Monday, 21 July 2014

21st July...

Last week was truly sad for humanity ranging from the Malaysian plane to the escalation on the gaza strip, it saw a quick sharp move lower in risk assets, with USDJPY heading back towards the low end of the 101-102 range which we find ourselves in. However, strong bids kept the hefty sub-101 stops safe for now. Likewise Gold saw a quick roundtrip from 1300 -> 1325 -> 1300. EMFX took a bit of a hit, but like the others, we saw a sizeable reversal.

The EURUSD was interesting last week, as the market headed lower to test very important weekly support areas.

EURUSD daily tech chart
1.35 really seems to be the line in the sand for the meantime, with a quick test of this area last Friday afternoon. However the market reversed to post a close above the rising trendline and critically above 1.35. Given the outlook for the summer (as discussed before), I don't see us leaving this range trading dynamic any time soon, hence still looking to fade these levels.

The fundamental outlook for the EUR looks bleak at best, while peripheral markets remain relatively strong, current account surplus is still v.healthy and risk appetite is very high, the EUR will struggle to fall meaninfully. But the divergence of monetary policy will soon become too much and the EUR will weaken. Here we see the 1y1y swaps for EUR and USD.

EUR-USD 1y1y swaps
It is expected that in 1Y's time the 1Y rate spread is around 75bps, far more than the current 21bps. As discussed in my last blog post, taking these values and assumptions into account, the EURUSD should weaken to below 1.30 in the next 12 months.

Furthermore, inflation has been diverging quite a bit recently, and expectations are also diverging. This is of course benefital for the EUR in terms of real rates, yet should weigh on the market as it will cause a further divide in monetary policy.

EZ vs US 2yr inflation swaps
I am, as suggested, a fan of the USD in any medium term outlook (given my belief that US rates pick up in H2, but i'll get onto that later). But the short term technical support in the EUR, makes me think selling AUD or CAD will be better played vis a vis the EUR.

Such as when looking at these two set-ups below.

EURCAD vs 2yr spread
I've tweeted a lot about the USDCAD and respective divergence with interest rates, yet throughout this time the EURCAD has stayed interlocked with 2yr spreads, until now. We are starting to see a divergence, and as such, I'm rotating my CAD shorts from USDCAD longs to EURCAD longs.

EURAUD vs 2yr spread
Here we see the EURAUD... it has diverged from rate spreads for a while. Mostly because the low volatility environment has supported the AUD in general (like with EMFX or NZD) as can be shown by the carry/vol chart below

AUD vs carry/vol

So while I am bearish the AUD in general, we have to respect the fact that it is up in this area for good reasons, and as such betting against right now is probably not the best plan, that is, until volatiltiy rises. Furthermore, there has been a lot of international demand for the AUD, and in particular Aussie debt... a triple A rated nation with a 10Y yield 3.4% is very attractive, especially given that it was ~100bps higher just a few months ago.

So, while I like the set-up in EURAUD, I'm holding off a bit to see how things play out. Especially with the NZD... Going into next week, here we can see the RBNZ probabilities

implied probability of OCR
 Given last weeks poor CPI print, the NZD got hit hard as there is a growing chance we don't see a hike this week. However, if we do, expect a lot of the move to be reversed. On the other hand, a temporary pause in OCR hikes will most certainly lead to NZD weakness.

Looking now at the GBP, I'm still rather bearish, and this sentiment is growing day-by-day. The market is pricing in a 2014 rate hike, something I see very unlikely given the persisting weakness in real earnings (BoE target for nominal wage growth is ~2.5% by year end, lol no chance)

We've started to see some smaller data prints start to disappoint (not just estimates, but overall) and a few more will really kick the overbought market a little, causing a more sizeable shake out of the longs

BNP Paribas' positioning indicator
GBP daily

The 1.70 is a really important level, and with the longs rather saturated, risk:reward is definitely with selling these areas for a move lower to support areas. Especially combining the idea that I feel a 2015 rate hike from the BoE is much more likely we could very well see general weakness, not just in the shorter term but throughout H2.

Another look at positioning is via 3 month 25-delta risk reversals as per below.

My preferred indicator for "smart money" not CoT. Demand for downside puts has picked up a fair amount in the past week.

Anyway, the GBPUSD has two components, the GBP and the USD. Going into the last part of the year, I certainly see US rates picking up, and am still expecting to see 75bps on the 2yr by xmas.

In fun bonus charts, here is 1Y realized vol for the GBPUSD

GBP1Y realized vol
Here's the fun part... the all time low in realized is approximately exactly 1Y after I was born... So this past 1Y has been about as exciting as my first year on the planet, for the GBP at least.

With regard to the 10Y now, the recent drop-off due to geo-political tensions presented a good selling opportunity to me.

Looking at the simple driver of the 10Y, economic surprise. We would expect to see US10yrs head higher with a pick-up in US macro. Everything I see when looking at the US economy suggests we do see a much stronger H2, and as such paying US rates now is good (as talked about here)

Using the USDJPY as a proxy would work, however, how I am going to play it is short USTs (2.45% on 10Y)

Instead of buying USDJPY, I want to take the current opportnuity to enter into a 3M long volatiltiy trade.

Even though the current 3 month implieds are much lower than 2007, one critical factor to remember is that the Curve is still rather steep (as demonstrated by the 1Y-3M)

JPY 1Y-3M implieds
JPY vol termstructure, now and 7yrs ago
When comparing current term structure with that off Summer of 2007, we see that while short dated vols are much lower, there is far less complacency on longer dated vols. Unlike in 2007 when the curve was almost flat.

So it is still reasonably expensive to buy volatility, so now more than ever timing is critical.

USDJPY daily
I don't think, much like with EURUSD, we break this week, or even next. But it is eventually coming.. As I have mentioned, topside calls are very cheap, and frankly I think we see a break upwards, however being short USTs covers that thesis comfortably, as such I want to treat this as a volatility trade. So a 3 month straddle (ATM) costs 230 pips. Each day I put off entering the trade I save around $120 of theta, so I don't want to rush into buying this straddle and timing is as always key. I will also delta hedge with discretion throughout the live of the trade, however I will try to keep it relatively delta neutral, however depending on my short term views I may use the delta to hedge against my UST trade or even alongside it. Lets see.

Either way... in summary.

  • I like EUR short term
  • I dislike GBP short/medium term vs USD (short term vs EUR)
  • Paying US rates here is great
  • Tactically waiting to get long USDJPY vol... will not wait more than 2 weeks though.
  • CAD and AUD expensive, NZD at risk next week
  • Earth is a depressingly sad place.

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