Author: Mark Dow

I’ve run into some confusion lately on FinTwit with respect to ‘currency swap basis’ and ‘currency swap rate’. The discussion was about changes in currency hedging costs for euro and yen-denominated investors buying US fixed income assets. Admittedly, it’s easy for people who aren’t deep global fixed income practitioners to confuse them. I thought this simple description might help.

A currency swap is supposed to reflect the interest rate differentials between two countries. But it never works out to exactly that. There’s usually a small difference. And that difference is called the ‘basis’. ‘Deviation from theoretical’ is how I think about it. So, the basis is not the cost of the hedge, but it is one component of the overall swap rate, which is the cost of the hedge.

The original market point I was making is that the costs of hedging out the currency exposure in dollar-denominated assets has increased more than the yields on those assets have, and this has been an underappreciated force that has been weighing on the US bond market.

I thought this email captured my views pretty succinctly, so I decided I’d share it. Please ask questions if you have them in the @BehavioralMacro stream and I will answer them as best I can during jury breaks. Good luck.

“Hey X. Sorry again about the slow response. Still terrible with email and on top of that have been (and still am) on jury duty. I posted this on my blog back in April.

https://behavioralmacro.com/markets-in-the-medium-term/

I still think, amid all the tape bombs and geopolitical noise, that this is the operating environment until roughly end of summer. If we get into a full blown trade war, it will of course get uglier, but whether we do is still too path dependent for us to know. I have been in ‘keeping P&L mode’ more than ‘making P&L mode’ since I posted that piece. I had a ridiculously good Q1 in my Trading style and don’t want to mess it up. In my Investment style I have been waiting for us to finish the consolidation pattern to deploy more cash. Not too worried about the Fed, about overheating, or about a recession for the foreseeable future. I think EM continues to underperform until the market begins to think it has some clarity on where the Fed’s terminal rate will be and when we are likely to get there. At least this is my working hypothesis. Hope all is well out there in the Hamptons.

 

Best,

Mark”

Surfacing from pup training to share two words on currencies. I was prompted by a DM this morning from a sub who follows EM ccys very closely, and by the price action this morning/late last week, which to me has evolved in favor of seeing some USD softness soon. (Just look at today’s intra-day reversal in silver.)

I have posted below his question (pretty sure my assumption that the sub is a ‘he’ is correct) and my brief answer. Please feel free to follow up with questions in the stream or in DMs.

Question:

“Hi Mark, what is your best estimate of when a short USD / Long EM position is tradable? I take that this is to some extend data dependant and we probably need to see a bit more softer US data to conclude that the top is in for rates and the USD, but given the sharp corrections we have already seen in certain EMs, I am starting to getting increasingly tempted. Do you have any thoughts in terms of the timing here? Cheers!”

Answer:

“Hi. So, first one has to specify if we’re talking about a trade or a position. And if you are looking to position EM ccys, you have to start with what your current weighting relative to your benchmark/mandate/risk tolerance is. I would want to be modestly overweight here from a strategic POV. So, if you are underweight EM ccy, it makes sense to add here IMO. Need to leave room in case the EM unwind goes further (easily could), but I think the levels and the dynamic warrant adding. If you are flat, you can still start here to get overweight, but, again, make sure you leave room to add. On the tactical side, makes sense IMO to take a shot here at being more aggressively short USD, but with stops in mind/in place. Yes, for a short USD position to really run the data would have to cooperate somewhat, but the positioning and psychology is at least now somewhat favorable to try short USDEM here.”

Monday morning, Trump tweeted the following, ostensibly about currency manipulation:

Russia and China are playing the Currency Devaluation game as the U.S. keeps raising interest rates. Not acceptable!

— Donald J. Trump (@realDonaldTrump) April 16, 2018

But it wasn’t about currency manipulation. It was about the Fed. He was laying down a marker for later blame while at the same time preparing the ground for stepping up political pressure when and if the interest rate hikes start to bite. It also serves as a subtle first trial balloon, to see what kind of pushback/reaction he gets—with the ambiguity in phrasing serving as plausible deniability if not well received.

This is obviously conjecture, and it’s hard to get into Trump’s head. But when it comes to tweeting, there is usually a propagandistic method to his madness.

So, let’s take a look at what we do know.

We know Russia is not a major economy by any metric. And what exports it does have (commodities) are not exchange rate sensitive. And Russia doesn’t have a history of competitive FX manipulation. So, it wasn’t about Russia, which was likely thrown in to create the impression of a broader issue.

We know the Chinese exchange rate had been a real issue, but not so much any more. It is one Trump repeatedly mischaracterized/misunderstood during the campaign, but the Big De-peg of 2005 and the massive ULC-adjusted CNY appreciation thru 2013 pretty much took that issue off the front burner.

It’s true that Trump often tries to put lesser or bogus issues on the table in the hopes of getting something for negotiating them away later, and the US is in some sense in trade negotiations with China, but it’s a weak play, the issue wasn’t top-of-mind, and there was no need to reference Russia or the Fed if trumping up a negotiating point with China was the objective.

And we know that the timing makes more sense with respect to the Fed. Rates have been hiked now a half-dozen times, the growth optimism felt back in January has cooled/is cooling. The prospect of a slowing—or even moderating—economy has to terrify Trump, since he has pinned his political hopes on delivering outsized growth. It’s the only play he has. He both needs the Fed to blame if growth falls short and for the Fed to “cooperate” as much as possible. Moreover, his administration announced two new Fed Board governors the day of the tweet, so this issue was top-of-mind. And he has shown zero compunction in trampling on the integrity of any person or any institution that gets in the way of what he wants, whatever the systemic implications.

If you believe, as I do, that growth will soon settle back in with a two-handle and not a three-handle, the temptation for Trump to increase political pressure on the Fed will be too great to resist—unless the GOP and his base revolt in consequence, a bet that recent history suggests is not a good one.

This week was unusual for me in that I had three institutional investor friends come a-calling here in my sleepy little hamlet. Always great to see old friends who speak the same language. Lots of good discussion.

The upshot is that it forced me to distill my thoughts for the next six months or so. You will have already picked up on them in bits and pieces if you’ve been tracking @Behavioralmacro tweets closely over the past month or so. And I insert here the usual caveat that what I’m about to say could turn out to be totally and utterly wrong. But, all of us need a base case, so here’s what I boiled mine down to:

I call it the ascending triangle scenario.

The shock and pain of the January-February selloff forced everyone to take a deep breath and reassess the backdrop. We now need to wring out that extreme reading of euphoria, digest the rate hikes that we had been shrugging off, and recognize that growth is much more likely to have a run rate with a two and than a three handle. In short, market and growth expectations have to continue the process of coming off the January boil

In a sense, the shock created a mini disaster myopia dynamic. This process often plays out in an ascending triangle type pattern (if you can conceptualize one for growth expectations as well). And it resolves to the upside once the oscillations decline in magnitude, volatility dies down, and the January shock starts fading in our memories.

This is what an ascending triangle looks like:

 

We are entering the “bad” season for risk taking, many are licking their wounds from Q1’s volatility, and fundamental and technical consolidation referenced above needs time to play out.

The implication is while we can expect to return to the highs, it’s hard to imagine us getting anywhere meaningfully beyond them until this rough triangle plays out and risk appetite is replenished, which I’m guessing would likely be sometime this Fall.

To set up for this period, I added to discounted fixed income products to increase carry, taken the overall beta of the Investment book down, and increased in selected sectors like US home builders, which, in my view got hit too hard out of overdone fears of higher rates and higher wage inflation. I also like names that have a secular growth story–to the extent one can find them and get good entry points.

I have not changed my views on EM, but I do expect it to under-perform over much of this upcoming period. In part because its relative strength is no longer a surprise to anyone, and in part because any decent USD rally would shake out EM investors who came to the party late.

Hope this is helpful. Good luck.

I get asked often about what books I would recommend for getting a better handle on behavioral finance, markets, macro, pattern recognition, etc.

Back in 2012 I posted The Book List that covered a lot of ground–especially on the behavioral side. But I got asked again today, and I boiled it down to three books, one on behavior, one on central banking, and one on patterns and markets. This is where I recommend someone start.

Here are the books:

On the behavioral side, Thinking Fast and Slow–help you realize the extent to which our judgements are thoroughly damaged by emotions/cognitive biases. If you haven’t been exposed to Daniel Kahneman, it will blow you away. You’ll understand how there is no way markets can be rational or efficient–not even in the aggregate.

On central banking, Angel Ubide’s Paradox of Risk really gets you into the heads of the major CBs in the crisis and past-crisis period. You don’t have to agree with all of his prescriptions for this book to help you get past cynical market myths and aphorisms to see how CBs really think about equities, inflation, moral hazard. It also has excellent color on the debates the major CBs had at critical points in time. Angel has spent enough time in both policy circles and markets to see the whole picture in way few do. (Sorry, Jim Grant.)

On patterns/markets, Stan Weinstein’s Secrets For Profiting in Bull and Bear Markets. Ignore the old and cheesy cover, it’s a great introduction to patterns and stock cycles. Yes, the world has changed since then, but basic building blocks of patterns and cyclical tendencies have not.

Happy reading!

We’ve sold off very sharply in a short period. Many investors—probably the majority—think this is mostly technical and the basic global fundamentals have not changed. This group will be buying this dip. Others are worried that so much stimulus on a fairly full-employment economy will lead to inflation the Fed will have to stamp out, and, more concretely, fear the January Average Hourly Earnings number triggered a broader market realization of this. This group sees maybe a bounce, but more trouble ahead now that global central bank normalization is unambiguously on.

Behaviorally, after such a long, strong run, the BTD crowd is the more likely to prevail. The muscle memory is fresh. Traders like successful retests. And the overall case for this selloff being predominately technical is pretty strong. I’d cuff 75% odds that Friday was the bottom of this correction. And if that’s the case, it’s almost a certainty that we’ll be shocked at how fast market sentiment toggles back to the bull case.

Obviously, if this is wrong, the next leg down would likely be panicky and painful once investors realize it wasn’t.

However, if Friday was indeed the local bottom, my guess is that we rally back to or near the previous market highs. And it would be in the run up to those previous highs where we start looking for divergences to gauge the strength of the bounce. At least, this is the road map I am running with unless/until thing change.

For divergences, you’d want to look primarily to market internals. Advance-decline lines, new highs vs new lows, momentum indicators, these are the kinds of things you want to track. Vol needs to work it’s way lower too.

If you want to add risk here and are in a position to do so, I would recommend, as a general guideline, the sectors and names that held up best in the correction, not the ones that sold off most. It’s counter-intuitive for many of us, but strength tends to beget strength—even if constitutionally some of us are hard wired to shop for ‘laggards and bargains’.

Whatever you do, make sure you get your sizing and your stops right to manage that risk. Good luck.

Here’s an interview I did a couple weeks back with Anthony Crudele. Covered a lot of bases. Comments/feedback encouraged. Hope you like it.

http://www.futuresradioshow.com/podcast/180/

I wanted to follow up briefly on the bitcoin post from December. 

To me it still looks like a bearish pattern has to finish playing out.  Just going by the pattern–and bitcoin has been textbook both on the way up and on the way down–it looks like there’s at least one good down-leg left.

The reason bitcoin has adhered so well to textbook stock patterns is because there are no fundamentals and the emotions run very high. Basically it gives you an exceptionally clean read on sentiment.

If you’re short, though, remember to keep your size in check because in this last bounce alone it has been oscillating between 10 and 14k. Makes it really hard to hang onto if you’re carrying any size.

Here’s the chart:

Good luck.

 

 

[signinlocker id=675]The two themes that have been lurking in the shadows in support of the euro are now strutting their colors. The first, is that the US is closer to the end of its hiking cycle than the beginning, while the ECB is just starting its normalization. The second is that in this phase of the global risk cycle when US valuations look full to many, investors tend to migrate out the spectrum from core to peripheral investments. This too has tended to favor a weaker dollar.

Last week the euro had a big break out. So did the yield on the 10-year bund. It’s not a coincidence. And just because we all see it doesn’t mean the odds will be in your favor if you fade it. I could be wrong, but this has all the hallmarks of a move that is fresh and could have legs. Probably not wise to try and fade–no matter how heavy the positioning–until you see price and correlation signs that the above narrative is weakening. In fact, the break is fresh enough, and vol levels are low enough (despite last week’s pop), that outright calls or call spreads probably still make sense. (NB: the low tick in euro vol in 2014 was just before the big euro move lower.)

Here are the charts:

But, on the other hand….spec euro positioning in futures is the most long its been in the past 10 years

Manage your risk. Good luck.[/signinlocker]