Tuesday, 26 January 2016

February Rates & FX outlook

The start to 2016 has been very volatile to say the least, to the ~10% decline in Equity markets, ~25% decline in oil prices and a chunky widening in credit spreads.

What both frustrates me, but provides opportunities, is that during this sell-off, much like last August cross market correlations have jumped rapidly to 1. Whether you load up a chart of E-Minis, US10s, CDX HY, USDJPY, AUDUSD, Oil.. they are all tracking tick for tick. Rightly or wrongly, they will probably do this for a while as they did through September, whilst markets digested everything, volatility subsided and underlying drivers of each asset eventually came through.

Going back to the start of this weakness, it was sparked by China.. no one really doubts this, the rapid move in CNY triggered 1% candles in US equity futures at 1:15am UK.. It was both good fun to see everyone become a china expert and a royal ballache to wake up to drastically different prices, but for the past 2 weeks now, China has remained quiet where as markets have remained impressively weak. The narratives have switched from China driving the markets to Oil, and who knows what is next (my money is on HY, but we'll see).

Going back to the point of this, I think that the jump in correlations is a clear and present opportunity to express some better underlying macro trades that two weeks ago made sense to a lot, but under current sentiment wouldn't be nicely welcomed. Think, just general sentiment is now for Equity to close the year negative, even US 10s have been called to end at 1.5%. Whilst I understand there are some concerns out there, the fact we are *so* sure of this bearishness now we are down 10% solidifies the view that its people panicking. This doesn't mean I will be right, I am just saying people are reading the tape as gospel and ignoring the underlying fundamentals which funnily enough haven't really changed in the past 3 weeks. (at least equivalent to the size of the market move)

Firstly, TIPS.. The trade everyone loves, but everyone loses on... I really think tips offer some great value here. US 10 year break-even inflation stands at 1.33% down from around 1.55% at xmas as shown below. As per, it correlates well with oil.. which of course is ES, which is US 10s, which is CXD HY which is Oil etc etc.

With Inflation broadly, its mostly reliant on core domestic trends rather than "transitory" oil moves, and domestic trends remain  on balance positive to the US with my personal expectation of CPI to continue to tick upwards.

As such, the market noise that we've had YTD and over the past 6 months offers good entry points into BEs

US 10 year breakeven vs. Oil 
With correlations, it is clear that this (along with many trades) is sensitive to movements in oil for the immediate term, but it is a trade I really fancy here.


On US rates more broadly, they've been recieved lower as "risk off" or whatever we want to call it, has led to demand for bonds. It's been such a sharp, fast move that EDZ7 trades where Z6 did just 3 weeks ago.. The Curve has been pushed an entire year back! To me, this is just stupid given the underlying fundamentals have barely budged.

EDZ6 / EDZ7
Such a rally in bonds is something I am fading.. But it is once again linked to equity/oil/risk etc, which is frustrating but does offer a great price to fade the majority of this front end (and whole curve) move.

FFZ6 vs E minis
Moving tick for tick, the front end has tracked risk lower.. and here is my game plan for the FOMC this week... Thinking back to September last year firstly; We had seen a very similar move (sparked by china too) where front end rates were trading with Equity.. We can infer from this that we would see dovish behaviour from the fed sparking further fears (almost a realization of potential fears) and vice versa. So what we saw in Sept was the fed back tracking on what they had mostly told market participants was going to occur and this was a clear policy mistake - this meant the Oct meeting was used to tee up Dec. Looking to this meeting, I believe the Fed won't want to do that again, and thus will use this meeting to tee up march. Crushing vol, restoring a bit of confidence and ultimately resulting in the YTD moves giving back at least half of the move.

Now there was a lot of talk about how the Fed only goes when the hike probability is over 60% (or whatever it is), and as it stands FFZ6 sits at 60bps which is marginally more than 1 hike left this year. So I see this meeting (as I did in Oct here) to get short the US rates spectrum. Many ways to do this, Curve steepeners on front end, outright shorts, options trades.. but what I've opted for are Payer ladders on US 5s and short calls on EDZ6.

FVH6, or the 5 year future is currently trading in this well established range (something highlighted in my 2016 outlook piece where I am short a straddle on US 5s)

FVH6

Selling topside and buying a put spread offers a short vol, short rates and negative premium trade with the pay-off as such. I believe rates will drop throughout Feb as the Fed tees up more hikes, equity markets bounce and risk sentiment recovers somewhat. I am not sure we sell off enough to take out the lows but a move back to 119 works for me.

US 5 year options trade


On to FX.. I am positioned in rates for a hawkish fed, and I think the risk:reward in buying the USD is significantly less attractive here vis a vis rates. It also offers a decent hedge against a dovish fed on two accounts; firstly the USD should sell off but also considering EURUSD correlation to risk and its nature as a funding currency any further weakness sparked by a weak fed would lead EURUSD to take 1.10 in my opinion.

EURUSD
The charts see a consolidation / wedge forming, with heavy resistance towards 1.10, but its likely that we would see plenty of stops and a blow out through this on a dovish fed, trading as high as 1.12 in the following days.

EURUSD vs 10 spread
Here we can see why I prefer taking a rates trade for a hawkish fed, the divergence of EURUSD from rates gives us an equivalent 300 pip cheaper entry for short EURUSD (well for one way to look at it) but given the vol skew in EURUSD I would hedge my short rates with a 1.10 or 1.11 calls. As we are not only trading on the edge of the wedge but also its a cheap hedge right now.

EURUSD vs 2y real rate spread
Longer run Real rate spreads will be the key driver where we see little medium term dislocation between "fair value" and EURUSD.

One last trade, less related to FOMC, is EUR 5s10s flattener which I think is quite attractive here.

Trading towards the top end of its range at 70bps, This is quite steep when considering the rest of the curve.. More so, 5s are trading -0.25%, not far from the ECB depo rate (even if they cut again, which ftr I think they will, with an extension of QE)

EUR 5s
Much like with $ 5s, I've also got the same position in options on in € rates here.

EUR 5s10s
With less and less bonds eligible for QE purchases, extending along the yield curve will continue and demand will pick up for 10s and in this backdrop I would favour a flatter curve with the main risk coming from a sizeable bund sell off which doesn't seem too likely with the recent ECB rhetoric and oil backdrop supporting this.

In conclusion, my opinion is that right now, the fed will look to add confidence to the markets by staying firm to their plan and the hiking cycle by setting up the next meeting as a more likely than not situation, as such selling rates broadly should work as markets will start to decorrelate and trade back to fair levels. Buying EURUSD calls appears like a cheap hedge, and EUR 5s10s flattener looks like its at good levels.

1 comment:

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