2016 Rates & FX Macro trade ideas

In this slightly longer piece I will present my thoughts, ideas and themes which I think will play out in the medium run, throughout 2016, across the various asset classes.

G10 Rates Outlook

• Short L M7 against ERM7 at 131bps, targeting 160/180bps with a stop below 110bps

In recent weeks, and in lieu of a tightenting Fed, GBP rates have seriously outperformed, diverging from a strong link with US rates that has been seen for many years. Growing sentiment regarding the Bank Of England that they will likely be dovish has led to this, with some pushing back the 1st hike to 2017. The divergence away from the Fed, and towards the ECB can be seen below.

Months to 1st hike indexes for Europe, US and the UK

With the UK economy ticking along very nicely, its interesting to see how the Fed is so much more prepared for a tightening cycle, yes inflation is higher.. but wage growth (at 3% y/y) and subsequent pressure in the UK is greater and with an on average (2.3%)  GDP growth it seems fair to start tightening to prevent later pressures. 

Unfortunately as is the case with all global central banks, they are placing far too big of an onus on their response to Oil prices, thinking back to the ECB in January, there is almost zero chance we would have seen QE or further easing had Oil stayed at its 2014 levels. But of course, it didn't. And we are now trading $35 or so, and dis-inflationary pressures remain on headline CPI, worse is that the desired "base effects" that were due to roll off in the coming months won't have as strong of an impact on CPI worldwide. 

Nevertheless, the UK rates market is pricing in very little tightening, and a very shallow curve, taking this against the backdrop of European rates looks favourable right now. The ECB "shocked" (admittedly against stupid expectations) hawkishly and whilst we saw quite the reaction in front end EUR rates, they will still be firmly anchored from QE flow and negative rates - even being optimistic on Europe, I will still look to receive their rates. Getting into the trade is simply done by selling June 2017 GBP LIBOR futures against EURIBOR futures (L M7 - ERM7)

L M7 - ERM7

We've had the "great divergence" between European and US rates, but with UK rates almost 1% from the wides, we have room to move in this direction, as such entered at 131bps, looking for a move towards 160/180bps during the course of the year. We have a relatively well defined stop area in the 110/115bps range.

However as mentioned, its not just against EUR rates where there is a good set-up, but longer out the curve against the US looks good too.

• Short UK 5 year vs US year at 40bps, targeting 10/20bps, stopping at ~50bps

Similar rationale on the UK rates front, the market seems to be seriously discounting any possibility of a hawkish surprise from the BoE, and with the Fed hiking, it will give Carney et al perfect timing to shift tone.

UK vs US 5 year

More specifically on the 5s, it offers the best relative value against US along the curve, with clear entry and exit levels.

• Recieve AUD 2yr at 2.35%, targeting 2% and risking a move to 2.5%

Australian Rates have moved significantly in recent weeks, against a tide of fundamentals suggesting otherwise. Watching the price action, specifically post the Oct Fed meeting, it seemed A$ rates were being paid along with all $ rates. This offers a good entry point, and opportunity to get long Australia. Domestic data has certainly ticked upwards, with a couple of strong Unemployment reports, but broadly the overall economy remains incredibly vulnerable to a slowdown in China and declining Commodity prices.

AUD 2s vs Iron ore

Seen clearly above, Iron ore (and the commodity spectrum) has continued to decline aggressively, and whilst the overlay is spurious, the idea is strong. Stevens has told us to "chill" for the Xmas period, but with a worrying China (on the verge of further easing vis a vis CNY weakness), weak economic activity through lower commodity prices and crucially an outperforming AUD that has risen 5-7% (depending on index). This is going to be of most concern going through to the new year and should pressure rates markets.

My base case is that we see further cuts next year as we approach the end of the commodity cycle, possibly bringing the base rate to 1.5%, this gives us more room to target below 2% if this gets going. 

This idea plays a further part when considering the FX outlook later on, but broadly, unless we can see a rather sizeable commodity bounce the risks to this trade seem limited to an overly hawkish fed lifting global rates - which seems unlikely. 

On to the US curve and the real limportant question is how many times they hike - finsih after fed..

• Short USD 3m5y straddle

Yellen and the Fed managed perfectly to hike, and keep asset markets in check. It was hawkish enough for the curve to remain relatively stable and do as expected and flatten a touch, but she also acknowledged potential risks. Building on this theme, I am looking to sell vol on the belly of the curve, US 5s. Unfortunately for me I am limited to maximum of 2/3 months out due to futures volumes, but in swaptions I would recommend at least 6 months. Implied vols aren't spectacularly high right now, 3m futures IV is 3.5. Using simple approximation, this equates to a roughly 4.5bp move per day in US 5s.

US 3m5y implied vol (price vol)

Given the outlook for the US economy, which does include in my eyes potentially faster than expected inflation and strong growth - but against a world which is easing and arguably in trouble (EMs), I believe the US 5 year will stay fairly well fixed at around the 1.5/2% level that it has traded over the last few years, for the entirety of the next year, and given a 2 month straddle breakevens at 1.32% and 2.12% I feel comfortable selling this (as seen below)

US 5y and 2 month breakeven range

We also need to discuss the terminal rate, in the aftermath of the rate hike, long end yields have dropped, with 30s coming off 5-6bps. The 5y5y fwd swap sits at a mere 2.63% and there is clear potential for this to edge lower. My preferred way is to constantly be selling US 10s +25bp payers through out the year, rolling every month or so. I find it hard to see in the global context long end $ rates to really escape those of Europe or elsewhere given how they are effectively anchored to one another, even if the front end can diverge.

Lastly for rates, looking at some European rates, and more specifically Sweden. Economically, Sweden is looking good, as does Norway (but oil niggles). With the Riksbank recently changing tone, and shifting upwards the inflation focus as well as growth estimates its possible sweden can surprise us next year - currently the expectations are for lift-off at earliest 2017, more likely 2018 - and not before 2% inflation! but with upward pressure to rates and strength emerging in many G10 core nations then paying rates in some of these less obvious places might work. SEK 1y1y stands at -0.07% and we could see this trade all the way towards 10/20bps with an impulse of inflation and continued optimism in the economy.

Core CPI highest -> Lowest, Norway, US, Sweden, UK, Europe, Japan

Having come from quite serious disinflation/deflation, Sweden has recovered (although its not to say their economy was ever really *bad*) and we could see paying Sweden work out well.

This is unfortunately dependent on what happens in Oil too however, it seems with Oil in this area, we should expect Draghi to lean more towards Easing - even though his, and my own, outlook on the Economy is good. It pushed too far last time, and its possible that if it were to happen again further easing could occur.

This leads to a nice idea in inflation that I've got which is to pay 5y German inflation, which currently trades at 65bps. On the one hand, I am reasonably confident in European and G10 (ex aus/Nz) growth next year, which should place upward pressure on inflation, and if oil continues to stay weak the ECB will likely play with more QE which could stoke the market to price in higher expectations as it did after Jan.

So buying 5y inflation bonds whilst selling 5y govt bonds looks like it could work well. Alternatively, you may not want to sell German 5s as ECB buying may keep it pinned so outright long on 5y inflation bonds also works (but prefer the spread trade).

• Pay German 5yr inflation at 58bps, targeting 100bps, while risking a move to 30bps

FX Outlook:

FX is going to be more difficult I imagine, after 2015 was mostly range bound in the majors, there is very little expectation of *big* moves this year. Implied vols trade at the lower end of the years range, and close to historic means, but significantly above 2014 levels. It's difficult to see with how we are lined up for overall FX market volatility to realize meaningfully higher - after all 2015 we saw plenty of action ranging from CHF de-peg right at the beginning, to wild 5% ZAR swings, and a plethora of emerging market Devaluations. 

This last point could remain a key factor going forward and I suspect there will be even greater emphasis from Central banks on their effective exchange rates. China have recently introduced a basket mechanism to diversify away from the USD - this is important as we would expect to naturally see the CNY therefore depreciate going forward, however this is by no means guaranteed especially when considering the basket composition. What this means is it seems less likely that there will be a sharp move in CNH - Current vols stand at 7, which is not to far of the likes of USDJPY or GBPUSD, yet it's likely (as it has done much in the past) realized will underperform as such I would like to sell USDCNH 3m vol here. It implies a daily move of around 0.43% (6.75/sqrt(252))

• Short USDCNH 3m Straddle, delta hedged daily at 6.75%

Vols have tracked Spot higher, but skew remains tight. The main risk to this trade is the idea that PBoC do devalue / let it go.. in which case we would likely trade north of 7, in which case owning a 3m one touch costs around 17% of notional and could serve as a hedge (ignore the delta on it on the overall structure) to our short vol trade.

In G10, as mentioned before, I don't really have a gutsy view on the majors, broadly I'd expect to see the USD under-perform in a backdrop where GBP (due to rates re-adjustment) or Sweden (rates again) could do well but nothing large in terms of move.

So I look to crosses for ideas, and one that I jump straight too is selling Australia and New Zealand. selling these two in a basket against GBP + SEK looks attractive right of the bat, seems fairly cheap and the macro drivers definitely look attractive.

For AUD, the combination of the RBA, and my expectations that their rates continue to drop after being weighed on by the commodity downcycle should result in weakness. Moreover, AUDNZD is well defined in a range and we sit at the bottom end of it, NZ economically is certainly starting to improve, but a continued easing bias from the RBNZ could see pressure especially due to relative strength in recent weeks of the NZD.

 

On the other hand, for sure the Riksbank don't like a strong SEK, but there is enough breathing room for some mild appreciation. With one of the most impressive economic outlooks, and driving forward alongside Europe suggests the SEK could outperform.

GBPSEK/AUDNZD basket

Alternatively and a little riskier, would be to short AUDNOK straight out, economically, norway is far better suited to deal with this Commoditiy shock. Not only has the Norges bank preemptively cut, but their domestic demand is showing very strong signs, from the highest Core CPI across G10 to stably strong retail sales. One downside is the impact on unemployment, which has increased in line with oil price declines, however the impact of lower commodity prices has impacted the fiscal balance significantly more, with Norway running a 9% surplus, with Australia's likely to be towards -3% after the Government releases new estimates soon. A similar picture with Current account, with Australia's declining markedly whilst Norways has remained rather strong.

To sum, I like Norway's economy, I believe they are well prepped for this commodity decline and will be well suited to cope, whilst Australia continues to deteriorate, and as such prefer to play AUDNOK from the short side - though I wish FX played alongside the fundamentals they often don't. But with AUDNOK at c6.25

AUDNOK

There is a lot of relative value commodity determination in this, which is not ideal as I have no firm views on copper against Oil for example.. This is purely a country play, however Oil plays high beta to copper/iron and is marginally less dependent on China so can see an environment where Oil outperforms thus supporting this thesis.

USDCAD is an interesting one, alongside oil prices, the CAD has been absolutely hammered, and is now trading close to extreme long term levels.. much like with Norway, their economy is clearly impacted by Oil, but to this extent? We will have to see, but with USDCAD at 1.40, this could be an out of consensus short that could perform well. But with Oil still dropping its hard to pull the trigger just yet, but it does seem very cheap

USDCAD

Especially given that rate spreads don't support the last 3 months of USDCAD strength and aren't even at their wides

US 5 - CAD 5s

 

Emerging markets are an interesting case, broadly they have moved a long way and have priced in the Fed moves fairly well - however when considering sustained commodity price weakness it seems difficult to see a lot of the exporter names rally, and in Asia, with further CNY weakness it would be difficult to see the ADXY index rally meaningfully. Carry is starting to compensate risks such as in turkey and south Africa, but risks seem to high for me personally to step in here, and I would expect basket cases such as Brazil (currently at 3.86) to trade well through 4 again next year.

One of my last trades in FX is mostly a hedge against my underlying biases of a weaker USD and this is to buy a 3m EURUSD 1.07 digi put, which costs around 33% of notional. In lieu of a potentially hawkish and optimistic Fed, and with Oil and these levels once again pressuring the ECB (given how senselessly responsive they are to it) could see a dip back into dovish rhetoric with the ECB concerned about EURUSD close to 1.10 and not parity.. so its seemingly a cheap hedge against this idea to me.

Equity/Credit outlook:

In credit to begin with, the HY space has been in the news a lot recently, but there are many things to consider other than just looking at the ETF HYG, index composition is heavily leaning towards energy/commodity names, and with this space being weak, its no surprise to see these names widen and drag the whole of HY with it. Goldman produced a nice chart (below) which loosely suggests risks of a recession given where HY spreads trade - its more of a nice thought provoking chart, however on twitter/media a lot of the thought has been panicky and shallow.

We need to consider Impacts on default rates when looking at credit, as ultimately that is the key determinant here. Sure, MtM losses on cash bond holding can lead to redemptions -> more weakness especially in lower liquid times, but essentially if you buy these bonds at 7.33% above USTs, unless the default you will be making this. Which is why looking at the CDX HY (credit default swap index of HY debt) the total return this year has outstripped the SPX (on corporate default rates I refer you to a SocGens 2016 credit outlook where they do a great job of analyzing default rates and how they are unlikely to spike here )

With the positive outlook from the Fed, and strong corporate growth in the US, I see at least for H1 a positive return in the high yield class. A goldilocks fed should spark risk on, with acceptance of a strong economy but also remaining accommodative enough to support growth.

CDX HY trades at 485 as I type, and a synthetic forward trades at 555bps or so (6 months) on the s25. Selling protection at this level looks attractive, but even more so is selling payers given the huge implied pick up. A 3 month (cant get liquidity further out) 525 payer breakevens at 580. I would use this premium to source trades in other spaces. Cash HY is likely to outperform on a bounce in risk so using this 65bps to fund HYG calls could work well, or just run with the short payer anyway.

• Sell protection in HY US credit via a 525 payer for 65bps

Namely looking at European and Japanese equity markets against US.

• Long Eurostoxx and Nikkei against US at index level 100, targeting 15% outperformance

ES vs VG

European equity has underperformed US in recent weeks, although is set up with much more favorable terms with the ECB potentially embarking on more easing (not my base case but possible) and economic growth to see definite upside could result in strong corporate returns and a strong eurostoxx. Same in Japan, looking at the economy here, its doing well - recent Tankan data was robust, labor market tightening is accelerating (jobs-applicant ratio at 1990 levels), continued accommodation from the BoJ (however no more extensions to this). Nikkei likely to reach new swing highs over 21,000.

Although I don't have strong convictions in equity space, and these are consensus views that I agree with, however in US equity, I struggle to much upside and would continue to sell vol here. Dips will likely remain well supported throughout the year, and we will inevitably reach some point where we've dropped 5% in a few days and the media starts to panic, the skew widens considerably and the VIX term structure inverts - but as things stand these continue to present buying opportunities with the US economy performing well.

Either way, just some of my thoughts on financial markets through 2016, it does seem to be setting up to be interesting and I wish you all good luck - oh and disclaimer, don't listen to anything I say here, it'll probably all be wrong!

Happy Christmas Readers

December Outlook - ECB & Fed

December is being set up as a rather critical month for the markets, with the two biggest central banks expected to diverge policy. First up, and in just under a weeks time from now is the ECB, where currently estimates are for around a 20bps depo cut (to -0.4%), although not fully priced in on the EONIA curve, looking at 2 year german bunds they are currently sat at -42bps.

The issue I have is that I really don't think that the ECB needs to ease more, however we have to position from what we think they will do and not what they should. But looking at what is most important; inflation, then we can see that compared to the beginning of the year when they embarked on QE, its really not so bad.

EUR CPI y/y and 2y inflation swap

CPI has ticked back into positive territory (okay its still awful, but its 0.7% higher than jan) and inflation swaps, which are arguably useless in *predicting* inflation, have tended higher recently and are close to 1% again from the 0% when QE was enacted. Other data from Europe continues to broadly impress, whether it is strong money supply growth or an unemployment rate that has dropped 1% this year... I would be optimistic on the Eurozone outlook. This being said, it seems more than likely that Draghi will cut the deposit rate (with a large amount of exceptions as per Switzerland) given the rhetoric he has put forward over the last few months.

However I still firmly believe that he is playing purely reactively to Oil prices (and the commodity spectrum in general), and propose that if Oil was still sitting quietly above $50 or so, we wouldn't even be talking about any ECB action this December. But we are, and thats just how it is.. One decent tell we've had today is from the SNB, rumours that they've used quiet markets to intervene a tad in the CHF to push it to post peg-break lows on a TW basis.

Whilst not too much of a tell, its worth noting that they acted ahead of ECB QE in January, only they got everything completely wrong that time, they might be pushing up EURCHF in preparation of weaker EUR expectations. Weak analysis at most, but worth considering in my opinion. I dont particularly have any specific trades in the rates space, but at least the combination of improving macroeconomic indicators as well as continually accommodative central bank would lead me to want to take on equity and credit risk. Though I was thinking that taking advantage of differences in vols and skew, funding upside equity calls (3700 on Eurostoxx) by selling payers in itraxx main (90) could work well as a cheap cross asset risk reversal structure.

Soon after the ECB, we have the Non-Farm payrolls teeing us up for the 16th where we see the Fed, as of yet there hasnt been any sort of meaningful mark-up in volatility for this event, with 17th expiry trading at 13% in EURUSD, which against a historical 1m vol of 9 is high, but nothing that really stands out. Some news-y people are probably going to starting saying how this is the "most important NFP ever", but bollocks to that, if a number now was enough to sway the FOMCs mind, then they were never going to hike, at the end of the day 3/6/12 month averages are around 200k, more than enough to maintain a falling unemployment rate, even a print as low as 100k won't be overly damaging to the general trend and would likely see the U/E rate flat at worst (assuming nothing much in labor force participation).

One thing it might lead to is repositioning going into the 16th, washing out the weak 25% of the market in the no hike camp or worrying the 75% but either way you would expect to see any move faded as it won't change anything.

Which then takes us to the announcement, there was a while ago people suspecting they wouldn't go in Dec as its the holiday period and liquidity blah blah, but that hasn't stopped policy decision in the past, the Taper (remember how much of a big deal that was?? lol) and won't stop them this time. But the key market moving news will come from what Yellen chats about in the conference and if we get this "dovish hike", which I personally think we will. I mean, the markets, the curve and sentiment is already in place for a dovish hike, EDZ6 is just a few ticks below 99 with the FF curve implying 3 hikes by next December. So one argument for the USD bull camp / pay rates people is that there is little room to be more dovish, and only room for a hawkish tilt.. which makes sense to a certain degree. But I think that when looking at positional indicators and price action, the market feels stubbornly long, mostly in short EURUSD. It makes sense to be short into ECB but after that? I ceratinly see a high chance of large covering into the Fed.. after all the trade has been the divergence of expectations, we've had that... its now being realised and those that have had the trade can take their profits and pat their backs.

One popular way I've seen to trade further USD upside is with 1x2s, which a few macro managers I talk with have recommended. This does present the risk that if the USD rises sharply these guys will have to increasingly buy USDs as they become short gamma and this could help fuel another leg.. and for these traders, they are zero cost on any downside so arent concerned about a short squeeze in the slightest.

 

On a very very simplistic regression model using rate spreads, the current 2y differential of 1.1% implies a 1.05 level on EURUSD, if the markets just roll as expected along their respective yield curves and there is no change to expectations of monetary policy between now and this time next year we see a 2y 1yf spread of 1.54% which implies via this model a EURUSD exchange rate of 0.97. Firstly, this is incredibly simplistic analysis and assumes things stay as they are with both the historical correlations and the monetary policy, both of which wont happen. The forward curves do however show us more interesting features, namely how in the $ curve and how the actual steepness is far less than it was a year ago looking at price action here there hasn't been anything close to a "huge" shift higher in US rates, if anything it was a bounce of low levels not seen in years, painting a very different picture to spot front end rates.

And looking at the spread against EUR rates, we see the "wides" in monetary policy expectations occured comfortably in March, at 30bps wider than present even with EURUSD at its lows, so possibly this leg lower through 1.08/1.10 has been an overly speculative / positional trade and will be disappointed in a glorious short squeeze...

Or maybe it wont, we will see, should be a good month nonetheless with plenty of opportunities.

27th October - Fed and RBNZ

It's been a while since my last blog post, and plenty has happened, I was fortunate to spend most of the summer (and that volatility) on the trading floor of a multi-strat hedge fund which was quite the experience, now I'm back at uni and now that I've settled back into things, I thought I could blog again.

Broadly, my views are quite light right now, no overly strong conviction ideas in any asset but still got some ideas to share. Firstly comes from the event risk we have this week  - The FOMC meeting. Now no one is expecting a rate hike, and that's fair enough, whilst technically a "live" meeting its highly unlikely. What we should expect from this though is for them to confirm/kill the idea of a Dec hike. One issue that the Fed faced in September was financial volatility (be it the VIX/SPX or whatever), that is a clear obstacle that has passed us now with the SPX upwards of 2070, and as such these financial conditions are back to pre-summer levels.

SPX vs VIX

This should at least, on the margin, result in a lean towards a rate hike in December, given all the fed has said towards the idea that they will raise the base rate this year there what little credibility remains at risk. Key numbers from the labour and growth markets remain clearly in favour of the hawks, yet it is still inflation that lags behind. The real hope lies with wage data, which as we've seen in the UK has started to finally pick up, AWE stands at 3% and looking strong with continued labour market strength. It is certainly likely that we could start to see a similar move in the US going forward, and with the constant discussion of the base effect of oil coming off, inflation upside is starting to be a real consideration.

Looking at a 2y zero-coupon inflation swap, we currently see 1.06%, which may be around what we realize, but going through year end I would prefer to pay inflation at these depressed levels.

US 2 year inflation swaps

So the game plan for FOMC, Personally I sit on the camp which expects to see a broadly more hawkish outlook. Hence I am looking to the front end rates markets to take advantage of this as the USD has had a sharp rally over the past few sessions and doesn't offer up the same risk:reward as in Rates.

Fed Funds Jan contract

 FFF6 is sitting near its highs, as the doves are in charge of the front end, 2 year rates are at year lows and the long end remains well and truly anchored to around 2%. This to me, seems like a cheap play on the Fed actually sticking to their word (even if we've seen them go back on it plently of times, and similarly with BoE).

Alternatively I would look to UK rates market to liven up post FOMC, with the short sterling curve as its flattest levels of the year, getting into steepeners here offers good levels as well as a strong play off any potential hawkish-ness that arises from the Fed.

Short sterling Curve Jun '16-17

At a mere 38bps, M6-M7 looks like a good spot to play any hikes, and with UK rate hike expectations pushed back so far (now out ot 14 months as per MS), but with the many positive signs from the labour markets and wages I think at the very least we are mis-priced as these levels and should be paying front end.

Average weekly earnings, at post crisis highs.

On to the other Central bank talking on wednesday; the RBNZ. With the Base rate standing at 2.75% and the vast majority seeing no change at this meeting, I think we have a distinct chance of seeing a very dovish report. Mostly given the sharp (7%) uptick in the NZD this month, something that the RBNZ will be very much against. Whilst when charted it appears like a realtively small retracement from the larger decline, we've seen plenty of times (namely Aus) that even a mere uptick is not good enough and they'll look at the very least to talk it down.

NZD TWI

As a short term position, a 25 delta put, 0.6650 (against spot ref of 68) for 1 week trades at about 70NZD pips, which on the surface seems quite expensive, so would be interested in selling some 70 strike calls against this to cheapen our downside as I see limited chance of the RBNZ doing anything to meaningfully leave the NZD higher. Obviously with the FOMC so close, one should look to a better cross, maybe AUDNZD, which in itself is looking rather cheap, at least against rate spreads, here I would look to longer dated (>3m) bullish option structures, such as 1.10 digi calls (which costs around 35% of notional, with a knock-out at 1.04 this cheapens to 25%)

audnzd VS 2 year spread

In NZD rates, its more mixed, with 3m OIS sat at 2.6670, or approx in the middle between hike/no hike. However given the path of the NZD and RBNZ rhetoric I would expect to see a further cut towards 2.50 before year end. It still seems attractive to recieve NZD rates, albeit much less so now than before, though there is very little chance in my eyes that we see an even semi-hawkish RBNZ with the NZD sat here and data only "meh" at best.


Just a relatively short one to start with, hopefully i can get into the rhytm of a weekly piece again which should be fun, but these are just my thoughts on potentially hawkish fed / dovish RBNZ.

1st June - FX & Rates thoughts

Pretty much finished my exams now, 1st year all but over and now a long boring summer awaits.. But hopefully the markets will be interesting enough to provide us with plentiful opportunities to take.

I've been looking at the $ returns in European assets. Below shows normalized returns of both the DAX and a basket of 10y+ EGB sovvies.

DAX and EGB $ returns

Returns in both have been rather stagnant of late, and this is hardly surprising given the EURs fall in line with the DAX's and Bunds rally. I'm still in the mindset that the EURUSD has "relatively" limited downside, at least compared to analyst prediction, which have recently stirred up again. I'm still of the opinion that the reaction function of a higher USD will ultimately impact the US enough (and benefit the RoW) to the point where monetary policy expectations start to converge again... whether this means later Fed hikes or earlier RoW is yet to be seen.



DAX (inverted) vs. EURUSD

Looking at this chart, we can see the strong correlation between EURUSD and the DAX recently, this was highlighted before in one of the last blog posts - but in the past week, maybe through heightened greek fears, maybe not. We've seen a large-ish divergence in the two. Friday was the first time since just over a month ago we've seen a sizeable DAX sell off with little EUR movement. However of course, there are plenty of risks to the bullish European equity theme, but I think ultimately the majority of factors are supportive, ranging from my positive outlook on the Eurozone to the of course accommodative ECB.

Because of this I'd like to look at selling DAX puts, and using the premium to fund a EURUSD call. In an ideal world, I think I would look to structure this in a slightly more exotic way, maybe with some sort of x-asset KO or the such, but alas I can't. So simply selling dax put and buying a EURUSD call will make the most of both these ideas. As we looked at before, Vol In the DAX is at record levels relative to the SPX, so its potentially a wise idea to buy some deep OTM puts in SPX as a global equity hedge for this idea, but I'm not sure I'll need to pay the premium for this.

Ultimately I've been really rather happy with the EURUSD recently, buying it back in April towards 1.06, and then just 2 weeks ago in my last blog post getting bearish just shy of 1.14 - we stand pretty much at 1.10 now which seems reasonably "fair" right now, but with an upward drift bias.

That's my current play in this space, not too interesting, not much going on. NFP next week should be interesting, ultimately I don't think even if it was 300k+ we'll see a June Hike so reactions (bullish USD) could be fade potential.

In the bund space, I've only gone and recreated this stupid chart that the sell-side have adored the past few weeks..

Bunds vs JGB

I mean it is compelling isn't it? well kinda.. but if anyone was to believe this then Bund puts are quite cheap. I was looking at a sept 151 put in FGBL, which is approximately the low we put in back in early May, and it costs a mere 50cents. If this does occur, which is a big if, the option would have an intrinsic value of ~200 cents on expiration in sept and probably worth much more before than, offering a decent risk reward set-up. Of course, we have the ECB meeting this week, and I'm sure some concern about this movement in rates will be addressed, and draghi will waffle on about the QE program and people will go back to remembering that there is only one direction for Bunds... maybe. I mean, if the stronger H2 EZ plays out, and inflation ticks higher then they must surely accept higher nominal rates, after all we are only at levels seen at the beginning of the year.

Thinking more about the longer end - it does seem rather capped. We had all this excitement last month about the "taper Tantrum" part two, but that has died down rather rapidly. I like this chart which shows US 30 year swap rates overlayed with Copper. Maybe its a nice correlation, or maybe its more important that global growth prospects are the clear and present danger for higher rates, regardless of US growth. I mean after all, global rates are fairly well anchored to each other, and in think back to two weeks ago when the USD was pretty weak. Global asset managers loved picking up USD debt with the USD at such a discount especially vis a vis the EUR.

We also see Global PMIs trending lower on this chart and while I am optimistic on global growth (mostly due to higher USD / lower Oil) this downward trend will most certainly keep the long end pinned lower, especially in our low realized inflation world.

However on the shorter end, divergence is still reflected clearly. Here is a CIX of a DXY weighted 2yr swap spread of the US against the RoW. It's been a clear driver, and understandably, but its been trending lower as Fed hikes have been pushed back and back. But to me, broadly the USDs strength will be limited, and even if the spread rises, it won't support the USD as much as it has in the past. I think as we move into the hike cycle, the raw spread in support of the USD won't be as important, even now I think its importance has been overstated. At every stage, the US rates market has outperformed forwards (mostly) and we'll merely be moving along an upward sloping curve which the forwards (as calculated from the curve) see. so we could simply plug in the forwards to this and we could see a DXY 2y spread upward of 0.7% next year... but that's not to say the DXY is going to be 105+..

On the other hand, I do think that USD bearishness is limited without a major drop in this carry you now get in the dollar - its sometimes like this that I wish forwards were a predictor of price. All this time I've been bearish the USD, but its really relative to everyone's bullishness and more of a sideways drift lower in DXY.. and so I wish we could have a 1Y fwd in EURUSD under parity as per forecasts.. this would make sell-side forecasts so much more interesting :P alas, fwds are just a bit of fun maths and nothing more.

On the NZD.. since I last looked at it here where I presented the idea that the RBNZ could cut rates. Since then some smaller banks have agreed with me, and more recently HSBC have thought this is possible. More importantly the NZD TWI has dropped from 160 to 149, and the crucial cross with AUD has pulled back a lot, but still high.

NZDAUD

The NZD OIS market sees around a 50% chance of a cut in the next 3 months or so, from pretty much 0 a few months ago, this is a primary factor on the lower NZD. But its also fallen out of favour from the momentum/tech guys, with us trading yearly lows under 0.71

Carry/vol is also a great indicator for NZD - and both don't paint a pretty picture. Carry has dropped remarkably as the market has seen the turnaround in the RBNZ rhetoric.

Carry/vol vs NZDUSD

As I've suggested, against a lot of critiques, is the idea of an easing RBNZ... many simply suggest they won't cut and will just use FX and words to achieve their goal, but I think serious risks in China, domestic inflation (yes, yes I know housing blah blah) and declining Terms of Trade will see the RBNZ react, especially in a world of cutting CBs - they'll hardly be out of place!

Taylor Rule for New Zealand

Here we can see the Taylor rule for NZ.. now I know all the arguments for/against this.. but we can see quantitatively the justification for lower rates, maybe not 0.75% of course, but lower - lets say 3%. Still we'll see, I'm not 100% sure they'll cut at the next meeting, and I'm not even short the NZD anymore, I've taken it for its ride and am happy, but the concern for us is the positioning is heavily short and we appear to be quite overextended, so by no means would I want to short here, bounces, maybe...

Still not too many idea, Exams probably have a part to play in that, but im nearly done and I'm sure the twitter/blog flow will pick up :)

Thanks for reading y'all

17th May 2015 - FX/Rates thoughts

So I'm about to enter my exam season, which will pretty much keep me pre-occupied for the next 3 weeks - its crazy how quickly this year has gone, regular readers and friends on twitter can surely remember me panicking about my A-Levels last year, and some even as far back as GCSEs I'm sure.

But I just want to write a shorter piece for whilst at exams. Generally speaking, and maybe its because i'm arguably more focused on exams, I'm struggling more bigger thematic/directional ideas in the FX and Rates markets. However this maybe the dynamic we are in until the elusive rate hike.. which is now priced for Dec/Jan, and as such the markets are just in a "wait-and-see" mode. Either way, I'm not completely out of thoughts, just not as many as normal. The first thing to look at is obviously the EUR and bunds etc. Because they are still very much in the forefront of everyone's thinking.

EUR/USD vs US-EUR 10 year swap

10 year swap spread has tightened to 130bps, down from the 160bps a while back.

If you remember back a while, I positioned for a tighter spread, but now I think we've come in enough for that view to have diminished in the short run. I still think EUR long end rates should be higher, but I'm of course wary of the large QE flows etc.

Normally, the EURUSD rate is not too sensitive to the longer end spreads, but it seems clear from this overlay that it has been. Much the same reason i'm sure as to why the EUR is well correlated to the DAX for example. A lot of flows, both real money and CTA flow has been "hedged". Well this isn't new to anyone, we've all been talking about it for months, but it just still seems to be around, not sure for how long though, would expect this to diminish as markets settle down... (I'm not one for correlation trading lol, but would expect lower correlations going forward, and it intuitively makes sense)

EURUSD vs DAX inverted

Looking ahead however, I am still constructive on European equity, the conditions are still rather strong, and of course we have this minor greek issue in our way, and maybe the tail risk is somewhat under-priced (as it always is) but I'm not expecting doomsday there. So at least in this market we can potentially build some ideas.

DAX vs 2 year EUR real rates, a bit iffy, but its a supportive factor, that and euroarea growth accelerating this year and QE etc etc

Looking at ATM implieds in DAX and SPX, we can see the premium in VDAX is crazy high.

Infact so high  we gotta zoom out the chart into the monthlies before we find a time when Dax vols were 80% higher than SPX

The skew is equally interesting, if you follow me on twitter, you would have seen my long SPX risk reversal trade, which is doing nicely, but I think that DAX is probably even more interesting. selling downside in the DAX is obviously risky, but probably worth it. I mean those of you that know me, know I'm a bit of a theta whore, but this does seem like good value especially going into the summer doldrums.

Furthermore, we see that Bund futures, have set-up, at least from a tech perspective, a bit of a base.

Potentially we could see a pop in RX which would likely be construed as EUR bearish assuming USTs are like meh.

Combining these, I can't help but end up with a shorter term EURUSD bearish bias. And this is strange coming from me, as I've been calling for it to pick up every since we dropped around 1.08 (just see older blog posts).. but we trade now, just shy of 1.14 and we may getting a bit ahead of ourselves, and if the lazy correlations remain then a move back towards 1.10 is on the cards for now.

In other FX markets, We've had time for the GBP to settle down, if you read back to my election piece here you'll see that I bought a zero-cost GBPUSD risk reversal, we currently sit ~800 points higher then when I recommended that and I've now covered.

GBP vs STIR rates

We were ultimately taking a view that the election risk premium was too much (inferred fom the divergence from rate spreads), and now that risk is passed we've joined back up together and the outlook for cable is pretty clear... its all about relative monetary policy, as it always has been, and not some pointless election (pietro ;) )

So that trade has done well, I have leaned on the more hawkish side in both the US and UK for some time, still expecting a 2015 hike, and the BoE to be not too far behind at all, but right now I don't see anything particularly interesting in GBP rates, I mean I'll probably moan about the proxy (5y5y) terminal rate being too low (especially vis a vis USD rates) as I have done on twitter many times in the past, but ultimately its not huge, and its probably the macro economic textbooks telling me this and not what the current economy is saying.

Silver

 In other markets, Silver continues to push higher, after breaking out of this range, my long straddle idea is working well with Silver moving quite a bit quite quickly. Needs to clear 18.25 really.

Looking into possible long Silver vol trade.. spot in a tight range, and implieds cheap to FX composite. pic.twitter.com/htUcLhtFoM

— Jere Wilkinson-Smith (@JeremyWS) May 11, 2015

USDJPY is similarly a one which we should look to position long vol in... but as I said, the summer markets may be slow so we don't want to burn premium on this just yet. 

However that being said, because realized is so low, the USDJPY implied discount to the overall FX market is quite large, so premiums are cheap-ish, but still I think I'll wait till after exams

And broader Vol themes, especially in the rates market (3m5y) is heading lower, even after some larger moves in the FI space recently, and FX vols will likely track lower into the summer, assuming we don't have that June Hike, which is very very unlikely.

FX vs rates vol

The move we have seen in rates is clearly a mix between a few factors, higher inflation expectations I'm sure plays its part as I have looked at many times before, but we can't forget term premium which has moved higher, likely pushing nominal yields with them, and ya know at the same time burning a few CTAs fingers.

10Y ACM  term premium

Yup so that's pretty much it from me.. no shocking ideas or themes, which I'm glad about, hopefully I won't miss much whilst on exams :)