Sunday, 29 March 2015

April FX & Rate thoughts

Another month... more of the same, we saw the USD index trade up through 100 before reversing and slamming lower (currently 97.5), also persistent underlying strength in the UST market with 10 year yields firmly back below 2%. It also highlighted some under-performance in euro-area peripheral debt markets - Italian benchmark 25bps up from the lows.

Central banks remain biased towards being dovish, in part through marginally lower growth expectations but mostly through the continued disinflation. Still in part to the likely transitory impacts arising from the drop in oil we've seen.

2y inflation swaps, top-> bottom, GB, US and EZ

However when looking at market expectations, whether its because of further monetary easing or otherwise, there has been a noticeable up tick in inflation expectations (excluding the UK). 2Y EZ HICP swaps trading 50bps higher YTD.

This is important I believe, as it brings into question the likelihood that EGBs stay incredibly low. Further to what I looked at last post here, I still think there may be an opportunity in the not-too-distant future to position for higher EUR rates, not necessarily on the short end, but most definitely in the long.

A much thrown about chart in the last few weeks is the relative economic data surprises in the US vs Europe.

Citigroup economic surprise indexes
There has been a rather stark, almost equal and opposite move in data surprises. Which I can only really put down to the large move in EURUSD, data strength has been exported from the US right to Europe when it needs it most (kinda).

So right now, we've got a low EUR, decreasing real rates in Europe and QE... argue as we like about the possible success of QE programs, the environment is rather good in Europe for outpeformance and stronger growth.

This is highlighted from the BAML fund manager survey chart below.

So what does this all mean for us then... well I think this is supportive for European Equity for starters, but that doesn't come at a surprise, with the Dax up some 20% YTD. What is important about this is that all these inflows into europe have been currency hedged. So for every purchase of European equit, ETFs/fund managers have been selling EURs keeping it pinned lower. The question really is, 'at what point is the EUR cheap enough for portfolio managers to remove / have no ccy hedge'. I can't pretend to answer that, however without being overly presumptuous, most sell-siders have been targeting parity (or something lower) and with that around 10% lower I think the somewhat /lazy/ PMs will probably hold off for now against removing these hedges.

Furthermore we have the remaining issue of USTs yielding significantly more than EGBs, last time we saw the 10y swap spread at 1.6% and I suggested buying USTs / shorting bunds. We stand today at 1.48% and my convinction on this trade is growing. Not only in part from the bids into the UST complex, but also the possibility that long end EGB rates could rise.

I really like this bond pointed out by @macrokurd

Austria 2062, currently trading at a ridiculous 210. Ultra long duration and a prime candidate to short.. but lets be honest, I still wouldn't want to fight the overwhelming yield demand, but 0.9% for an almost 50 year bond.. come on! its gotta end soon!

More simply, do you short bunds? probably not. or at least not yet. How many times has it got to levels where 'it can't go lower!!' yet still does..

So what? Steepeners? hmm.. maybe, but difficult to decide where, steepeners in the 5s10s sector may work, EUR 5s10s swap is currently 30bps,

Or do we look to Euribor futures? - well here we have June 2018 implying 26.5bps, 2017 at 9.5bps. If we do see, as I expect, an uptick in Eurozone data then it's possible to see this curve steepen somewhat.

Another market that could be interesting to us is New Zealand.

We have an economy growing nicely, but a central bank that has just hiked the base rate by 100bps, and a market that has rapidly priced out further hikes accompanied by RBNZ dovish rhetoric. They still bitch and moan about a higher currency, and while the NZDUSD is far lower.. on a Trade weighted basis the NZD is still strong. Importantly, the AUDNZD, all time lows just above parity is key, and I think the RBNZ will continue on a dovish bias.

The RBNZ has hiked before and cut, nothing stopping them again.. I am sure, with inflation ticking lower we could potentially see a scenario (much like the RBA/BoC) where the bank cuts rates in a pre-emptive manner.

Combining the last two ideas, we can foresee a situation which would be beneficial for EURNZD

EURNZD vs 2y swap spread
There has already been a large divergence, and if yield spreads tighten then it should be supportive for the cross. It's hard to know why there has been such strength in NZD relatively, I mean firstly its hardly like volatility has dropped, if anything its much higher and heading in 0.8 direction (lol).

Just RFQ'd on a 6 month 1.50 digi call with 1.40 KO and it comes in at 28%. almost 4:1 risk reward ratio, though a 1x2 call spread may also look attractive.

Lastly, on the Fed. Whilst I was skiing, Yellen and Co. came out with what was seemingly a largely dovish move. FF futures and ED really struggling to make their mind up.. aimlessly wandering until NFPs or other good data comes out to suggest a strong US economy. Alternatively whenever the Fed speaks the futures leg higher (FFZ5 up around 12bps since Yellen).

It's funny, even if US data has disappointed expectations (as per CESI), its hardly bad. The Labour market is still strong, a solid 2.2% Q4 growth rate confirmed last weeks, PMIs doing fine... so Fed, what's the problem? To me, the economic picture is not drastically different to when the Fed was comfortable with a June Hike, and the removal of patience indicates we are close to that first hike. If we are then ED steepeners look good, alongside my short sterling steepeners.

A mere 2 and half hikes between june 2016 and 2017... if the Fed is serious about normalization, then I think we would see more than this.. however I'm not in this trade to see this realized, I think the curve is too flat given the state and outlook of the economy, and while the USD may be acting as a wind-break to US macro, its not a major game changer imho.

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