Top trades of 2014

So, over the last few days, we've seen various sell-side institutions come out with top trades of 2014 so lets have a look

Goldman Sachs

#1 Long S&P, funded by short AUD executing in the December 2014 futures contract at 1986.8, targeting 2250 (+13%) and stop below 1855 (-6%)

Rationale for this is as followed "Long the S&P 500: “Earn the DM risk premium, Offset by a short AUD position: “…Hedge the risk “"

#2 Long 5-year EONIA swap vs. short US 5's at -61bp, looking for a move to -130bps 

This is because "Growth Differential Widens and Service Price Inflation Diverges, also Forward Guidance is in the Price"

Broadly speaking, they are placing a trade on the expectations that the Fed are moving towards tightening while the ECB are doing the opposite.

#3 Long USDCAD at market (at the time was 1.0550) looking for 1.14 in 12 months

·         Canada’s current account position has been in deficit for some time

·         Slowing reserve diversification into the CAD has recently pushed the BBoP into deficit

·         The BoC is also concerned about weakness in the export sector and low inflation

·         Domestic demand may no longer receive a boost from the housing market

·         The BoC is one of the few central banks with scope to cut rates

·         US growth and tapering may move interest rate differentials further against the CAD

·         In particular, a sell-off in the US front end could significantly accelerate a $/CAD rally

·         We forecast $/CAD at 1.14 in 12 months' time

As of writing, these are all the released trades from GS, but more are expected throughout the week

Now onto,

Bank Of America

#1 Short US 10y at 2.78% looking for 3.5%

#2 Buy GBPCHF via call fly

#3 Buy MXNJPY

#4 Short EURGBP via 6M digital puts

The entire research note can be found here

https://www.dropbox.com/s/4i68iaapamjkhmz/BoA%2520Top%2520Rates%2520and%2520FX%2520Trades%2520for%25202014%5B1%5D.pdf

Thanks

Taper Trades

Depending on where you read, the chance of Taper centres around early 2014. However the various asset classes show a very different, individual picture.

By looking broadly at the major few asset classes we can see how to best position for the "inevitable" Taper. Throughout this we need to remember that going into the Sept 18th the market was positioned such that Tapering was expected - the market was surprised, but we can use those values as a benchmark to compare to now.

Firstly, Gold (GLD) -

The precious metal has been incredibly weak (spot ref, 1242) recently, down 10% since the Sep 18 no taper FOMC announcement, roughly the same loss since the first major mention in June.

The fact that the gold price has been so depressed shows that, at least commodity traders, fear that tapering could be very soon. In fact the delay in Sept. hasn't changed much and we will still head much lower.

US Treasuries, (TLT/IEF) -

However, UST yields, which would broadly do the inverse of gold regarding tapering are currently 13 bps lower than Sept 18. This to me suggests that the Fixed income markets see Tapering being less likely and the direct buying of USTs and MBS from the Fed has pushedyields lower. In fact for not one instance has the US 10 year yield traded at a level seen at the Sept 18th FOMC meeting.

However the Belly of the curve - the US 5s have dropped in yield far more than the 10's. This is because the 10s price in a guaranteed tightening cycle where as the current 5s may just be on the edge and as such the yield has dropped much more since (I'll touch on this more later)

The USD, (UUP) -

Of course, after the QE program was continued in September the USD reacted poorly. But since has recovered nearly all the loses since then and is trading at around 80.64 on the Dollar index (DXY). We must remember the weighting of the constituents for the DXY as the EUR is over 50% and we saw a rate cut there, and the JPY has had further BoJ intervention (talking mainly). So we can judge that the USD as a whole is broadly a touch weaker since the FOMC, roughly to the same extent as the bond markets. 

When we consider these 3 asset classes combined, the so called FICC (Fixed income, currencies and commodities) we see that when we scale the chart to the Sept 18th FOMC day there is a large variance in performance as shown below

So, How I interpret this is as followed:

Gold is lower (on the chart it is inverted and green) since Sep 18th suggesting that Tapering is just around the corner, and as such a strong NFP will result in a December Taper.

US Dollar index is barely changed pricing in tapering, but not as much as gold - so suggests the consensus view of January 2014 for Tapering to start

US 5 years are much lower, suggesting the belly of the curve isn't buying into the taper idea any time soon and it has dropped off subsequently. This in my opinion would be pricing in a March or later Taper.

So the gameplan for me going forward is that to position into December and year end would be to Short US 5's, via futs, cash, etfs etc (just get long interest rates) and to simultaneously be long gold. This would mean that if there is a surprise and we see a December taper then the losses on Gold should be less than the gains on Short USTs because of relative values at the moment. If the opposite were to occur then Gold would rally significantly and USTs would only rally a bit (therefore a hedged, well risk-adjusted profit).

At this time, staying vigilant on the USD and being short USTs / Long gold would work well ( maybe long 1 GLD while short 2 TLT or something to this effect).

Thanks for reading, Good luck.

Jeremy.

From - http://seekingalpha.com/instablog/5913501-jeremyws/2443311-taper-trades

Some models

So following on from my last entry on "fair value" I would post a bunch of varying models for FX pairs. But a quote from Kit Juckes of Soc Gen

"In all FX models, the sensitivity of a pair to any factor changes over time. So people build models, then test them on a sample..."

In other words, the model works at showing the past perfectly, but needs to be constantly adapted for the future. Either way, I've got a few that work pretty well - most include Vol skews, equity perfomance etc and most importantly Rate differentials. R^2's are all above 80, and some even into the 90's suggesting great relationships here.

Most of my models relate to EURUSD but there are some for others and they show the deviation from Actual in a histogram in the second pane.

Firstly - A plain and simple YTD modelled DE2US2 rate implied EURUSD

Green = model. Reuters Eikon

The simplicity of this model can't be overlooked as short term rates are crucial in pricing FX, and as Schatz and US 2's are so liquid they are a perfect combo to consider.

_________________________________________________________________________________


Next - A medium term Swap fair value model, using 1Y EUR swaps as the basis, this is based over the last 2 years and has a very good tracking ability. This is the easiest tradable equivalent so convergent trades are easy.

Still a very simple model and of course it will be very related, it has both a component of interest rate differentials and EURUSD spot values.

_________________________________________________________________________________

Next - this next one is a composite of the first model, but it incorporates 1 month 25Delta risk reversals, i.e. the skew in the volaitilty between the 25D puts and calls for the one month expiration. A pretty generic indicator of position sentiment and probability of upside/downside.

_______________________________________________________________________________

Next - this one shows the expected 1 year rolling 3M libor differential between US and EURs, basically a derivative of the speed of rate changes between the two, as it stands the rate differential is pretty much 0bps modelled to about 1.32 on the EURUSD. when considering the Dec 2015 contracts though, the interest rate diff is close to 30 bps, but will more likely trade around the June wides of 70-80bps once tapering occurs (especially after ECB rate cut) and as such, once interpolated with current 1 year spread models, the EUR is expected to be trading at ~ 1.26, then in 2015 at 1.17.

This is broadly inline with consensus estimates for 1 Year EURUSD rates

Forecast for EURUSD, bbg

________________________________________________________________________________


finally - A very long term look at the EURUSD based on the 2005-08 hike period. This one follows well on the day-to-day moves but at a lower relative move. suggesting that in the long run the current variations in the interest rates have little fair value impact on the long term price. But considering the first - we know that they can be used for all time frames.

But because of the l/t nature the deviations are much greater from this fair value.

________________________________________________________________________________

GBPUSD model

Firstly - this one incorporates both Vol skews and interest rate differentials, much like the third one for EURUSD

This YTD model is my main for the GBP, and so far there haven't been any major divergences which is good for the model - bad for trading.

_________________________________________________________________________________

AUDUSD model

This one is far more interesting, the AUDUSD is very sensitive to interest rate differentials, but on the 5yr duration. More on this here

- https://www.dropbox.com/s/hzpoo212ed5q9uu/SG%2520AUD%5B1%5D.pdf

But also, the value of commodities is key, most notably copper. And so I've incorporated both of these into this model and this is the most peculiar of all the models.

this is a longer term model shown over this year and there have been some amazing risk adjusted returns. And as it stands there is a 500 pip deviation in fair value, and considering how easy copper is to trade there is real potential here.

Either way, this is just a few charts quickly put up to show how my models are fairing at the moment, but I'm always adjusting them so they do change.

Where is fair value?

Well after the ECB rate cut today, I thought I would look at some regressions for the relationship between spot FX rates and respective interest rate differentials

I'll first look at the AUDUSD and will follow the same steps for each FX pair, Firstly here is a chart comparing the AU-US 5 year yield spread to the AUDUSD on an almost YTD look

AUDUSD vs AU5US5 spread

Using this data, when we run it through a regression calculation we see a value of 78% for the R^2, high enough from this one variable correlation to consider useful enough in making a model from it. As such I plotted the respective values and came out with a linear regression which follows the expected idea that higher Interest rate differential (in bps) correlates with a higher AUD

AUDUSD vs AU-US 5yr spread (bps)

Using this R^2 value  we can create a model and below we can see the spread between the interest rate model and the AUDUSD spot price.

Currently, as seen, the spread stands at around 500 pips, or in other words, the AUDUSD is undervalued by 500 pips to its interest rate model (based only on 5 years spreads). In an ideal world we would position ourselves with a mindset to be in a 5yr tightening trade, while also being in a Long AUDUSD trade - if weighted properly then the trade will be hedged and P/L will be defined by the path of the model below.

Now considering other pairs, I'm going to look at the EURUSD vs the 2 year rate differential we get R^2 of merely 54%, however the price feed has a one month break in data which puts of this value, but the divergence is often so small its not noticeable. However if the 2 year rate spread moves to 25bps the model forecasts a rate of 1.285 for the EUR +/- 150 pips as the fair value level. This is currently far below spot market and as such the EUR potentially could fall very far if short term bund yields drop more.

EURUSD vs US-DE 2 year spread (bps)

But throughout the period of the model the divergence has moved much further than 100-150 pips from fair value, but currently the EUR is overvalued by around 350 pips to current fair value (which could drop more after ECB cut)

For the GBP, a view that if rate differentials on the 2 year (currently at 10bps) dropped to 0, then the implied fair value would be 1.5252 with a range based on the standard deviation of the model divergence of 1.55-1.500. With the recent tendency of Mean reversion between UK and US rates this is a distinct possibility until Carney backs down somewhat on Fwd guidance, then the mkt expects UK interest rates to race away from US (by race, like 50bps but yeah) and using the current model would see 1.7230 (but the model changes every day based on price changes so it would be dynamic)

Either way, Interest rates are key in pricing FX rates and as such need to be considered at all times, Above calculations have used relatively recent data but the ideal still holds true.

Market update - ECB in view

If you've followed me for a while on twitter or my daily webinars, it will be no surprise that the ECB could cut rates soon, In fact I've been calling for it since the end of the Summer. But all of a sudden the market finally woke up to the fact the ECB need to do something. Even though 25 bps won't do much to inflation / expectations / growth / unemployment, it will show that the ECB are ready and willing to act to prop up the EZ.

In terms of the options market this drop in the EURUSD was seen by the sharp widening of the 25 delta risk reversal from -0.15 to -0.4 in a short time. The EUR them precedded to drop and the 25d RR stand at -0.788 now.

EUR1MRR (white), EURUSD (purple), EUR 1 week vol - 1 month vol (green)

furthermore a term structure view suggests the market is positioning itself for volatility ahead of the ECB meeting on Nov 7th, and now 1 week vol is 1.6 points higher than 1 month.

These ideas can all be shown together in the Vol surface below

We can see the higher implied volatility in the 1 week than up to 6 months, but in the very short term the 25d risk reversal is small, only getting bigger with time

Today, the expectations of intervention from the ECB grew as credit risk and premiums tightened somwhat across Club Med credit markets.

Here we can see Italian, Spanish and then Portuguese 5y CDS mid spreads today, all down around 10-15 bps on the day.

This came at the same time as Spanish 10 Yrs have dropped to 4%, testing their post crisis lows, and Greek 10 years down to ~8%. Now up 403% in price (ex. coupons) since the Q2 2012 low.

Overall, it would have to seem like the credit markets now expect to see some sort of dovishness from the ECB next week. This comes at a time that the CitiFX economic surprise index for the EZ drops to negative territory

As Barclays FX puts it

"Any month end demand for EURUSD was obliterated by a wall of EURxxx supply as the deflationary issues rear their head and people start to think more seriously about ECB action later on this year or at the start of 2014. Nowotny kicked things off in Asia talking about liquidity provision and EURUSD was lower as stops were triggered down to 1.3688. Swathes of EURGBP and EURCAD supply from spec names kept the headline pair very much under pressure "

The idea that a lot of the move came through the Crosses is seen here through a heatmap of FX volume as seen on the Reuters dealing platform (2nd largest by volume in the world)

All in all, I'd put the chance of a 25bps cut next week at about 30%, with a 50% chance in Dec and then 20% not at all (as per Goldman)

But even though the EUR has dropped, there is still a long way to go to meet 2 year yield differentials

EUR (blue) vs. US/DE 2 year yield spread (green)

- UBS: Now expect 25bp refi rate cut and a 50bp marginal lending rate cut at Nov meeting.

- BAML: Believe ECB will cut refi rate by 25bp next week, but will refrain from cutting the deposit rate. Inflation likely to remain at low levels, therefore no need for ECB to move after next week's cut.

- BNP: Now expect a refi rate cut of 25bp before year-end.

- JPM: Now expect 25bp refi rate cut in December. - RBC: Do not look for ECB to lower rates in the near term.

- Barclays: ECB to remain on hold. Wait for inflation forecasts at Dec meeting.

- CS: Should leave door open for possible rate cut in Dec when 2014/15 inflation forecasts are announced.

- RBS: Now expect 25bp refi rate cut in November, with a 50bp cut in marginal lending rate, while deposit rate remains unchanged.