Below courtesy of extract from a.m. edition of Rareview Macro’s “Sight Beyond Sight”… MarketsMuse Editor note: notwithstanding the ‘caveat’ immediately below re: focus on FX, for those who are chewing on Apple ($APPL), MarketsMuse editorial team recommends a full read of below
An astute friend and mentor once said: “Deciphering the tea leaves of macro is an art developed over time, not purchased in an online tutorial”. In our humble opinion, today’s edition of Sight Beyond Sight is a good example of reading the tea leaves.
The majority of today’s note is related to Foreign Exchange but has implications across all assets going forward. If you are not a dedicated FX investor and not interested in making or saving money read no further.
On a risk-adjusted return basis the overall trading ranges across regions and asset classes are narrower than normal. This is prime example of indecision or neutrality after a strong relief rally in risk assets, especially in Equities.
The one outlier is the US Dollar, which continues its march higher towards regaining its status as an “asset” currency once again. The US Dollar is stronger relative to 9 of the 10 currencies in the G10.
The Dollar-Yen (USD/JPY) and New Zealand Dollar (NZD/USD) both broke key technical levels overnight – the Yen as a result of Japan’s trade deficit widening by more than expected, on an unexpected rebound in imports, and the Kiwi because of another disappointing milk auction that will weaken the country’s Terms of Trade, as well as negative Producer Price Index (PPI) data, and a growth downgrade by its Treasury yesterday.
The one currency trading stronger relative to the US Dollar is the British Pound (GBP/USD), albeit only marginally. The Bank of England (BoE) released its Monetary Policy Meeting Minutes and while minor, the tone was slightly more hawkish, and for some, helps re-establish a higher risk of interest rate hikes of “earlier rather than later”. Although defeated on the vote by a margin of 7-2 (it was expected to be 9-0), Martin Weale and Ian McCafferty’s became the first dissenting voters on the main policy interest rate since Governor Mark Carney took over in July 2013. In fact, no members have supported a tightening of policy since July of 2011.
While front-end UK interest rates (symbol: L Z4) are seeing some relief after the violent move lower in yields over the past week GBP has given back the majority of gains since the interest-rate decision. The lack of follow through buying should be concerning for GBP bulls, especially considering the relentless sell-off since early July.
Our view is that the BoE has recently taken over from the Bank of Japan (BoJ) as the central bank with the worst communication strategy and we agree with the assessment of the press that Governor Carney has become an “unreliable boyfriend” – he never shows up when he is supposed to or calls when he says he will.
Additionally, the Deputy Governor Ben Broadbent is speaking at the Jackson Hole symposium at the end of this week. Although he will likely hold the consensus line (i.e. he speaks on behalf of the Governor) some believe he is the most likely candidate to eventually make the vote to raise rates 6-3. All this does is cloud the trading environment further and after the recent PnL destruction in the UK interest rate and currency markets we struggle to understand why professionals want to go back for more. We are not interested in their continued appetite for punishment in fixed income and plan to remain safely sidelined in these markets like we have for most of the year. It is just a lot cleaner to traffic in other asset classes.
Finally, while the GBP is stronger relative to all the G10 nations and the USD only stronger relative to 9 of the 10 G10 nations, with the GBP being the one exception, the Euro-Dollar (EUR/USD) is showing the largest negative risk-adjusted return and the Dollar-Yen (USD/JPY is showing the largest positive risk-adjusted return across all regions and assets. What is interesting, however, is that the risk-adjusted return in EUR/USD is larger than Euro-Sterling (EUR/GBP) despite the release of the hawkish BoE Monetary Policy Meeting Minutes and USD/JPY is larger than Sterling-Yen (GBP/JPY) for the moment.
The observation begs the question: what is driving today’s sentiment for Euro and Yen weakness relative to the US Dollar? The data for Japan Weekly Securities Investment Abroad is set to be released shortly and this may signal that one answer for this Euro and Yen weakness is related to French OATs (i.e. Fixed Income).
Morgan Stanley, in a morning update, stated that “French OATs reported foreign, including Japanese, liquidation in recent days, with funds flowing into Treasury Notes.”
We have had trouble validating that information this morning but that does not matter. The fact is that while Japanese investors were net sellers of European government bonds in the first half of 2014 (Source: Japanese Ministry of Finance and Bank of Japan) Japanese investors bought more than 20 bln EUR of French government bonds in May (13 bln EUR) and June 2014 (7 bln EUR), and increased their net stock of French debt by 14 bln EUR in the first half of 2014. The acquisition of French bonds in May was the highest for a single month on month purchase recorded by Japanese investors for all European countries (Source: ABN Amro; data goes back to 2005).
Additionally, the 10-year generic French OAT-German DBR interest rate spread has bottomed at 32 basis points in June; this was just after the record purchases of French debt, from its intra year high of 72 basis points at the start of 2014. The current spread is now compressed and hovering near the bottom of the long-term range at 38 basis points. (Source: Bloomberg)
The key point here is that Japanese investors are very long of French fixed income and the argument that France is a source that yields more than Germany has been overtaken by US Fixed Income, as the 10-year bond now yields 2.4% vs. Frances 1.38% and the France-German spread has compressed. An additional ~1% matters in today’s global reach for yield, period.
After multiple years of inflows many are now acutely watching for a reversal out of European assets. We have already seen a reduction in exposure by real money in European equities and the subsequent rotation of that money to Asia on the view that the business cycles of the two regions are diverging (i.e. Asia stronger vs. Europe weaker). To the extent that Japanese investors are involved in a shift away from France (FYI – would also signal Italy given large purchases in that market as well), it should help to drive USD/JPY higher and EUR/USD lower.
What does this all mean?
It means that while some positioning metrics may suggest certain currency crosses have built meaningfully, the fact remains that, relative to a longer historical perspective, professionals do not yet have a large enough long US Dollar position if the current momentum in the currency starts to beget further momentum.
Secondly, did anyone notice that US equity volatility was actually slightly bid up during the recent rally compared to June? The key point here is that the US Dollar will exhibit the same tendency and that will provide volatility traders with a “gamma opportunity”. It is important to note that has not existed in quite some time given the one-way rolling crash in volatility and this allows for the entrance of a new investor base to the US Dollar.
Answering the question about whether Emerging Market currency weakness will follow next is more difficult to handicap. For those not following these trends closely, the US Dollar has been trading in a “triangle” – it is much stronger relative to the G10 (i.e. becoming an “asset” FX) but much weaker to Asia Emerging Markets (i.e. remains a “liability” FX of funding leg for the carry trade). We would just say that anything is possible and that any sign of EM FX vulnerability would hurt professionals even more – but at the same time possibly trigger an auto-correlation event in macro strategies, i.e. “performance return chasing”.
We are not sure if the release of the Japanese data will really signal something this granular or trigger an even larger move in the US Dollar. The same can be said about today’s release of the FOMC Minutes (i.e. expected to be slightly hawkish and USD supportive) or Friday’s Jackson Hole Symposium (i.e. Fed’s Yellen is expected to dovish but the ECB Draghi is an unknown). What we do know is that the US Dollar, as measure by the DXY Index, is set to break out on the “weekly” charts regardless come Friday and that has been elusive for quite some time. In the past what follows is model-driven strategies buying it and that is important to recognize because CTA’s make up ~40% of all hedge fund assets under management and deploy the most leverage.
Overall, that is the way we decipher the tea leaves right now. As it happens, the analysis fits neatly with our bullish view on the US Dollar that began on July 3rd or well before the consensus jumped on that bandwagon. We hope our friend and mentor who gave us that advice back in the day would be pleased with the way we have applied it.
Model Portfolio Updates
We rarely provide mid-week performance updates given the high potential for intra-week volatility, nor do we regularly discuss the broader model portfolio in general in these pages. We would rather highlight a learning experience after a losing position than ever take a victory lap following a winning strategy. We are wrong plenty of the time as well and always prefer humility over ego.
That said, the model portfolio is +1.5% this week and +5.2% YTD. The gains are broad based so far this week and do not include this morning’s positive PnL but the long US Dollar position due to the over-concentration (i.e. ~80% of the NAV) is the largest PnL contributor. As a result, we believe it is prudent to be more sensitive to risk managing other positions, especially after they have met the majority of our objectives. Therefore, actually realizing the gains is very important.
Additionally, the forced risk reduction in August of core strategies in the UK currency and front-end interest rates markets caused a lot of PnL duress in the professional community. The same can be said about the US front-end interest rate market as well, albeit to a lesser PnL extent. The key point here is that the underperformance by the largest investment managers who use the same industry benchmark as us (see details HERE) is becoming that much more acute. As we enter the third trimester of the year more than a few well-known investment managers are resigned to the fact that they will actually close the year with negative returns. While we very much appreciate that they manage large sums of money in the real world and we only have a model portfolio, we do not want to narrow this divergence and are looking to build on our strong outperformance on paper.
What this means is that we will not hesitate to cut positions faster and add them back when it fits our view again. As a result of the PnL outperformance it also means that we may uncharacteristically increase the frequency of short-term tactical trading positions when opportunity arises. One example of these “extra bullets” to shoot was Monday morning’s purchase of the German DAX futures on the view that Europe was not going to just bounce due to exhaustion but see more follow through beyond a relief rally than professionals were willing to accept. While we do not anticipate having to do so, and are even prepared to stomach some difficult down days, we will not hesitate to reduce the size of our long US Dollar position so as to not give back the overall gains.
One example of us “risk managing other positions, especially after they have met the majority of our objectives” took place in Apple Inc. yesterday. Near the US cash equity market close, we took profits by closing our long Apple Inc. (symbol: AAPL) exposure.
Given the current rally in the stock, the large amount of premium outlaid relative to the overall model portfolio NAV (i.e. 75 bps), the option strike we were long (i.e. 99.23), and our price target by Oct (i.e. ~$106) we had entered the sweet spot for profit taking. With no desire to roll-up the option strike price and limited tolerance for an abrupt surprise near the actual product releases or actual option expiration we felt it was well-timed to close the position.
Specifically, we sold 2000 AAPL October 99.29 call options at $4.40 to close. As a reminder our cost basis was $2.17. The history is as follows:
1. Bought 1000 AAPL 10/18/14 C99.29 calls for 1.78 on June 26th.
2. Sold 1000 AAPL 10/18/14 C106.43 calls at .75 on June 26th.
3. That equated to being long the 99.29-106.43 call spread for $1.01, with a 7:1 payout ratio, 115 days of time value, and 15 deltas.
4. On August 8th, while on vacation, we bought back the short leg of the call spread – 106.43 calls – for $0.95.
5. Also, on August 8th, we paid $2.58 for an additional 1000 of the 99.29 call options.
6. That equated to an outright long of 2000 of the 99.29 call options for a $2.17 average.
7. Adding the $2.17 cost basis to the $0.20 loss on the 106.43 calls (i.e. sold at $0.75 vs. bought for $0.95) our overall cost basis was $2.37.
8. After accounting for transaction costs we netted ~$2.00 which contributed about 35 basis points to the NAV.
Not all bad things come from market wobbles/corrections. We would like to thank the High Yield bond investors that helped trigger the market pullback at the end of July which wrongly dragged AAPL to $93 from $98. They so generously allowed us to double our position and take advantage of the broader investor anxiety. We politely ask those same investors to please provide a few more of those “gifts” into the interest rate normalization cycle.
Every one of these updates illustrated above, including yesterday’s closing of the position, were sent in real-time via Twitter.
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