Policy error vs max easing
In my last post, I discussed the "policy divergence" narrative of US vs Europe. Coming into this year, this narrative had been a primary driver of markets:
- US policy error: Fed signaling liftoff despite crashing inflation BEs;
- European max easing: ECB negnom & QE against growing underlying money supply.
In my post, I mentioned that I spent most of January flat or net short USD based on a view of re-convergence, which had two parts, as shown in the screenshot of the post to the left.
I was concerned that #2 was under threat from recent FOMC dismissal of USD strength, so I raised cash and opened risk-off trades to hedge against hike vol. I wondered if I was capitulating or not. Afterwards, I managed to avoid the EURUSD selloff from 1.13 to 1.07, and catch the rally back up. But I was indeed right about both of my above points, after all: I had indeed been capitulating back in January. And now the re-convergence theme seems to be at hand, as "lower-for-longer" combines with "2015 liftoff" to create "sooner, but slower".
Sooner, but slower vs terminal easing
Since then, it's become clear that much of the drastic decline in BEs was a function of the oil impulse effect: breakevens price off of headline CPI rather than core, but food & energy price inflation have little correlation to core. As oil has stabilized, as have BEs, and the Fed "policy error" narrative has given way to "sooner, but slower": enough transience in the BE decline to allow a Fed hike this year, but a slower pace thereafter until growth convincingly accelerates. The same narrative reversal has happened in Europe, as QE and negnom announcements have come and gone, and the underlying economic pickup has shifted the attention to when ECB easing ends.
Indeed, the 6mo correlation between EUR & USD 1y1y OIS forward rates (a proxy for expected path of policy rates, shown to the right) has gone from sharply negative in late-2014 to slightly positive as of this week. A sharp reversal in this correlation higher began in mid-April, as bunds began to selloff and trickle down into global rates vol & risk premiums, including a steepening in US 5s30s from 10bps to 15bps. This occurred on the back of EURUSD squeezing higher, which itself came on the back of crude's rally. Crude stabilizing allowed for an unwind of the crowded policy divergence portfolio: short EURUSD, long DM sovereign duration.
"Sooner but slower" is the new "story"/heuristic for the US market, which allows for the curve to steepen and be more sensitive to the labor market & financial conditions than inflation thereafter. This is why I am short ED Z0 (as a proxy for terminal rate) and playing for a US fixed investment cycle with ED Z5Z7 steepeners.
In Europe, the narrative has shifted from pricing in new negnom & QE policy actions, to looking at the strengthening economy and asking what the terminal dates are for these easing policies. The Fed is signaling for a liftoff about a year after beginning to taper QE and the ECB has stated QE will extend at least through 2016; if we assume a taper beginning end-2016, an equivalent one-year grace period implies liftoff end-2017. This amounts to 30 months; only a couple of weeks ago, this was priced (via the Morgan Stanley M1KE months-to-first-hike index) at 57 months, so the bund selloff seems more clear after the fact. But this makes me avoid betting on the first ECB hike, since M1KE is currently around my expected value of 30 months, and I instead prefer steepeners in the late-2017 to mid-2019 part the Euribor curve, but only tactically: if the Euribor curve sufficiently steepens over the next 3-9 months, I would love to take the other side of the trade, to play my view that late-2017 would be too late for a new hike cycle (due to the US & global economy business cycle turning back down) and would be a policy error, but only once the current higher discounted growth phase in European markets matures.
US 30yr yields have convincingly broken through their 200dma, as shown above: the bear steepening bond market's signal to the Fed is "Hike, away. RIP policy error". This bodes poorly for equities, which have been riding a discount factor wave since October lows: first due to the BoJ, then ECB. Equities globally have been trading off of relative valuation & arbs versus their government bonds, which have been trading off of relative valuation & arbs versus lower-yielding government bonds, and as the Fed approaches its first hike and ECB & BoJ QE impulses fade, equity volatility could return. To play for a VIX spike over the next few months, I like the August 20/24 VIX call spread here, which provides a 6x1 reward/risk profile as shown above. I also like put spreads in SPY, XLU, XLP, & IBB. With the VIX so low, I would love to fade any breakout attempts here in US indices. I've closed my exposure to SXAP in Europe.
I am agnostic about oil here, but think it is likely due for a correction. After large price declines, historically crude trades in a range afterward, and we are nearing range highs. But the peak impulse of crude declines onto breakevens (and consequently the yield curve) has likely passed. The US curve will likely continue to steepen as long as the "sooner, but slower" thesis holds, which in my opinion will be until accelerating economic growth challenges the "slower" part of the thesis and the curve resumes flattening (this time, bear flattening) all the way into the next easing cycle. I took a small initial position in a TLT call spread this week, as a flattener exposure hedge against my short rates positions in the US & globally. I would've preferred doing it with a TIPS ETF but its options aren't liquid.
Outside of the US & Europe: Canada, UK, & New Zealand all present interesting potential trades, as well. As shown in the chart to the left, the US, UK, & Canada all have 1y1y OIS rates at around 1%. New Zealand is at around 3.5%, China 2%, and Europe 0%. I tend to think that the real policy divergence will be between the US and UK on one hand higher, and Canada (which has an equivalent 1y1y OIS to the US & UK) and New Zealand on the other lower. I am back to max size long USDCAD (after sizing down my CAD short post-Jan BoC, and playing NOK on the long side for a swing on the crude rally), and remain near max size in my long GBPNZD.
Regarding my NZD position, I am short against GBP, USD, & AUD. After this recent spike in AUDNZD & GBPNZD, I trimmed a little GBPNZD and wanted to find a hedge for my AUDNZD. I came across my friend Jeremy Wilkinson-Smith's recent piece showing that AUD has a beta to EMFX of about 1, despite carrying much less. This is partially a function of the RBA's focus on the exchange rate over the last couple years, and partly due to the economic volatility related to China's slowdown. So I sold some AUDZAR at 9.62 to have a positive-carry hedge to an AUD correction in the meantime. This new South Africa exposure also allowed me to exit my PBR long for a sizable gain, as I swapped one EM exposure for another, albeit different, one.
I'm feeling especially good about my long GBP and short CAD given their respective forward curves are quite similar, a perfect setup for a policy divergence trade. As the forward curves chart to the right shows, NZD & AUD expected rate paths slowly (almost) converge over 5yrs. I expect this convergence to come about much quicker and sooner, and think the NZ curve is going to invert. This is mainly because the Chinese forwards curve, although it's fallen a lot, is still pricing in a slow return to normal beginning sometime in 2017. I'm expecting the best-case scenario to be a slow, managed deceleration to sub-5% GDP growth, which will require much more easing, especially as bad debts have to be rolled over.
My big NZD short discussed above is partially a direct bet on Chinese slowdown/rebalancing, as the knock-on impact to commodity prices & Australia's economy make NZD the ideal short candidate with AUDNZD so low. Another China (as well as DXY/EM) knock-on trade I have is long USDSGD, which has essentially nil carry, as Singapore is effectively the "Switzerland of East Asia". Of course, whether China has a soft or hard landing is unclear. The current policymaker stance allows for a great China-bullish hedge, however: long Chinese equities, which I have done through long positions in QQQC, CAF, & VIPS. My "greater fool" theory regarding being long Chinese equities is that policymaker signaling will be sufficient to get out in time, but either way I like the natural hedge.
- Mark Dow - Tweet about yield curve
- Jeremy Wilkinson-Smith - May FX rates & thoughts
- Eric Burroughs - Remember, China's stock market boom is officially sanctioned