Analyzing the #voljihadi theme for my book

Bullard put

Amid a historic decline in rates & breakevens across the curve on October 15, St. Louis Fed President James Bullard dropped vague hints at the possibility of QE being extended. The sharp decline reversed back higher, although the trend in rates continued lower after albeit at a slower pace. Importantly, the S&P 500's forward P/E rose to new highs, even as forward EPS estimates declined.

What happened?

The October risk-off trend was originally ignited by (1) the decline in oil prices and (2) Bullard's comments that the markets were "making a mistake" in its rate path pricing. A combination of and interplay between a rising USD, crashing oil prices, and scarcity of government bonds amplified the wave down in rates. The rising USD resulting from policy divergence concerned many and "policy error"/deflationary risks became increasingly accepted themes. But it was poor dealer liquidity that exacerbated the fixed-income market moves into historic territory on October 15.

Eurodollars short covering

The policy error risks seemed to influence money markets, which have traded "through the dots" ever since a sharp short covering rally in October. However, a couple weeks later, Bullard clarified his view by suggesting the market "misread" his comments in October. Yet the ED & FF markets continued trading in their new range.

Eurodollar net commercial (inverse of speculative) positioning. Source: Sentiment Trader

Eurodollar net commercial (inverse of speculative) positioning. Source: Sentiment Trader

The disconnect

December 2015 Eurodollars futures: price, open interest, & volume. Source: TDAmeritrade

December 2015 Eurodollars futures: price, open interest, & volumeSource: TDAmeritrade

At present, FFZ5 is at 99.54 and EDZ5 at 99.27, implying a Q4 liftoff and low financial stress/conditions over the next 12 months. This has been the primary driver of the equity rally since October, which as mentioned above has been driven entirely by higher forward multiples (discount factor effect). At the same time, the October FOMC statement, Bullard's reaffirmaion of his hawkish rate path, the most recent FOMC minutes, and yesterday's comments from perennial centrist Atlanta Fed President Dennis Lockhart all suggest the Fed is looking past the fluctuations in USD and inflation breakevens and planning for a summer hike.

Which way will implied paths converge?

So who will end up being right, the market or the Fed's communication? Supporting the money markets are USD appreciation, its consequent passive tightening of financial conditions, the recent wage growth negative surprise, and declining headline inflation, breakevens, & commodities prices, all highlighting deflationary risks.

In support of the FOMC path are payrolls, consumer confidence & sentiment, JOLTS, small business sentiment, and the decline in gas prices (which disproportionately favors high-MPC and younger-age consumer real income), which all suggest a booming economy with broader reach across income, wealth, & age groups.

The FOMC is expecting inflation to bottom around the middle of this year and for these sharp declines to be transient and reflective of financial risk premia fluctuations rather than consumer expectations. Indeed, survey-based measures of inflation expectations and Fed models for inflation expectations, risk-neutral yields, & term premia all support the FOMC's view. As such, the risks skew toward the market needing to reprice, as Bullard has said. Fed Chairwoman Janet Yellen is reprising former Chairman Ben Bernanke's role by distinguishing between transient & sustainable impulses to inflation rates.

What's this mean for my book?

I am one of the unlucky (or perhaps, just dull) traders that have either faded or stayed out of much of the latest up wave in the USD. My logic boiled down to two things:

  1. A view that a cyclical turn in European PMIs was underpriced given monetary aggregates, the "Japanification" fully priced into long German forwards, and a "sell-the-news" on a fully-anticipated ECB sovereign QE signal; and
  2. A view that the rise in USD gave the FOMC room for a combination of "lower-for-longer" and steepening further down the money market curve as inflation & path uncertainty risk premia came back in.

Recent data flow, the FOMC minutes, and Lockhart's speech increasingly confirmed to me that I was wrong about #2. And with money markets a full quarter behind the Fed's liftoff communication, I had little room for error, especially given the risk this has to the USD (both from higher front-end yields and the "policy error" feedback loop unless/until data vindicates the Fed's "transient" view).

So step one was to raise some cash. A big goal of mine this year is to keep it simple and minimize overtrading. When my view changes or faces uncertainty, especially after a poor hit-rate streak as I've had of late, it makes sense to derisk a bit and take a step back.

I had steepeners in reds/greens on, so step two was to sell the reds and leave myself outright short greens. This again raises cash and reduces the risk from my short USD positions.

At the same time, the main risk from money markets repricing is from the unwind of equity forward multiples, which had risen in sympathy to lower expected short rates. There's no risk premium in the front of the curve, and a normalization would reprice equities and unwind the "Bullard put" (which pushed back this process). Large-caps have had the largest benefit from this dynamic, particularly staples, utilities, and tech. Like my friend Guillermo Roditi Dominguez summarized: the labor market is sufficiently strong that "spoos & blues" is over.

12mo forward P/E ratios: S&P 500, 400, & 600. Source:

12mo forward P/E ratios: S&P 500, 400, & 600. Source:

I had small positions in QQQ & XLU puts already (thanks to my #voljihadi view of real economy/financial market divergence) but in light of this, step three was to reduce my upside equity exposure by booking PnL in some call options & long single-names. I also added index ETF straddles, making sure to avoid going into sector-specific selection in order to keep it simple and minimize basis risk. With the VIX at 20, stocks could go higher before lower, but I don't think we are far away from mean VIX levels for 2015; we are likely to be in a new vol range that will become clearer in Q1 or Q2. Net-net, these shifts raised a little bit of cash, materially shifted short my net directional equity exposure, and again, provided some more room for me to hold my USD positions and add to them.

Whether my USD shorts end up being right or wrong will be all about whether we see a reversal or consolidation when it turns. Until then, I think my equity vol exposure provides a good hedge, and gives my other trades (for example: short CADMXN, short NZDJPY, long Aussie govies, long US banks vs Canadian banks, long India ETF, short UST 30yr) more room to run in either PnL direction without negatively impacting my psychology.

Optionality vs capitulation

It is completely possible that I am merely capitulating at the worst time and rationalizing. My raising of cash is an acknowledgment of this. But at the same time, when I look around at the massive declines in crude & copper and rise in the USD, the potential for knock-on impacts coming out of unexpected areas seems higher than normal. The global economy is rebalancing and not exactly in the most optimal of ways. I don't know when or where these dynamics can lead to unexpected consequences, but I take the risk of it (albeit more directly so to the RoW than the US) seriously enough to like the optionality of equity vol.

I am bullish US macro, and agree with the FOMC's assessment that the current hits to breakevens will be transient, leading to higher real incomes, real spending, and eventually tight labor markets (and perhaps even housing reacceleration, given these low rates & generational handoff). But between now and then, I think equity markets are due for a repricing and that current IV levels may only seem elevated by using heuristics that worked during the low-vol regime of 2012-2014 and that are obsolete now. I wouldn't be surprised to see a 10-15% correction and a choppy overall year for US equity markets. At the very least, I'm happy to hold some dry powder now to deploy later this quarter or early next.

2015 macro analysis & outlook (teaser)

Below is a 50-slide teaser for our 2015 macro outlook deck. We will be presenting the full version (including an in-depth macro analysis of Europe, China, Japan, and others) in early February at NYU's Leonard N. Stern School of Business in NYC. In the coming weeks, we will be providing details for public sign-up to attend this presentation. Keep in mind seating capacity is limited.

Please click the link below to download & view the deck. We welcome all questions, comments, critiques, and suggestions at Thank you for reading!


Malala and Western Opportunism

Malala Yousafzai watches on as UK Prime Minister David Cameron speaks.

By Nael Sanaullah

As a Pakistani-American, I’m a citizen of two of the most controversial, problematic countries in the international community. So when Malala Yousafzai became the youngest person to receive the Nobel Peace Prize, I was simultaneously immensely proud and inspired, yet also relieved to see positive international news coming from one of my homelands. It was a great day for Pakistan and Pakistanis alike, the world over. However, despite the uplifting news, I eschewed letting this news detract my attention from the underlying, nuanced issue of Malala’s rise to superstardom, especially in the West.

Let’s not forget that the same Western leaders who praise Malala for her courageous struggle have been the persons responsible for (or party to) air striking and indiscriminately murdering her fellow Pakistanis, ethnic Pashtuns, and Muslims. These same leaders and their self-designated white man’s burden have hijacked and bastardized Yousafzai’s movement. These same leaders’ pernicious actions have forged the destructive path the Taliban has taken in treating young girls and other people like Malala, by initially causing (in the 20th century) and now exacerbating the group’s incapacity to distinguish between modernization/liberalism and Westernization/cultural encroachment, through imprudent interventionism and unlawful violent provocation. These same leaders have denied education for and murdered more children than any terrorist organization, whether indirectly or directly. These same leaders, mostly neoliberal themselves, have also thoroughly ignored the Marxist aspect of Malala’s message. (“I am convinced Socialism is the only answer and I urge all comrades to take this struggle to a victorious conclusion. Only this will free us from the chains of bigotry and exploitation.”)

These same leaders and their self-designated white man’s burden have hijacked and bastardized Yousafzai’s movement.

The actions of militant groups like the Taliban are undoubtedly inexcusable. But one mustn’t allow certain Western politicians’ and journalists’ narrative of the innocent brown girl being saved by the righteous white man, from the grips of her savage male captors, fool them into thinking that the root cause of the anti-feminist, anti-education leanings of the Taliban and other militant Islamists is anything but a reaction to the neo-imperialist activity of the West in Muslim lands. Nor should they allow these intellectually dishonest politicians and journalists to fool them into buying into supporting further military action in these areas by propping up Malala as proof for its necessity.

Ironically enough, the most prominent of Western politicians peddling his or her own propagandist version of Malala’s story, none other than Barack Obama himself, won the Prize only 5 years back. This is the same leader to whom Malala boldly expressed her concerns of drone attacks (which have gone up substantially under his administration) fueling terrorism. If anyone deserved the Peace Prize, it was Yousafzai. But her win begs the question of how legitimate and principled the Nobel Peace Prize really is, and if the aforementioned false narratives are also being promoted by the Norwegian Nobel Committee itself. After all, it’s mostly comprised of Norwegian politicians, all of who are appointed by the Norwegian Parliament. Thus, it’s hardly likely that the Nobel Peace Prize is free of politicization and/or Eurocentrism. In fact, the first Peace Prize given to someone outside of Europe or the Americas was handed down 60 years after it was first awarded, without even Gandhi ever receiving these honors.

Hopefully one day, Malala’s vision of a properly and equally educated Pakistani populace being will become a reality. Maybe then the masses in Pakistan will recognize that although militant Islamist groups are not on their side, neither are neo-imperialist Western governments, nor the political establishment who’re allowing their destructive exploits to continue unchecked. It is education that allows for more nuanced sociopolitical discourse to take place, for endogenous modernization, rather than imposed Westernization or Islamization, as well as the transmission of a uniquely Pakistani perspective into the global conversation, fighting the presently dominant Western paradigm.

Investigating the lead-lag relationship between HPA & OER growth

Matt Boesler posted an interesting chart today showing a leading relationship between house price appreciation & OER. Expounding on this idea & data set results in some interest conclusions about the likely trajectory of core inflation in the US.

Housing, technically shelter, is the largest component of core CPI, with a 42% weight in the basket. Shelter is decomposed into primary residence rent and owners' equivalent rent (to have a smooth proxy for housing prices). OER & housing prices have seen material divergences since the Case-Shiller 20 index began being published in 2000. However, a closer look shows a strong lead-lag relationship between the % YoY changes in OER vs Case-Shiller, with some data fitting leading to 21 months as a useful time lead. Linear & polynomial (3-degree) regressions with this time lead are presented below.

Using this regression analysis to model % YoY OER, and linearly standardizing the modeled OER (to account for much wider range of % YoY rates in housing prices vs rents), a rough but useful projection of future OER, and consequently housing price inflation, is in the pipeline based on the leading indicator of housing price growth. With this, we constructed a projection for housing's net contribution to core CPI % YoY, which is presented below.

Based on current housing prices, the model suggests that housing alone will provide 100-140 gross basis points to core CPI YoY growth rates by H2 2015, or 50-70% of the way to target inflation. This includes an approximately 40bps increase in net bps contribution to core CPI YoY, in the next 21 months, implying that even if non-shelter core inflation rates stagnate at their current 0.46% YoY rates--all the way through 2015--core inflation will still return to Fed target. If non-shelter core inflation rates can simply reverse solely their 2013 deceleration, over the course of the next 21 months, the implied core inflation rate would be just under 3%, and 1yr fwd inflation expectations (the FOMC FG criterion relevant to rate policy) would likely have breached the FOMC's 2.5% symmetrical target ceiling. These scenarios serve to illustrate how impactful the extra 40bps net housing contribution to CPI can be.

Looking beyond housing, there are good reasons to believe that non-shelter inflation is poised to accelerate materially and be the driving force behind overall inflation acceleration:

  1. Less policy uncertainty & drag. Fiscal cliff and fiscal policy uncertainties, which pervaded in 2011-2013, were huge drags of federal & corporate spending, as well as crushed money supply growth despite open-ended LSAPs. These policy concerns materially diminish this year, and as should their sharply deflationary impulse. 
  2. Private sector accelerating behind the scenes. Real private wages are accelerating impressively, and the sharp disinflation phase since 2011 has been fundamentally tied to a private-public divergence on the back of austerity (public wage growth has hovered around zero since H2 2011 post-debt ceiling debacle).
  3. Supply & demand of fixed capital seeing trend shifts. H2 of last year was the first time since the GFC that US net private domestic investment went positive. Capacity has been expunged and now a combination of nascent short-term demographic tailwinds and low capacity & costs means fixed investment is likely set to return. Supply & demand of fixed capital is what drives prices fundamentally.
  4. High-velocity credit growth & capital spending is beginning to accelerate. Leading indicators for capex (which should also see a positive impulse from fiscal policy stability) are picking up for the first time since 2011, and other high-multiplier entities that have been risk-averse since 2008 (like state & local governments) are beginning to spend again after healing their balance sheets. C&I loans and consumer credit demand also heating up.
  5. Producer prices & input costs are accelerating. Pipeline inflation.

Vince Foster had a terrific piece over the weekend analyzing the recent behavior of long-term yields. Although I share his concerns about long-term NGDP potential growth rates for the US (absent immigration boom, public infrastructure investment, etc), especially regarding the question of not being able to escape ZIRP again in next recession, I think that US core inflation is set up for cyclical acceleration. I expect to write soon about some of Vince's arguments, as well as some of the near-term risks I see in the global economy.

Is the taper the bridge between the new normal & escape velocity?

2012 was a pivotal year in the global economy, as the two largest balance sheet impairments in the world (US household & EMU periphery sovereign) finally received alleviation. US housing prices bottomed in January 2012, and Draghi sold a put on euro exit/breakup risk a half-year later. This began a process of global normalization & rebalancing of BoPs & global labor competitiveness. 2012 finally gave the signal that a reversion from the "new normal" may be within sight. This was reflected best by the fact that real & nominal yields & wage growth bottomed in 2012.

Since then, the topics of growth & monetary policy normalization have been in the driver's seat of markets. Monetarists opposed the taper based on perceived efficacy of marginal LSAPs. Fiscalists downplayed any real impact LSAPs ever had in the first place. Debt deflationists expressed weariness at the prospects of a 1937-type moment with a coincident fiscal cliff & LSAP taper. However, these are all context-free assessments of the impact LSAPs and their taper can have.

Also beginning in 2012, Jeremy Stein presented a unique approach to LSAP assessment to FOMC discourse. He noted that LSAPs work most directly by altering the supply & demand curves for risk premia, like the corporate credit risk premium. Among the various second-order impacts, he identifies one with corporates as a conduit, which diminishes money velocity & optimality:

How should one expect a company to respond when its long-term borrowing costs fall not because of a change in the expected future path of short-term rates, but because of a change in the term premium? As noted earlier, many macro models—like the Fed’s FRB/US model—treat the two sorts of shocks as having similar effects. But is there any reason to believe that, in reality, the response to the two might differ?

A basic corporate-finance analysis suggests the answer may be yes. To see why, consider the following example. A risk-neutral firm faces a rate on its 10-year bonds of 2 percent. At the same time, it expects that the sequence of rolled-over short-term rates over the next 10 years will average 3 percent. Hence, there is a term premium of minus 1 percent. What should the firm do? Clearly, it should take advantage of the cheap long-term debt by issuing bonds. But it is less obvious that the bargain 2 percent rate on these bonds should exert any influence on its capital spending plans. After all, it can take the proceeds of the bond issue and use these to pay down short-term debt, repurchase stock, or buy short-term securities. These capital-structure adjustments all yield an effective return of 3 percent. As a result, the hurdle rate for new investment should remain pinned at 3 percent. In other words, the negative term premium matters a lot for financing behavior, but in this stylized world, investment spending is decoupled from the term premium and is determined instead by the expected future path of short rates.
— Jeremy Stein- Evaluating Large-Scale Asset Purchases, Brookings Institution, October 2012

Thus, LSAPs can actually incentivize corporates to prefer refinancing to borrowing, bonds to loans & equity, and buybacks & dividends to capex. The lower real rates, spreads, & risk premia (including Stein's term premium example) cause buybacks & dividends to have artificially inflated relative EPS growth/RoI potential [1], while capex RoI [2] potential remains depressed with aggregate demand. Once aggregate demand starts normalizing, as began in 2012, any remaining LSAP-induced RoI advantage held by capital structure arbitrage becomes a net negative tradeoff for the real economy vs financial economy. The tailwinds incentivizing shareholder capital return begin to "crowd out" capex potential at this stage, even as corporates are flush with cash. [3]

Suppose that theoretical RoIs & risks for real (bank loans, capex, hiring, structures) & financial (bond issuance, buybacks, dividends, reinvestment) economy sources & uses of capital from 2009-2015 are as follows in the top of the chart to the left [4]. Similarly, theoretical return/risk ratios for real & financial economy allocations, and the ratio between real & financial economy return/risk profiles [5]. Click to enlargen.

These estimates are based on nothing but my own intuition, and may be nothing more than a practice of bias confirmation [6]. But the key point is to highlight how real rate, spread, & risk premium normalization can drive small fluctuations in the relative return/risk profile of marginal investment, which can be sufficient to swing allocation decisions in the favor of investment into the real economy. 

The taper announcement has already been coincident with the beginning of loan growth accelerating for the first time post-stimulus. This has been driven by the commercial & industrial sector, particularly in loans from small banks, suggesting there may be a corporate balance sheet strategy shift in play in response to the eliminated prospect of downward pressure in reals, spreads, & risk premia [7]. Surely, part of this timing is likely due to coincident economic recovery being a shared causal factor. But it seems like more than coincidence, especially considering the rising-rate risks to credit growth people were concerned about. The policy uncertainty removal by the taper announcement, simply by giving a flexible yet clear timeline for LSAP exit, likely also provided much-needed guidance for capital allocation plans.

In order for escape velocity, the pathway would have to be as follows:

  1. LSAPs
  2. Cumulative retained benefit [8] for federal government, shadow & TBTF banks, & corps
  3. "New normal"
  4. Real wage growth bottoms
  5. Corporate capex unlocks retained LSAP liquidity into the real economy
  6. Private credit demand accelerates & endogenous loan/deposit ratios rise [9], helping begin a feedback loop
  7. State & local tax revenue acceleration offsets sequester of LSAP liquidity due to federal austerity by injecting a smaller, but higher-multiplier version in its place
  8. Financial lending & securitization unlocks retained LSAP liquidity into the real economy
  9. Real wages, capital goods PPI, core CPI, NGDP accelerate, furthering the feedback loop
  10. Virtuous cycle ("escape velocity") of lending, spending, & investing begins, ZIRP ends

Right now, we are in between (4) & (5), and capex has been a long time coming. I believe that a well-timed LSAP taper could be the key to moving past the new normal and toward igniting the self-sustaining process toward escape velocity. LSAP-induced corporate preference shifts have a small outright impulse on the economy, but a large one relative to the other constrained & low-impulse sectors, and enough of one to make marginal capital sourcing & allocation decisions shift from financial markets toward banks & consumers. Perhaps enough to bridge the gap between a "new normal" economy & one in escape velocity.

So far, we have seen upticks in loan growth & capex intentions, and rate-sensitive indicators are all concurrently rebounding. Follow-through in these leading indicators & their coincident counterparts will support the case for nascent escape velocity. Charts below courtesy of Business Insider / Matt Boesler / Aneta Markowitz / Societe Generale.


  1. Buybacks reduce share count, thus boosting EPS & equity share price. Depressed risk-free yields, term premia, & corporate credit risk premia inflate the spread between borrowing costs & share earnings yield, incentivizing corporate treasurers to allocate marginal capital toward collecting such risk premia via shareholder return plans like buybacks & dividends. A shift from equity & loan to bond financing also takes advantage of LSAP distortions, and further pads the RoI that eventually also boosts EPS.

  2. These dynamics above in [1] especially relevant when the alternatives of cash (negative real return) and fixed investment (high risk) are being held back by weak aggregate demand.

  3. As the labor market recovers, the expected risk-adjusted return on marginal investment in the real economy increases. As it approaches the risk/reward profile offered by marginal investment in the financial economy, small LSAP-driven boosts to the risk/reward profile of capital structure arbitrage can be the difference between the real economy narrowly receiving marginal capital allocation and the financial economy narrowly receiving it/

  4. These are pretty much baseless values, but the exercise shows a plausible scenario in which a small increase in real yields, after a long period of suppressed reals, spreads, & risk premia, can have a high multiplier impact that sets in motion a domino effect of unlocking retained liquidity into the real economy. The impact of risk premia pricing impacts capital structure arbitrage risk/reward on a continuous scale, but the decision between capex & buybacks is a discrete, binary one, and the nonlinearity emerging from this intersection is the source of the power of the well-timed taper.

  5. The impact of risk premia pricing impacts capital structure arbitrage risk/reward on a continuous scale, but the decision between capex & buybacks is a discrete, binary one, and the nonlinearity emerging from this intersection is the source of the power of the well-timed taper. The dashed line marks the parity level of marginal expected risk-adjusted return on investment between capex & balance sheet strategies. As the green area rises above the parity line, the real economy gets a boost from nonresidential fixed investment, helping to ignite other latent sources of growth from other sectors, into a virtuous cycle of money velocity.

  6. Values to be taken with a massive grain of salt, utility of exercise to be taken with a moderately-sized grain of salt.

  7. It doesn't have to be large; it just has to be sufficient to drive capex to accelerate.

  8. "Cumulatively retained benefit" refers to the retained savings driven by LSAP-induced risk premia repricing, plus retained earnings driven by second- and third-order arbitrages resulting from LSAP-induced risk premia repricing. These are what the Fed "injects", and the "unlocking" of them into the real economy is sufficient for a self-sustaining business & investment cycle. Lower interest expense, longer duration financing, capital structure arbitrage earnings & premia accrual, and others comprise these cumulatively retained benefits from LSAPs.

  9. Real equilibrium interest rates are a reflection of money supply & demand. This is reflected by loan/deposit ratios, which is correlative with money velocity and similar metrics. LSAPs flood the system with exogenous deposits, which are created at primary dealers and credited to their clients that sell bonds that the PD turns over to the Fed via LSAPs. Ex-LSAPs, the remaining endogenous deposits show a different story since LSAPs began. Most importantly, endogenous loan/deposit ratios have implied higher equilibrium real rates during LSAPs, suggesting LSAPs suppress real rates. However, endogenous loan/deposit ratios moving higher would also reflect underlying private credit demand elasticity returning to above-ZIRP price levels.