Below commentary is courtesy of extract from a.m. edition of today’s Rareview Macro’s “Sight Beyond Sight”
A Simple View: US Dollar, Gold, SPX, UST’s
The objectives we have laid out continue to materialize across the themes we are focused on.
The Q&A session with President Mario Draghi following today’s European Central Bank (ECB) meeting has concluded. We will leave it to the people with PHDs to debate the intricacies of what he had to say. But if price is the voting machine that always tells you the truth, then the weakness in the Euro exchange rate highlights that the press conference was simply dovish. Expect these same PHD’s to keep chasing as they lower their price targets again.
As evidenced in our most recent editions of Sight Beyond Sight, there was little doubt that Draghi would not strike a dovish tone. With his emphasis on a unanimous vote for further action if necessary and formally adding in the notion that the ECB’s balance sheet will return to 2012 levels (i.e. ~1 trillion higher), Draghi did a good job of walking back the negative tone that the media have tried to portray over the last 48-hours, especially the speculation about an internal battle/dissent/revolt building up against Draghi.
For us, it was never about whether the professionals sold the Euro after the event. They were going to do that anyway as the trading dynamics continue to point towards the Euro buckling under its own weight regardless of what Draghi says. Instead, we were more focused on a short covering event not materializing ahead of tomorrow’s US employment data and that has been largely removed for today.
So those bearish have to contend with the following factors:
- Bank of Japan (BoJ) Godzilla easing in ninja like fashion;
- People Bank of China (PBoC) “black box” targeted easing;
- European Central Bank (ECB) explicit balance sheet increase with Germany support;
- US Mid-Term Elections that reinforced the establishment and removed the fringes for a centrist right move;
- Seasonality in your favor and underperformance by professionals.
The list could go on but that is not a bad week’s work. What remains is a US employment report tomorrow that shows a further removal of the slack in the economy and an improvement in the wage data. The key point here is that main street needs to extend an olive branch to the Federal Reserve as any sign of “good inflation” (i.e. higher average hourly earnings) will change the narrative for the December FOMC meeting.
If we get that sign tomorrow, a stronger US Dollar and higher yields will be too much to handle for Gold.
It is important to note that a lot of professionals have deployed more risk to currencies and new risk to commodities. So their ability to add a long position in Equities is now lower and no one wants to buy these highs. That is pretty ironic given this year’s “alpha trade” has been to be counter-intuitively long an index and short single stocks.
If the US data tomorrow is very strong tomorrow, the mindset will be that the speed and degree of yields moving higher (i.e. yields have more gearing to the data than the USD at this point) will weigh on stocks. That is a natural view if you just pressed your long US Dollar and short Gold view. That means these same professionals need a liability and are waiting to short the S&P 500 on weakness.
The risk to their view is that they are wrong and any drawdown is very limited in time and price because fundamental investors will embrace the trajectory of an improving economy and limit the emphasis on rates rising earlier than expected. That would be just another example of the market not letting professionals back in unless they are willing to pay the offer price.
Again, we do not operate with a polar mindset and we do not have to be forced to lean one way. That is because we are long the US Dollar, short Gold, long stocks and, as outlined below, have just protected ourselves with a higher yield view.
Style Drift and Short US Fixed Income
A force recon marine once told us to be very mindful of the “Good Idea Fairy”.
Among military men, that means that right before you go on a mission and after you and your team have planned it out, then the upper brass come down with all these “good ideas” to make the mission easier, i.e. get more equipment, take chemical gear, or bring a dog or bullhorn, etc.
Applying that term to trading, when you have outperformed the market is precisely when suddenly everything looks like a way to make more profit.
While we are the first to acknowledge that we run a model portfolio only we are mindful of remaining disciplined in what has worked so far this year.
In fact, outside of poor risk management, we are of the view that one of the main reasons why an investor would pull their money from an investment advisor is because a portfolio manager is moving away from their core discipline. So we are very conscious of “style drift” and we want to emphasize that the recent trading activity will not be the start of a pattern.
To be clear, we have stated that we would look to be opportunistic given the outperformance of the model portfolio. Specifically, we said we would look for 5-10 situations to express a short-term view but would not risk more than 1% of the NAV. Our view is that risking 1% is NOT unreasonable when you are up 17%. Additionally, we would argue that if this was a real vehicle that the investors who were in it would actually demand that you increase risk when others cannot or if you are outperforming this much.
So far we have spent 10 bps on a long financial sector trade (i.e. XLF 12/20/14 C24) and 9 bps on a 3-day reversal punt in crude oil (i.e. USO 11/7/14 C30 and C30.5). That is 19 bps of the 1% in a defined risk profile.
If that cannot be appreciated by some in our audience then just chalk it up to the fact that we are selling a newsletter, and part of our unique selling proposition (USP) is to present tactical trading ideas.
In that spirit, we spent another 21 bps yesterday on a tactical opportunity in US Fixed Income. We now have spent 40 bps of the 1% on three short-term trades in a defined risk profile.
While it may not always appear as if we pay it much attention, in fact we spend a lot of time looking at US fixed income and it has historically been a large part of our trading tool kit. In 2014, however, we have just viewed this asset class as a “C Trade” relative to other core investment strategies. That view has served us well all year.
That said, we tend to make exceptions around inflection points similar to our Eurodollar steepener trade expression in mid-October when spreads compressed violently.
The inflection point today is that we convinced ourselves (and some others) that US yields will struggle to go up again due to deflation concerns or that foreign reserve managers will be buying large quantities of US bonds in perpetuity due to their easier monetary policy, and that the better outlet for interest rate differentials or US economic normalization is to go long on the US Dollar.
At times we know that we can be the best contrarian indicator and when we feel that way, such as at this moment, it is prudent to protect ourselves in case we are wrong.
It just so happens that as a result of this dogmatic view prevailing on the Street right now, that “optionality is positively convexed” in Fixed Income. Put another way, the asymmetry for yields to move higher is very steep at the moment and options are so cheap that the risk-reward is greater than 5 to 1 if the US employment report exceeds expectations tomorrow, especially if there is a new element of wage pressures given that the Federal Reserve is more focused on the “good inflation” now.
A key takeaway from yesterday’s price action was that the UST 5-year lead fixed income in both directions. The key point being is that the 5-yr duration is the fulcrum point of the curve heading into tomorrow’s job data.
Details of the trade are below but we essentially purchased a put option on the UST 5-year IN CASE the data tomorrow significantly exceeds expectations and we turn out to be wrong on our US Dollar position in that the gearing to normalization in the US would be seen more strongly in interest rates rather than the US Dollar in the near-term. Spending 21 bps to protect multiple percentage points of gains on the other side of this view at this point given the sentiment and momentum extreme in the US Dollar is responsible.
Again, we are mindful of “style drift” and that “punting” is a recipe for a reduction in AUM either through losses adding up quickly or investors pulling their money out. We hope that you have grasped the difference in what we are trying to achieve and that the levels of our conviction in this series of recent trades are sized very accordingly, i.e. less than 1% of a 17% gain in the model portfolio.
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