Why we won't see US QE again for a while

Say you're Fed Chair Yellen today. You face a truly a Dickensian tale of two economies. The unemployment rate is at target while inflation is far from it. Labor market internals suggest possible shadow slack potential while inflation internals imply upward pressures. Goods markets are flagging with global weakness while services are surging on the back of domestic acceleration. And there's an equally analogous duality in policy prescriptions given these confusing signals, with the likes of Vice Chair Stanley Fischer proposing liftoff and Bridgewater CIO Ray Dalio urging for patience.

The Dalio thesis

The latter has been expressing his concerns about risks stemming from Fed tightening ever since the taper tantrum. In a recent note, he suggested that the most likely next big Fed policy stance shift will be easing with more QE rather than a normal tightening cycle: "We are saying that we believe that there will be a big easing before a big tightening. We don't consider a 25-50 basis point tightening to be a big tightening ... To be clear, while we might see a tiny tightening akin to what was experienced in 1936, we doubt that we will see anything much larger before we see a major easing via QE."

This is premised upon the belief that by the time the Fed needs to ease again, financial asset yields and spreads will still be too low for conventional easing to succeed; hence, the need to restart QE (perhaps with assets further out the risk curve that still have spread). In my opinion, this is likely to be incorrect; I believe that rates, curves, and spreads will be more normalized by the time has to ease again.

Mr. Dalio seems to believe that higher rates will send shocks through financial markets that will manifest in a domestic growth downturn. As he says: "Since the 1980s ... lower interest rates were required to bring about each new re-leveraging and pick-up in growth and because secular disinflationary forces have been so strong." This is similar to Richard Koo's "QE trap" thesis. But I believe this is an inaccurate interpretation of how higher rates will impact the real economy. This is mainly due to the fact that housing equity, financial assets, and credit qualifications have such a higher distributional skew than in prior cycles. The people with Mr. Dalio's "leveraged long bias" are far removed from the economic situation of the median consumer.

Who is leveraged long?

Ever since the housing recovery began in 2012, low rates and spreads have not been really fueling real activity. There have been ample benefits for those who can access credit to borrow, like private equity firms borrowing to buy property and corporate CFOs borrowing to buyback shares. There have also been ample benefits for those who have a lot of financial assets; new QE deposits are credited to institutional prime brokerage accounts, and mainly circulate within financial market transactions. All this has done is drive up inflation in the FIRE sector: asset prices (think ETFs inflows as % NAV, low to negative UST term premia, corporate capital structure arbitrage), rents, luxury housing, & collectibles. To the median consumer, this just means rents and capital appreciation that far outpace wage growth. Without targeted easing (like LSAPs in muni debt or consumer ABS), there's little pass-through of loose financial conditions to the real economy when rates & spreads are already low.

If loose Fed policy has driven asset price inflation instead of consumer inflation, why would higher rates drive down consumer price inflation? The FX and commodities channels are very important in this regard, especially when the rest of the world is easing, as the commodities crash has shown. But US inflation rates have taken these shocks in stride, with 6mo annualized measures (which remove the base effects from the oil crash) already having rebounded back to target. Based on this base effect alone, by the time the Fed hikes in Q4 (if it does), YoY core inflation will likely be visibly on track to its target unless oil crashes again. Certainly, there are headwinds to inflation from abroad, particularly through imports and core goods. But domestic-facing inflation, the kind relevant to US monetary policy, like in wages, rents, and services, is accelerating without sign of an impact from tighter financial conditions. Most importantly, demographic impulses are reversing back to positive again for the first time in a decade (which matters, like, a lot), unlike Europe, China, & Japan.

Surely, a rate shock can impact the real economy temporarily, as the taper tantrum depressed housing activity for a short time. However, this was a sharp shock (partly due to the longevity of QE-induced levered carry position buildups, the exact type of situation Chair Yellen wants to avoid by taking a sooner-but-slower approach to hiking), and still new home sales and starts have rebounded back to cycle highs. In reality, the median consumer does not have access to abundant easy credit outside of auto loans, despite the pervading low rates and spreads, and does not have large exposure to financial assets. In this environment, as Mr. Dalio himself has stated, spending growth will converge down to income growth, which will be primarily driven by wage growth, which is indeed accelerating. Wealth effects and price-senitive credit growth matter much less.

How would market volatility & weakness abroad impact US real activity?

I do indeed expect higher rates to send shocks through financial markets. Ever since the taper tantrum, we have seen various shocks: in duration, oil, EMFX, and now China. This is clearly a result of the marginal relative tightening in US monetary policy, which is itself a function of the US's better policy responses to the Great Recession. However, each of these shocks blew up low-multiplier trades like the Fed forward guidance or OPEC production "puts". The most recent, the EMFX "carry trade", was another "artificial arbitrage" that was funneling loose Fed policy into EM credit growth (rather than in US mortgages for example). Unless spreads are very elevated, monetary easing has little pass-through to the Americans who need it most.

Certainly, there will be weakness in manufacturing and "shale state" employment. But this massive surge in the USD is also a boon to real incomes, and thus real spending. Indeed, real PCE growth is right back to its cycle highs and five out of the last seven quarters have seen consumption alone (without the other GDP components) account for 2% annualized real GDP growth. There is likely much more in the pipeline, due to elevated savings rates, which in my opinion are due to the gradual pace by which consumers gained faith that the gasoline savings were permanent (i.e. that gas prices won't surge right back higher). I think this is due to the availability heuristic: after massive price declines in 2008-2009, energy prices surged back to near pre-crisis levels. As consumers' expectations of future gas prices decline further, the retained gas savings will likely be spent further.

Source: @NickFP, Bureau of Economic Analysis.

Source: University of Michigan Survey of Consumer Expectations.

Higher rates will likely crimp corporate profitability as well, but again, unlike prior cycles, corporate profits have mattered less for real economic activity. Profits have surged to all-time highs, and with much of the growth coming from margin gains due to higher capital/labor ratios, this has partially been at the expense of the median consumer. Large corporates have deployed much of their accumulated profits in a capital structure arbitrage, borrowing to buyback shares and collecting the credit/equity yield spread to further boost profits. Furthermore, after almost two decades of rampant globalization, the US stock market has much more foreign sensitivity than the US consumer or real economy. Higher Fed rates will definitely hurt emerging markets, but this pass-through to US corporations is unlikely to impact the median US consumer seeing costs decline. Loose financial conditions have clearly played a significant role in corporate profitability, and although tightening policy will likely hurt earnings, it won't impact hiring or capex as much as things like buybacks, M&A, executive compensation.

The biggest risk from higher US rates is China, and I do expect China to continue to decelerate until leveling off around 3-5% real GDP growth. The PBoC will likely have to cut RRR sharply in order to stem the tide of capital outflows without constricting domestic money supply. It remains to be seen if Chinese policymakers have sufficient tools at their disposal to smoothly navigate the rebalancing. But higher US rates will only further destabilize the Chinese economy, thanks to its now-soft currency peg. Like the oil crash, this will likely materially negatively impact global growth, financial markets (including in the US), and corporate profits (including in the US), but not the median US consumer.

Even then, why not wait until seeing the whites of inflation's eyes?

If the Fed can normalize rates & spreads at least a little bit, without disrupting real growth, then it will have regained considerable policy potency for the next time it needs to ease. It makes complete sense to me that financial markets and the real economy can diverge; in fact, this has been my expectation since 2013. Additionally, because of the long lags between policy and its impact, waiting longer could be simply increasing the risks for a destabilizing normalization out of the Fed's control. Higher inflation = lower real rates even without hikes.

Blowing up ZIRP/QE trades, especially with an "avalanche patrol" method as described by Mark Dow, is likely beneficial from a financial stability perspective. Deeply-entrenched investor assumptions are the keys to leverage buildups, as the taper tantrum and EMFX routs have shown. I believe Chair Yellen finds similarities between 1997-98 and 2015-16, and doesn't want to repeat former Chair Alan Greenspan's mistake of engendering the perception of a "Fed put" in response to the financial volatility stemming from emerging markets and a higher USD. The eurodollar curve clearly shows that the market already doesn't have much faith in the Fed's willingness to look past market volatility. Further sacrificing credibility by reversing course on the stated hike path will only further convince investors that there's a Fed put.

Hiking rates may even provide an unexpected boost of confidence. If the Fed hikes rates and markets fall without disrupting the real economy, that would provide a strong positive signal to invest. It would also shake out rentiers for growth-oriented investors. As a recent example, loan growth began its marked acceleration in early 2014 right after the taper began, about six months after former Chair Bernanke hinted at it. I would not at all be surprised to see inflation and spending accelerate just before or as the Fed begins hiking; indeed, it is my base case.

Total commercial bank loan growth % YoY. Source: Federal Reserve.

With all this said, I still very much appreciate the risk of the end of the long-term debt cycle, especially due to the student loan boom, the only substantive impaired debt-driven household demand growth. If these liabilities aren't restructured, then the next downturn could unleash another wave of household deleveraging that could again constrain monetary policy. However, there is also the upside risk of looser fiscal policy in response to the next recession, and optimal fiscal stimulus (i.e. infrastructure spending, student loan forgiveness/restructuring, regressive tax cuts) could drive up money demand sufficiently to allow for a normal rates curve. 

What's the trade?

In January, I expressed my expectation that the S&P would return to October lows in H1 2015. Now that it has, Chair Yellen has a choice to make whether or not to act on it; inflation rebounding by year-end would mean she won't. I think within the next six months, we could see a return to S&P 1600-1700 (2000 & 2007 highs) on the back of a Fed hike that surprises the market by looking past the impact abroad. If we get there, I think it will be an excellent time to buy domestic-facing cyclicals, particularly financials. Indeed, I think buying financials and discretionary versus shorting staples and healthcare is an excellent pair trade here. Healthcare has arguably been one of the strongest beneficiaries of loose monetary policy.

Because of the removal of the oil crash base effect by the end of the year, my base case is for a December hike. I am confident the Fed will at least signal a hike by the end of the year, making Q1 2016 my bear case. As long as my bear case is met at a minimum, I continue to think short SGD is a great trade. China cannot withstand higher US rates and Singapore banks' exposure to China is enormous, having intermediated EM Asia & Chinese flows for years. I also continue to like mid-curve eurodollar & short sterling steepeners / long GBP based on the same view of normalizing inflation and rates.

My preferred hedges to my views are long Aussie duration, long JPY, short CHF, and long MXN.

Making sense of August: Chinese policymaker credibility

Last month was action-packed, with the Chinese currency policy shift and the crash in risk assets. So what happened?

CNY regime shift

The PBoC's new CNY reference calculation announced in mid-August is a shift in rebalancing policy from (a) using a gradually appreciating RMB to boost household purchasing power; to (b) marginally de-linking from the USD's imported effective tightening. This is due to three main reasons:

  1. Capital outflows were forcing the PBoC to keep selling USDs, overwhelming the intended boost to household purchasing power;
  2. The desynchronization of the US & Chinese cycles made linked monetary policies suboptimal;
  3. The August 4 IMF review of RMB inclusion into the SDR basket recommended a delay in adoption until the RMB were more "freely usable".

Similar to how the SNB removed its EUR peg ahead of expected ECB QE, the PBoC marginally de-linked from the USD ahead of expected Fed hikes. But, as fund manager Mark Hart noted, this also reintroduced FX risk "in a system with about $29 trillion in bank assets for the first time in a generation." China has been facing capital flight since last year, but the risk now is that it snowballs into a feedback loop given the new depreciation risk. Indeed, there was a record decline in Chinese FX reserves in August, as the PBoC defended the CNY after the "devaluation".

China's market crash resumes

The CNY paradigm shift occurred against a backdrop of the Shanghai Composite consolidating its summer crash, with state purchases starting July providing a support around 3500. A few days after the deval, the Chinese securities regulator signaled that that the CSF (the Chinese Securities Finance Corp, the PBoC-funded conduit for government share purchases) had concluded its buying operations, at least for the interim. It underscored that conditions of "excessive volatility" and "systemic risk" would bring the CSF back into buying mode. But this was a far cry from what many traders had interpreted as the state defending index price levels, and combined with the CNY shock, it sent Chinese stocks tumbling.

By Friday the 21st, the Shanghai Composite had broken down through its 200dma and the support of a six week bear flag that had been consolidating the June crash. This technical breakdown rid investors of the notion that the worst had passed in China's stock market, and was especially important given the amount of leveraged speculation on the way up (and the extent that government purchases had supported the market in July through mid-August). And so, the Chinese stock market crash resumed.

Global crash

This is what sent shock waves reverberating across asset classes. Perhaps most fundamentally, it diminished investor faith in the credibility of Chinese policymakers. The stock market boom and the optimism of its prospective wealth effect was now a net headwind with no bottom in sight. Capital flight reaccelerated after the CNY move, despite outflows being one of the reasons behind the new CNY regime. And all of this despite of hundreds of billions of CNY spent defending the Chinese stock market and currency.

Thus began the unwind of the rally in risk assets since October 2014, which was driven entirely by rising multiples, with falling forward EPS estimates, widening credit spreads, and deteriorating market breadth. As I said back in January: "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." It turned out to be Q3 when it became clearer. Vol will chop in a higher range and cash will likely have to become a higher allocation in investment funds, especially vol-sensitive strategies like risk parity. Shifting equity/bond correlations will only further drive the need to deleverage and normalize cash allocations.

So what now?

China's capital outflows continue and it wouldn't be surprising if the PBoC allowed further depreciation and stopped defending the CNY post-deval. But even if capital flows stabilize, the growth rate is going to continue to decelerate. I've written and tweeted about many bearish China trade expressions, most vocally this year with the NZD. But it, along with copper, AUD, and many EMFX have already seen massive declines. However, in my opinion short SGD is still far from mature, short Japan is just getting started, and Australian duration is back to being a buy here and on dips.

Singapore banks have external/foreign assets of around 250% of GDP, the majority of which has been lending to Chinese corporates. Against this, the banks have external liabilities are around 200% of GDP, with about two-thirds being interbank claims representing non-resident SGD deposits in foreign banks. Singapore has a massively outsized banking system that effectively intermediated flows between ASEAN and China for the last several years, loan/deposit ratios at 1997-98 levels, dwindling foreign reserves, a highly leveraged private sector, and an expensive but deflating housing market.

Now that China has devalued, the MAS is likely to defend the banks' assets by onshoring their liabilities. This suggests sharp downside risk for SGD. SGD funding is tightening, as SOR and LIBOR have diverged and as this trickles through, domestic banks will set off a domino chain of credit tightening to foreign banks, and then to the Asian countries to which these banks are lending, with BoP strains and FX feedback loops being the result. We may not see 1998-style contagion in EM Asia sovereigns, but we could likely see similar feedback loops in the private sector, with Singapore's banking system being right at the heart of it. I was long EURSGD for about 1000 pips last month (see this Twitter thread), but the risk asset crash provided EURMXN levels too attractive to ignore, and so I am now short SGD vs mainly USD & MXN.

Along with US healthcare, Japan has been the most crowded trade as per YTD inflows/AUM, and against a backdrop of sharply slowing Asian demand, a JPY appreciation vs EUR KRY & CNY, and now a reversal of all YTD gains in the Nikkei. The underperformance of the Nikkei since the post-crash bottom, combined with the risk of JPY appreciation with the BoJ seemingly on pause with QQE and running out of paper to buy, makes me like shorting the popular DXJ ETF.

The RBA seems to be done with its easing cycle for now. Further macro weakness should assert itself through the long end of the curve. The curve has a long way to go to flatten, as well as to converge vs US/UK and Europe/Japan, and that's why I am back to long and strong 10yr AUGB futures (this time without short AUD or NZD hedges). I plan on writing more about this trade in a later post.

Despite the massive risk selloff, Treasuries barely budged. This is due to three main reasons: 

  1. Petrodollar flows into USTs dried up beginning in Q4 in response to the oil price crash;
  2. The leveraged investment community is/was far too long USTs, having absorbed the petrodollar flow shock and then some (thanks in part to ECB QE/negnom and "stories" of DM rate convergence), and then reacted to the August VaR shock by deleveraging,
  3. Chinese reserves declined at a record pace.

Chinese UST holdings are primarily at the front end of the curve. Although it's possible China was selling bonds in late August to finance CNY purchases by offering USD into the market, I think it was the hedge fund community's positioning that drove the new stock/bond correlations. A lot of price-insensitive central bank buying of USTs is gone and has been replaced with vol-sensitive, price-insensitive buying by risk parity and vol-targeting funds. These funds are now deleveraging, allowing the term premium to renormalize. Combine this with the lower likelihood of a September FOMC hike (thanks to the equity crash), and you can see why I continue to like eurodollar steepeners (and for the interim, short the long end). For what it's worth, I still like them if the Fed hikes in September, and I believe they will by January.

I don't think the S&P will V-bottom this time like it has in recent corrections, but I do think volatility is a sell here; I dumped all of my long VIX and puts exposure into the crash and am officially no longer a #voljihadi. The ICJ (implied correlation index), which is at levels that prevailed throughout 2014, highlights how dislocated volatility has become from correlations (index vol is a function of (1) component vol; and (2) inter-component correlations). Between FX, rate, & equity vol, equity is the most attractive to sell and rate to buy, in my opinion. But again, I think the VIX will settle into a higher range than in recent years, and that cash allocations have to rise further. I love the idea of a long XIV/short DXJ pair trade.

I started buying crude vs gold (1x2 ratio) during the crash, and got lucky with timing. I had viewed the expiration of Pemex's hedges to be a catalyst for oil, and thought that gold's price action during the stock crash was very underwhelming. However, I added further to the trade after seeing sharp crude selling come in at the 50dma, which signaled to me that momentum investors were adding/pressing shorts. If crude takes out its 50dma, I think it will see a sharp short squeeze back to a 60-handle.

I plan on writing out my theses on the above trades (short SGD, short Nikkei, long AUGBs, ED steepeners, short VIX, and long crude vs gold) in future posts and in deeper detail.


Monetary policy trajectories & narratives

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.

US 30yr Treasury yield. Notice the higher high and breakout through the 200dma (yellow line).

US 30yr Treasury yield. Notice the higher high and breakout through the 200dma (yellow line).

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.

Curve steepening

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.

1y1y OIS forward rates: US, Eurozone, UK, Canada, China, New ZealandNotice that the US, UK, & Canada are all priced around 1%.

Ex-US, Europe

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.

OIS 1yr forward curves: USD, EUR, GBP, CAD, CNY (rhs), AUD (rhs), NZD (rhs). Note the large convergence between AUD (green line) & NZD (purple line) to within 50bps of each other after five years. Also note the kink at 1y1y in the Chinese curve, still not pricing in a regime shift type of slowdown, whether hard or soft.

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.

Related links

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: Yardeni.com

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

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 naufal@macrobeat.com. 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 perceived 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 interventionist 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.