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.
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.
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:
- 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
- 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.
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.