April FX & Rate thoughts

Another month... more of the same, we saw the USD index trade up through 100 before reversing and slamming lower (currently 97.5), also persistent underlying strength in the UST market with 10 year yields firmly back below 2%. It also highlighted some under-performance in euro-area peripheral debt markets - Italian benchmark 25bps up from the lows.

Central banks remain biased towards being dovish, in part through marginally lower growth expectations but mostly through the continued disinflation. Still in part to the likely transitory impacts arising from the drop in oil we've seen.

2y inflation swaps, top-> bottom, GB, US and EZ

However when looking at market expectations, whether its because of further monetary easing or otherwise, there has been a noticeable up tick in inflation expectations (excluding the UK). 2Y EZ HICP swaps trading 50bps higher YTD.

This is important I believe, as it brings into question the likelihood that EGBs stay incredibly low. Further to what I looked at last post here, I still think there may be an opportunity in the not-too-distant future to position for higher EUR rates, not necessarily on the short end, but most definitely in the long.

A much thrown about chart in the last few weeks is the relative economic data surprises in the US vs Europe.

Citigroup economic surprise indexes

There has been a rather stark, almost equal and opposite move in data surprises. Which I can only really put down to the large move in EURUSD, data strength has been exported from the US right to Europe when it needs it most (kinda).

So right now, we've got a low EUR, decreasing real rates in Europe and QE... argue as we like about the possible success of QE programs, the environment is rather good in Europe for outpeformance and stronger growth.

This is highlighted from the BAML fund manager survey chart below.

So what does this all mean for us then... well I think this is supportive for European Equity for starters, but that doesn't come at a surprise, with the Dax up some 20% YTD. What is important about this is that all these inflows into europe have been currency hedged. So for every purchase of European equit, ETFs/fund managers have been selling EURs keeping it pinned lower. The question really is, 'at what point is the EUR cheap enough for portfolio managers to remove / have no ccy hedge'. I can't pretend to answer that, however without being overly presumptuous, most sell-siders have been targeting parity (or something lower) and with that around 10% lower I think the somewhat /lazy/ PMs will probably hold off for now against removing these hedges.

Furthermore we have the remaining issue of USTs yielding significantly more than EGBs, last time we saw the 10y swap spread at 1.6% and I suggested buying USTs / shorting bunds. We stand today at 1.48% and my convinction on this trade is growing. Not only in part from the bids into the UST complex, but also the possibility that long end EGB rates could rise.

I really like this bond pointed out by @macrokurd

Austria 2062, currently trading at a ridiculous 210. Ultra long duration and a prime candidate to short.. but lets be honest, I still wouldn't want to fight the overwhelming yield demand, but 0.9% for an almost 50 year bond.. come on! its gotta end soon!

More simply, do you short bunds? probably not. or at least not yet. How many times has it got to levels where 'it can't go lower!!' yet still does..

So what? Steepeners? hmm.. maybe, but difficult to decide where, steepeners in the 5s10s sector may work, EUR 5s10s swap is currently 30bps,

Or do we look to Euribor futures? - well here we have June 2018 implying 26.5bps, 2017 at 9.5bps. If we do see, as I expect, an uptick in Eurozone data then it's possible to see this curve steepen somewhat.

Another market that could be interesting to us is New Zealand.

We have an economy growing nicely, but a central bank that has just hiked the base rate by 100bps, and a market that has rapidly priced out further hikes accompanied by RBNZ dovish rhetoric. They still bitch and moan about a higher currency, and while the NZDUSD is far lower.. on a Trade weighted basis the NZD is still strong. Importantly, the AUDNZD, all time lows just above parity is key, and I think the RBNZ will continue on a dovish bias.

The RBNZ has hiked before and cut, nothing stopping them again.. I am sure, with inflation ticking lower we could potentially see a scenario (much like the RBA/BoC) where the bank cuts rates in a pre-emptive manner.

Combining the last two ideas, we can foresee a situation which would be beneficial for EURNZD

EURNZD vs 2y swap spread

There has already been a large divergence, and if yield spreads tighten then it should be supportive for the cross. It's hard to know why there has been such strength in NZD relatively, I mean firstly its hardly like volatility has dropped, if anything its much higher and heading in 0.8 direction (lol).

Just RFQ'd on a 6 month 1.50 digi call with 1.40 KO and it comes in at 28%. almost 4:1 risk reward ratio, though a 1x2 call spread may also look attractive.


Lastly, on the Fed. Whilst I was skiing, Yellen and Co. came out with what was seemingly a largely dovish move. FF futures and ED really struggling to make their mind up.. aimlessly wandering until NFPs or other good data comes out to suggest a strong US economy. Alternatively whenever the Fed speaks the futures leg higher (FFZ5 up around 12bps since Yellen).

It's funny, even if US data has disappointed expectations (as per CESI), its hardly bad. The Labour market is still strong, a solid 2.2% Q4 growth rate confirmed last weeks, PMIs doing fine... so Fed, what's the problem? To me, the economic picture is not drastically different to when the Fed was comfortable with a June Hike, and the removal of patience indicates we are close to that first hike. If we are then ED steepeners look good, alongside my short sterling steepeners.

EDM6-M7

A mere 2 and half hikes between june 2016 and 2017... if the Fed is serious about normalization, then I think we would see more than this.. however I'm not in this trade to see this realized, I think the curve is too flat given the state and outlook of the economy, and while the USD may be acting as a wind-break to US macro, its not a major game changer imho.

March FX & Rates outlook

There has been a lot of discussion in the past few months all about negative rates in Europe/Denmark/Switzerland, however I think what is more interesting is to consider the impacts on the Bund curve, against say, JGBs. Japan has obviously struggled with deflation for many decades now, whilst its a relatively recent wave hitting the European area. Tho this being said, every bund trades through JGBs across the entire curve!

JGB vs Bund sovereign curve

There are a lot of issues in the Eurozone, from growing Grexit concerns to structural fiscal issues, however I don't believe that we are going into a period like Japan.

This chart from Martin is one of many that show optimism in Europe:

#EUR: how about 3% EMU GDP growth? What a difference a month makes in sentiment, e.g. https://t.co/T6tYNnL2qT pic.twitter.com/WewvAnX08r
— Martin Enlund (@enlundm) March 9, 2015

It is of course worthy of note that the wave of disinflation/deflation has been exacerbated by commodity prices, in particular oil price declines, however the basing factor will mean that the impact will disappear from the headline figures over time. And whilst we may not see massive inflation, we may see a definitive pickup.

This might have quite the impact on Bund yields (and other zero-bound rates), primarily those in CEE.

HUF / PLN / EUR 5 year swaps

There has been a sizable uptick in Hungarian and Polish rates in the past few session, and it feels like there may be more pain to come, as even though there may be a global hunt for yields, what we may see is a re-convergence of longer maturity rates.

What I mean by this is that if large global flows are going to be looking for yield, the clearly you'd look straight to USTs. One would much rather own a 10y UST at 2.2%, than polish rates at 2.1% as per above for example, and these flows may act to re-converge all DM rates.

While at the same time the idea that bund yields (and other zero-bound 10s) could actually pick up.. Thus when we see the 10 year USD/EUR swap rate at 160+ bps I think that the upside is rather limited and we are approaching the ultimate highs.. its possible that Fed hikes and upside data surprise may shock this higher, but I don't think we trade too much higher, and considering carry and roll would not hate Long USTs vs short Bunds here.

USD-EUR 10y swap

Looking to FX now, the EUR has been really hit, currently tradig firmly under 1.10, with the DXY storming towards 100. On a technical picture there isn't much support until this channel as per below, around 1.04/05

EURUSD weekly

From a gut-feeling perspective it certainly feels like the EURUSD is situated at a worst case for Europe/ best case for US kinda area, especially given the pace of decline, and while fundamentally the USD is strong, we are way ahead of ourselves - but this isn't new and fading the USD is still too risky. But with the EUR side, positive surprises in the macro picture might start sparking inflows, thus far any flows into Equity/Debt (which are large) have mostly, if not all, been FX hedged. From a managers perspective owning the USD makes sense. Especially given the yield pickup as per earlier, and the "expected" appreciation. But these are flows that are unlikely to capitulate and reverse, so we need new flow into EURs, but from where? don't know. we'll see.

But I think EURAUD could pose a decent short term opportunity at current levels, trading the range of 1.40/1.50

EURAUD vs 5y spread

A potential double bottom here offers good value to get in and play this range, Both via a spot trade for a short term move, and a 1x2 call spread (3 month, strikes ATMF and 1.45)

EURAUD 1x2 call spread

Receives small premium if there is a break lower, and is starts to lose at 1.49 at expiry.

On to the GBP a little...

I posted this trade on twitter last week:

and a 1x2 put spread looks good (1.54 and 2x at 1.50), receive premium and protect down to 1.45 handle pic.twitter.com/4opphN7GLn
— Jere Wilkinson-Smith (@JeremyWS) March 2, 2015

Doing well thus far, with cable dropping towards 1.51, but obviously with this structure my delta flips from short to long if we drop much further so I need to be careful, but its a decent start and I don't think that we see the market getting too ahead of itself into the General election.

GBPUSD daily

Still quite a fair amount of protection being bought into the election (tho I would love to see a riskies composite against many currencies, because obvs GBPUSD is hugely skewed due to USD call demand, and EURGBP riskies skewed due to EUR put demand, so ya know, if anyone wants too then that'd be great :D )

GBP vol premium vs Global

GBP vol premium is fairly minimal, but on a z-score its quite extended against its mean going into the election (this is 3 month vols). But its not at the super panicky Scottish Ref levels yet.

Lastly, I am going skiing next week (yay!) and its a fab time to buy EURs... almost 1.40!

GBPEUR