FX & Rates thoughts - April 2017

Hi guys! 

So another blog post, once again starting by showing the very well defined range in US 10s.. This seems to be driving markets and narratives, and will likely to continue doing so. Since the last blog post, when US 10s were also at 2.35% we have had a nice round trip to the top of the range, and back to the bottom. Mostly because the fed really ran against market expectations and hiked in March.. but then positioning, a debate between hard and soft data and a topping off of inflation has brought these expectations back down to earth.

In the immediate term, it seems Friday's price action has put a floor in yields for now. This seems to line up with other rates markets - Bunds look to have found support against the lower trend-line (charts below).

US 10y yield daily chart

Bunds daily chart

Friday's NFP had a bit of everything for everyone.. weak headline and mediocre wage growth coupled with decent u/e rates - it seems the market has spun the narrative that lower NFPs are signalling we are reaching full employment, and that a running 3m avg of 150k+ is still very strong. I can't massively argue with this logic and am still leaning on the opinion that market is now under-pricing fed activity.

Comments from Dudley and other fed-speakers has shifted the conversation away from Fed funds and towards Balance sheet in the past month or so... So I suppose we start here for this blog.

UST holding by the fed against maturity, and cumulative (taken from NYFed SOMA page)

Above shows the breakdown of UST ownership by the fed. n.b. not MBS, just USTs. (average holding somewhere in the 2021s/22s)

With the Fed balance sheet at 4.475tr $ (FARBAST INDEX), we can see see just from the cumulative graph that this unwind of the balance sheet is going to be a *slow* process. Arguments can be made that they unwind MBS related stuff first as less direct secondary market impact, but aside from the detail, the raw amount to unwind is massive. A purely passive rolloff of this ownership will take 5 years at least to have a substantial impact on the fed's balance sheet to bring it down to more neutral $2-3tr, levels.

I for one cannot, and will not, try to make a prediction of what the direct impact on monetary conditions will be from BS reduction.. is 1tr equivalent to 25bps of FF?? I have no clue.. I dont think anyone is really going to be able to make a concrete guess at that, including the FOMC.

So with the discussion around pausing the FF hikes to start the reduction, I don't think this is an overly viable option to take, rather the fomc should clearly signal the pace, timing and size of the BS reduction (whether its through selling or just rolling off) and be tepid to begin with, ramping up the pace if necessary, but not using it as a replacement for FF rate.

Ultimately however, the balance sheet will be massive for a very long time, probably well into the next down cycle, and so the cynic in me would suggest that it won't ever fully normalise as the chances of not having a recession in the next 5-7yrs in US macro is so slight.

All this being said, we will be having much greater conversations in the coming months than what I've just said, and I have no doubt that towards sept the Fed will start being a bit clearer with what this involves.

On trade ideas, I think with the marginal buyer of long end US paper disappearing there is arguments to be made for a steeper curve. One that I look too is US 5s30s (in swaps charted)

US 5s30s daily

We trade in a nicely defined range, and has been flattening for the past few years, and rightly so. The reason I like this trade however is that if we get a serious discussion around BS reduction in the next few months, and the fed do, for whatever reason, deem it as a replacement for FF hikes being long the belly will perform nicely as there is a lot of roll built into it, and short the long end should continue to work.

It also carries nicely as a trade (2bp per month) which relative to the volatility of the underlying curve offers decent Carry/Vol. The technicals line up to allow for a clear defined stop and breakout (if the theme gets momentum).

The only things that make me uncertain, primarily come from the growing concerns around the pick up in inflation.

Looking at Oil y/y, it continues to drop and will be around 0 some time this summer..

They say it's about Easter, but it's mostly not.

By the way, Germany, doesn't this mean ECB should cut rates? pic.twitter.com/Tg1LluO5zC

— Martin Enlund (@enlundm) March 30, 2017

This chart from Nordea above is perfect in summing this up, and is not just a phenomenon in europe, but for global inflation.. Core CPI globally remains meh at best. Further, the upside surprise this has caused will soon fade, and as we see below in the Citi Inflation suprise index, we have perhaps topped out on inflation "suprises" (fwiw this chart correlated v nicely with Oil y/y % change, which suggests this surprise index will be back below 10, and 0 by the summer).

Citi inflation suprise index

So what does this mean? Well, basically a few central banks (looking at you, ECB) got a bit too excited, and frankly with Core CPI going nowhere, the discussion about a tightening cycle is frankly ridiculous at this stage. Not something that should be realistically discussed for a good year at best imo. However this doesn't mean that we should be receiving EUR to me.. There will be a time not too far where we hit the serious discussion of tapering, and then perhaps curves can start to price in a realistic hiking cycle.. for the meantime, EUR 2s5s at 30bps probably is fair for a neutral upward sloping curve, but much like the US 2s5s did, it has serious potential to move steeper as we get into the cycle (in perhaps 1y time).. Buying dips in EUR 2s5s could be a fantastic trade in the next 6m-1y, but probably not right yet.

US 2s5s during taper tantrum

Ok, so there were a few rates thoughts, currently my book is set up with two trades from previous blogs

-- ILS 1y5y reciever at 1.50% vs EDz7z9 at 69 bps

-- SEK 1y1y reciever at -0.185% vs EUR 10s30s steepener at 59bps


On the ILS trade, the long/short rates trade idea has performed very well so far, Recieving ILS argument was made before, and still holds very valid today. BoI very sensitive to tradables and energy inflation, both of which are going against them as ILS rallies and oil y/y fades. the 4bp roll per month provides a nice buffer, and the ED curve steepeners hedge out global rates risk.

ILS 1y5y vs ED

A 10 month fwd 5yr ILS now trades at 1.31%, representing a PnL of 19bps from that leg.. On the ED, it is the same level as entry so 0 pnl.. Right now, given the correlations that ILS has to outright US rates, I look to cover here for +19bps and re-enter in a few weeks/months time when US 10s are back towards 2.5%, thus i am left long EDz7z9 at 69bps. Which fits well for a move back towards 75/80 towards June.

Onto SEK, managed to whether the volatility in EUR rates and maintain the reciever, a 9m1y is still marked at -0.25%, so a PnL of just 6bps.

The hedging leg here in EUR 10s30s trades at basically flat again off 61bps, but rolls the odd bp per month and provides coverage.. Stops at B/E for the 10s30s.

So along with these two pair trades, I like adding that US 5s30s steepener, otherwise nothing really new to me in Rates as shown by the chart below which show how much is priced into dec 2017 front ends... i.e. nothing, nowhere.

fix-z7 spreads

So, onwards and upwards to FX.. and the EURUSD is just.... ahh, Rate differentials. Sigh.

EUR vs 10y spread

A very strong relationship continuing here. As such its rather boring, EURUSD does appear to be leaning on a rather strong upward trendline here coming in at 1.0550s, so i expect a big of a fight around these levels from the bulls.

JPY vs US 5s

USDJPY is a bit more interesting, trading "cheap" to US rates.. balancing precariously above 110 it does provide, imo a nice level to lean off for tactical longs. Especially if US rates return to the range. USDJPY might be a more asymmetric, and carry positive expression of Short US rates here, especially considering the story from japan is quite quiet now the year-end stuff has passed.

perhaps eurjpy then looks quite cheap to own some topside in? if EURUSD is battling against support, and so is USDJPY, then double whammy in eurjpy!

EURJPY

As documented by many, Le Pen risk premium is being placed into EUR right now, but the risk still seems limited to me. EURJPY skew is chunky so could fund upside by selling downside here. Tight stops at 117 for spot trades makes sense for a move to ~120. 

One potential FX trade I like here, primarily leaning on Le Pen being a non-event for markets is buying some very tight EURCHF DNTs

a 1 month (may 10th), 1.0575/1.0825 double-no-touch is priced at ~10% given that spot vols are being marked higher for the risk event.. 

eurchf range

Vols are priced about 0.5 wide in 1 month EURCHF, so I would imagine the DNT isn't traded far away from BBG mids, perhaps 12-14%.. offering a decent 7+:1 risk reward for eurchf continuing to be boring (and no le pen).. decent pay-off to me and locked in loss for a significant tail risk (if le pen does win).

In other FX markets. USDZAR has been attracting a lot of headlines, with the FX heavily selling off, CDS widening as ratings agencies look to force IG selling (2-4bn of SOAF paper), so one can easily argue that FX will remained pressured, but with a neutral and supportive global environment, and the terrible macro becoming marginally less terrible, it seems it may be a nice currency to own, and now at a discount.. 

Technicals see us at a crossroad, so I steer away from spot trades as I dont want to be washed out on any news that could really hurt.

Instead 3 month 13/12.5 put spreads cost about 0.7% of notional, offering a 7:1 payoff to expiry.

Not a great deal of other things are interesting me right now.. Tho I do stress, this is me taking a "break" from markets, had an amazing holiday to Morocco, and planning my 3 month long summer holiday, so expect things to remain quiet from me, both here and twitter.

In summary

-- Covered ILS 1y5y for +19bps, left EDz7z9 steepener to trade the US 10y range.

-- Maintaining SEK 1y1y vs EUR 10s30s for now with a +8bps running pnl

-- Entered into a US 5s30s steepener at 58bps, stops at 50bps for a BS related trade

-- 1 month EURCHF 1.0575/1.0825 DNT, bbg mid at 10% (likely offers 12-14% tho haven't checked) for a good r:r Le pen snooze-fest

-- 3 month USDZAR 13/12.5 put spread at 0.7% of notional, as a way to cheaply participate in any continued EM rally