Tuesday, 2 August 2016

August FX & Rates outlook

It's been a while since I last posted here, having spent the past 3 months taking exams and travelling around Asia. It's been a relatively quiet period in markets with this thing called Brexit happening, but just over a month later, it seems like its been mostly forgotten.. and its hardly been the apocalyptic world ending mess that some predicted in the mean time.

In other markets, the broad USD is still painfully boring in a very tight range, credit has been crazy strong (both HY and EM) as investors have flocked to carry on any dip, Vol is  low, as of writing the past 10 days in SPX has realized an incredible 4.5 points, and commodities have been mixed with oil tanking (lol) and gold/silver rallying somewhat. Lots to talk about then.

BoE and GBP markets

First section, I want to look at the BoE. We've got the MPC meeting and accompanying inflation report on Thursday morning. a 25bp rate cut is fully priced into front end GBP markets - Aug OIS trading at about 22bps so more than a full cut is priced into markets as we stand. Cable has been rather resilient, helped by mild $ weakness the past few weeks and is seemingly trading comfortably above 1.30 - sentiment is obviously quite bearish but the price action doesn't seem to agree quite yet. Cable would be a clear sell on rallies up towards 1.40, but also to me quite a nice buy on dips /if/ we traded below 1.30 again. We're clearly being led around by rate spreads, and so this meeting could be rather important with some nice asymmetry.

GBPUSD vs 2y2y rate spread

Going into the meeting, GBP vols are fairly low all things considered, partly due to recent realized vols being very low (traded in a few hundred pip range for weeks) and given that there is a full expectation for action. My concern here is that if the BoE doesn't cut at all, cable would likely rally along with rate differentials and the latent short position being squeezed out. 1.35 area would seem fair before it started getting trickier to rally.

Regarding the decision from the MPC, the way I see it is as follows; The BoE doesn't need to cut, the BoE doesn't want to cut, /but/ the BoE might cut for the sake of action and response. In this aftermath of Brexit, there has been no clear panic (heck, even thought gbp dropped 10%, it never got close to panic trading especially given calls for 1.15 area), other financial markets remained very solid (looking at equity markets here) and vol is low and contained. The BoE has been for a long time, in my eyes, heavily data dependent... where much like the Fed, the data is equity and vol.

GBP1M and FTSE vol

Now actual data was poor, sentiment and PMI data fell off a cliff, implying some contraction in H2 GDP, which is very ungood. The main argument for the BoE to cut, is that they are now focusing more on maintaining growth as opposed to targeting inflation, at least in the immediate term, which frankly to me is total rubbish. Since 2008 we had (the now revised away) triple dip recession, and the BoE did a bit of QE, a bit of other nonsense, but nothing in base rate. And the way I see this, is how is this different? Now Brexit is unequivocally bad for our H2, but its not seemingly been /that/ bad.  Core, hard data remains stable in the UK, labour markets are doing well with no anecdotal signs off mass layoffs post-Brexit. Inflation is/was starting to turn, and swaps have moved higher on the weaker GBP.

UK curve (from Citi)

GBP 3M OIS

So with all that said, and how I don't think they should cut, but, they probably will, because we've seen in the past how CBs don't like to shock markets and their precious expectations. This doesn't mean however we shouldn't position for a surprise. The risk:reward looks compelling to call bs on all this rate cut talk. Firstly just by paying front end rates, at 22bps you make a small amount on a 25bps cut, you make 25bps on no cut, and ur risking 22bps for a balls deep move to 0%. So for a 1:1 payoff, you're leaning against what is a very small chance of 50%, and in my eyes a moderate, non zero chance of no action (lets say maybe 30-40% of no cut).

Paying later dated stuff isn't a terrible idea either (tho less compelling), negative rates seem out of the question (for now) in the UK given the backlash that has had in Japan and Europe on Banks... banks are too important in the UK to put them under that sort of pressure and the negative feedback loop there will be far worse than any brexit stuff. Whilst UK bank shares haven't done well, it would be unwise to put them under more pressure much like Japan and Europe below.

TOPIX banks, and SX7E
So to summarise in trade ideas, given my view on the asymmetry of this meeting, 1:1 risk reward on 50bp cut to no cut, small gain on 25bp and a ~30% of no cut, I like paying front end here.

In cable, downside seems limited unless the BoE goes big (but unlikely for aforementioned backlash). Taking advantage of negative skew and cheap vols could sell 1.30 puts to buy a 1.33/1.35 call spread. (pretty much zero cost as i type with spot at 1.3230)


US markets and Fed


 So plenty to talk about here too - we have an important data release on friday in the form of NFP and then Jackson hole before the "live" September meeting.

The problems I have when discussing or thinking about the fed is my tendency to care about global occurrences, perhaps too much. Stemming from the way I view the Fed funds rate, which is not as a number that I see on my screens, but all relative to other central banks, think of the FF as more like FF-G3 base rates.. and that every time europe/japan or whoever cuts, its tightening from the Fed. Some pass through from this obviously occurs in FX, having seen the USD rally 25% over the past 2 years, to a large extent on rate differentials, but more so going forward it limits the fed greatly. Probably capping us at max 2 hikes per year (if everything was perfect) and more likely just 1, in Dec.

This doesn't however mean its not a bad play to be short US rates here. The fed loves to tee up meetings, and looking at domestic data there is all the reason to be talking hikes right about now.. in fact if it wasn't for that whole brexit thing, june would have been a viable option too. I ask myself, why not Sept? well, there are no massive known risks like with the brexit vote, the FOMC has made it clear that more hikes are coming, data (equity and hard data) is good (tbc this friday too). So why not? well, they might still, but with trump coming more into view, 9 CBs easing post Brexit, and a slowly looming issue in oil, patience might be used.. plus, Yellen is just so December

8th vs 12h continious ED vs 2yr $ swap
The above is an interesting chart I've been looking at and pondering, the curve(orange) is at the lows where as outright front end is middle of the range.. typically the two move together but steepeners have clearly not been popular. I think at a rate of 14bps (far less than 1 hike per year) is low from a macro view and also on short term metrics vs outright. So I look to pay the curve a bit going into NFP / JH and Sept meeting.

In USD, I'm actually neutral to bearish. Take USDJPY, it seems inevitbale at this point we trade below 100, and its hard to put a number on when the BoJ cares again, because we could have thought it was 115/110/105 and now 100.. but who knows after that, 95?.. or maybe they dont care like they used too. EURUSD im fractionally bullish due to negative feedback loops that occur with a higher USD or wider rate spread to Europe which should cap any DXY advance. FX is certainly not the space I want to play the Fed in, I dont think its at all clean enough right now to do so with, hence looking at rates for now.

EM / Carry bid to infinity

well, what a 6 months its been for certain carry positions. BRL up hugely, CDS trading on par with Turkey (from well over double at xmas).. heck, even ZAR is rallying a ton, and you know when that happens people are sifting through the excrement just for any hint of yield. Domestic fundamentals in the two aforementioned countries, as well as many other EMs hasn't drastically improved.. so its one of two things to me, either we were grossly undervalued beforehand or low inflation, negative rates is just continuing to push investors into anything that yields. In reality its probably a nice mix of the two.

For a select few, here we see Carry/vol (using 3m rates and IV)

3m Carry/vol, Brazil, Turkey, SA and mexico

Brazil has performed very well here, so no surprise assets there have performed so very well.., turkey has somewhat deteriorated recently given political shenanigans (read: sh*tshow)

Mexico the worst, and hasn't really improved to the same degree as others, hence not being sweeped up as much as others and seeing some under-performance there (oh and Trump). Other assets such as HY CDX have a carry/realized vol of around 1, and have been performing very well too. So the question needs to be asked, will this continue / when do we call bs on the rally ? probably not soon, with no major risks that could seemingly derail, and never-ending low rates and inflation it would take a lot to not want to own stuff at 5+%.. neverthless, we've seen crazy inflows into EM, like record crazy this year.. so the boats getting awfully lopsided and the exit door getting smaller and smaller.. If oil were to kick off again (once again unlikely), then it could get messy fast but not a huge concern on the radar just yet. Perhaps look to trade within EM and just pick up the better names (or higher vol adjusted yielders). Say being long INR/TRY/BRL/IDR etc whilst selling a basket of beta weighted lower carry (and arguably higher risk EM) such as MXN/KRW/AUD could work well to bring in a bit of carry and not risk a massive turn lower in EMFX broadly.

Jumping on the bandwagon now seems unwise, but many still will as FOMO is just too big these days, I mentioned KRW earlier as a potential to sell, mostly looking at two factors.

CDX HY vs $KRW
$KRW often trades like a vol product (one that is cheap to buy) but has recently overshot some other x-asset moves.. secondly, China is still a concern to me, and just as no one is talking about it (and CNH vols/skew is back to nothing) is precisely when they'll come out and do something, with KRW highly exposed to this.

Anyway, just a quick update on some market dynamics from me, and if you're foolish enough to still be reading, here is a bonus chart that everyone seems to love right now..

totally not a concern... yet...


Thursday, 21 April 2016

April/May FX&Rates thoughts

So it's near the End of April, and it seems we can "now" start 2016, and thus subsequently ignore the first 3 months of hectic volatility in every asset and US recession calling. A broad outlook to me is positive still, at least in the US. Some slow down in growth momentum, highlighted by calls for a bad Q1 GDP, but the remaining data remains stable, especially inflation.

What is key for the Fed is not data, as much as they say so, its the SPX, its the VIX, its HY... Where each of these has seen a significant improvement. The S&P is back to 2100, the VIX is clearly sub 20, and chilling down in the low teens and HY spreads have improved dramatically, with CDX HY trading close to 400!

CDX HY and VIX back to lows


These combined, put the financial conditions in a better situation than last October, this generally feels like a repost of this article I wrote back in Oct.(http://macrocreditfx.blogspot.co.uk/2015/10/27th-october-fed-and-rbnz.html)

And once again, it definitely means that on the margin we should expect the Fed to surprise with a hawkish tilt going forward. Thus I look to position for a sell-off into next weeks FOMC.

Another factor that is seemingly now "bullish" is higher oil.. whilst a year ago, and according to the textbooks lower was better - but a goldilocks range for oil (and notably low volatility) is the most ideal situation here, especially for the HY/Shale types. This also takes pressure from declining inflation readings which once again on the margin should prove beneficial for US rate hikes this year.

For me now, the only main risk against a June Hike (excluding some unforeseen madness) would be Brexit... which could take place a week after the June meeting. Whilst I, and the market, sees a low (less than 25%) chance of a leave vote winning, it's a tail risk that the would hate to tighten into as it potentially causes political and economic issues in the worlds second largest economy. So this is what niggles at the back of mind as someone paying rates here.

Trade 1: 5s30s flattener at 135bps, targeting 120, risking a move above 140.



Here we can see the set-up, leaning on this downward trend, we can establish a flattener. Most of the leg work likely to be achieved from the 5s, which have seemingly rejected another move lower to 1% and have quickly headed towards the middle of the large 1-2% range. On the 30s, global anchorage of longer end rates remain to support duration and with the USD weakening a tad recently, there could be an increase in demand for longer end paper that pays some 2.7% in $s. When comparing against japan or europe, there is a significant yield pick up even after swapping out the ccy, and so real money flows from these would likely keep a lid on longer end rates. Alternatively, sell payers in 30s whilst selling recievers in 5s with a delta that is equivalent to a 5s30s flattener but gives us more optionality on the outcome, albeit with limited returns.

The main risk to this trade, aside from an overly dovish Yellen is a continued pickup in inflation expectations which put a greater pressure on term premium and the longer end of the curve. However inflation expectations have moved a lot which Oils leg higher so it may struggle to keep heading higher.

Trade 2: Buy $ 3m2y straddle against 3m10y

Grey - 2s vol, Orange 10s, Blue 5s
As we saw in October, the shift from a dovish fed to a hawkish one, sparked a pickup in volatilty in the front end more than the belly or longer end. As such, I would take the opportunity whilst x-asset vol flows weigh on Rates vol, to get long 3 month 2year vol looking for a repeat of November. Either outright, or as I prefer against selling 10y vol which whilst will move, should be contained by more global factors.

Trade 3: Buy Peripheral Debt vs Corporate HY

European HY markets have performed very well, with 5y Crossover trading at a mere 300bps, this compares to a comparatively wide levels for BTPs at 120bps.


The rationale for this trade is a normalization of BTPs as a risk proxy, but hedging out any potential market weakness by paying Xover. some causes for this divergence include a continued under performance of European Financials, specifically Italian and the inclusion of IG rate corporate credit into the ECBs buying program which has supported (indirectly) HY debt markets. This is a relatively low conviction, but lower risk trade.

Trade 4: Buy Canada STIR vs US at 6.5bps

M7 STIR spread
Canadian rates have moved a lot, especially versus the US, and while fundamentals in both are broadly in line, Canada has sold off mostly in part to Oil's rally so there is some embedded risks to oil in this trade, however it's setting up as a good risk:reward to pay the spread at 6.5bps, risking a move to 0 whilst targeting a possible 25bps move higher. Once again a play that the US moves first and that the BoC remain cautious which pushes down the curve somewhat.. the strengthening CAD should hel p with that as the BoC (as hinted last night) is starting to be concerned with it and its impact on exports.


In FX, I have very little conviction anywhere. The EURUSD keeps flipping up and down in its range, whilst I am Bearish US rates, I am less bullish on the USD, and wouldnt be overly surprised to see us take out 1.15. In JPY, thats had a wild ride, where the market has called out the BoJ to a large degree of success so far, but one has to question with the improving risk backdrop / commodity price increase / BoJ that USDJPY downside is limited here.

AUDUSD remains bid with commodities (notably Chinese domestic metals are rocketting!) however as we approach 0.8 I start to see limited upside and the risk:reward is skewed to downside. EMFX and other EM assets have been very well supported by general risk sentiment and the recent Argy offering highlights the demand that is out there.

GBP is purely a brexit sentiment trade for the next two months as we hear more and more on polls, whilst staging a relief rally now (partly USD weakness), cable looks keen to burst higher through 1.44/1.45 however I'd expect to see hedgers and sellers re emerge and the upside on GBP is limited until we get *much* more clarity on what could happen.

Cross-asset vols broadly seem cheap to me, given the potential shocks and risks we see in the next 3 months, but very selectively will I buy vol. In US equity, it seems very cheap but the fed will try not to spook the markets here and whilst earnings are relatively lame, the market is shrugging it off.



Monday, 7 March 2016

March FX & Rates outlook

Global markets have seemingly shrugged off the start of the year, and if we are all in agreement then the year can start now... There is a fair amount to consider, we've an imminent ECB meeting, the FOMC towards the end of the month and a lot of action in the HY/commodity space.

Firstly, a quick primer on the ECB this week: what I see baked into these markets is similar to last Decemeber in terms of a move in the Depo rate, which currently stands at -0.30%.. 3m3m EONIA forwards trade at a 10bps discount to this (from 15 a few sessions ago), and this works as a decent proxy for expectations but speaking to a few people 15 or 20bps is what they are looking for as they believe the ECB will deliver.

ECB Depo - EONIA 3m3m forward


I'm less sure about the rate, but there is a definite expectation on non-rate action; such as a new tiering for negative rates (in some sense similar to Japan/Swiss etc) which would be welcomed by the market, and lastly an increase of €10/15bn EUR on the QE program. Now this is a lot, but I believe after the disappointment felt in December, and the sharp asset moves (especially on front end rates) the ECB would be keen to avoid this.

Whilst I am not sure how they will surprise, I think they will. One possible caveat to this is that there has been a decent move higher in inflation expectations (5y zc swaps up 20+bps in the past 2 weeks) and the strong bounce in oil, however with headline inflation taking another dip its hard to see anything else other than dovishness. Another possible headwind is the rhetoric surrounding negative rates that all kicked off last month, specifically around Financials (and those CoCos).. but personally I think that was a narrative fitted to price action and not an overly large concern - but worth considering.

EUR TWI is positive y/y and since the inception of negative rates/ QE, which whilst not a massive problem its something I feel the ECB would like to change.

EUR y/y
Some form of downside in EUR looks good to me especially with front-end skew being bid to 0. With EURUSD at 1.10, and given my bearish US rates theme (later on in this), I think being short is a good tactical play, however given the potential risk of disappointment like last time I'm preferring options to spot, given the crazy moves in EUR back in dec.

eurusd 25d riskies
10s30s is also interesting to me, its been steepening quite a fair chunk. In my last post I recommended 5s10s flattener, and looking at 10s30s at 80bps, I am keen to look to extend this out the curve, especially given a surprise from the ECB and the very tiny chance of any upward revisions to inflation (or continued increase in market inflation expectations).

German 10s30s
I am less sure there is any juice left in BTPs, the spread has dropped to 122bps from 150 a few weeks ago which is where i was a buyer.. but here, not for me.


Now on to the Commodity spectrum, and today / this week, we've seen an almighty squeeze (and thats what it is) in a lot of commods.. true, however that metals bottomed a long while back, and this is an important tell to me. With Chinese peak pessimism occurring at this time, one has to wonder if the EM collapse story is gone now, especially as we look to any upside in growth. EM credit / FX / equity has been an incredible story YTD, outperforming in the midst of G10 markets blowing up. Brazil CDS trading back below 400 (from 500), even ZAR is up (after carry) YTD.. and thats quite something.

Oil has been a big driver of many markets, and somewhat fairly, but we have to step back after a move like today and re-evaluate.. Personally, I've been long inflation (which is by-proxy long oil) but I'm starting to look and think we've potentially squeezed enough.

Front month CL
 Now I know there isn't much in a line, or a moving average, but given the move we've had I would start to consider that we've approached a stronger resistance area around $40/bbl. There are still many issues that haven't been resolved in the last $10 rally, albeit I think we did see the low, I think we could trade lower in the immediate future. Owning puts isn't the worst idea to me, implied vol gets hammered on a rally and cheapens downside and we now stand at 50, being long vega here isn't bad either with 100d realized vol sat closer to 60.

Copper is similar, now trading close to 2.30, up from sub 2 not long ago. But we stand at resistance, and would be concerned of a pullback which could put the brakes on global risk, so owning hedges now is a) a cheap time b) a good price.

One other way I'm playing this is in USDCAD, I like the $ exposure given what I'll write about next. the CAD side, its a fairly simple 2 factor model that seems to run it; Oil, and rates spreads (which themselves are autocorrelated to oil).

By the looks of it, it seems a cheaper way to play Oil downside and as such USDCAD calls are attractive to me.

CADUSD, Oil, and 2y rate spread
A simple regression would indicate FV for USDCAD to be around 1.36/1.37, contingent on the variables being steady. For indicative purpose, a 1 month 1.36 call costs 32 pips.

SPX over 2000 is good. Good for risk generally, and interesting for the Fed, which remembering back to Sep-No-hike, played an key role. This makes for potential hawkish trades into the FOMC

Looking at the ED curve, its still well-below where we started the year, and has some catching up to do with other markets in my opinion.


This is an index of the average contract-contract roll in EDs, I.e. 3 month slope for the first 10 contracts. we started the year at 15bps, implying a rate of 60bps per year (or just over 2 hikes), we recently traded as low as 4bps, or less than one hike.. I think curve steepeners in this sense offer a good risk:reward with limited downside (cos realistically it'll really take something to go negative) and a look back towards 15bps+.

Elsewhere, the 10s look expensive on the 5s10s30s fly, and whilst being outright short is one way to play, selling 10s here looks good for a reversion of another 10bps or so.

US 5s10s30s
With Core inflation in the US looking strong, employment growth good and broader macro risks disappearing I see no reason why the Fed would not continue to hike this year - however March is unlikely, its too soon after the shockwaves that hit around the beginning of the year, so I see this setting up very very much like last year.. with March = Sept, April = October, and most importantly June being like December.. a Hike! of course, of course, the usual data dependent bollox applies here, but as things are going now, I see 2 more hikes this year. which makes fed funds and Eurodollar curves remain attractive.

So remain bearish US fixed income vs. everywhere else, though stick to the front end if playing outright as global anchoring of longer end rates will probably keep a cap on 10s+

As with the GBP curve, the idiocy that occurred there was just quite something with the talk of negative rates and at one point the GBP curve being flatter than EURs courtesy of Barclays here.


Months to hike index was also greater in UK, and still stands at ~40months.. but Brexit innit. Oh well. Markets gonna market.

All in all, should be an interesting month but I'm positioned for a shorter term dip in risk, whilst seeing the next 3 months in $ rates very attractive to short.

Thanks for reading.

Tuesday, 26 January 2016

February Rates & FX outlook

The start to 2016 has been very volatile to say the least, to the ~10% decline in Equity markets, ~25% decline in oil prices and a chunky widening in credit spreads.

What both frustrates me, but provides opportunities, is that during this sell-off, much like last August cross market correlations have jumped rapidly to 1. Whether you load up a chart of E-Minis, US10s, CDX HY, USDJPY, AUDUSD, Oil.. they are all tracking tick for tick. Rightly or wrongly, they will probably do this for a while as they did through September, whilst markets digested everything, volatility subsided and underlying drivers of each asset eventually came through.

Going back to the start of this weakness, it was sparked by China.. no one really doubts this, the rapid move in CNY triggered 1% candles in US equity futures at 1:15am UK.. It was both good fun to see everyone become a china expert and a royal ballache to wake up to drastically different prices, but for the past 2 weeks now, China has remained quiet where as markets have remained impressively weak. The narratives have switched from China driving the markets to Oil, and who knows what is next (my money is on HY, but we'll see).

Going back to the point of this, I think that the jump in correlations is a clear and present opportunity to express some better underlying macro trades that two weeks ago made sense to a lot, but under current sentiment wouldn't be nicely welcomed. Think, just general sentiment is now for Equity to close the year negative, even US 10s have been called to end at 1.5%. Whilst I understand there are some concerns out there, the fact we are *so* sure of this bearishness now we are down 10% solidifies the view that its people panicking. This doesn't mean I will be right, I am just saying people are reading the tape as gospel and ignoring the underlying fundamentals which funnily enough haven't really changed in the past 3 weeks. (at least equivalent to the size of the market move)

Firstly, TIPS.. The trade everyone loves, but everyone loses on... I really think tips offer some great value here. US 10 year break-even inflation stands at 1.33% down from around 1.55% at xmas as shown below. As per, it correlates well with oil.. which of course is ES, which is US 10s, which is CXD HY which is Oil etc etc.

With Inflation broadly, its mostly reliant on core domestic trends rather than "transitory" oil moves, and domestic trends remain  on balance positive to the US with my personal expectation of CPI to continue to tick upwards.

As such, the market noise that we've had YTD and over the past 6 months offers good entry points into BEs

US 10 year breakeven vs. Oil 
With correlations, it is clear that this (along with many trades) is sensitive to movements in oil for the immediate term, but it is a trade I really fancy here.


On US rates more broadly, they've been recieved lower as "risk off" or whatever we want to call it, has led to demand for bonds. It's been such a sharp, fast move that EDZ7 trades where Z6 did just 3 weeks ago.. The Curve has been pushed an entire year back! To me, this is just stupid given the underlying fundamentals have barely budged.

EDZ6 / EDZ7
Such a rally in bonds is something I am fading.. But it is once again linked to equity/oil/risk etc, which is frustrating but does offer a great price to fade the majority of this front end (and whole curve) move.

FFZ6 vs E minis
Moving tick for tick, the front end has tracked risk lower.. and here is my game plan for the FOMC this week... Thinking back to September last year firstly; We had seen a very similar move (sparked by china too) where front end rates were trading with Equity.. We can infer from this that we would see dovish behaviour from the fed sparking further fears (almost a realization of potential fears) and vice versa. So what we saw in Sept was the fed back tracking on what they had mostly told market participants was going to occur and this was a clear policy mistake - this meant the Oct meeting was used to tee up Dec. Looking to this meeting, I believe the Fed won't want to do that again, and thus will use this meeting to tee up march. Crushing vol, restoring a bit of confidence and ultimately resulting in the YTD moves giving back at least half of the move.

Now there was a lot of talk about how the Fed only goes when the hike probability is over 60% (or whatever it is), and as it stands FFZ6 sits at 60bps which is marginally more than 1 hike left this year. So I see this meeting (as I did in Oct here) to get short the US rates spectrum. Many ways to do this, Curve steepeners on front end, outright shorts, options trades.. but what I've opted for are Payer ladders on US 5s and short calls on EDZ6.

FVH6, or the 5 year future is currently trading in this well established range (something highlighted in my 2016 outlook piece where I am short a straddle on US 5s)

FVH6

Selling topside and buying a put spread offers a short vol, short rates and negative premium trade with the pay-off as such. I believe rates will drop throughout Feb as the Fed tees up more hikes, equity markets bounce and risk sentiment recovers somewhat. I am not sure we sell off enough to take out the lows but a move back to 119 works for me.

US 5 year options trade


On to FX.. I am positioned in rates for a hawkish fed, and I think the risk:reward in buying the USD is significantly less attractive here vis a vis rates. It also offers a decent hedge against a dovish fed on two accounts; firstly the USD should sell off but also considering EURUSD correlation to risk and its nature as a funding currency any further weakness sparked by a weak fed would lead EURUSD to take 1.10 in my opinion.

EURUSD
The charts see a consolidation / wedge forming, with heavy resistance towards 1.10, but its likely that we would see plenty of stops and a blow out through this on a dovish fed, trading as high as 1.12 in the following days.

EURUSD vs 10 spread
Here we can see why I prefer taking a rates trade for a hawkish fed, the divergence of EURUSD from rates gives us an equivalent 300 pip cheaper entry for short EURUSD (well for one way to look at it) but given the vol skew in EURUSD I would hedge my short rates with a 1.10 or 1.11 calls. As we are not only trading on the edge of the wedge but also its a cheap hedge right now.

EURUSD vs 2y real rate spread
Longer run Real rate spreads will be the key driver where we see little medium term dislocation between "fair value" and EURUSD.

One last trade, less related to FOMC, is EUR 5s10s flattener which I think is quite attractive here.

Trading towards the top end of its range at 70bps, This is quite steep when considering the rest of the curve.. More so, 5s are trading -0.25%, not far from the ECB depo rate (even if they cut again, which ftr I think they will, with an extension of QE)

EUR 5s
Much like with $ 5s, I've also got the same position in options on in € rates here.

EUR 5s10s
With less and less bonds eligible for QE purchases, extending along the yield curve will continue and demand will pick up for 10s and in this backdrop I would favour a flatter curve with the main risk coming from a sizeable bund sell off which doesn't seem too likely with the recent ECB rhetoric and oil backdrop supporting this.

In conclusion, my opinion is that right now, the fed will look to add confidence to the markets by staying firm to their plan and the hiking cycle by setting up the next meeting as a more likely than not situation, as such selling rates broadly should work as markets will start to decorrelate and trade back to fair levels. Buying EURUSD calls appears like a cheap hedge, and EUR 5s10s flattener looks like its at good levels.

Thursday, 17 December 2015

2016 Rates & FX Macro trade ideas

In this slightly longer piece I will present my thoughts, ideas and themes which I think will play out in the medium run, throughout 2016, across the various asset classes.

G10 Rates Outlook


  • Short L M7 against ERM7 at 131bps, targeting 160/180bps with a stop below 110bps
In recent weeks, and in lieu of a tightenting Fed, GBP rates have seriously outperformed, diverging from a strong link with US rates that has been seen for many years. Growing sentiment regarding the Bank Of England that they will likely be dovish has led to this, with some pushing back the 1st hike to 2017. The divergence away from the Fed, and towards the ECB can be seen below.

Months to 1st hike indexes for Europe, US and the UK
With the UK economy ticking along very nicely, its interesting to see how the Fed is so much more prepared for a tightening cycle, yes inflation is higher.. but wage growth (at 3% y/y) and subsequent pressure in the UK is greater and with an on average (2.3%)  GDP growth it seems fair to start tightening to prevent later pressures. 

Unfortunately as is the case with all global central banks, they are placing far too big of an onus on their response to Oil prices, thinking back to the ECB in January, there is almost zero chance we would have seen QE or further easing had Oil stayed at its 2014 levels. But of course, it didn't. And we are now trading $35 or so, and dis-inflationary pressures remain on headline CPI, worse is that the desired "base effects" that were due to roll off in the coming months won't have as strong of an impact on CPI worldwide. 

Nevertheless, the UK rates market is pricing in very little tightening, and a very shallow curve, taking this against the backdrop of European rates looks favourable right now. The ECB "shocked" (admittedly against stupid expectations) hawkishly and whilst we saw quite the reaction in front end EUR rates, they will still be firmly anchored from QE flow and negative rates - even being optimistic on Europe, I will still look to receive their rates. Getting into the trade is simply done by selling June 2017 GBP LIBOR futures against EURIBOR futures (L M7 - ERM7)

L M7 - ERM7
We've had the "great divergence" between European and US rates, but with UK rates almost 1% from the wides, we have room to move in this direction, as such entered at 131bps, looking for a move towards 160/180bps during the course of the year. We have a relatively well defined stop area in the 110/115bps range.

However as mentioned, its not just against EUR rates where there is a good set-up, but longer out the curve against the US looks good too.

  • Short UK 5 year vs US year at 40bps, targeting 10/20bps, stopping at ~50bps
Similar rationale on the UK rates front, the market seems to be seriously discounting any possibility of a hawkish surprise from the BoE, and with the Fed hiking, it will give Carney et al perfect timing to shift tone.
UK vs US 5 year
More specifically on the 5s, it offers the best relative value against US along the curve, with clear entry and exit levels.

  • Recieve AUD 2yr at 2.35%, targeting 2% and risking a move to 2.5%
Australian Rates have moved significantly in recent weeks, against a tide of fundamentals suggesting otherwise. Watching the price action, specifically post the Oct Fed meeting, it seemed A$ rates were being paid along with all $ rates. This offers a good entry point, and opportunity to get long Australia. Domestic data has certainly ticked upwards, with a couple of strong Unemployment reports, but broadly the overall economy remains incredibly vulnerable to a slowdown in China and declining Commodity prices.

AUD 2s vs Iron ore
Seen clearly above, Iron ore (and the commodity spectrum) has continued to decline aggressively, and whilst the overlay is spurious, the idea is strong. Stevens has told us to "chill" for the Xmas period, but with a worrying China (on the verge of further easing vis a vis CNY weakness), weak economic activity through lower commodity prices and crucially an outperforming AUD that has risen 5-7% (depending on index). This is going to be of most concern going through to the new year and should pressure rates markets.

My base case is that we see further cuts next year as we approach the end of the commodity cycle, possibly bringing the base rate to 1.5%, this gives us more room to target below 2% if this gets going. 

This idea plays a further part when considering the FX outlook later on, but broadly, unless we can see a rather sizeable commodity bounce the risks to this trade seem limited to an overly hawkish fed lifting global rates - which seems unlikely. 

On to the US curve and the real limportant question is how many times they hike - finsih after fed..

  • Short USD 3m5y straddle
Yellen and the Fed managed perfectly to hike, and keep asset markets in check. It was hawkish enough for the curve to remain relatively stable and do as expected and flatten a touch, but she also acknowledged potential risks. Building on this theme, I am looking to sell vol on the belly of the curve, US 5s. Unfortunately for me I am limited to maximum of 2/3 months out due to futures volumes, but in swaptions I would recommend at least 6 months. Implied vols aren't spectacularly high right now, 3m futures IV is 3.5. Using simple approximation, this equates to a roughly 4.5bp move per day in US 5s.

US 3m5y implied vol (price vol)

Given the outlook for the US economy, which does include in my eyes potentially faster than expected inflation and strong growth - but against a world which is easing and arguably in trouble (EMs), I believe the US 5 year will stay fairly well fixed at around the 1.5/2% level that it has traded over the last few years, for the entirety of the next year, and given a 2 month straddle breakevens at 1.32% and 2.12% I feel comfortable selling this (as seen below)

US 5y and 2 month breakeven range
We also need to discuss the terminal rate, in the aftermath of the rate hike, long end yields have dropped, with 30s coming off 5-6bps. The 5y5y fwd swap sits at a mere 2.63% and there is clear potential for this to edge lower. My preferred way is to constantly be selling US 10s +25bp payers through out the year, rolling every month or so. I find it hard to see in the global context long end $ rates to really escape those of Europe or elsewhere given how they are effectively anchored to one another, even if the front end can diverge.

Lastly for rates, looking at some European rates, and more specifically Sweden. Economically, Sweden is looking good, as does Norway (but oil niggles). With the Riksbank recently changing tone, and shifting upwards the inflation focus as well as growth estimates its possible sweden can surprise us next year - currently the expectations are for lift-off at earliest 2017, more likely 2018 - and not before 2% inflation! but with upward pressure to rates and strength emerging in many G10 core nations then paying rates in some of these less obvious places might work. SEK 1y1y stands at -0.07% and we could see this trade all the way towards 10/20bps with an impulse of inflation and continued optimism in the economy.

Core CPI highest -> Lowest, Norway, US, Sweden, UK, Europe, Japan
Having come from quite serious disinflation/deflation, Sweden has recovered (although its not to say their economy was ever really *bad*) and we could see paying Sweden work out well.

This is unfortunately dependent on what happens in Oil too however, it seems with Oil in this area, we should expect Draghi to lean more towards Easing - even though his, and my own, outlook on the Economy is good. It pushed too far last time, and its possible that if it were to happen again further easing could occur.

This leads to a nice idea in inflation that I've got which is to pay 5y German inflation, which currently trades at 65bps. On the one hand, I am reasonably confident in European and G10 (ex aus/Nz) growth next year, which should place upward pressure on inflation, and if oil continues to stay weak the ECB will likely play with more QE which could stoke the market to price in higher expectations as it did after Jan.

So buying 5y inflation bonds whilst selling 5y govt bonds looks like it could work well. Alternatively, you may not want to sell German 5s as ECB buying may keep it pinned so outright long on 5y inflation bonds also works (but prefer the spread trade).


  • Pay German 5yr inflation at 58bps, targeting 100bps, while risking a move to 30bps

FX Outlook:

FX is going to be more difficult I imagine, after 2015 was mostly range bound in the majors, there is very little expectation of *big* moves this year. Implied vols trade at the lower end of the years range, and close to historic means, but significantly above 2014 levels. It's difficult to see with how we are lined up for overall FX market volatility to realize meaningfully higher - after all 2015 we saw plenty of action ranging from CHF de-peg right at the beginning, to wild 5% ZAR swings, and a plethora of emerging market Devaluations. 

This last point could remain a key factor going forward and I suspect there will be even greater emphasis from Central banks on their effective exchange rates. China have recently introduced a basket mechanism to diversify away from the USD - this is important as we would expect to naturally see the CNY therefore depreciate going forward, however this is by no means guaranteed especially when considering the basket composition. What this means is it seems less likely that there will be a sharp move in CNH - Current vols stand at 7, which is not to far of the likes of USDJPY or GBPUSD, yet it's likely (as it has done much in the past) realized will underperform as such I would like to sell USDCNH 3m vol here. It implies a daily move of around 0.43% (6.75/sqrt(252))

  • Short USDCNH 3m Straddle, delta hedged daily at 6.75%
Vols have tracked Spot higher, but skew remains tight. The main risk to this trade is the idea that PBoC do devalue / let it go.. in which case we would likely trade north of 7, in which case owning a 3m one touch costs around 17% of notional and could serve as a hedge (ignore the delta on it on the overall structure) to our short vol trade.

In G10, as mentioned before, I don't really have a gutsy view on the majors, broadly I'd expect to see the USD under-perform in a backdrop where GBP (due to rates re-adjustment) or Sweden (rates again) could do well but nothing large in terms of move.

So I look to crosses for ideas, and one that I jump straight too is selling Australia and New Zealand. selling these two in a basket against GBP + SEK looks attractive right of the bat, seems fairly cheap and the macro drivers definitely look attractive.

For AUD, the combination of the RBA, and my expectations that their rates continue to drop after being weighed on by the commodity downcycle should result in weakness. Moreover, AUDNZD is well defined in a range and we sit at the bottom end of it, NZ economically is certainly starting to improve, but a continued easing bias from the RBNZ could see pressure especially due to relative strength in recent weeks of the NZD.

 

On the other hand, for sure the Riksbank don't like a strong SEK, but there is enough breathing room for some mild appreciation. With one of the most impressive economic outlooks, and driving forward alongside Europe suggests the SEK could outperform.

GBPSEK/AUDNZD basket

Alternatively and a little riskier, would be to short AUDNOK straight out, economically, norway is far better suited to deal with this Commoditiy shock. Not only has the Norges bank preemptively cut, but their domestic demand is showing very strong signs, from the highest Core CPI across G10 to stably strong retail sales. One downside is the impact on unemployment, which has increased in line with oil price declines, however the impact of lower commodity prices has impacted the fiscal balance significantly more, with Norway running a 9% surplus, with Australia's likely to be towards -3% after the Government releases new estimates soon. A similar picture with Current account, with Australia's declining markedly whilst Norways has remained rather strong.

To sum, I like Norway's economy, I believe they are well prepped for this commodity decline and will be well suited to cope, whilst Australia continues to deteriorate, and as such prefer to play AUDNOK from the short side - though I wish FX played alongside the fundamentals they often don't. But with AUDNOK at c6.25


AUDNOK

There is a lot of relative value commodity determination in this, which is not ideal as I have no firm views on copper against Oil for example.. This is purely a country play, however Oil plays high beta to copper/iron and is marginally less dependent on China so can see an environment where Oil outperforms thus supporting this thesis.

USDCAD is an interesting one, alongside oil prices, the CAD has been absolutely hammered, and is now trading close to extreme long term levels.. much like with Norway, their economy is clearly impacted by Oil, but to this extent? We will have to see, but with USDCAD at 1.40, this could be an out of consensus short that could perform well. But with Oil still dropping its hard to pull the trigger just yet, but it does seem very cheap

USDCAD
Especially given that rate spreads don't support the last 3 months of USDCAD strength and aren't even at their wides

US 5 - CAD 5s
 
Emerging markets are an interesting case, broadly they have moved a long way and have priced in the Fed moves fairly well - however when considering sustained commodity price weakness it seems difficult to see a lot of the exporter names rally, and in Asia, with further CNY weakness it would be difficult to see the ADXY index rally meaningfully. Carry is starting to compensate risks such as in turkey and south Africa, but risks seem to high for me personally to step in here, and I would expect basket cases such as Brazil (currently at 3.86) to trade well through 4 again next year.

One of my last trades in FX is mostly a hedge against my underlying biases of a weaker USD and this is to buy a 3m EURUSD 1.07 digi put, which costs around 33% of notional. In lieu of a potentially hawkish and optimistic Fed, and with Oil and these levels once again pressuring the ECB (given how senselessly responsive they are to it) could see a dip back into dovish rhetoric with the ECB concerned about EURUSD close to 1.10 and not parity.. so its seemingly a cheap hedge against this idea to me.

Equity/Credit outlook:

In credit to begin with, the HY space has been in the news a lot recently, but there are many things to consider other than just looking at the ETF HYG, index composition is heavily leaning towards energy/commodity names, and with this space being weak, its no surprise to see these names widen and drag the whole of HY with it. Goldman produced a nice chart (below) which loosely suggests risks of a recession given where HY spreads trade - its more of a nice thought provoking chart, however on twitter/media a lot of the thought has been panicky and shallow.


We need to consider Impacts on default rates when looking at credit, as ultimately that is the key determinant here. Sure, MtM losses on cash bond holding can lead to redemptions -> more weakness especially in lower liquid times, but essentially if you buy these bonds at 7.33% above USTs, unless the default you will be making this. Which is why looking at the CDX HY (credit default swap index of HY debt) the total return this year has outstripped the SPX (on corporate default rates I refer you to a SocGens 2016 credit outlook where they do a great job of analyzing default rates and how they are unlikely to spike here )


With the positive outlook from the Fed, and strong corporate growth in the US, I see at least for H1 a positive return in the high yield class. A goldilocks fed should spark risk on, with acceptance of a strong economy but also remaining accommodative enough to support growth.

CDX HY trades at 485 as I type, and a synthetic forward trades at 555bps or so (6 months) on the s25. Selling protection at this level looks attractive, but even more so is selling payers given the huge implied pick up. A 3 month (cant get liquidity further out) 525 payer breakevens at 580. I would use this premium to source trades in other spaces. Cash HY is likely to outperform on a bounce in risk so using this 65bps to fund HYG calls could work well, or just run with the short payer anyway.

  • Sell protection in HY US credit via a 525 payer for 65bps
Namely looking at European and Japanese equity markets against US.

  • Long Eurostoxx and Nikkei against US at index level 100, targeting 15% outperformance

ES vs VG
European equity has underperformed US in recent weeks, although is set up with much more favorable terms with the ECB potentially embarking on more easing (not my base case but possible) and economic growth to see definite upside could result in strong corporate returns and a strong eurostoxx. Same in Japan, looking at the economy here, its doing well - recent Tankan data was robust, labor market tightening is accelerating (jobs-applicant ratio at 1990 levels), continued accommodation from the BoJ (however no more extensions to this). Nikkei likely to reach new swing highs over 21,000.

Although I don't have strong convictions in equity space, and these are consensus views that I agree with, however in US equity, I struggle to much upside and would continue to sell vol here. Dips will likely remain well supported throughout the year, and we will inevitably reach some point where we've dropped 5% in a few days and the media starts to panic, the skew widens considerably and the VIX term structure inverts - but as things stand these continue to present buying opportunities with the US economy performing well.

Either way, just some of my thoughts on financial markets through 2016, it does seem to be setting up to be interesting and I wish you all good luck - oh and disclaimer, don't listen to anything I say here, it'll probably all be wrong!

Happy Christmas Readers