February - FX and rates thoughts

Since my last blog post, we've seen a lot occur in the markets. In what was probably the most interesting month since the euro crisis of 2011/2012. We've had more than a lot of policy action, with Surprise cuts from Canada, Denmark, the move from the SNB and of course ECB QE to name just a few.

What is still being banked on across the financial markets, especially FX is the divergence of monetary policy, most clearyl visualized with the 1y1y USD and EUR rates charts as below.

USD vs EUR 1y1yf rates

However what is evident in the long end, and is becoming more evident in the rhetoric from central banks is that the doves are really acting as anchors... And while we've banked on this divergence, it may be far more difficult to materialize.

If we look at 5y5y rates, a basic proxy for terminal rates we can see that, yes while USD and GBP rates are higher, they are being dragged lower by those of Europe etc.

USD, GBP and EUR 5y5yf rates

Thus far, the impact has really only been on long end rates with investors obviously demanding USD rates at 160bps over EUR ones and therefore as EUR rates drop, there is a constant bid underneath USTs. Not only this, but for every down tick in the USD international investors will look to USTs and thus there is a lot of support / interrelationship, even if there is a so called divergence.

But bringing it back to central bank rhetoric, the FOMC mentioned how it has increased its attention of international developments, be it economic data or policy. As such, while the short end may still be chasing this dream of a 2015 divergence, in reality it may be far harder than we first thought.

There has been an uptick in market expectations for inflation across the world, and this seems simply as the last hurdle to overcome before we have hikes, however given the recent central bank action, I am finding it harder and harder to believe the Fed will (or even can) hike rates this summer, with Sept/Dec being far more likely to me.

However this, I think, is probably a transitory reaction function to global central banks - and the fundamentals still remain in tact, so a later / faster hiking cycle is what I look for.

Short sterling vs ED curve

As we can see here, we have Short sterling and Eurodollar curve between M6 and M8, both of which are incredibly flat. EDs back to 2012 flats and SS even flatter!

However, given the fundamental picture that remains in both countries, with strong labour markets / growth prospects and wages being the key drawback - steepeners on both I believe will work. However timing this is key, because so long as people are receiving the long end, this curve will get flatter and flatter, and right now everyone and their dog is loving duration (with good reason), however this a different trade that is just being pushed in the same direction by the flow.

So I've so far argued that the US is less likely to hike given the RoW, but at the same time suggested a steepener.. hmm... contradictory, but like I said, not entering just yet...

Short sterling curve vs 6mo ago

Pretty much every sector of the SS curve is >1% lower than where it was 6 months aog, and there is just over 50bps worth of hikes priced in between summer '16 and '18 which seems to little.

In FX land, the GBP is still being ruled by rate spreads, in a model with variables that haven't been updated in a year now, and still going strong. The biggest variable in this is the 1y1y spread.

GBP vs model FV

Looking at the EUR, this chart from @Fwred (from credit agricole) shows the resulting move in FX after a QE announcement.

I like this chart a lot, as one would expect the ccy weakens into the announcement, but in 3 of 4 cases (this doesn't include GBP, which in 2012 also rallied post BoE) the currency started to appreciate over the coming couple of months.

EUR-US CESI and EU/US equity ratio

Looking at this picture, we can see that for that European economic surprises have overtaken US ones, potentially the tide is turning somewhat with a possible acceleration from Europe later on in the year and a cooling off in US (much like what happened in the UK!!)

On top of this we see the relative equity performance between Europe and the US, which might result in EUR inflows which was a major factor supporting the EUR in the 2012/14 rally.

So the EUR... reasonably cheap right now, but it is still dangerous to short the USD even if it is getting (wayyyyy) ahead of itself. But 1.20 seems possible to me.

JPY vs nikkei

Therefore looking to fund long EUR in JPY, as currently JPY is a touch expensive to the nikkei at the moment, and coiling for a potential leg higher. EURJPY trades jsut above 130 and to me is good value for longs.

The Bank of Canada shocked us all with a rate cut, though in hindsight, much like Norway seems to make sense with weakening fundamentals and the immense drag of drastically lower (and still falling) oil prices. The CAD has reacted as expected, but it's not something I am willing to to fade, as against rate spreads its perfectly fair.

However, looking at the AUD, we've a tad divergence occuring. In this case the long standing correlation between AUDUSD and 5yr us real rates

Has suddenly diverged...

AUD rates has been heading lower, with the market definitely pricing in rate cuts from the RBA, the recent rhetoric from the RBNZ has flipped from hawkish to perfectly neutral with the 90 day bank bill futures curve flat out through 2017 at 3.5%

It would not overly surprise me to see a rate cut from the RBA, but house price growth is a big consideration here, in any case, vis a vis the USD and JPY I do think that the AUD is getting to be decent value especially as this divergence highlighted above grows... AUDNZD is still a favourite of mine.

Finally a little bit on EMFX, not my strong point, but noticing a few differences in the recent sell-off as opposed to older ones. Spot EMFX is trading lows (as per JPM index), and especially noticeable weakness in TRY / MXN. However, looking at rates, most likely due to the drop in global inflation / core DM rates, we've seen Turkey, SA rates drop meaningfully etc, but unlike other times, the demand in bonds is not at all reflected in a strong ccy.

USDTRY vs 10s

As we can see, in the past TRY sell offs we saw yields spike along side, yet in this case the opposite is occuring for the reasons mentioned above. But the currency is selling off for a reason... and problems exist in EM, however with global funding rates dropping the impact of higher rates is being pushed further back, and as such it might not be that unwise to look to EMFX.

A similar picture in South Africa,

$ZAR vs 10s

This historical picture shows the correlation, but currently $ZAR spot trades 1 big figure higher, whilst rates are 1 big fig lower at 7.1%, thus another sizeable divergence. Considering the supporting factor from lower US / core DM rates, it looks reasonably attractive.

However both ZAR and TRY are at their least attractive levels (based on carry/vol) in a year. CNH remains top even though implieds have spiked massively here. (25 delta riskies and ATM)

But when considering that there has been a global pick up in vol, comparing to G10 vol composite, CNH vol is in fact near the lows, and with high carry looks to be attractive. Whether we look to buy spot or take advantage of high implieds / riskies.

There has been discussion of a widening of the trading band from fix +/- 2% to maybe 3% as china looks to float the currency a bit more, but for the meantime, with spot at low levels vs the USD and on a vol adjusted carry basis, CNH looks aight.

Anyway, quick one from me today, been busy at uni... some contradictory trades to themes, but timing as ever is key blah blah blah.

FX weekly thoughts - Jan 5th

Over the Christmas period, maybe somewhat surprisingly, Investors still loved the USD, it felt as if as we changed over to 2015 speculators just had to own $s, and subsequently, the dollar had one of its best days in a long while (especially vis a vis CAD and GBP, +1.33% and 1.6% respectively)

More interestingly perhaps was the EUR, which traded as low as 1.2001, though this being said, with this much pressure it would seem probable for the (likely) hefty stops below 1.2000 to be tested.

EURUSD daily

We dropped through the 2012 "whatever it takes" low at 1.2043 without much difficulty, leaving the next obvious downside target at 1.1880 or so (2010 low).

We are seeing Record spreads between UST and bunds (or any EUR rate frankly), with the benchmark spread at over 160bps. While I know we shouldn't simply compare yields in different ccys, but its worth reminding that USTs are denominated in USD and Bunds in EURs.

US 10s vs German 10s

So with a hefty yield pickup over bunds, you also get to own USDs over EURs, which to many, given the divergent environment is rather attractive. Furthermore, Whilst this spread may widen further, bunds yields on a fast track to 0% will act as an anchor and will almost certainly drag US yields lower too, and with this continued theme of global disinflation (or at least expectations) the long end will still see plenty of demand.

However, I feel that perspective is certainly needed in the USD rally, while I do believe we head higher, its worth bearing in mind, we are already trading above the median Q1 '15 forecast for the DXY, and its only been one trading day!! On top of this, we are going into a year where it feels like  *everyone* is bullish to quite a large extent... so to be trading above Q1 f'casts and close to Q2s already seems like we may be getting a tad ahead of ourselves

DXY forecasts ranked from high to low for Q1

When we plot the USD against real 5 year rates, we are starting to see a bit of divergence occur, whilst not huge, and similar to what we saw in late sept/oct, it could put the brakes on the rally.

As opposed to looking at the broad dollar, the AUDUSD is seemingly the most sensitive currency to real 5 year rates, with an R^2 of 0.88 as we can see below

While small still, we are starting to see a touch of divergence in the past few weeks, suggesting the AUD could be supported, but when considering other factors (commodity prices, AUD rates) this is only one of a few key drivers, but nonetheless, it at leasts boosts conviction on the relative value AUDNZD, which down to 1.050 is once again at all time lows, which is cheap imo.

One last chart on FX and Real spreads... EURUSD vs. 2's real spread

EURUSD vs. real spread

Once again, it seems the USD may be getting a bit ahead of itself, when considering 2 year real spread.

I may be sounding like a bit of USD bear right now... but don't get me wrong, I can, and am, bullish but I do think that we could be in for some consolidation/pull back. Just think back 1 year, same sentiment as we have now, yet it took 6 months of consolidation before the consensus trade worked. Now I don't think we have 6 months, but until the ECB in late Jan, the USD may struggle to move much higher.

Looking for specifically at the GBP now, and wow its been weak. An illiquid friday in holidays saw a sizeable drop, trading through some large technical levels exacerbating the fall. Now I tweeted a chart like this one last week, and the GBP has been trading rich to rate spreads, and we still are, just less so...

When we look to play the US theme this year, paying the short end really doesn't seem like the best play, while it should work, the yield curve is so steep that a 1y1y fwd is 77bps higher than 1y swap so overcoming the carry will be tough, as such its far more intuitive to play the USD given the probable correlation.

However on the contrary in the UK, As I still am optimistic, shorting rates seems more attractive than trading the ccy. Even though the foot has been taken off the gas somewhat, the key metrics determining BoE policy aren't much different than the Fed. However looking at the short sterling curve you wouldn't have guessed...

Looking at Dec '15, there has been an entire 1 point rally, implying a 100bps lower LIBOR rate for this December, just since June...

A nice, although not totally reliable indicator, is the running sum of economic surprises (as per Citi's CESIs)

The top pane shows the clear slowing down of the UK economic surprise, whilst at the same time there has been a marked pick-up in US activity, a primary reason for the 1.72 -> 1.53 move in Cable, as the UK ticked lower as the US ticked up.

However, we are starting to slowly see a moderate pick up in UK data, and if there is any sort of Core inflation impulse higher, then I am sure we will start to see the hawks re-emerge. As such selling Z 15s here seems good.

A lot of big ticket releases this week from NFP, FOMC minutes, BoE statement, EZ CPI. However I have no clear biases on any of these, looking at some Dec data (globally) it was a tad weak, so maybe downward pressures on NFP (but consensus is only 240k), possibilty of a "deflation" print in EZ CPI after Spain's, but this is all in the estimates and thus shouldn't provoke *much* reaction. It might make for good trading, but is unlikely to change any of my macro biases or really matter.

FX weekly thoughts

This weeks major market moves centres around the FOMC on Wednesday where there is plenty of discussion about whether or not the fed decides to drop "considerable time". Given the recent NFP number there has been a large consensus shift to expect these two words to be dropped, and given the timing it would fit. Given we are expected to be approximately 6-9 months away from the first rate hike. 

However, there has been a lot of discussion around the impact of oil on monetary policy, an idea I brought up in my 2015 outlook last month. There is no denying that at 40% fall in the price of oil will bring about lower inflation, and the market expectations (as per 2 year $ CPI swaps) show this relationship clearly.

The Fed knows this, the Fed can see this, but should the Fed actually care? no. 

Yes, there will be a drop in CPI next year, whether the impact is as large as what the market expects is yet to be seen, but *if* CPI is below 1% and approaching 0%, does anyone actually think the fed will hike rates.. probably not. But at the same time, this drop in production costs, a supply side issue, should be of benefit to the US economy, and the impact on inflation should be short term at most...

But then explain to me why longer dated inflation expectations are cratering too, I can see the argument for oil impacting very near term inflation... but 10 years? 30 years? certainly not.

70bps is a lot, and it does time well with the oil price decline, but I still think there needs to be something else at play here. Something that the Fed should care about? well okay, maybe not, I just think its interesting and worthy of note to see that its not just near term inflation expectations that have been tanking.

Either way, this is probably a small issue - more pressing issues lean on the side of a hawkish fed and we can talk about dots and FF futures all day long but that probably won't achieve much. But in the last 6 months we've seen quite a drop in rate expectations, whilst at the same time the US economic story has hardly worsened. 

Personally though, I do think there is room for, even if it isn't directly warranted, for a moderately dovish Fed. Looking at EURUSD techs below, we can see that the EUR has found support with oscillators turning up and a recent bullish engulfing candle there is potential for a further squeeze higher next week on the chance of a dovish fed.

However, I am looking for these opportunities to sell higher, given that the macro fundamentals of a likely ECB QE and further rising of US short rates should still lead to a lower EURUSD over the medium run. Looking to sell 1.2660 if we get there.

Same sort of picture in Cable actually, from a technical perspective it looks like we could see a rebound, though this might be more a USD thing rather than a GBP one.

And looking at the drivers of the GBP, it still is being run by short end rate differentials, thus correctly looking at the relative macro pictures it should be easy to play the cable.

Here we can see the difference between Z5 Short term interest rate futures, and its clear to see the importance, and for the first time in over a year US 3m expectations for dec '15 where higher than the UKs.

Here we can see the rolling sum of Citigroup's Economic surprise indexes for both the UK (red) and the US (purple), in the past 4-5 months we've seen quite the divergence with US activity picking up and UK slowing down somewhat. However when looking at the overall level, the UK economy is no worse than that of the US in my opinion. Whether we are looking at the labour market or PMIs both are performing admirably and above that of the ROW

Furthermore, any potential shocks from Oil and its impact on monetary policy should be relatively neutral between the two economies so should not really be important. 

Just 6 months ago, the crossover between Eurodollar futures and short sterlings occured in Dec '17, however today its Dec '15, a huge underperformance by the UK, clearly shown in the cable's decline, however what I'm suggesting is that its unlikely to see a further fall in UK rates relative to US, given the relative macro picture, as such I'd expect us to be range bound between 1.55/1.60 until we get a new situation.

Another theme developing in G10 fx is that going on in Australia.

The OIS market has started to price in some rate action from the RBA over the next 12 months, specifically pricing in 30bps of cuts. With a record decline in Terms of Trade, continuing commodity price weakness and concerns from China its clear to see why. Many investors have jumped on the Recieve AUD rates bandwagon, which makes sense. But in terms of the AUD itself, I wonder to myself how much Australia and their fundamentals really matter to the long term picture of the AUD.

We can see the AUD (inverted) against US 5 year real rates, a very strong relationship, and with AUD still being considered a "high yielder" in the G10 space, a pickup in US rates is going to hit the A$ as we've seen. US 5 year real rates have picked up in the past few weeks due to the impact on breakevens from the oil price decline, as nominal rates have only headed lower/sideways. So once again, there is an argument to be made for the AUD to outperform *if* oil prices bounce.

Here we have a chart of US HY OAS for the energy sector, the spread is just shy of 1000bps currently, under-performing the market massively as oil prices drop and volatility (green) picks up.

This has been cited as the main reason for the Equity declines in the past week (just check the FTSE), as we've got the back and forth discussion on "are lower oil prices good or bad?" now I've read a few sides, mostly I see it as good, but I can see that such a sharp, sizeable drop can in fact be detrimental by completely killing investment in the energy sector for the mean time - though the benefits, at least for the US / UK still outweigh in my opinion, and as such dips in equity / HY should be looked at as decent opportunities.

2015 FX & rates outlook

Last year

2014 was an odd year, I can clearly remember reading through all the yearly outlook pieces and there were two distinct themes... Long the USD and position for higher US interest rates. In a sense then, we've seen a nice mix, the USD did infact rise, as pretty much everyone expected (fig 1), however US rates - no matter how we look at it underperformed expectations. Whether we are looking at the short end, where rates didn't manage to rise above the forwards or the long end where we saw quite the drop in rates, pretty much no one called it. (fig 2)

figure 1

The Dollar index is currently up 9.5% for the year, however it did take its time, for the first 6 months it was completely flat

Figure 2

Flattening of the yield curve was a big theme this year, with 30s dropping almost 100 bps, and the short end rising close to 40bps on the 2s

G10 returns vis a vis the USD (carry adjusted) fig 3

In G10 FX space, the AUD is the only winner against the USD, once adjusting for carry, with the SEK being by far the weakest - however this can hardly be a surprise given the Riksbank and on my top trades of 2014, long USDSEK was my preferred idea here

Overall, the ARS performed best even after a spot devaluation (just goes to show how powerful carry is!) followed by India. In last place, unsurprisingly... Russia.

figure 4

fig 5

Global monetary policy divergence was really the theme last year, but frankly this seems to be the main talking point for 2015 too.

Figure 5 is my favourite chart to explain 2014, 1y1y in EUR and USD.


However this time we have the potential for a few more risks to the global economy ranging from China to continued disinflation.


Geopolitical risks were also evident this year, primarily focused on Russia and the Middle east, one of my favourite spurious correlation charts is that of Russian CDS' against DAX. Whilst somewhat spurious, there is something behind it.

russia CDS vs DAX, fig 6

2015 outlook - FX ideas

#1 Long NOKSEK

I've been talking about the NOKSEK quite a bit on twitter recently.

Currently, in the NOK rates market there is a small probability of rate cuts from the Norges bank As per fig 7, whilst the Riksbank still struggles with Deflation.

Fig 7

However, I see the Norges still as a neutral central bank with a much smaller chance of a rate than the market currently sees, as such I expect upward pressure to short end market rates which should in turn benefit the NOK.

Figure 8

When loading up the NOKSEK against 2 year swap spread, we've seen quite the divergence in the past few months, mostly Oil related.

Figure 9

For the NOK to outperform, we are going to need to see Oil stabilise in the medium run. We've seen a pick-up in the correlation between traditional commodity currencies and their respective important commodities. This also heavily impacts Norway's Terms of Trade, which whilst lower, does not justify the extreme weakness in NOK as we can see in Figure 10 with Norway's ToT overlay against the NOK

Figure 10

So, I expect the NOK to outperform the majority of the G10 next year, but specifically against the SEK where we are likely to continue to see extreme Riksbank rhetoric, with the likelihood that market expectations of a hike get pushed back some years. As such, funding in SEK seems like a good pair trade.

Lastly, from a technical perspective, currently entry levels seem reasonably attractive, looking for a move towards the 1.15 area

#2 Short Eurodollars

A very popular trade in 2014... positioning for higher US rates. Currently, according to Fed funds futures (complied by MS into time to 1st hike) we are still expected to wait to Q3 2015, even though most economists still expect it to arrive in Q2.

This trade is not based upon the dot plot, I've covered my thoughts on that in the past, but I firmly believe the US economic growth story is pretty good, whether we look at PMIs and their momentum, or more broadly at the labor market, nearly everything is promising. The only drawback, much like the UK, is the lack of inflation - specifically wage inflation.

My trade is to position for higher short end rates, using an option structure as below.

Fig 11 &12

I'm looking at EDM6, or June 2016 Eurodollar futures, currently trading at 98.69, buying downside puts funded by selling upside calls brings in small premium over the 1y trade, with a breakeven point at 98.75 (at expiration) as can be seen on figure 12

Fig 12

I've been over the difference between rising US swap rates and an actual change in US rate expectations, swap rates merely are rolling up an already steep yield curve, where as fixed dates (like futures) show a better picture of monetary policy expectations in my opinion. One clear obstacle is positioning in this trade, everyone is short... however at less extreme levels that a few months ago.


#3 Long GBP basket

When looking at UK rates, we've seen quite a drop in BoE expectations. At one point, there was some discussion about a 2014 rate hike, clearly that hasn't occurred, so its all about when in 2015. Given the macro-economic backdrop (aside from wage inflation) would suggest to me a Q1/Q2 hike, but looking at the current short sterling curve... and the move in the past few months we expect a Q2/Q3 hike. Therefore there is room, in my opinion, for there to be upward pressures to rate hike and the curve.

Short Sterling Curve - fig 13

A good 80bps drop in the 3m LIBOR for year end 2016, has of course weighed on the GBP the last few months. But even closer dates, such as U5s, we've seen a 50bps move. For Cable, it has seemed that for the past 12 months all that has mattered is the distance between the two 1st rate hikes as we can see from figure 14

fig 14

There is no doubt the UK economy has lost some of the momentum that it had in late 2013 / early 2014, but even after that, the macro picture is doing well and as such I expect to see the GBP outperform throughout 2015. Currently, when you consider it against Non-USD pairs, the GBP is quite high.

EURGBP shorts still seem like a good idea, however I would like to sell at better levels. Currently, the EURGBP is a little cheap to rate spreads as per fig 15, so we may see some strength with which to sell into.

Figure 15

In EURGBP, a 1Y digital put, Strike at 78 KO at 84, indicative cost at 28% of notional.

figure 16

Furthermore, Long a spot basket against CHF/EUR/AUD/SEK

figure 17

The BoE is likely to be less dovish than what some expect, and combined with a strong UK economy, I expect to see GBP out-performance.

Theme #1 Oil prices

As I've discussed previously, commodity prices are likely to be a big factor throughout 2015, as they have been in the past few months. There is a strong chance that central banks will pay close attention to developments in oil prices specifically.

Figure 18

Figure 18 shows the USD (inverted), oil prices and US inflation swaps. Whilst I am unsure on the full cause of the major drop in oil, there some clear rationales... Weaker global demand / higher Oil supplies and of course a higher USD can sum up the move lower this past year.

The impact on inflation, and possibly more importantly inflation expectations from a decline in oil prices will likely drive global monetary policy, and with the current disinflationary trends, a decline in commodity prices, at least to me, seems like one of the biggest potential risks to any central bank hikes next year. Especially from the Fed where Yellen seems intent on finding an excuse not to hike, after all, she can keep saying data-dependent and can justify no hikes any time soon.


Theme #2  China


Chinese 2015 GDP forecasts (fig 19) have consistently been downgraded over the past year, currently seen at 7%, however there is a good risk that this could be much lower into the 6 handle.

Figure 19

The most obvious impact from a slowdown in China is for the AUD... As we can see in figure 20 Australia's terms of trade is at its lowest in 10 years, which will certainly weigh as we move forward into the next year.

figure 20

When we look at Iron ore prices, its clear that there has to be some weakness within china (being the biggest importer) and this has, and will weigh on the AUD assuming that we actually the weakness that is to be expected. while currently there are no rate changes priced into the AUD rate curve over the next 12 months, but if the mining slow down continues, and house price inflation is lower, then we could definitely see the RBA err muc more to the dovish side. In this given scenario, I would expect the AUD to trade lower towards 0.80 and below.

On the other hand, what if the PBoC / china does something... RRR cut? some sort of stimulus package? well, maybe... however, as China moves towards a more consumption orientated economy GDP growth will be structurally lower, so China may not need to be concerned with the current decrease in growth. Given this potential for Chinese intervention, a possibility for US rates to pushed back and then of course Australian debt offering quite the yield premium for AAA, then AUD would seem like a popular currency, especially on a sovereign/ cen bank diversification basis.

Theme #3  Volatility to pick up

Volatility has historically tracked the USD, mostly given the "safe haven" aspect, however this time is not the case.

figure 21

It's clear the USD is starting to react to the Fed hike chances, and we are likely going to see a pick up in volatility in the event of Fed hikes. I would therefore expect to see greater intra-day volatility throughout 2015, however I could bet that last year, people were saying the same about 2014... and that clearly didn't materialize. So whilst I expect a pick-up, I'm not going to be looking to buy vol, I'd much prefer to adjust my risks accordingly, maybe spend more time taking advantage of intra-day swings, but we will see how it goes.

figure 22

MOVE and FX implieds are likely to head higher, and given this, I like to use options to express some of my thoughts for 2015, specifically from the long side. Furthermore, when looking at implied distributions, and the potential for a trending market next year, then options are offering a perfect risk:reward profile over spot.