A long look at the CAD

The Canadian Dollar has been one of the most consensus short trades so far this year, and possibly the only performing consensus trade YTD, with the CAD down 3.5% so far, but off its lows.

Goldman Sachs, and many others came out loudly, suggesting short CAD for many reasons, but summed up by the following

·         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

     

 This has led to forecasts ranging from a median estimate of 1.14 by 2015, to highs at around 1.22 vs the USD.

USDCAD reuters poll

Implied volatility out to year end is around 6.5, implying a breakeven move of about +/-560 points from ATM (1.1015)

·         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

Addressing the points raised by the sell side, I believe the CAD to be less vulnerable than they suggest and potentially outperform many other currencies in the medium term. 

Tending to each one in turn, Canada's Current account sharply fell into deficit post 2008, but has stayed remarkably constant since, especially when considering the CA of say the UK which is a majorly concerning factor

(read more from this DB note on UK CA - http://pull.db-gmresearch.com/cgi-bin/pull/DocPull/3004-6FD6/80951965/DB_SpecialReport_2014-04-15_0900b8c0881c43e2.pdf)

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

The BoC is most certainly concerned regarding inflation outlook, particularly core CPI as can be seen from their last Meeting where they state 

*BOC: CORE INFLATION EXPECTED TO STAY WELL BELOW 2 PCT IN 2014 DUE TO EFFECTS OF ECONOMIC SLACK

Looking at a chart of CPI and Core CPI we can see that the BoC really should be far less concerned about disinflationary pressures than say the US, Eurozone or the UK and this will filter onto to latter points regarding monetary policy

Canadian CPI and Core CPI

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

Housing is also a major concern, especially considering the ramifications on Aggregate demand, but relatively speaking its no more concerning than the sluggish housing recovery from the US, the newly booming UK housing market or the more worrying NZ / scandanavian housing markets. So looking at this factor, while its not ideal for Canada, a global drift lower in housing will impact other places more so than Canada.

·         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

Some are calling for the BoC to cut rates, some are just expecting a far more dovish outlook. however in light of inflation, both Core and normal, I see no reason for the BoC to even consider a rate cut.

When looking at key drivers of inflation, such as energy prices, we can see that in CAD terms Oil prices are around 10% higher YTD

Oil in CAD

And even though the BoC have cited upward pressures from energy on inflation, I feel the market for interest rates incorrectly interpret the wording from the BoC regarding future rate moves. Even though the BoC is in a neutral stance (where they consider both cuts or hikes) I believe the next move to certainly be a hike.

Especially considering the growing growth prospects of Canada with its close ties to a strongly performing US economy, not only this, recent geopolitical moves, such as the Canadian-South Korean Free trade Agreement will only help Canada's presence in the growing East. 

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

And yes, the interest rate spread vs the US, especially on the short end may benefit the USDCAD which can be seen by the tight correlation between the 2yr swap spread and the spot price

USDCAD vs 2 year yield spread

Therefore we can see how a lot of the move higher in the USDCAD has been due to pricing the relative moves in the central bank policy - that is a dovish BoC and a hawkish Fed.

However considering upward pressure to CPI in the medium term, decent growth prospects (maybe less than the US, but better than most) and mostly stable macroeconomic indicators (U/E, CA etc, housing) I feel that some of the dovishness in the CAD is overstated and hence I am looking to build a position more closely aligned with a move toward a less dovish BoC

The question is where to fund the long CAD position, this is possibly the hardest question. I am still marginally bullish the USD in the 3, 6, 12 month outlooks, and I think the best opportunities come against the NZD, the CHF and the GBP.

In the case of the NZD and GBP vs the CAD, it can be seen that positioning is at extremes (taken via 25 delta 3 month risk reversals) and is therefore vulnerable to covering

CAD blue, NZD green, GBP red

My final chart looks at 1 year swap rates 2 years forwards as a proxy for monetary policy between the UK and Canada, and we can see strong convergence (red UK, blue Canada) between respective rates, and the spread is shown in green overlayed vs the GBPCAD cross rate. Once again, to me its clear that the weakness in the CAD is due to over-expectations regarding the dovishness of the BoC which I think will change soon. 

In terms of how I would play this, I don't see any simple opportunities in the volatility or rates markets that would overly differ from that of a spot trade pay-off and as such I'd look to buy the CAD vs. a basket of currencies with the weighting;

 25% vs. the NZD,

 35% vs. the GBP

 40% vs. the CHF.

April 14th - FX & FI strategy

G10 FX overview:

The EUR starting the week on the back foot  some headlines from Draghi from washington

A strengthening of the exchange rate requires further monetary stimulus. That is an important dimension for our price stability 

EURUSD opened a modest 0.4% lower after these words, but frankly it is nothing more than what we've heard before. We have been told that the EUR will lower inflation (10% in EUR = -0.5% in CPI etc) and it doesn't take much to have expected the ECB to consider the EUR in their forecasts. As such they don't particularly want a strong fx rate. It is clear that 1.40 will play a big part in this, much like 75 in USDJPY a few years ago, or 0.95 more recently in the AUDUSD, as such we need to tread carefully. The USDJPY held up incredibly well throughout the back end of last week at a time where the Nikkei (cash + futs) traded sub 14,000 and the US 10 year dropped into the low 2.6's. However from first glances this week, it seems to have found some support (and the DXY as well) and risks now present themselves to the upside. With a break of 102 being critical in the short term - 101.20 still defines the downside, where a break sees 100.

most important line in FX this week,  USDJPY daily

On the commodity $ bloc, the AUD, NZD look overextended for sure, but I will look into those in much more detail later. CAD has been choppy but I don't really see much direction, with 1.09 still being a key level to watch.

Rates / Equity overview:

Last week saw a significant move lower for yields across the world, with the US 10 year breaking lower from the chart I presented last week, yet no meaningful tick higher in volatility (volatility only going to rise, if rates rise?), and we saw the 5yr sector in particular trade much lower, down about 24bps

Us yield curve

Notably in the European debt markets we saw the German 10y bund trade at 1.5%, a level not seen in over 9 months, I would still say its on the ECB-is-going-to-act play driving yields and yield spreads lower and tighter.

On the equity markets, I posted a chart last week, and since looking at the VIX term structure inverting, we've seen a modest bounce today. Given we dropped for no reason, I don't see it out of question to rally for no reason. Business Insider's Matt Boesler did an article on it (Chart) 

Looking ahead this week, I'm rather neutral on the impact from the equity markets, but of course we need to remain vigilant as a dive towards 1800 on the SPX could lead to weakness in USDJPY potentially spilling into risk off in the FX/FI markets, but we'll cross that if/when we get there.

EURUSD and the ECB:

I've written quite a bit on my thoughts of what the ECB should do, and how the EURUSD is likely to react. Broadly speaking the TL;DR of my other notes is: EURUSD downside will be a USD story, and EURUSD upside will be a EUR story. But now I am going to focus on the implications of a EUR rate cut.

As discussed earlier, it is clear that the EUR is becoming a more important piece of the puzzle for the ECB. However, assuming we see a rate cut (negative depo or whatever else) the inital reaction is likely to be a sharp (50-100bps) drop in the EURUSD. But like last time we had a rate cut, I'd expect this drop to be short lived and not be a game changer for the EURUSD in the medium term.

Using these three charts as proxies (good ones) for some of the key determinants of the EURUSD, we can see why the EUR has been so supported, and why we'll likely see more support.

So we have relative equity performance proxied via bank share ratios, 3M EUR vol as a good proxy for FX market volatility in general, and then of course the Italian-German 5 year spread as an indicator for peripheral debt spreads and risk premium in the troubled EZ.

Considering these each in turn, a rate cut would almost certainly result in stronger EZ bank shares relative to US ones, not much needed explaining here.

Central banks love to kill vol, it's what they do best in the long run. While there may be a short term spike higher in volatility, a show that the ECB will act to prevent deflation and try to anchor expectations will undoubtedly calm medium term fears and as such, if volatility doesn't drop (as its already historical extremes) it would struggle to meaningfully rise. Given the true tendency for the USD to act as almost the ultimate safe-haven currency, and given its low short term rates (key that very short end is lower than EUR rates), this will mean the USD is used as a funding currency far more so than the EUR, and therefore with lower vol, comes a higher EURUSD.

On the last point, there is a cause and effect here. Firstly, the yield spread is lower as people have been buying BTPs, and this has caused larger FI inflows and help supported the EUR, but looking forward, we would expect to see futher tightening and further inflows into the EUR sov debt market further buoying the EUR even further.

Taken these three assets and building a composite indicator, we can see how closely it has followed the EURUSD before, and would lead me to believe that we could see a higher EURUSD on the back of a negative rate.

This was a quick look at what I believe a negative rate cut would do, and considering the likely consequence, I believe the ECB won't pursue this measure (or if they do, act in other ways to prevent EUR rising). However disinflation is a real concern, but as discussed before, leaving it alone is a really bullish EUR aspect (real rates idea discussed here)

AUD and the RBA

I feel I'm focusing too much on central bank rhetoric this week, but oh well, we have the RBA monetary policy meeting minutes coming up where I expect the RBA to have once again moaned about the AUD, which if we remember last time we rose to the 95 area vis a vis the USD they were pivotal in us turning lower. However, the idea isn't just strucutred on the minutes coming up, I feel the growing concern from China will likely weigh on the market, and there is a concern that if Us equity ticks lower risk could filter away from the market.

Positioning is also key, and according to Citi FX (one of the largest FX banks by volume) the AUD demand is starting to falter and given the market is quite overbought (up 9% in a few weeks) we could see a pullback as longs look to cover, citing the RBA as their "excuse" to take profits.

Extract from Citi

Clients positioned for growth and disinflation

Global Overview: Our flow signals do not change dramatically from last week. EUR remains the most oversold currency in the G10 – while AUD and CAD reach overbought levels. Client interest in selling EUR and buying AUD are both waning, leaving the currencies at risk for a correction. CAD demand remains strong into the BOC. 
  
Strongest Directional Signals: EURAUD selling at risk: An oversold EUR and waning demand to buy AUD is now the most “stretched” flow in the G10. The cross remains sensitive to any disappointing US and Chinese data. · 

They see EURAUD as being the most stretched in terms of positioning, and in fact I quite like buying in small amounts down here

From a technical outlook, we see Stochastics and RSI confirming the positional commentary from Citi, and given the AUD's outlook, I'm looking to buy around here (1.4665) for a move higher towards 1.49 (or so) 

Stops will be somewhere below the last low, but 1.46 is the area I'd be looking to cut at anyway.

German 10 Years - tactical shorts?

As mentioned earlier, Bunds traded at 1.5% on the 10Y, and I decided to short the futures at 144, the provides decent exposure to any possibility of a move lower in global FI, and also in case we start to see EZ data / inflation start to pick up. This trade won't perform well if the ECB does act, but that is a matter for June anyway.

10Y bund daily chart

Either way, I like being short bonds here on a tactical basis, as even though we've seen a large drop in yields recently, and sharp spikes in Eurodollar contracts, I think the actual fed path hasn't changed from 2 weeks ago, so I see bonds as structurally expensive here.

On other notes, been bearish SEK for what feels like too long, but its hopefully starting to pay-off with a lot of room above 6.60 vs the USD, and the Riksbank is sure to become more dovish after having a year of deflation.

April 7th

G10 Overview:

Last weeks only interest was the on estimate NFP, which sparked some buying of carry currencies, and also managed to leg volaitlity lower. It wasn't just DM carry that was bid, EM pairs were well bid also, meaning my long MXN, short EUR call from a few weeks back got closed from Here for a 2.5% gain. Would have bought other EM pairs, but can't, so... yeah. This search for yield pushed the AUD back towards 0.93, and with US yields looking subdued, there is potential for a break higher here. However amidst the constant back and forth regarding QE from the ECB, the EUR ended barely changed last week, only down 40bps of which most has been given back today. It is clear the line in the sand going forward is 1.3700 as shown from this chart.

A break lower, threatens a move towards 1.35 as longs would look to cover their gains. This fits reasonably tightly with my long USD bias that has been built over the last few weeks.

EURUSD

Likewise, USDJPY traded heavy today as US equity pulled further back from their highs, as such the 103 level is very much in play, further weakness from Equity and we will likely trade 102.65 ahead of larger bids down towards 102.50

USDJPY short term techs

Rates overview:

Quite simply, the lack of a "really" strong NFP, weak shorts across the US rate complex decided to cover at the key 2.8% handle in the 10's sending the US rates lower across the curve. It is important to note that nothing fundamental has changed and we can merely sell US bonds at a 10bps better price here. This being said, the short term technical picture is troubling and as such I'm looking to stay out until it settles.

Below we can see the US 10 year yield and the 1Y ATM volatility for a 10Y swap, the Implied volatility is as low as it was this time last year (pre-taper-talks). While I would love to position long Vol given the impending move I expect, I can't trade swaptions... so yeah.

US 10 year yield vs 1Y IV (please note, just because I overlayed them, doesn't mean I think either Vol goes to >100 or US rates go to 1.7%, Kthxbye)

For the USD, short term movements in the US rate complex will be important, as such depending on which way we break here, it will determine my bullishness/bearishness in the short term.

However its not just UST volatility that is low, FX volatility (in particular GBPUSD) is crazy low

GBPUSD 1 month volatility,  lowest in my lifetime!

As we can see, implied volatility traded on the bid side to 5 today, dropping hugely over the past few weeks, and while there are major global macro events still unfolding (ECB decisions, Fed taper program, Ukraine etc)

GBP 1 month vol

 However that was implied, if we look back at the past 1 months actual, realized volatility, we can see that on a closing basis, it was 3 (2.96 at one point)!! This is the lowest in my lifetime, as we traded in under a 1.5% range! This can be seen from the red line below (purple is implied, histo is the spread)

GBP 1 month Historical vol, 1 month implied vol, and their spread

When looking at the surface, we can see across most tenors a very small skew between call/puts, this being said, on the 1 month, the lowest demanded strike is 1.67.

GBP vol surface

Given the mean 1 month historical vol is 8.2 over the course of my 18 years, I think we do mean revert higher, however it is still difficult to see a catalyst for this... Global central banks still suppress volatility with their rhetoric, and this isn't likely to change anytime soon. The "goldilocks" US data is sure as hell not helping either. Even though theta is a bitch, and given no obvious reason for vol to go higher, getting long vol is tricky... But given the historic levels we are seeing, I can't really help myself.

As such I'm looking to buy a 25th-June-2014 ATMF (1.66) straddle, this costs almost exactly 2% of notional, meaning I need to see the GBPUSD move 2% from 1.66 to breakeven, however I will look to delta hedge this trade on a daily basis so as to more closely replicate a pure volatility trade. The latter tho, given my bearish tendency for the GBP layed out quite clearly in the second half of this I may skew my exposure sometimes to have a mildly short GBP position.

Still bearish GBPUSD as mentioned above, but playing via options in short term - also that expiration, because its the day of my final exam and I hope to have a nice win to make up for the stress of my Maths Papers!

US equity drop of presenting some short term opportunities

We've seen an almighty 3% drop from the high - frankly I'm surprised the world has ended, but hey... twitter acts like it has - yet, given the VIX term structure, I still see the best BTFD opportunities occurring modestly lower. Each of the last dip buying occurrences have seen 1 month VIX trade higher than 3 month (histo goes red). As it stands right now, this is not yet the case and so I'm quite willing to buy.

ES front month, VIX term structure, spot VIX

However, given the fact that as the S&P drops VIX rises, I like to get short VIX while also being long S&P. Mostly the VIX has turned around in the 20's so there is still upside there, but when we get there, I will look to sell short term 1730 puts on ES futures contracts, Obviously we are not there yet so I'm not sure the price of them (cba work it out either), but this is my play going forward. Looking to sell downside puts when the T.S. inverts and VIX >20.

Either way, I look forward to another slow week in FX (and you know its boring, when I start to look to the equity markets!), for the BoJ tomorrow, I expect not much, an ATM straddle expects about a 40 pip move, not too much.

Riksbank coming up soon, generic words - but deflation is a real concern there, so I expect it to be dovish at the very least. Still bearish SEK.

Thanks