FX weekly thoughts

This weeks major market moves centres around the FOMC on Wednesday where there is plenty of discussion about whether or not the fed decides to drop "considerable time". Given the recent NFP number there has been a large consensus shift to expect these two words to be dropped, and given the timing it would fit. Given we are expected to be approximately 6-9 months away from the first rate hike. 

However, there has been a lot of discussion around the impact of oil on monetary policy, an idea I brought up in my 2015 outlook last month. There is no denying that at 40% fall in the price of oil will bring about lower inflation, and the market expectations (as per 2 year $ CPI swaps) show this relationship clearly.

The Fed knows this, the Fed can see this, but should the Fed actually care? no. 

Yes, there will be a drop in CPI next year, whether the impact is as large as what the market expects is yet to be seen, but *if* CPI is below 1% and approaching 0%, does anyone actually think the fed will hike rates.. probably not. But at the same time, this drop in production costs, a supply side issue, should be of benefit to the US economy, and the impact on inflation should be short term at most...

But then explain to me why longer dated inflation expectations are cratering too, I can see the argument for oil impacting very near term inflation... but 10 years? 30 years? certainly not.

70bps is a lot, and it does time well with the oil price decline, but I still think there needs to be something else at play here. Something that the Fed should care about? well okay, maybe not, I just think its interesting and worthy of note to see that its not just near term inflation expectations that have been tanking.

Either way, this is probably a small issue - more pressing issues lean on the side of a hawkish fed and we can talk about dots and FF futures all day long but that probably won't achieve much. But in the last 6 months we've seen quite a drop in rate expectations, whilst at the same time the US economic story has hardly worsened. 

Personally though, I do think there is room for, even if it isn't directly warranted, for a moderately dovish Fed. Looking at EURUSD techs below, we can see that the EUR has found support with oscillators turning up and a recent bullish engulfing candle there is potential for a further squeeze higher next week on the chance of a dovish fed.

However, I am looking for these opportunities to sell higher, given that the macro fundamentals of a likely ECB QE and further rising of US short rates should still lead to a lower EURUSD over the medium run. Looking to sell 1.2660 if we get there.

Same sort of picture in Cable actually, from a technical perspective it looks like we could see a rebound, though this might be more a USD thing rather than a GBP one.

And looking at the drivers of the GBP, it still is being run by short end rate differentials, thus correctly looking at the relative macro pictures it should be easy to play the cable.

Here we can see the difference between Z5 Short term interest rate futures, and its clear to see the importance, and for the first time in over a year US 3m expectations for dec '15 where higher than the UKs.

Here we can see the rolling sum of Citigroup's Economic surprise indexes for both the UK (red) and the US (purple), in the past 4-5 months we've seen quite the divergence with US activity picking up and UK slowing down somewhat. However when looking at the overall level, the UK economy is no worse than that of the US in my opinion. Whether we are looking at the labour market or PMIs both are performing admirably and above that of the ROW

Furthermore, any potential shocks from Oil and its impact on monetary policy should be relatively neutral between the two economies so should not really be important. 

Just 6 months ago, the crossover between Eurodollar futures and short sterlings occured in Dec '17, however today its Dec '15, a huge underperformance by the UK, clearly shown in the cable's decline, however what I'm suggesting is that its unlikely to see a further fall in UK rates relative to US, given the relative macro picture, as such I'd expect us to be range bound between 1.55/1.60 until we get a new situation.

Another theme developing in G10 fx is that going on in Australia.

The OIS market has started to price in some rate action from the RBA over the next 12 months, specifically pricing in 30bps of cuts. With a record decline in Terms of Trade, continuing commodity price weakness and concerns from China its clear to see why. Many investors have jumped on the Recieve AUD rates bandwagon, which makes sense. But in terms of the AUD itself, I wonder to myself how much Australia and their fundamentals really matter to the long term picture of the AUD.

We can see the AUD (inverted) against US 5 year real rates, a very strong relationship, and with AUD still being considered a "high yielder" in the G10 space, a pickup in US rates is going to hit the A$ as we've seen. US 5 year real rates have picked up in the past few weeks due to the impact on breakevens from the oil price decline, as nominal rates have only headed lower/sideways. So once again, there is an argument to be made for the AUD to outperform *if* oil prices bounce.

Here we have a chart of US HY OAS for the energy sector, the spread is just shy of 1000bps currently, under-performing the market massively as oil prices drop and volatility (green) picks up.

This has been cited as the main reason for the Equity declines in the past week (just check the FTSE), as we've got the back and forth discussion on "are lower oil prices good or bad?" now I've read a few sides, mostly I see it as good, but I can see that such a sharp, sizeable drop can in fact be detrimental by completely killing investment in the energy sector for the mean time - though the benefits, at least for the US / UK still outweigh in my opinion, and as such dips in equity / HY should be looked at as decent opportunities.

2015 FX & rates outlook

Last year

2014 was an odd year, I can clearly remember reading through all the yearly outlook pieces and there were two distinct themes... Long the USD and position for higher US interest rates. In a sense then, we've seen a nice mix, the USD did infact rise, as pretty much everyone expected (fig 1), however US rates - no matter how we look at it underperformed expectations. Whether we are looking at the short end, where rates didn't manage to rise above the forwards or the long end where we saw quite the drop in rates, pretty much no one called it. (fig 2)

figure 1

The Dollar index is currently up 9.5% for the year, however it did take its time, for the first 6 months it was completely flat

Figure 2

Flattening of the yield curve was a big theme this year, with 30s dropping almost 100 bps, and the short end rising close to 40bps on the 2s

G10 returns vis a vis the USD (carry adjusted) fig 3

In G10 FX space, the AUD is the only winner against the USD, once adjusting for carry, with the SEK being by far the weakest - however this can hardly be a surprise given the Riksbank and on my top trades of 2014, long USDSEK was my preferred idea here

Overall, the ARS performed best even after a spot devaluation (just goes to show how powerful carry is!) followed by India. In last place, unsurprisingly... Russia.

figure 4

fig 5

Global monetary policy divergence was really the theme last year, but frankly this seems to be the main talking point for 2015 too.

Figure 5 is my favourite chart to explain 2014, 1y1y in EUR and USD.


However this time we have the potential for a few more risks to the global economy ranging from China to continued disinflation.


Geopolitical risks were also evident this year, primarily focused on Russia and the Middle east, one of my favourite spurious correlation charts is that of Russian CDS' against DAX. Whilst somewhat spurious, there is something behind it.

russia CDS vs DAX, fig 6

2015 outlook - FX ideas

#1 Long NOKSEK

I've been talking about the NOKSEK quite a bit on twitter recently.

Currently, in the NOK rates market there is a small probability of rate cuts from the Norges bank As per fig 7, whilst the Riksbank still struggles with Deflation.

Fig 7

However, I see the Norges still as a neutral central bank with a much smaller chance of a rate than the market currently sees, as such I expect upward pressure to short end market rates which should in turn benefit the NOK.

Figure 8

When loading up the NOKSEK against 2 year swap spread, we've seen quite the divergence in the past few months, mostly Oil related.

Figure 9

For the NOK to outperform, we are going to need to see Oil stabilise in the medium run. We've seen a pick-up in the correlation between traditional commodity currencies and their respective important commodities. This also heavily impacts Norway's Terms of Trade, which whilst lower, does not justify the extreme weakness in NOK as we can see in Figure 10 with Norway's ToT overlay against the NOK

Figure 10

So, I expect the NOK to outperform the majority of the G10 next year, but specifically against the SEK where we are likely to continue to see extreme Riksbank rhetoric, with the likelihood that market expectations of a hike get pushed back some years. As such, funding in SEK seems like a good pair trade.

Lastly, from a technical perspective, currently entry levels seem reasonably attractive, looking for a move towards the 1.15 area

#2 Short Eurodollars

A very popular trade in 2014... positioning for higher US rates. Currently, according to Fed funds futures (complied by MS into time to 1st hike) we are still expected to wait to Q3 2015, even though most economists still expect it to arrive in Q2.

This trade is not based upon the dot plot, I've covered my thoughts on that in the past, but I firmly believe the US economic growth story is pretty good, whether we look at PMIs and their momentum, or more broadly at the labor market, nearly everything is promising. The only drawback, much like the UK, is the lack of inflation - specifically wage inflation.

My trade is to position for higher short end rates, using an option structure as below.

Fig 11 &12

I'm looking at EDM6, or June 2016 Eurodollar futures, currently trading at 98.69, buying downside puts funded by selling upside calls brings in small premium over the 1y trade, with a breakeven point at 98.75 (at expiration) as can be seen on figure 12

Fig 12

I've been over the difference between rising US swap rates and an actual change in US rate expectations, swap rates merely are rolling up an already steep yield curve, where as fixed dates (like futures) show a better picture of monetary policy expectations in my opinion. One clear obstacle is positioning in this trade, everyone is short... however at less extreme levels that a few months ago.


#3 Long GBP basket

When looking at UK rates, we've seen quite a drop in BoE expectations. At one point, there was some discussion about a 2014 rate hike, clearly that hasn't occurred, so its all about when in 2015. Given the macro-economic backdrop (aside from wage inflation) would suggest to me a Q1/Q2 hike, but looking at the current short sterling curve... and the move in the past few months we expect a Q2/Q3 hike. Therefore there is room, in my opinion, for there to be upward pressures to rate hike and the curve.

Short Sterling Curve - fig 13

A good 80bps drop in the 3m LIBOR for year end 2016, has of course weighed on the GBP the last few months. But even closer dates, such as U5s, we've seen a 50bps move. For Cable, it has seemed that for the past 12 months all that has mattered is the distance between the two 1st rate hikes as we can see from figure 14

fig 14

There is no doubt the UK economy has lost some of the momentum that it had in late 2013 / early 2014, but even after that, the macro picture is doing well and as such I expect to see the GBP outperform throughout 2015. Currently, when you consider it against Non-USD pairs, the GBP is quite high.

EURGBP shorts still seem like a good idea, however I would like to sell at better levels. Currently, the EURGBP is a little cheap to rate spreads as per fig 15, so we may see some strength with which to sell into.

Figure 15

In EURGBP, a 1Y digital put, Strike at 78 KO at 84, indicative cost at 28% of notional.

figure 16

Furthermore, Long a spot basket against CHF/EUR/AUD/SEK

figure 17

The BoE is likely to be less dovish than what some expect, and combined with a strong UK economy, I expect to see GBP out-performance.

Theme #1 Oil prices

As I've discussed previously, commodity prices are likely to be a big factor throughout 2015, as they have been in the past few months. There is a strong chance that central banks will pay close attention to developments in oil prices specifically.

Figure 18

Figure 18 shows the USD (inverted), oil prices and US inflation swaps. Whilst I am unsure on the full cause of the major drop in oil, there some clear rationales... Weaker global demand / higher Oil supplies and of course a higher USD can sum up the move lower this past year.

The impact on inflation, and possibly more importantly inflation expectations from a decline in oil prices will likely drive global monetary policy, and with the current disinflationary trends, a decline in commodity prices, at least to me, seems like one of the biggest potential risks to any central bank hikes next year. Especially from the Fed where Yellen seems intent on finding an excuse not to hike, after all, she can keep saying data-dependent and can justify no hikes any time soon.


Theme #2  China


Chinese 2015 GDP forecasts (fig 19) have consistently been downgraded over the past year, currently seen at 7%, however there is a good risk that this could be much lower into the 6 handle.

Figure 19

The most obvious impact from a slowdown in China is for the AUD... As we can see in figure 20 Australia's terms of trade is at its lowest in 10 years, which will certainly weigh as we move forward into the next year.

figure 20

When we look at Iron ore prices, its clear that there has to be some weakness within china (being the biggest importer) and this has, and will weigh on the AUD assuming that we actually the weakness that is to be expected. while currently there are no rate changes priced into the AUD rate curve over the next 12 months, but if the mining slow down continues, and house price inflation is lower, then we could definitely see the RBA err muc more to the dovish side. In this given scenario, I would expect the AUD to trade lower towards 0.80 and below.

On the other hand, what if the PBoC / china does something... RRR cut? some sort of stimulus package? well, maybe... however, as China moves towards a more consumption orientated economy GDP growth will be structurally lower, so China may not need to be concerned with the current decrease in growth. Given this potential for Chinese intervention, a possibility for US rates to pushed back and then of course Australian debt offering quite the yield premium for AAA, then AUD would seem like a popular currency, especially on a sovereign/ cen bank diversification basis.

Theme #3  Volatility to pick up

Volatility has historically tracked the USD, mostly given the "safe haven" aspect, however this time is not the case.

figure 21

It's clear the USD is starting to react to the Fed hike chances, and we are likely going to see a pick up in volatility in the event of Fed hikes. I would therefore expect to see greater intra-day volatility throughout 2015, however I could bet that last year, people were saying the same about 2014... and that clearly didn't materialize. So whilst I expect a pick-up, I'm not going to be looking to buy vol, I'd much prefer to adjust my risks accordingly, maybe spend more time taking advantage of intra-day swings, but we will see how it goes.

figure 22

MOVE and FX implieds are likely to head higher, and given this, I like to use options to express some of my thoughts for 2015, specifically from the long side. Furthermore, when looking at implied distributions, and the potential for a trending market next year, then options are offering a perfect risk:reward profile over spot.

27th October, weekly thoughts

Coming up this week, we've got a few important events - namely the FOMC statement this Wednesday, but also other events such as EZ CPI, RBNZ OCR, Chinese PMIs and the BoJ. This week should be pivotal, and will likely set the tone for the rest of the year, specifically in G10 rates and FX.

Regarding the FOMC, we will see the end to the QE program with another 15bn taper. Discussion around considerable time might arise, however given current market pricing (via FF futures and EDs) it is expected that we have another 11 months until the 1st rate hike.  

MS M1KE

The problem is that the US economy is getting to the point where a rate hike is sensible, no matter how we put it, the recent risks that have developed in the past few months will likely (and hopefully) reside. Whether they be risks from China or Europe, they don't seem enough to really put of US hikes.

However, there is no escaping the fact that Yellen really doesn't want to hike, and there have been a few timely excuses that she will use to push back expectations. Namely weakness in oil prices leading to a drop in inflation expectations, however long term expectations have dropped only marginally. The ECB apparently loves the 5y5y measure, yet I am sure the Fed will forget to mention that long term inflation expectations are stable (ish), but will focus on shorter inflation swaps.

5y5y inflation expectations

Using a Taylor rule estimate for the US fed funds, we can see that even if we were to hike on we Wednesday its still dovish... But I know there are many flaws with a Taylor rule estimate, but I'm just using it to illustrate a point that even if Yellen wants to put off hikes, there will come a time in the not-too-distant future that she will be forced.

Mankiw's estimate for Taylor rule

It is worth bearing in mind the next couple of charts... 

EURUSD against 2 year swap spread

 The EUR still appears cheap to rates, and on the chance we see Yellen make some excuses, the USD is vulnerable to a short term correction towards 1.3000, that is where the pain trade is in the FX markets, and it seems more and more likely.

US 2 year govt bond yield

After the other weeks crazy rates move, US 2's have stabilised, yet are way below where they were, I prefer paying US rates, and shorting the USD, it offers a better risk:reward, and is hedged somewhat into FOMC.

On to the RBNZ and the NZD now... the 90 day bank bill futures see the next hike about 6 months away, however I would be more unsure about that. With NZ's Terms of trade plummeting (milk, innit) and a further slowing down in China, the RBNZ will be hesitant to hike further, and may even be regretting the recent 100bp move given the last CPI print. Either way, hikes are off the table, and it's very likely we don't see another RBNZ hike before the Fed.

90 day bank bill futures curve, now / 1m ago /3mago

 We can see the drop in rate expectations from the above curve chart for the 90-day bank bill, while not huge, its certainly not insignificant.

NZD vs carry/vol

Here we can see the impact clearly with Carry/vol (1y1y / FX vol). Furthermore, given risks to short run outlooks we should see a pick up in vol further, and combining this with lower NZD rates, the NZD is likely to under perform.

Next up... Brazil, and we have some elections! now I know very little about these, as I haven't been following. But Dilma Rousseff is probably going to win given recent pollings, and options markets have moved accordingly with a sizeable mark up in vols, and 1 weeks still around 40 (as of friday)

USDBRL 1 week ATM vol

The vol surface is interesting too, with very little skew between puts and calls, which is quite odd around risk events!

BRL vol surface

USDBRL

$BRL had gone from being the best performing ccy (carry adjusted) for the year just two months ago, to barely even flat. The sharp sell-off has led some banks to suggest buying, given the "oversold" nature of the BRL currently and the high implied yield from NDFs (just shy of 10%)

However, BRL and BRL options are outside of my investable universe, so I'm just watching, but it's interesting nonetheless.

In $RUB, we are starting to get into that area where I'm going to start looking at the RUB in a constructive way... Implied have spiked higher with 3m ATMs at 15, with 25d riskies at 5. With the RUB firmly in the intervention zone for the Central bank and with plenty of firepower I would expect the large sell-off to start to slow down. 

USDRUB and 2 year swaps top pane, vol and rr's in bottom

 The RUB is incredibly vulnerable and I'm certain weakness in oil prices are not helping, this being said, I am looking to buy (via options) through till year end. (short 45 calls, long 40 puts - taking advantage of skew, whilst long RUB)

RUB 1y xccy basis

Looking at the basis, the $ liquidity problems are still firmly about, however it is starting to come off a little which should take away from the local demand for $'s

Anyway, just some quick thoughts. Have a good week.

On the USD and US rates

Last week we saw quite an incredible move in US rates, it is quite difficult to describe henceI'll let a chart tell the story...

US 10 year yield

We saw a huge move, probably the largest (once adjusted for yield) ever. Nearly everyone I've spoken to since the move last Wednesday that sits on the sell-side said their rates desk got absolutely slaughtered. Especially given the exposures that rates desks can take on, a 3% move in a currency is big... but a 3% move in the price of the US 10 year note is massive - and it hurt a lot of people.

The craziest thing is, that we ended the week only marginally lower from where we opened.

USD 1y1y

The forwards and especially the short end got hit lower and have stayed down, 1y1y has dropped by over 50bps and the expectations of rate hikes from the Fed have been really pushed back... Using Eurodollar futures we can see that the market had pretty much agreed on July 2015. However, one day the market in its infinite wisdom just decided to push that back to November!

CS 1st hike date

However it wasn't just US rates that went a bit crazy, we saw a large move in Peripheral rates too! Italian 2y's also had a busy day on Thursday with yields doubling in a few minutes!

However this does present us with some trade ideas, firstly and simply with the USD. The big event next week is clearly the FOMC statement where we will finally see Yellen's actions. The move in rates must have something to do with how people are perceiving Yellen, however it is still very likely that the QE program will finish, but any discussion about "considerable time" are out of the question it seems.

Currently, it seems after the recent rates move the EURUSD is trading fairly cheap to 2 year spreads, and its perfectly feesible to see a pickup towards 1.300 in the coming weeks.

We've still got extreme positioning, and the USD does seem overextended still (even at 1.28) as I was quoted saying here (http://blogs.reuters.com/global-markets-forum/2014/10/08/fx-musings/)

We were trading around 1.26 then, and I stick with my price target towards 1.30.

One way the Fed could push back expectations is by lowering NAIRU forecasts, possibly to below 5% to buy some time for Yellen to push back rate hikes. This will of course weaken the USD, but I think the bigger question is the disinflation we've seen in 2014 (particularly last few months in 5y5y inflation swaps) a problem for monetary policy? 

I mean, there may be demand issues but given the move in inflation is global and we've seen a large drop in oil/commodity prices, its clear to me that oil prices are in fact impacting monetary policy, or at least market expectations of policy.

This scatter from @boes and @ericbeebo is particularly interesting as it does show the strong relationship between the two.

And assuming that Yellen leans on the dovish side, its a conveniently timed excuse to be even more dovish!

As such I think that Cable offers decent upside along with EURUSD. As we can see from the chart, the 1y1y spread is still important for the pair and this will most certainly continue going forward, but assuming we see some further short term weakness in US yields from a dovish yellen then the USD will weaken and the GBP is already marginally cheap (and heavily shorted).

All in all, we've seen a monster move in rates, and a complete shift in sentiment regarding 2015 and the Fed, however from what I see, its only a transitory thing due to oil/commodity price declines and as such I once again am looking to pay rates, short Eurodollars and buy the USD - just at better prices.

*sorry its a short and quick one with very little detail but I crammed it in (got to study... or something). I will try to write some more / better posts in the future