Emerging Markets - 29/01/2014

So the CBRT had an emergency meeting where the following headline came through

*TURKEY'S CENTRAL BANK RAISES OVERNIGHT LENDING RATE TO 12.00%

*TURKEY'S CENTRAL BANK RAISES BENCHMARK REPO RATE TO 10.00%

So Turkey raised rates quite considerably and a full list can be seen here

CBRT rate hikes, HSBC

As expected the TRY caught quite a substantial bid, moving from 2.25 to around 2.15, not too bad. However there was one overarching problem with this, the substantial rate hike which accounted to about 225bps would severely damage the macroeconomic picture. That is on top of an already slowing economy so it really won't end well, but they had little choice... FX reserves are under $40bn and trying to talk the TRY higher failed many times.

So what what remembered was that this was the CBRT's last move, they couldn't realistically put rates up again, and couldn't really intervene directly. As such the TRY really struggled giving back all the days gains to trade back towards pre-CBRT levels

USDTRY 2 day tick

The market somewhat settled down, with USDTRY trading around 2.24 (stopping out HSBC after just 12 hours)

@UlasAkincilar @katie_martin_FX pic.twitter.com/JvLjhDhVKr stop was 2.24, now price touched that some places(on reuters), others came very clos
— Jeremy W-Smith (@JeremyWS) January 29, 2014

At this point the days move was already incredible, but what came next was utterly ridiculous.

*SOUTH AFRICA RAISES BENCHMARK RATE TO 5.50% FROM 5.00%

The market was a tad surprised to say the least with 25 of 25 economists expecting no rate hike. This however (much like BoE in 1992) made traders interpret the recent hikes as weakness on the part of both ZAR and TRY which both immediately started to tank.

USDZAR

The USDZAR reversed the initial spike lower on higher rates and proceeded to move 3% upwards, and over 4.5% from the days low (post CBRT)

This fear spread to all the asset classes and quickly we saw the USDTRY trade up to 2.32, causing risk off across the market, ES dropped, Bond were bid, JPY was bid etc etc.

ES white, TRYUSD yellow

However, more concerning was the contagion that spread in EMFX where the RUB weakened to 5 year lows vs. the USD and all time lows vs. the EUR

USDRUB 5yr

Not just RUB, but even the stronger (CA surplus EMs) ccy's sold off with the HUF down 1.5% vs. the EUR and PLN down 0.5%

All things considered, I really don't see this action today being a solution to the problem, it won't fix the structural deficit for turkey, it won't encourage Speculators to buy TRY (and could like with BoE 1992, cause the market to test the central bank and destroy the ccy) and finally it will hurt the macroeconomic picture for TRY.

In summary, today was the largest ranged day for over 5 years with around 7% from high to low, based on spot. It also pushed the 1 month IV to its highest since 2009

USDTRY range

TRY 1 month Implied Vol

Best part is, the FOMC haven't even annouced their plans yet, which will likely involve a $10bn taper, which could worsen the situation for EM FX even more.

Forward Rates

Since the beginning of 2014 there has been a significance divergence in some of the forward rates for major currencies. This should be a key factor going forward for the FX markets as the guidance and expectation from Central banks should be a critical factor.

Below shows some 1y rate 1y forwards

1Y1Y rates for GBP, USD, EUR, CAD

As we can see here, CAD 1Y1Y rates have dropped by around 25bps, EUR rates down by 8 or so. Yet USD and GBP forward rates have risen marginally.

This divergence will be very important when looking to the medium term, as we can the fixed income markets start to react and so far, in FX, only the CAD has responded to the changes in central bank outlooks.

Since the taper though, the market has moved to from a state where it was considering the (at the time) present factors, and instead has moved to considering how these are going to change over the next 1/3/6/13 months etc.

This point can be illustrated by simply looking at the EURGBP, right off the bat there should be no obvious implications of a Fed Taper, there is no excess correlation with the USD between either of the EUR or GBP and as such it should have been a neutral event. But it wasn't.

EURGBP hourly

As we can below - the EURGBP has traded mostly in tandem with 1Y implied yields (from forwards) for the most part of the last 5 years. But these 1Y rates on show the current picture, when looking ahead now, we need to consider how they rates are going to change.

EURGBP 1Y implied yield vs EURGBP

That is why, since the Fed Taper - and pretty much since it became an idea in the early part of 2013, the EURGBP has been trading much closer to that of the 1Y1Y spread. (shown below)

1Y1Y spread vs EURGBP (red) and 50 day correlation

We can see the correlation moved from mixed to decisively red, where red shows a negative correlation (because the spread is inverted on the right axis)

As we can see that now looking at 1Y1Y rates are far more important than just 1Y rates as now investors are caring much more about the central bank path than pre-taper.

The reason why the taper is so important is it has acted as a psychological change from "uber-dovish" to "cautiously hawkish" and this means that the markets will start to consider the fact that base rates will soon be on the rise (as opposed to the idea that we've ZIRP ad infinitum).

Now in the case of the EURGBP the central bank divergence is pretty obvious - ECB have recently cut rates and will have to ease more, where as the day-by-day pressure on the BoE to hike is increasing (consider U/E recently). As such selling rallies in EURGBP should be good all year.

Another example is AUDNZD.

Here is a chart of the AUDNZD spot, AU-NZ 2 year spread, and the spread between the 2 year rate 1 year forward.

AUDNZD vs rates

Once again, since mid 2013, the AUDNZD has become far more correlated with the forward rate spread as opposed to the current spread. The divergence between the RBA and RBNZ is quite clear, but relatively minimal in comparison to others.

So, looking forward, using the idea that the market will start, albeit slowly, to noticing forward rates more and more the EURUSD looks to be a good sell going forward. So long as the rates factor becomes more important than the relative balance sheet and also the strong Current account position of the EZ.

But providing it does, the EURUSD will come under heavy pressure as the expectations widen more and more, and the yield spread widens to a point where the EURUSD can no longer justly trade at these levels.

Finally it would be easier to just pay USD rates and recieve EUR rates but it should filter through to the FX markets.

And here where the current implied yield is in Blue as well, we can see how it is very much like EURGBP pre 2013 where it only cared about now, as opposed to the future.

This is could be what we are looking at if the EURUSD starts to price in the future as opposed to the present. (ok maybe not 1.20, but under 1.30)

AUDNZD downside vol too expensive

Firstly, the AUDNZD has been very, very weak over the past year, unsurprisingly to a point, but now it seems a little extreme to me.

Below we can see the AUDNZD plotted against the AU 2 - NZ 2 year yield spread, and an accompanying model (AUDNZD=Bid,0= 1.202 + 0.1465 x (AU2YT=RRBid Yield,0-NZ2YT=RRBid Yield,0)) to show the divergence when related to price.

AUDNZD, rate spread (red) and model (purple)

Right now, with spot trading 1.07, we are clearly below where the rate spread would otherwise see us trade. over the course of the year the AUDNZD and rate spread has an R^2 of 85% suggesting that the theory the related FX to rates held strongly.

However right now, with the 2 year spread at 41 bps this prices in the AUDNZD at ~1.14 (+/- 1.5%), but it is clearly outside of this range by quite a lot. But when using this relationship to see why we are trading where we are, we see that the AUDNZD is pricing in a rate spread close to 100bps (more precisely 90bps +/-8), more than 50bps wider than current.

AUDNZD model with 90 bps and 125bps 2 year spreads as question

As we can see here, at 90 bps the model expects the AUDNZD to be trading at 1.0702 (pretty much spot)

Which in essence given the relative similarity of the AUD and NZD yield curves (in terms of shape) and given their equal base rates, means that the AUDNZD is trading currently with ~50 bps of RBNZ rate hikes built in. With the RBNZ unlikely to raise rates 50 bps in the coming 6 months then we have some potential opportunities. First comes from the idea, that if the RBNZ puts of the inevitable rates hikes a little longer, then Spot should, over time move towards the rate fair value in which case buying spot at 1.07 would be a good idea, and even if the RBNZ does hike, it currently prices in 50bps as we trade now so there is a clear buffer.

RBNZ OCR rate path

Furthermore though, when we consider the volatility smile for AUDNZD we can build some ideas.

1M, 3M, 6M vol smiles

We can see that, somewhat unsurprisingly there is a higher IV for puts vs. calls. And this would make sense in the 1Y duration as that is most likely when the rate spread between AU and NZ is at its widest. Above in the calculation, 125bps is put in to the calculation and returns a value of 1.02 for AUDNZD. So a move towards parity is technically possible, but for now, a long way off.

But for now, when considering the 6M duration, the 10 delta put is trading at 8.21 (mid) and the strike on the 10D put is around 1.01

AUDNZD and 10 delta 6M strikes

So we can see that the 10D strike is 1.01, and given that the market is already pricing in 50bps of hikes, it is unlikely that in 6M that it could trade 600 points lower and price in another 35-40 bps of hikes. And therefore, based on the level of IV and the probability that it manages to trade that low, it would make sense to consider selling these puts naked. The heightened level of IV for the puts on the short term makes this trade, at least from a risk:reward standing very attractive to me.

A way to increase the premium (and in turn, the amount you receive by selling) would be by also selling the 10D calls with a strike of 1.16. AUDNZD is unlikely to recover that far in 6m due to similarity in the RBA and RBNZ rate paths.

So entering a 6M 10D strangle would receive approx. 57 pips or just over 0.5%, not huge, but when factoring in the probability of a move outside of those bands in 6M it is a very strong chance this trade will perform.

conversely you could increase the delta ( bring the strikes closer to ATM) and hope to receive more in premium and you would, but also decrease the probability quite substantially that the AUDNZD trades outside the band. For a 20 delta 6M strangle you receive around 129 pips (1.25%) but the strikes are 1.03 and 1.13.

But like I said, this isn't about being in a strangle as much as it is about the downside puts being far too expensive up to 6 months, based on the idea that the AUDNZD is unlikely to move to a situation where it prices in a 125bps differential on the 2yr.

My trades of 2014

2014 should see the occurrence of tapering (if not next week) and as such we will likely see rising rates going through next year, and as such we should see a rising USD on the back of it.

As we can see the relationship is clearly very strong and with rates only heading higher through 2014 broad USD strength is likely to come about.

As such the basis around my trades for the year are USD bullish and bearish bonds










1st trade: Short EURUSD via 6M 1.3750 put, entered at 7.6%

The timing around my USD bullishness is the hardest thing at the moment, while I'm sure we do eventually rise, it's just when, that is why I'm entered into a longer dated put in the EURUSD

Firstly, with Volatility so low in the FX world, the cost of the trade is quite cheap, and as such if we see a pick-up in IV the option value should benefit.

Furthermore, the premium payed on the trade is 290 pips and a strike of 1.3750, therefore the B/E on the trade is 1.3750 - 290 pips = 1.3460.

Ideally my targets on this trade are for the EUR to be below 1.30 in 6mo

2nd trade: Long USDCHF at market (0.8875) stop under 0.85 and a target of 0.9750

The CHF has the most to lose from the major currencies, and as I expect EURCHF to rise to 1.25/27 by year end 2014, the USDCHF should do very well with broad USD strength.

He we can see the last couple of years in USDCHF and horizontal lines represent the exit levels.

3rd Trade: Long USDSEK at market (6.57) stop under 6.25 and a target of 7

Broadly the same idea as the previous two, but with weak inflation in Sweden, it is likely that the Riksbank stays very accommodative and potentially cuts rates, so on top of USD strength, the SEK could be very weak too.

4th Trade: Short US 5's, stop under 1%, looking for a move to over 2%

This trade was entered on the 27th of Nov when the US 5's where at 1.35%, and broadly speaking with tapering, the 5's should rise substantially, to at least their previous highs. Entered via futures.

This is all being played off the idea that Monetary Policy is likely to diverge through out 2014 as shown below

DecTaper and Implied Vols

Next Wednesday we've got the final FOMC meeting of the year where it will be revealed whether or not the Fed has decided to taper its $85bn/month asset purchases.

As it stands, We've had pretty decent payrolls (last 2 month >200k) and a headline U/E rate hit 7% yet very few predict a DecTaper, consensus is for March '14

*Reuters poll on when will the fed announce Tapering

Gold has had a huge offer capping its advance the last week, and likewise in the USTs where the 5's have risen 20bps since I shorted (here), the price action is surely worrying for those expecting no taper.

Furthermore, if we look at the options markets there has been some interesting moves in Implied Vol as we've rolled into the FOMC meeting on the Spot Week contracts

As the contract rolled into encompassing the FOMC meeting yesterday, we saw a large spike in IV, while this is to be expected the move in SW EUR IV as shown above was the largest 1-day % change on a YTD basis, much larger than the September meeting spike and the NFP for Nov.

 Here we have USDJPY IV for the Spot week ATM contracts, where the Spike in IV, while well below the actual IV level, was the  joint highest on a YTD basis. This equalled the moved seen pre September meeting where the USDJPY moved >1,25% on the day. So as it stands, that seems to be a decent benchmark to go off, when deciding the markets sentiment going into next week.

Finally we have the AUD SW ATM IV where we can see the move has been by far the largest so far YTD, and considering the move post Sep FOMC meeting was a swift 1.73% rally, we can see that the market is preparing itself well in advance for some large vol moves. In this instance, the actual IV level is greater than in September, so we can definitely see the options markets are getting concerned about some surprises.

Finally a 3D surface view, we can see the inversion in the term structure quite clearly and this follows out until about 2-3 months, however the Risk reversal skew on the SW is relatively small, therefore suggesting the cost of either a put or a call is somewhat similar showing that there is currently no noticeable bias to market sentiment, if the Put IV > Call IV by more than 2 points then there would be some serious worries but it is not so bad currently.

However, according to Soc Gen traders

"1wk usdmxn paid at 15.5, it's 15/16.5 now.  1wk usdbrl paid at 15.25 and then 15.5, it's 15.2/15.8 now.  Rest of the curves are around 0.3-0.4 higher on the day too now

While its not an EM proper AUDUSD also getting lifted - 1m rallied from 9.7 to 10.1 paid and all requests that we are seeing in aud related pairs are buyers"

So we can see that the AUD is being used as a proxy for EM exposure due to its greater liquidity and similar PA characteristics, and all trades being buyers of options suggests that there is a real concern about the volatility that could ensue next week. (remember IV~= the cost of the option).

And from CitiFX

"FOMC event risk priced in the short dates is not fading at all. USD gamma is getting more and more expensive as we approach the event."


We should consider that USDJPY options tend to be the highest volume and most liquid as shown here from DTCC data

All in all, we can't quite yet gauge a proper look at the option expected impact of the FOMC, until the contracts roll into ON and we can look at premiums and costs of ATM straddles etc, but as it stands now, the early protection via options has broadly been largest this year and as such we need to be very careful going into next week.

GL

Top trades of 2014

So, over the last few days, we've seen various sell-side institutions come out with top trades of 2014 so lets have a look

Goldman Sachs

#1 Long S&P, funded by short AUD executing in the December 2014 futures contract at 1986.8, targeting 2250 (+13%) and stop below 1855 (-6%)

Rationale for this is as followed "Long the S&P 500: “Earn the DM risk premium, Offset by a short AUD position: “…Hedge the risk “"

#2 Long 5-year EONIA swap vs. short US 5's at -61bp, looking for a move to -130bps 

This is because "Growth Differential Widens and Service Price Inflation Diverges, also Forward Guidance is in the Price"

Broadly speaking, they are placing a trade on the expectations that the Fed are moving towards tightening while the ECB are doing the opposite.

#3 Long USDCAD at market (at the time was 1.0550) looking for 1.14 in 12 months

·         Canada’s current account position has been in deficit for some time

·         Slowing reserve diversification into the CAD has recently pushed the BBoP into deficit

·         The BoC is also concerned about weakness in the export sector and low inflation

·         Domestic demand may no longer receive a boost from the housing market

·         The BoC is one of the few central banks with scope to cut rates

·         US growth and tapering may move interest rate differentials further against the CAD

·         In particular, a sell-off in the US front end could significantly accelerate a $/CAD rally

·         We forecast $/CAD at 1.14 in 12 months' time

As of writing, these are all the released trades from GS, but more are expected throughout the week

Now onto,

Bank Of America

#1 Short US 10y at 2.78% looking for 3.5%

#2 Buy GBPCHF via call fly

#3 Buy MXNJPY

#4 Short EURGBP via 6M digital puts

The entire research note can be found here

https://www.dropbox.com/s/4i68iaapamjkhmz/BoA%2520Top%2520Rates%2520and%2520FX%2520Trades%2520for%25202014%5B1%5D.pdf

Thanks

Taper Trades

Depending on where you read, the chance of Taper centres around early 2014. However the various asset classes show a very different, individual picture.

By looking broadly at the major few asset classes we can see how to best position for the "inevitable" Taper. Throughout this we need to remember that going into the Sept 18th the market was positioned such that Tapering was expected - the market was surprised, but we can use those values as a benchmark to compare to now.

Firstly, Gold (GLD) -

The precious metal has been incredibly weak (spot ref, 1242) recently, down 10% since the Sep 18 no taper FOMC announcement, roughly the same loss since the first major mention in June.

The fact that the gold price has been so depressed shows that, at least commodity traders, fear that tapering could be very soon. In fact the delay in Sept. hasn't changed much and we will still head much lower.

US Treasuries, (TLT/IEF) -

However, UST yields, which would broadly do the inverse of gold regarding tapering are currently 13 bps lower than Sept 18. This to me suggests that the Fixed income markets see Tapering being less likely and the direct buying of USTs and MBS from the Fed has pushedyields lower. In fact for not one instance has the US 10 year yield traded at a level seen at the Sept 18th FOMC meeting.

However the Belly of the curve - the US 5s have dropped in yield far more than the 10's. This is because the 10s price in a guaranteed tightening cycle where as the current 5s may just be on the edge and as such the yield has dropped much more since (I'll touch on this more later)

The USD, (UUP) -

Of course, after the QE program was continued in September the USD reacted poorly. But since has recovered nearly all the loses since then and is trading at around 80.64 on the Dollar index (DXY). We must remember the weighting of the constituents for the DXY as the EUR is over 50% and we saw a rate cut there, and the JPY has had further BoJ intervention (talking mainly). So we can judge that the USD as a whole is broadly a touch weaker since the FOMC, roughly to the same extent as the bond markets. 

When we consider these 3 asset classes combined, the so called FICC (Fixed income, currencies and commodities) we see that when we scale the chart to the Sept 18th FOMC day there is a large variance in performance as shown below

So, How I interpret this is as followed:

Gold is lower (on the chart it is inverted and green) since Sep 18th suggesting that Tapering is just around the corner, and as such a strong NFP will result in a December Taper.

US Dollar index is barely changed pricing in tapering, but not as much as gold - so suggests the consensus view of January 2014 for Tapering to start

US 5 years are much lower, suggesting the belly of the curve isn't buying into the taper idea any time soon and it has dropped off subsequently. This in my opinion would be pricing in a March or later Taper.

So the gameplan for me going forward is that to position into December and year end would be to Short US 5's, via futs, cash, etfs etc (just get long interest rates) and to simultaneously be long gold. This would mean that if there is a surprise and we see a December taper then the losses on Gold should be less than the gains on Short USTs because of relative values at the moment. If the opposite were to occur then Gold would rally significantly and USTs would only rally a bit (therefore a hedged, well risk-adjusted profit).

At this time, staying vigilant on the USD and being short USTs / Long gold would work well ( maybe long 1 GLD while short 2 TLT or something to this effect).

Thanks for reading, Good luck.

Jeremy.

From - http://seekingalpha.com/instablog/5913501-jeremyws/2443311-taper-trades