBP, as policy scope looks very limited and I have no edge on the politics. So, back to Carney and why L Z7H8 at 7.5 looks wrong, especially given backdrop of this global cyclical pickup in growth. Carney's emphasis on a lack of remaining capacity poses some interesting questions. First, if spare capacity is gone and potential has been drastically reduced (big assumptions indeed), then a period of upside data has to be interpreted as increasing the policy path quicker than the market is currently priced. Or said in another way, periods of increased economic activity in the UK relative to expectations could be interpreted as excess demand. Which in a sense, just adds juice to GBP on outsized data prints. So while the market thinks the BoE set up a dovish hike via the "limited extent" language, by narrowing potential, they actually increased the near term policy path as the threshold for upside data is now narrower, i.e. a lowered bar. So ya aggregate hikes is still super low, but the second and maybe even last move, likely could be quicker than most expect.  In sum: if potential is kept at this crazy low, 1.6, BoE tolerance for outsized data prints will be limited and thus increasing policy scope at the beginning of the the forecast period. That is not so dovish. If you are targeting FX, the key is to have threat of outsized moves relative to STIRs pricing, unless Carney is as dumb as everyone is saying. I expect hawkish BoE rhetoric to continue into the next inflation report in February, which will lift Q1 implieds from these low levels. 

Oil/Copper Ratio is Bottoming



This is a chart that has been of great interest to me over the past few weeks. On the one hand, this commodity move looks overdone as the post NPC adjustment in China re financial conditions has led CGBs lower to move over 4% in 10s, which will pressure WMPs. However, I cannot discount the fact that global growth is still solid, there is a solid inflation hedge bid in markets and I am pretty negative USD. So.... Well, absolute commods exposure given positioning and Chinese credit impulse, yours. However, playing commods in a relative sense, seems a bit more tolerable, especially as the derivatives in FX make a lot of sense to me. Given oil's more diversified demand base and improving supply situation, especially relative to copper which still is in pretty steep contango, the +oil -copper trade could make sense in the coming months.

We can start with copper. As is the case in crude, spec longs are very stretched on the back of increased industrial activity in China. Yes, I've heard the EV narrative, but kinda seems like something a few guys came up with at LME dinner to justify the recent move. To me, China industrial bid was brought to life in a massive way beginning over a year ago, as Kyle Bass showed,  China's fiscal stimulus is now bigger than its post '09 move. This is all occurred while copper along with the base metals complex was under owned in general, leading to a reflationary rotation. Post NPC, financial conditions are tightening a bit, which will effect WMP flows into base metals and domestic credit creation. What also should be troubling for copper bulls is, we have had a massive fiscal push from China, which makes up over 40% copper demand, supply disruptions in Chile and Indonesia, despite all of this, the contango continues to be very steep in nearby and calendar spreads..... Crude seems to have a much better supply picture. Backwardation has persisted with OPEC cuts moving storage levels lower, US shale growth is likely overstated, and political tensions between Iran and KSA are bubbling. Of course demand has also benefited from increased Chinese investment and industrial activity, but in a relative sense, China is less than 20% of global crude demand. I also think this year there has been, and will continue to be, a big inflation hedge trade in commods that will likely persist as central banks are perceived to be behind the curve. Oil markets are really the only ones deep enough to accommodate that bid. Risk parity, spoos/blues crowd can hedge in tails but buying crude is another way for them to hedge inflation risk in some size. Yes there is a hiding of crude in products and it is unclear how long KSA will let Iraq (in US) and Russia (in China) take market share, but given domestic political considerations such as budget deficit/austerity and Aramco, KSA may have no choice. Simply, oil has better fundamentals, a bottom in this ratio should have some interesting FX ramifications. 

AUDRUB Short



We will look at AUD (below in CAD chart) and everyone knows the structural credit story, but in a cyclical sense, what I keep coming back to, despite China's fiscal push and subsequent rally in commods, Lowe was not able to get a hike in this year. If this terms of trade couldn't overcome domestic credit situation, what will. RUB in general looks kind of interesting and is another way to trade this +oil-copper expression. CRB is still at relatively early stages of easing cycle, terms of trade are improving with brent and the trade balance picking up again. With CRB cutting likely again December taking key rate to 8%, recent positive trend in private sector lending should continue. Of course the story is inflation, which has now reached a post Soviet era low and is over 100 bps below the banks 4% target. Given that backdrop, one would think Nabiullina should be more aggressive in releasing the clamps of higher lending rates, and RUONIA is sort of pricing that over shorter term. Even though it may be net econ negative, I think the CRB will continue to be excessively gradual. Recent policy statement described the key rate as "moderately tight" and in what is the key point, inflation expectations remain elevated. That does not sound like a central bank that will do a neutral real rate below 3-4%. Despite that, real income is picking up leading to positive increases in the service sector and of course the brent pass through will continue to benefit other elements of the economy in the coming months. Another element for RUB is the relative strength of its biggest trading partner, EUR. EUR makes up over 25% of exports, given their cyclical uptick, demand should be resilient; continued uptick in trade balance should continue. In a sense, being short this cross is thematically positive EUR econ beta and short Chinese industrial demand, which is kind of where I want to be.

Short AUDCAD




A lot of structural noise in this cross given each country's respective household debt and housing bubble, but in a terms of trade sense, it is a decent outlet for this trade expression. Yes there has been some policy divergence this year has the BoC has done 50 bps while the RBA has done nada. However, the BAs have been bid as Wilkins and Poloz have both been quite dovish in terms of expectations for the next rate move, saying the bar is much higher for the next hike. It is also worth contextualizing this rhetoric with the pending changes in BoC macropru in RE that is supposed to kick in 2018, likely adding to the BoC's hesitancy to move in rates. So while the improvement in terms of trade will be CAD positive, the credit loss cycle could be finally near. This is certainly possible, but that possibility is also the case in AUD. AUD should probably be on the offer v most major crosses, as it looks like an even bigger piece of shit than CAD, which isn't easy. Think about it, over the last 16 or so months China has engaged in a massive fiscal splurge which has been heavily focused on the industrial side, and Lowe has not been able to hike once, not even get any real steepness in OIS. Wage growth is stuck at around 1.9% and the RBA is still looking to get AUD lower. While in CAD's case there is a sighting of a phillips curve with wage growth picking up, which has justified their relatively hot retail numbers this year. Ya, the structural stories suck in both economies, but in a relative CB sense and in terms of trade, CAD should be favored.


Or Just Long EURCLP



Next time back with more charts. Thanks for reading. Best way to reach me with comments or questions is via email: jonturek@gmail.com

Leverage and Timing October 30

I don't want this post to act as mea culpa, but I do want to dwell a bit on some of the ideas I have posed over the past couple of months, which in a MTM sense have been wrong. I want to further dig into my US 2s v Schatz trade (yes, red/green steepner in ER "worked") and the USD/CHF short, both of which I pontificated would be good trades going into year end. During my encounters with macro people I look up too, it was always engrained in me that macro is a combination of leverage and timing, with my two recent ideas I got the timing wrong, but the reason I bring this up is because I believe this mistake has a lot to offer in terms of coming moves in macro, especially re CB's and their toolkits, and this is what I will focus on. Especially in light of the recent ECB decision.

Ignoring the Potent Force of Forward Guidance

As European economic activity has accelerated in a cyclical sense, I found it hard to rationalize the German schatz at -65bps, or to paraphrase Hugh Hendry, everything is fine. However, I contextualized this perceived irregularity a bit differently. My thinking was, the Fed was far closer to neutral, as green and out ed$, US IOER to 2s, 1s2s, 2s5 all indicated; and the ECB was just at the beginning of a paradigm shift in terms of policy as data was reaching its cycle highs. We were about to see a profound mean reversion in the US DE 2s spread. Remember, post EMU creation, the average of that spread is less than 40bps, it is now over 230. I went into that due to periphery funding concerns and the more positive effects of QE on the relevant transmission channels, the ECB would be more inclined to shift its sequencing in the coming months to reflect its desire to move away from NIRP first (get EONIA on a path to 0) and elongate QE. You could say I was half right, but that would be wrong, to be explained later. In a sense I thought at around 208 bps and converging economic and policy moves, this spread would begin to lag the move in EUR, and at a minimum it could not widen.

1y1y EONIA



A few weeks ago, at the Peterson Institute, Bernanke presented his most recent paper, which focused on temporary price level targeting. In the paper he also discusses, forward guidance and the difference between the delphic (think Fed dots type, like a modal) and odyssean approach (ECB "well past" model or more threshold driven). The paper's kind of unsaid theme was about achieving more policy flexibility at the zero lower bound, so in this context, these two subjects overlap quite obviously. Basically, my pontification in light of this paper and watching Mario Draghi comment on it is, the ECB has gone for a more odyssean approach to forward guidance which has capped potential policy scope in the medium term (EUR killer) and in a shadow sense has actually had an easing effects, despite the ZLB, all what Mario intended. The ECB has not been shy about this in recent rhetoric, whether it be Praet, Coeure, and especially Draghi, they have been adamant how potent forward guidance has been as a policy tool. And with this I will revert back to the elongation of QE, the nine month extension just announced. Sure, Mario loves funding the periphery, but it feels to me that at this stage the core desired impact of QE is its ramifications for forward guidance and not its standard transmission channels (spreads, lending etc.). In a sense, the nine months, i.e duration of the APP extension and potential for longer is of much more significance in a marginal sense than the 30B a month number. So back to the nuance in the different forms of forward guidance. I think Draghi learned from the Fed's tantrum in '13 that the market will maintain its curvature if you crush policy scope. Draghi may think where the Fed went wrong is that they set up set up a natural transition path from taper to hikes, i.e. their existing delphic forward guidance in the form of dots, made the market price the whats next, something Draghi has pushed back with "well past." Draghi has swiftly cut out the tail of a tantrum by drilling into the market this "well past", saying ya QE will end, but don't worry, EONIA is going nowhere for a while. So what does the nine month extension + longer if necessary do that is more impactful in the 270B itself, it delays the markets ability to price normalization, as the market has to factor in nine months + possibility of another extension and then the well past. Basically, through forward guidance tools, Draghi has convinced the market that DFR is not getting touched until at least Q3 2019 and probably later. This is what I missed. And all of this in a meta sense, is Draghi capping the EUR/USD at the ECB's staff macro assumption of 1.18. Yes, the ECB is behind and the Euro economy in a high level cyclical sense is doing very well, but I am struggling to find good r/r expression that does not fight Draghi. Open to good ideas as I thought this box in 2s was a winner.

At the Same Time, There is a Trade in Bunds

I don't think I'm the only one to use AUD/JPY as decent gauge for broader econ growth, especially in light of the worlds beta to Chinese credit growth. Chinese macro in general has been rather tricky this year and I have been on both sides of the fence. On the one hand, I liked paying duration in KRW curve as a lag to the rise in copper prices, but I have also been skeptical about copper's rally (relatively steep contango despite rally in spot) and more broadly the sustainability of China's doubling down of credit growth. TSF (Total Social Financing) continues to reach astronomical levels, up 21% ytd, but on the positive side, industrial profits have surged higher. Are the supply side reforms working or is this just a doubling down pre the NPC, which has come and gone? That question is above my pay grade, but the question of sustainability re these policies in the light of rising consumer price pressures is worth looking at. I have been thinking about this for a little bit, but post NPC and Zhou's goodbye comments re deleveraging, it may be worth to explore. So, we know the Hayman argument that China is not immune to laws of economic gravity and they are about to go through a credit loss cycle. I am highly sympathetic to that case, but timing it is far beyond my capabilities. However, a key framework for me, especially in looking at global economic activity, is looking at lags to Chinese credit and output, i.e. the G10 cyclical pickup makes a lot more sense lagged to the Chinese budget deficit growth, CRB RIND Index (which is a better reflection of physical demand) and Chinese PMI's. So China has been full throttle for the past 16 or so months, what has the potential to slow that down, outside of a credit event? I have been thinking that not nearly enough attention has been paid to rising Chinese inflationary pressures on the consumer side. Of course, everyone talks about PPI as much of the developed world imports those costs. However, CPI has been quietly rising all year and hit a 7 month high in August. This is hardly warning of an imminent problem as CPI is still below 2% and well inside its recent variance levels, but the trend since January is higher. First, while the highest political sensitivity is to food prices, they do distort the data. In September, headline CPI came in from 1.8 to 1.6, almost entirely driven by food prices. Pork prices fell like 12.5%, which weighed heavily on the numbers, and distorted gains in milk and eggs, which both rose. Now, ex food, CPI grew 2.4% up from 2.3, services increased by 3.3 from 3.1 and politically sensitive costs such as fuel, rent and utilities rose by 2.8% from 2.7. I think part of the reason Chinese CPI has been ignored, is because the headline number is deceiving, inflationary pressures, especially in non elastic sense, seem to be on the rise. If that is the case (granted that is a big if), policy makers may be inclined to slow supply side reforms and credit growth which will have a negative consequences for commodity prices and likely global growth. Yes, China has somewhat tightened mon pol in the sense of creating carry and getting CNH bid, but of course in a general sense for domestic borrowers, credit is in overabundance. Couple this with signs of slowing housing prices, maybe there is a near term hiccup for the "synchronized global growth" narrative. Given speculative activity onshore, short copper is tough to hold, even if you could find some mid curve contracts that roll down positively. AUD/JPY will be my gauge of how this plays out, as it happens to have positive correlation to bund yields. I think in general, inflation is on the rise in Germany and the ECB is willfully behind a real pickup in domestic growth, but with that said, there looks to be a seasonal slowdown in inflation coming in Q4 for Germany. This could be coupled by slowing Chinese industrial demand, which I have showed previously correlates very well to German HICP inflation. I think a nibble at RXZ7 makes sense with a stop at 50 bps in yields. Not gonna pay the bills, but could be a bit of a pain trade if bunds trade sub 30 bps again in the coming weeks. The other thing is how bunds have reflexively been reacting to the EUR. Of course this makes sense given German econ beta to its current account, stronger EUR caps future growth which the long end discounts. So in a sense, bunds have three driving variables in the near term which all seem to be positive, at least for the time frame of this tactical position. First, inflation/data both seem poised for a temporary drop, inflation due to base effects and survey data is at cycle highs. Second, either ECB rhetoric is persistently dovish or it gives the EUR a bid back +1.18, bund reaction should asymmetrically positive. Third, is this beta to Chinese industrial economy which could see a shift due to rising price pressures. Would love to hear comments on this, because pricing the China variable has been the hardest but most important macro variable this year.

AUD/JPY v German 10y Bund




USD/JPY

In this context, it makes sense to talk about USD/JPY. If you recall, I posed at the end of last post how the UST/JPY correlation post YCC could be under threat in the coming quarters. This drew at a lot of responses, mostly critical actually. While I understand why this is contentious, as the BoJ has functionally made the JPY a response function to USTs. At the same time, what I'm thinking about is not that radical. I do not have a strong view on the economic spillovers from tax reform, although this sort of fiscal push at potential is questionable, especially from a multiplier effect. Anyway, my focus has been on the deficit side. Yes, the US economy seems to have positive tailwinds from deregulation and buoyant survey data especially re capex. I am actually in the camp that growth in the US will stay above trend in the near term, around 2.5ish. Can we escape (sustain 3), eh, not so sure as the consumer scope doesn't look to be there with wage growth sub 3. Does productivity make a move in '18, maybe, but if it doesn't, the scope for a new consumption acceleration is not there with savings rates already coming in and household debt if anything deteriorating. So how do I rectify my bias that the long end could trend higher in yields and USD/JPY may actually underperform? It's credit. My mentor has actually opened me up to this view, but I'm not sure he would agree with this expression. Nominal GDP is around 4, U3 is 4.2, the economy is operating above trend and the output gap is gone. Yet, with all of this, US fiscal deficit is running over 3%. Yes, sure some of this is due to differed tax receipts as advisors have pushed clients to wait for tax reform. But still, seems wide given the economic environment, and especially since gov't expenditure has actually been a drag on GDP. With all of this, it looks like the WH is going to push through its deficit financed tax cuts. Ya, you can call me skeptical they are going to pay for themselves, especially as they are dynamically scored under a 3% yearly GDP assumption, something we have not done in over eight years. The Blanchard crowd can say r<g so borrowing capacity is "free," maybe in "theory." And yes, JPY accounts have massive UST exposure, will they feel uncomfortable with the direction of US fiscal policy, tough to say, also, typically the big accounts are hedging liabilities, i.e are held to maturity, so no MTM. Despite that, I could envision a case where a rates sell off in the long end on worries about the US deficit and that encourages USD selling, which will be quite pronounced v Yen and thus break the UST/JPY correlation. Reversal in capital account within this cross has serious potential. Another thing is, USD/JPY positioning is stretched again, with the market very short JPY, which gives me the confidence to put this on already. I will also expand in the Fed section why I have trouble buying this recent pickup in the USD in a general sense, despite the upswing in growth and expectations, both seem quite real.

Long USD/SEK, for some USD beta, and NOK/SEK

Alright onto SEK, which still offers some interesting opportunities following the kixs strength this year. Growth and inflation have both been above Rix estimates but as they have effectively outsourced monpol to the ECB, the Rix staff estimates still don't expect a repo move until Q3 of next year. Actually a decent theme in the macro community has been trying to play sort of vigilante on the Rix through the ccy. Of course they are behind, plus you get the global econ beta as SEK being an open economy does well in these periods. However, a bit of a reversal looks to be upon us and I want to look at it in the NOK and USD crosses. Yes the Ingves reappointment has already been priced but there are still a few catalysts. To me, NOK/SEK looks to be a nice long as inflation convergence should begin. NOK inflation has been on its ass all year after a profound drop, but with PPI picking up, thanks to the rally in brent, there has to be some trickle into the consumer side, even if beta is smaller than most DME's. Norges isn't going anywhere,  Olsen in recent speech targeted 100 bps of tightening by 2020. However, given brent rally, domestic data should pickup and inflation as well. Also, CESI in NOK looks due for a mean reversion. USD/SEK long also should have divergent inflationary pictures in Q4 as CPIF in SEK looks like its rolling on the lag to kix strength. Of course both Norges and Rix have ECB beta, but it is interesting with market priced for Rix being behind but at the same time is pushing out EONIA, a bit of dissonance. If the ECB is still doing QE in '19, which seems distinctly possible as Draghi said it will not come to a sudden halt, will Rix really be moving repo into positive territory? I doubt within the context of their constant guidance that is plausible: "For inflation to remain close to target, it is also important that the krona exchange rate does not appreciate too quickly. This could happen if, for example, the Riksbank's monetary policy deviates clearly from that of other countries." Rix hiking into ECB QE extension next September, eh, does not sound like it. So, for this trade, you get the inflationary lag from pick up in terms of trade for NOK while SEK CPIF comes in below 2, should be a nice Q4 trade.

NOK/SEK



USD/SEK




Fed Chair, Balance Sheet and FCI's

Hard for me to go a whole post without commenting on the Fed, especially in light of all the headlines. For me, at the end the day, the market dictates what these guys/gals can get away with, sure I'd prefer to see Powell than Taylor but I'll say two things to calm down the spoos and blues crowd. First, even Taylor's bias would find it hard to be more "hawkish" than Yellen and co have been this year. Met the median dot, started SOMA adjustment, every presser meeting was live for a policy change, and the curve is at post '07 lows, pretty hawkish..... Second, the market is too powerful and global debt is too high for Taylor to price his bias in ed$, sure we can steepen, but there is no paradigm shift. With that said, back to policy expectations.

FCI's

I have been thinking about this a lot this year as Financial Conditions have clearly become a key factor in determining policy. The question is, is monpol the tool to deal with it, or is macro prudential the one to keep asset prices in line; its the Blanchard, Haldane v Borio and BIS, "leaning vs cleaning" debate, if you will. I happen to think the old guard will continue to thwart off the rebels (BIS) and be hesitant to apply monpol as a tool to keep equities and credit spreads in check. Does a Powell Fed change that, maybe, but still think with regard to FCI's Dudley is in charge, and he prefers forward guidance/macropru approach. I think the biggest reason against it is, monpol does not act on a reciprocal basis when it comes to stock markets. Yes, they react using monpol if markets tank, but the inverse has not and should not assume a reciprocal response. First, valuing overvaluation is easier said than done; Greenspan and "irrational exuberance" was four years prior to the Nasdaq top in 2000. Asking CB's to time markets has had limited empirical evidence of being effective or even useful.

Balance Sheet and the USD

As many of you probably remember from my last post, I made what seemed like a peculiar call on what I perceive to be the interrelation between a lack of vol in long end of the yield curve and the tightness in ed$ spreads, reds and out. And based of this I saw limited potential scope for further tightenings and thus a capped USD. Well....... ehhhh, reds/greens have begun to steepen and the USD rally has picked up steam on the back of it. We are probably not done yet, so if we get meaningfully above a hike and a half in U8U9, it will be a great trade to flatten. Basically my thinking is, and why I like looking at September is, SOMA changes will begin autopilot in Sept of next year. This means between U8 and U9 the Fed will "unprint" $600B at $50B a month. Now, I do not expect this to be symmetrical in a transmission or a lag sense as printing that amount had, but I do think it is fair to be skeptical that they can get hikes in and take out this much liquidity, especially from a liability side (reserves). To sum,  the basic bet is, this USD rally is somewhat capped, unless you think the Fed can meet dots and have a full year on autopilot with regard to SOMA. So, can USD catchup to this steepener in ed$, yes, can it rally meaningfully back to its highs, yours. To be honest, I am sort of in the Stein camp on balance sheet, and not sure I see the rush. G4 QE has seemingly had the biggest impact on term premia, as I thought and now Yellen has confirmed, not SOMA holdings as Bullard suggests. The other argument, which I think has been a core one for broader policy this year has been retooling. The Fed wants a higher marginal effect of QE for the next recession, as there is little doubt they will be capped by the ZLB. The question is, if the Fed thinks this HQLA shortage is keeping curves and back end yields repressed, then won't this demand just offset their selling? To end, I will reference Brainard's recent speech regarding balance sheet and rate hikes as I have been thinking along her lines in recent posts. First, the Fed cannot continue to move the neutral rate lower and then wonder why FCI's are so loose, its policy oxymoron. Second, reason two, other then having a response mechanism, why the Fed waited to touch SOMA until we were well of the ZLB is that it served as a buffer in a shadow sense, i.e. allowing the Fed to retool in FFTR a bit more easily. Of course in a marginal sense, in '18 when the Fed tries to go to 2, that will be more impactful than the 25 bps from 50 to 75. However, there is a double whammy now as the buffer from the stock of the b/s will be less impactful. Just another thing to keep an eye on.

EDU8EDU9 vs DXY




Maybe for next time: 

Too what extent will "retooling" be a force in '18 for the ECB,  worth pondering as the markets have pushed positive rates in EONIA out until 2021-22.

Thanks for reading. If you want to reach out, email jonturek@gmail.com, is the easiest way for me to respond.

September 18

I guess the only real place to start is the BoE. While the market is still finding it difficult to digest the fact The Bank could be going as soon as November, I want to lay out a few scenarios on the potential tightening path and its consequences for sterling. As for those who have read my two previous posts, GBP has been summer fascination and the September MPC was what I was looking for. In my opinion, what the market missed and in fact continues to discount, is how much of an EM the UK has become. Sure, wage growth sucks, spare capacity continues and a lack of domestic investment due to uncertainties regarding Brexit persists, but it doesn't matter. With inflation near 3% and EUR/GBP on a tirade towards parity, Carney had to step in and defend the currency. Yes, the pass through from the post Brexit led inflation is fading, but if Carney did not prevent GBP from falling through the cracks against EUR, above target inflation would reappear again.

FX targeting is back at the BoE, the question is can they maintain this GBP strength. In my view, there are two potential paths, and they are both quite binary for GBP. 1) Carney's rhetoric post the MPC statement was crucial in the fact that it gave more of a legitimacy to a near term move. I think the BoE learned a lot from their August meeting and inflation report. In that presser, Carney tried to steepen the OIS curve, which he thought would be GBP friendly, but did not give enough indication of when the first move will actually come. Which in essence, is what Carney's ideal would be, he thought if he could provide more scope to a future tightening cycle, GBP would catch a bid, but the market called his bluff. It turns out to steepen the SONIA curve, Carney had to show near term intent, and he did. Now, short sterling rates have priced in a bit more, but still the market is skeptical there is any significant scope to the BoE's move. Given the internal economic sluggishness and extreme economic beta to increases in rates, Carney could get stuck in a one and done sort of situation. If that transpires, the market will punish Carney and GBP, and since the market reaction in GBP has already been so strong, the likelihood of this sort of move has only increased in my view. 2) The BoC model has to be at play as too many got burned by Carney's old stomping ground. Are the situations analogous, well, not really in my view, but it may make people more hesitant about fading the move. Sure, real estate linked debt is high in both countries, but Poloz and Wilkins have wage growth and improving retail activity, that is to say, the BoC has domestic "reasons" to move from the zero lower bound while Carney is in effect just lagging external factors, i.e. the EUR. So while I reject the comparison, the market will likely wait to meaningfully fade this GBP move, and shorts could continue to get squeezed. I am inclined to think the former case (1) is the more likely outcome, but I will be patient.

As I was saying, as opposed to the BoC, Carney has an external variable which he needs to lag in FX to cap cost push inflation. So, if Carney's move is really about the EUR, the September MPC told us a lot more about the ECB than it did anything else. As we have discussed, it's hard to believe given meager wage growth and Brexit effect on domestic investment, that Carney actually wants to go, which means, Draghi won't try and push the EUR lower in October. Why would Carney feel the need to get in front of continued EUR strength if Draghi was going to try and move it lower over the coming weeks? ER curve is too flat. I still prefer m8m9 steepeners.




EUR/USD inv v US 2s Schatz Spread



It is my preferred lever, if you will, to play a narrowing of the schatz US 2s spread instead of being long EUR/USD. However, I want to look at this chart from an ECB perspective and why the ECB could be less inclined than you think to try and reverse the EUR twi move. I think we have gotten a few hints of this, Draghi's September presser, Couere's recent speech on FX pass through and in my view, Carney's decision to likely get a rate hike in by years end. The question is, if EUR strength really is "endogenous" which is likely to be a key buzzword, will Draghi try and fight flows going into year end, I don't see it. My pontification is, when the market becomes more aware that Draghi is not a catalyst for sub 1.15 EUR, then the front end rate spread being held back by those very concerns can begin to narrow. Consensus is, Draghi can't touch depo and get EONIA closer to zero because of what it will do to the EUR, well maybe 1.25 EUR is more tolerable than the market currently believes...... Another element is, in trade weighted terms, if the ECB is moving the front, you better believe Rix, SNB and BoE are as well; that could diffuse some of the externality ccy strength. Combo of depo and longer but lower QE remains alive and well to me.

Relative spread in E$ and ER, z7z9 vs US Dollar



Other than external flows, potential policy scope has played a large role in both the EUR's rise as well as the USD's fall. One of the reasons, barring any funding problems in EM, I do not see how the dollar has a sustained move higher, is what is the scope for Fed moves relative to other CB's. I.e. lets say USD weakness has fostered a meaningful uptick in global growth and inflation will move higher, will that be an exclusivity to the US economy? If oil goes to $60 and US CPI is meaningfully above target, is that a world where EUR, CAD, GBP, SEK, etc is also not seeing inflation targets met? If that is the case, all of those CB's have a lot more of an adjustment to do in the front than the Fed does. I guess, my larger point is, if r* is not meaningfully higher in the US than where it is now, the potential scope of tightening for other G10 central banks is greater. Which is why I will say, despite this being quite contentious, a Fed hike in December doesn't really matter. Sure, if the Fed gets it priced rates, e$'s, and the dollar will adjust, but not meaningfully as it is hard to see the economy making a significant move above potential. Flip side, it does and global synchronized growth takes the next step, does schatz stay at -65 bps, in fact, it probably has tighten much quicker than US 2s. 200 bps in schatz US 2s spread is much too steep for me and it carries positively. Also, final point, if the ECB wanted to move EUR, why come out in advance of Q4 base effects on HICP inflation as transitory, surely that could have been a weapon to talk EUR twi lower.....

https://www.ecb.europa.eu/pub/pdf/other/ebbox201706_07.en.pdf

That brings us to another point, why is the market projected scope for further Fed hikes so shallow, especially considering the known positive knock on effects of the weaker USD into growth and inflation. There are likely many reasons but I want to offer one that is a little off the beaten path. Yes, inflation has been persistently low and we have no idea what a Trump Fed will look like, but there is another potential factor in my view. We'll likely find out on Wednesday that beginning in October the Fed will begin its SOMA adjustment, and ya, UST vol is on its ass.... My thinking is, what if the market is potentially pricing in that "vol" in richer e$'s...... Bare with me. The September 2014 statement regarding balance sheet was pretty clear, the reason the Fed had to get o/n rates meaningfully above the zero lower bound before doing b/s runoff was so that they had a lever to pull if we tantrum part two or if it effects the outlook. In this context, it makes a little more sense why the Fed path is this shallow; either b/s has replaced hikes as the tightening mechanism or the market quietly thinks the pain threshold for runoff is much lower than the "like watching paint dry" Fed does and they expect SOMA changes to run into problems over the next two years. When it does, o/n rates will be the first lever they pull. Just a thought, as it also confounds me how low rates vol is given this backdrop, but just maybe, the market is pricing in potential problems elsewhere.

$ Funding looks Relatively Healthy, For Now (JPY and EUR 3m basis swap)



The dollar thesis I am most sympathetic to is the liquidity one. As I have touched on, the profound amount of dollar liquidity unleashed this year has been a large global stimulant. We know the dollar short position in EM issuance and even in spot has moved considerably this year, the question is, what upsets the apple cart. So far, dollar funding is normalizing and none of Trump's trade restrictions that could potentially mess with current construct of the current account look very likely. So, in my view, until the balance of liquidity is to recede, if that is normalization of bill issuance or an EM problem (China), its hard to see a change in the current FX trend. I still believe, if there is a trend change, funding and shortage is likely the cause for a dollar rally, but those stresses do not appear to be there just yet.

Does USD/CHF, lose Either Way?

One of my mentors sent me a chart of CHF/JPY during one those of risk off nights emanating from the Korean Peninsula. He was saying, quite rightly, how does the country which the missile is going directly over, have their currency appreciate against swissy?! It really is something. What I saw in the chart was, CHF/JPY over the last year is just a 10y bunds chart. Kind of interesting, maybe easier to sleep at night being long CHF/JPY than short RXZ7? Anyway, this point and really the causality behind the correlation has ramifications for the dollar swissy cross. What if the CHF v USD can play in reflation and kill it on flows if global econ turns lower again? CHF playing in a positive economic upswing is super odd, but maybe in this cross it could work. A little more background as this idea came to mind from discussing the SNB with a very smart macro guy, who brought up the idea that the SNB could go a lot sooner than people think. Anyway have to give him credit. We know how CHF will outperform, if shit hits the fan, flows overpower Jordon and the SNB's best attempt to talk it lower. Now, the flip side is where it gets interesting, as CHF is the ultimate funder in a positive risk environment. Lets say, global growth chugs along, FDI flows from Swiss reverse and the ECB begins its move in tightening. Well, CHF will lag that, won't it? In the latter scenario, global growth continues its upswing, EUR/CHF is likely +1.20, which is all the SNB is really going for as they don't really have an inflation target. In the September SNB statement, there was a language shift regarding CHF overvaluation, it went from "significantly" to "highly valued", almost as if to say, the conditions are getting there. And there is another crucial element, part of the SNB tightening mechanism, I.e. less of a need to weaken CHF, will be selling some risk assets, which happen to be largely USD denom. Yupp, positive capital account adjustment, despite "risk on." So, the latter scenario (upswing in growth continues), which is likely the bigger risk to the trade, the SNB could hike rates in first half of '18 and be repatriating some USD assets all while the Fed is on hold..... The prospect of a currency with an 11% current account surplus actually moving tighter on o/n rates, despite how ridiculously low their deposit rate is now, is a very powerful force, one the market is likely underestimating. Another thing, it gives you some positive correlation to G10 rates. If you can live with the carry, this trade could work, time to look at some one touches.

Back to US Econ

As I said in my previous post, in my view, which is likely contentious, this Fed tightening cycle has been quite "normal." In shadow rates (Wu-Xia), the average tightening cycle post Volcker has been around 300 bps, we are at 298 before the September meeting. I know, impossible, there is no way the terminal rate is sub two and a quarter and even if it is, FCI's are super loose. The latter is true, but also more of an equity/dxy story. Maybe policy is tighter than financial liquidity infers. Bank lending has collapsed, M2 growth in YoY terms is meh to weak, and velocity continues to suck. It is feasible that the rebuild from these storms will be the boost the economy is looking for, but to me, it still looks weak relative to the rest of the world. And this only feeds into the lack of scope in terms of monpol action. Despite this, it's still hard to like duration in USTs because my handle on China continues to be weak, the positive knock on effects in inflation from a weaker dollar have only really begun to pass through the system, and positioning is still super long. Curve steepeners could be a better play.



Oil boost since November OPEC deal (Yes, this is a chart crime, but point is important)



I'll leave the science behind legacy wells and depletion rates to the pros, but from what I have been reading, the US cannot grow oil production in perpetuity, in fact rig growth looks likely to be topping out. This week the EIA revised slightly lower shale output numbers for the first time in a while. The consequences of peaking US oil production is massive in terms of price and inflationary expectations, but I want to look at it in terms of how big of a boost US oil has been since the OPEC deal last November to GDP. Gross private fixed investment has been kinda dependent on a growing oil patch, as we saw in Q1. What if investment dies as a result of a peak in domestic oil production? Is the knock on in capacity utilization rates back at 75 and a turn lower in industrial production, it is beginning to look that way to me.

Can the Oil Curve get over the Shale Hedgers? 



Somehow I always end up coming back to the Fed, and here is more. Given the recent Chinese PPI number there is plenty of reason to think US inflation will rise in the coming months. This is likely behind the recent steepening in the e$ curve. As Fed rhetoric from Evans, Brainard and Kaplan have suggested, they are uncomfortable with the current state of inflation, so it will likely take more than one or two good readings for the Fed to get excited. Also, despite the recent rally in spot, under the Fischer 2015 Jackson Hole view, looking at oil prices two years in advanced, prices don't indicate significant future price pressure. Does inflation pick up into year end, maybe, but are they for US centric reasons, I.e. the Phillips curve, not so sure. The tradable side of imports is not really big enough to make the weaker USD a US only story, which really caps any meaningful dollar strength.

End on CAD, as I have been as Wrong as Anyone on Fading Poloz



If you are looking for a Phillips curve sighting, Canada may have it. As unemployment has come in close to 6, wage growth has started to really pickup, the question is will prices follow. I was as a quick as anyone in wanting to fade the BoC, as I just didn't see how growth in retail consumption could have been kept up given concerns in household debt and a lack of gains in the oil sector, only bolstered by the currency strength. Well, I'm not sure I have changed my view, but maybe for the first time I can sort of see what Poloz and ToTEM (BoC DSGE model) are seeing. If retail activity is going to be a buffer for reduced investment and housing, it may have legs given that its growth is quite organic with this upturn in wages. And if retail activity is expanding, despite the currency appreciation, prices should follow. The question we have to ask ourselves before getting excited about fading CAD or BA's is, if these wild ones felt comfortable initiating a tightening cycle at 1.2% inflation, lets say we get to 1.7%...... Inverting the curve does not seem to spook them. So ya, maybe BAX strip over 30 for next year makes a sense.

On the side

If anyone wants to send me data sets on JPY holding of foreign govies, it would be much appreciated. Think the potential for a breakdown in USD/JPY 10y UST relationship post BoJ YCC, could be almost be upon us. Food for thought until next time.

Thanks for reading, if you would like to reach out, my email is jonturek@gmail.com

Jackson Hole

As we head into one of the key macro/central bank periods of the year, I thought I would share a few thoughts with regard to policy changes and expectations. I think it is very interesting that we are entering a time where the ECB will discuss the evolution of their sprawling easing program, the Fed will be beginning to unwind their balance sheet after the September meeting, and vol in rates is on the floor. Another important aspect of this jigsaw is the knock on effects of these two events. With regard to the ECB, how does the BoE, Riksbank and SNB respond if Draghi outlines a withdrawal of monetary easing in October? As a whole, the dichotomy between perceived event risk and market pricing is large, which means macro could be pretty interesting going into year end. As a side, the black and white charts of my previous post, are dead! Instead, I overcame my laziness and put speciality charts, such as workbench, into excel. Long live clear charts.

Jackson Hole and ECB Going Forward

Instead of giving trade ideas for Friday specifically, I want to look at the broader picture and try and discern what are the ECB's practical options as QE inevitably takes on a different form. I believe JH will only be the beginning, as the amount of ECB trial balloons will surely accelerate into October. For context, I have written in the past that the ECB will likely remain persistently dovish this year despite improving data, and that the inevitable transformation of policy will not look like the Fed's playbook from '14. For me, there are two key reasons why this is still the case. First, from Draghi's perspective, the APP (asset purchase program) was of course meant to narrow the massive output gap, but the major policy initiative was a convergence in spreads and to stabilize funding and capital flows for the periphery. As I wrote before the French election where I advocated buying BTPs, budget deficits have come in, but PSPP (public sector purchase program) has covered most of the cracks. Spain can run a -5.5% budget deficit and borrow 10y money at 1.6, Italy can fund itself at bunds +180, only in this paradigm does "austerity" become a bit more tolerable, if existent at all. This is why the ECB "taper" will not look that similar to the Fed's; the delicate balance of measuring how much withdrawal the perif can take with an upswing in economic activity will lead Draghi to be a bit more creative in his final two years. I am aware that the current ECB statement language indicates a more traditional policy path, i.e. similar to Fed playbook, but I think going into the October meeting the market will have to adjust certain probabilities in rates across the curve and by effect in FX. I want to avoid such binary terms such as "hawkish" and "dovish" as I think these two terms overlook the significant nuance and complication that will go into Draghi's exit plan. My pontification is that the current perception of the ECB exit sequencing is wrong, but does pulling the front end less negative instead of steepening the curve through taper, constitute as "hawkish", my feeling is not.

With that background in hand, Long 100.125P in ERM8, and short bobls, OEZ7 with a -40bp stop. (I've seen an interesting put fly but would love see other interesting convex structures). What I like about this thesis is, it will only take a famous ECB trial balloon for it to pay off, even if the Fed '14 model is the ECB what practically takes place. Now, this idea in theory contradicts with my core theme of this year, persistent ECB dovishness on the basis of keeping periphery spreads super tight. In essence it does, but the fundamentals of this trade expression convey certain assumptions that I want to explore as they are likely being underestimated by the market. And, these two trades provide a very convex outlet for a multitude of these variables being assigned a greater probability by the market in the coming months.

There are three likely scenarios in my view:

Option 1) Hike instead of taper. In Q1 of next year, a 10 bp DFR (depo rate) hike could come to soften the blow to buba of a dovish APP reduction to 40B a month for 2018. OIS out until April of next year has less than 10% chance of rate move. Again, despite the current ECB statement, I think Draghi may look at pushing EONIA closer to zero as a way to keep his periphery spreads project alive and well and appease German hawks. If anything, pushing up STIRs in Euroland could prove to actually be quite stimulative, as the banking sector would certainly welcome it with loan growth already picking up over 2% in '17. Due to scarcity concerns, Draghi at the current rate of purchases can likely get to around June, so take APP down slightly to keep program for most of '18 at a minimum. In this quid pro quo, hawks at the buba get a hike and Draghi continues to fund periphery budget deficits, albeit at a bit of smaller pace. The fact is, from Mario's perspective, APP works while NIRP reviews are a mixed bag, why not keep the more effective policy tool going? Draghi can push EONIA on path back to zero as a much healthier form of tightening relative to making significant changes to APP. A switch in the exit sequencing looks to me as much easier way out for Draghi, and the market is not pricing it, 4bps in ERZ7-M8.

ERM8 100.125P, vol in reds is super cheap



Option 2) Draghi has made it clear to markets that only one thing matters: "Our mandate is neither growth nor employment, but price stability." Would it surprise me if Draghi says screw you to the buba, core HICP inflation at 1.2 is not high enough, and considering recent EUR move weighing on 5y5y inflation swaps, he could have a case that to get inflation to mandate, the current state of mon pol is still appropriate. Draghi can also say, Chinese credit growth is likely to slow next year, Euro econ runs on a lag to CH expansion, do I want to be withdrawing stimulus into that? Very easy to see how Draghi takes the most dovish way out, especially if pressures from German election do not really mount and inflation begins to roll.

Biggest risk to ECB exit trades, China



In prior posts I have looked at Chinese imports from Germany as a leading gauge for HICP inflation, and it has largely played out so far this year. However, I think this chart better encapsulates the lag from Chinese credit expansion onto German HICP inflation. Despite three year highs in copper and a pickup in the credit impulse, I still remain skeptical of the durability of the current expansion in China. The rally in industrial metals looks to be more driven by WMP issuance and inflows, as domestic stocks remain very elevated. However, if German inflation is operating on a few month lag to Chinese credit expansion, prices could still slow over the coming months, which gives Mario an easy way out and bunds trade back into the teens. This is likely the biggest non geo-political risk to the trade, but one can easily say, Mario will be too late to notice and the German pressure will force action. The beta of Euro rates to Chinese industrial expansion cannot be underestimated, so to counter maybe add a receive AUD leg onto the trade to better hedge out CH risk? This sort of deflationary risk also speaks to raising rates being advantageous over taper. If Draghi hikes DFR 10 or even 20 bps, he can easily stop if deflationary risks from China or oil are to reemerge. With taper, the Fed model suggests some sort of monthly auto pilot is most ideal, as big monthly deviations will cause increased vol in rates land. Another thing for Mario to factor in if he is skeptical of current upswing as Trichet's shadow hangs.

The other side of the Chinese Coin



So, if Chinese credit impulse indicates that HICP inflation in Germany should fall, the rise in the RMB suggests the exact opposite. To me, this is a powerful chart because as I have talked about, persistent weakness in the USD is a powerful global stimulant. I am sympathetic to the view that dollar scarcity will reemerge following a normalization in bill issuance, but if until then, the debt ceiling and persistently low inflation in the States keeps the dollar on the offer, that weak USD stimulant will be alive and well. Lots to balance here, especially when Chinese fundamentals have proved so difficult to properly judge as individual variables, let alone systematically.

Option 3) More consensus exit sequencing. Draghi likely extends QE slightly into 2018 but lays out plan of eventual path to 0, obviously not including reinvestments. Draghi acknowledges output gap is narrowing, inflation forecasts for 2018 rise slightly, and DFR hike first or second quarter '19. The biggest pull to move Draghi in this direction will not be economic, as I have tried to emphasize, to Mario's credit, he is a big picture guy, cyclical upticks will not shake him off his systematic and structural goals. Scarcity is the real problem for the QE forever camp, unless much bigger capital key deviations are tolerated, which is tough to envision, QE parameters will have to change. German WAM is slightly above its lows, but still down to near 5. In this case, Draghi is forced to lay out plan in many stages to begin taking monthly purchases to zero, as QE reaches its natural limit.

5y Bobls v 1y1y EONIA 



In theory, given my thesis, paying rates on 2y schatz should be a better trade expression. The reason I prefer bobls is its flexibility to different scenarios. In my base case, ECB talks market into pricing in a DFR move more quickly and pushes off significant taper talk, can bobls still trade inside a rising 1y1y EONIA? The generality is, if the ECB can ever so slowly push EONIA closer to 0, bobls would have to follow suit. In case two, Draghi stubbornly continues APP close to its current form for most of 2018, I don't think bobls can trade inside depo again, especially given the pickup in domestic economic activity and HICP inflation. This is really sort of the obvious asymmetry, unless Draghi expands QE, I do not see bobls trading at a real rate of -200 bps. The other point is, if Draghi goes full out dove, he kills EUR before German current account can effectively adjust to trade weighted strength, this would in essence shoot higher inflation expectations and likely prevent a persistent rally in the belly out. Case three is likely the most self explanatory. Threats of more traditional exit sequence will crush the overbought belly of the German curve, look how bobls sold off following Sintra. The latter case, despite being third on my list of probabilistic outcomes, shows why the bobl short is more advantageous to schatz, as it has more beta the Fed model of taper.

EU GDP v Expected Real 5y Bobl (reals are a nebulous concept to me, but I used 5y5y swaps here)



Draghi and Inflation

Part of the reason I think the street and even ECB rhetoric has the exit sequencing wrong is because of inflation. Yes, inflation has accelerated meaningfully this year, even Euro super core inflation is picking up. However, in Draghi's "hawkish" Sintra speech he effectively told us real rates have to be zero. So while core HICP inflation has made progress at 1.2, does it really satisfy, "the close to but below 2%" mandate, maybe for Weidemann but not for Draghi. So inflation still needs to pickup and this move in EUR is not helping. The question is, if Draghi needs an outlet to appease the Germans, why does moving EONIA closer to zero have less of a negative inflationary impact than tapering? The answer may lie in a working paper from the ECB, which was released in June (http://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp.2075.en.pdf). The paper goes over a VAR based model which estimates the impact of APP on inflation and real GDP.  The paper did not compare APP effects and impacts as opposed to using overnight rates, especially past the zero bound, but rather the models results are interesting with regard to the timing of inflationary impact. In effect the model attempted to quantify the lag through in the different transmission mechanisms, lending, FX, etc. What we learn is, there is a much higher higher residual time variance for inflation as opposed to real GDP. This means, by tapering, Draghi will risk messing with the positive lagged effects of the APP, especially on inflation, as they are still making there way through the system, even if some have peaked (VAR model suggests based off APP changes in '15, Q4 2016 and a 0.36% impact is the peak effect). Considering the general negatives we have seen with NIRP, it makes a lot of sense to me that taking the front end less negative will not have as big of an effect on inflation, as the bank lending transmission onto broader loan growth will likely be more positive. Can Draghi appease the buba and at the same time actually keep this uptrend in inflation, just may be, moving EONIA closer to 0 instead of big APP changes is that outlet.

EUR 5Y Forwards, Maybe let EUR do the Work?



In my opinion, Draghi's concern with the recent EUR may be a bit overstated, especially as it is everyones base case for a dovish JH speech. Yes, effects of rising trade weighted EUR negatively impacts growth and inflation, but, it disproportionately hurts German econ. We have already begun to see this in German survey data, PMI and ZEW starting to come in from very elevated levels, but also in the German stock market. Remember, since EMU inception, Germany has kinda taken current account surplus from others in the bloc to make their own monstrous surplus +8% of GDP. The contrarian in me says, well, Draghi is in a place where his priorities are systematic in nature (tighter perif spreads), and the biggest threat to him having to remove those safety measures is, German economic expansion.... The variable with the most beta to restoring some balance among the EU economies, i.e. leveling out German growth with an adjustment to current account, may be a slightly stronger Euro. Sure, Euro has effectively tightened some financial conditions in the EU, but the core effects look largely Germany bound, which actually prevents Draghi from having to rush on mon pol changes in the name of quieting the German hawks. In an Ideal world, Draghi knows relative weakness in EUR is a large boost to inflation expectations and trade across Euro Area, but at current levels it may actually smooth out some of the disparities in the continents relative growth rates.

Regime change in relative curves, German v US 2s10s



Something I've noticed over the past few months is that the US-German 10s spread trades tighter than the respective 2s spread. If you look at this series over more significant time frame, you will see this has not been the case for over five years. This paradigm shift does make sense given consensus outlook for the ECB and Fed respectively. Inflation in the US is rolling over and the ECB is about to taper, so 10s spread should tighten, which likely every macro HF has on given its positive c&r. With regard to 2s, yes, the Fed is towards end of hiking cycle but there is no way the ECB goes at rates before Fed is done, so 2s still trade super wide. I want challenge both of these assumptions and even suggest that with Fed SOMA changes to begin in October, this paradigm can revert back to its recent norm. In my mind the narrowing of schatz and US 2Y makes a lot more sense in my ECB framework than narrowing in the belly and out. Fed will be making conscious effort to turn duration lower for the sake of tighter financial conditions, while the ECB may go out of their way to keep duration, especially in perif, bid. On the flip side, the Fed is getting to the end of their tightening rope in o/n rates, while the ECB could be just beginning..... Short schatz long US 2s also works, especially given spec shorts in US 2s, or trade below.

ERZ7-M8 v EDZ7-M8, 9.5 bps

Fed Tightening Cycle has been more "Normal" than you think



While one wouldn't think it, on a relative basis, this tightening cycle has been pretty "normal" for a post Volcker cycle. In shadow rates (Wu-Xia above), you're at over 300 bps of tightening for this cycle if the Fed goes again in Dec, in my opinion a bigger than 40% chance. Also, if you asked the Fed at last year's JH, not sure Fischer would have told you the odds would be high that by year end '17 we would be this close to in policy rate to r*. However, given the calcs and weightings of prior months, inflation on YoY basis is stuck. The Fed has already tried to hedge future CPI readings by saying they will focus on sequential readings instead. Of course it is hard to say what the Fed path will be if Janet is replaced by Cohn in Feb of next year, which has contributed to the shallow path in reds, greens and golds, but with core PCE stuck near 1.5 and bank lending contracting, the writing is on the wall. This does not even take into account if SOMA changes begin to go awry in 2018, a very real possibility that the Fed and market is discounting in the name of a steeper curve and tighter financial conditions. But in my view, the latter will be taken care of by a normalization in Treasury issuance.

14bps, US 2s and Effective Fed Funds, Unless r* Moves Higher, the End is Near



US 2s inability to really sell off since Jan has been very telling. My thinking a few months ago was, this is the most obvious r/r short, 2s trade 5 bps outside IOER, 14 bps from effective Fed Funds, and they have great optionality on Fed surprising market with more hikes. It turns out I was not alone. People like to talk about market messages to the Fed, like, "what does it say that despite 3 hikes since the election and spoos are still at ATH's". My answer would be, look at the curve. 1s2s like 8 bps, and the 2s are about to invert with with o/n rates if the Fed goes again in Dec. This is either a massive mis-pricing or the curve is sending a message. I bet the latter and am emboldened by the fact positioning is so heavily skewed to the other side. I would say, going into JH this position is less appealing to me as Yellen could use Jackson Hole to remind the market who is in charge, but as a whole, I expect a big narrowing of US 2s German 2Y schatz spread.

Interesting dynamic between Fed and ECB could start in JH. 

In the spirit of Jackson Hole game theory, it is fitting to end this post on something a little bit out there and not readily practical, but I here it goes anyway.

I think it is well accepted in the CB community that coordinated tightening, if justified, will have to be the name of game, no one is looking for a '94 type move in rates. This is where Draghi must think, when it's time for the process of real ECB normalization to begin, the Fed will have to play ball. It's simple, Draghi is looking at the Fed's expected policy path priced in ED$ and saying, they are nearing the end, especially as inflation has come down significantly the business cycle is very old in dog years (about to be second biggest post war expansion).  Not hard to see, especially if problems arise from SOMA changes, that the Fed could be reversing course over the next 18 months. Well if that's the case, that creates a much cleaner buffer to hawkish policy shifts from the ECB, and in a sense, they did the same thing for the Fed. What happens to duration in USTs after QE is wound down and the Fed outlines dots path to neutral rate of +3 if the ECB doesn't come in and quash term premium? From Mario's perspective, why can't this play out in reverse, i.e. Fed keep some sort of lid on EGB term premium while ECB takes APP to 0.... This is a very out there, but its worth keeping in mind over the next couple of years. Mario could be thinking, its time for Janet to return the benevolence that ECB QE showed the UST curve in '14. Of course this would have massive FX implications that Draghi would want to avoid; it's a work in progress.

Short Sterling Rates still discounting BoE (L U7-M8)



Quickly touching on my BoE thesis from last post, I think it is more in tact than the previous presser would suggest. GBP/CHF long has moved but is basically unched over the month. While Carney's presser was interpreted as dovish, I actually thought he just went over justifications of a hike despite sluggish growth... Spare capacity receding, and if that process is to accelerate, OIS curve has to price in more and sooner hikes. Message from Carney, in my view was, ya economy is sluggish but if ECB moves the needle and EUR/GBP continues to shoot higher, I'll be forced to move. Reason I like pound swissy pair is, SNB in that situation will come out and likely say the opposite, that they are not following as geo-politics have kept CHF too strong this year. I believe I am right in saying that we will not be hearing from Carney at JH, but his deputy, Broadbent will be there, worth keeping an eye. Economy looks weak and FX pass through onto inflation is waning, but if Carney does not keep up, FX driven price instability will return.


Thanks for reading. My email is jonturek@gmail.com, please reach out. Have nice rest of the Summer.


Jonathan Turek