Tuesday, 2 August 2016

August FX & Rates outlook

It's been a while since I last posted here, having spent the past 3 months taking exams and travelling around Asia. It's been a relatively quiet period in markets with this thing called Brexit happening, but just over a month later, it seems like its been mostly forgotten.. and its hardly been the apocalyptic world ending mess that some predicted in the mean time.

In other markets, the broad USD is still painfully boring in a very tight range, credit has been crazy strong (both HY and EM) as investors have flocked to carry on any dip, Vol is  low, as of writing the past 10 days in SPX has realized an incredible 4.5 points, and commodities have been mixed with oil tanking (lol) and gold/silver rallying somewhat. Lots to talk about then.

BoE and GBP markets

First section, I want to look at the BoE. We've got the MPC meeting and accompanying inflation report on Thursday morning. a 25bp rate cut is fully priced into front end GBP markets - Aug OIS trading at about 22bps so more than a full cut is priced into markets as we stand. Cable has been rather resilient, helped by mild $ weakness the past few weeks and is seemingly trading comfortably above 1.30 - sentiment is obviously quite bearish but the price action doesn't seem to agree quite yet. Cable would be a clear sell on rallies up towards 1.40, but also to me quite a nice buy on dips /if/ we traded below 1.30 again. We're clearly being led around by rate spreads, and so this meeting could be rather important with some nice asymmetry.

GBPUSD vs 2y2y rate spread

Going into the meeting, GBP vols are fairly low all things considered, partly due to recent realized vols being very low (traded in a few hundred pip range for weeks) and given that there is a full expectation for action. My concern here is that if the BoE doesn't cut at all, cable would likely rally along with rate differentials and the latent short position being squeezed out. 1.35 area would seem fair before it started getting trickier to rally.

Regarding the decision from the MPC, the way I see it is as follows; The BoE doesn't need to cut, the BoE doesn't want to cut, /but/ the BoE might cut for the sake of action and response. In this aftermath of Brexit, there has been no clear panic (heck, even thought gbp dropped 10%, it never got close to panic trading especially given calls for 1.15 area), other financial markets remained very solid (looking at equity markets here) and vol is low and contained. The BoE has been for a long time, in my eyes, heavily data dependent... where much like the Fed, the data is equity and vol.

GBP1M and FTSE vol

Now actual data was poor, sentiment and PMI data fell off a cliff, implying some contraction in H2 GDP, which is very ungood. The main argument for the BoE to cut, is that they are now focusing more on maintaining growth as opposed to targeting inflation, at least in the immediate term, which frankly to me is total rubbish. Since 2008 we had (the now revised away) triple dip recession, and the BoE did a bit of QE, a bit of other nonsense, but nothing in base rate. And the way I see this, is how is this different? Now Brexit is unequivocally bad for our H2, but its not seemingly been /that/ bad.  Core, hard data remains stable in the UK, labour markets are doing well with no anecdotal signs off mass layoffs post-Brexit. Inflation is/was starting to turn, and swaps have moved higher on the weaker GBP.

UK curve (from Citi)


So with all that said, and how I don't think they should cut, but, they probably will, because we've seen in the past how CBs don't like to shock markets and their precious expectations. This doesn't mean however we shouldn't position for a surprise. The risk:reward looks compelling to call bs on all this rate cut talk. Firstly just by paying front end rates, at 22bps you make a small amount on a 25bps cut, you make 25bps on no cut, and ur risking 22bps for a balls deep move to 0%. So for a 1:1 payoff, you're leaning against what is a very small chance of 50%, and in my eyes a moderate, non zero chance of no action (lets say maybe 30-40% of no cut).

Paying later dated stuff isn't a terrible idea either (tho less compelling), negative rates seem out of the question (for now) in the UK given the backlash that has had in Japan and Europe on Banks... banks are too important in the UK to put them under that sort of pressure and the negative feedback loop there will be far worse than any brexit stuff. Whilst UK bank shares haven't done well, it would be unwise to put them under more pressure much like Japan and Europe below.

TOPIX banks, and SX7E
So to summarise in trade ideas, given my view on the asymmetry of this meeting, 1:1 risk reward on 50bp cut to no cut, small gain on 25bp and a ~30% of no cut, I like paying front end here.

In cable, downside seems limited unless the BoE goes big (but unlikely for aforementioned backlash). Taking advantage of negative skew and cheap vols could sell 1.30 puts to buy a 1.33/1.35 call spread. (pretty much zero cost as i type with spot at 1.3230)

US markets and Fed

 So plenty to talk about here too - we have an important data release on friday in the form of NFP and then Jackson hole before the "live" September meeting.

The problems I have when discussing or thinking about the fed is my tendency to care about global occurrences, perhaps too much. Stemming from the way I view the Fed funds rate, which is not as a number that I see on my screens, but all relative to other central banks, think of the FF as more like FF-G3 base rates.. and that every time europe/japan or whoever cuts, its tightening from the Fed. Some pass through from this obviously occurs in FX, having seen the USD rally 25% over the past 2 years, to a large extent on rate differentials, but more so going forward it limits the fed greatly. Probably capping us at max 2 hikes per year (if everything was perfect) and more likely just 1, in Dec.

This doesn't however mean its not a bad play to be short US rates here. The fed loves to tee up meetings, and looking at domestic data there is all the reason to be talking hikes right about now.. in fact if it wasn't for that whole brexit thing, june would have been a viable option too. I ask myself, why not Sept? well, there are no massive known risks like with the brexit vote, the FOMC has made it clear that more hikes are coming, data (equity and hard data) is good (tbc this friday too). So why not? well, they might still, but with trump coming more into view, 9 CBs easing post Brexit, and a slowly looming issue in oil, patience might be used.. plus, Yellen is just so December

8th vs 12h continious ED vs 2yr $ swap
The above is an interesting chart I've been looking at and pondering, the curve(orange) is at the lows where as outright front end is middle of the range.. typically the two move together but steepeners have clearly not been popular. I think at a rate of 14bps (far less than 1 hike per year) is low from a macro view and also on short term metrics vs outright. So I look to pay the curve a bit going into NFP / JH and Sept meeting.

In USD, I'm actually neutral to bearish. Take USDJPY, it seems inevitbale at this point we trade below 100, and its hard to put a number on when the BoJ cares again, because we could have thought it was 115/110/105 and now 100.. but who knows after that, 95?.. or maybe they dont care like they used too. EURUSD im fractionally bullish due to negative feedback loops that occur with a higher USD or wider rate spread to Europe which should cap any DXY advance. FX is certainly not the space I want to play the Fed in, I dont think its at all clean enough right now to do so with, hence looking at rates for now.

EM / Carry bid to infinity

well, what a 6 months its been for certain carry positions. BRL up hugely, CDS trading on par with Turkey (from well over double at xmas).. heck, even ZAR is rallying a ton, and you know when that happens people are sifting through the excrement just for any hint of yield. Domestic fundamentals in the two aforementioned countries, as well as many other EMs hasn't drastically improved.. so its one of two things to me, either we were grossly undervalued beforehand or low inflation, negative rates is just continuing to push investors into anything that yields. In reality its probably a nice mix of the two.

For a select few, here we see Carry/vol (using 3m rates and IV)

3m Carry/vol, Brazil, Turkey, SA and mexico

Brazil has performed very well here, so no surprise assets there have performed so very well.., turkey has somewhat deteriorated recently given political shenanigans (read: sh*tshow)

Mexico the worst, and hasn't really improved to the same degree as others, hence not being sweeped up as much as others and seeing some under-performance there (oh and Trump). Other assets such as HY CDX have a carry/realized vol of around 1, and have been performing very well too. So the question needs to be asked, will this continue / when do we call bs on the rally ? probably not soon, with no major risks that could seemingly derail, and never-ending low rates and inflation it would take a lot to not want to own stuff at 5+%.. neverthless, we've seen crazy inflows into EM, like record crazy this year.. so the boats getting awfully lopsided and the exit door getting smaller and smaller.. If oil were to kick off again (once again unlikely), then it could get messy fast but not a huge concern on the radar just yet. Perhaps look to trade within EM and just pick up the better names (or higher vol adjusted yielders). Say being long INR/TRY/BRL/IDR etc whilst selling a basket of beta weighted lower carry (and arguably higher risk EM) such as MXN/KRW/AUD could work well to bring in a bit of carry and not risk a massive turn lower in EMFX broadly.

Jumping on the bandwagon now seems unwise, but many still will as FOMO is just too big these days, I mentioned KRW earlier as a potential to sell, mostly looking at two factors.

$KRW often trades like a vol product (one that is cheap to buy) but has recently overshot some other x-asset moves.. secondly, China is still a concern to me, and just as no one is talking about it (and CNH vols/skew is back to nothing) is precisely when they'll come out and do something, with KRW highly exposed to this.

Anyway, just a quick update on some market dynamics from me, and if you're foolish enough to still be reading, here is a bonus chart that everyone seems to love right now..

totally not a concern... yet...


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