Thursday 29 August 2013

Macro Risks Loom in September

Volatility has returned to markets this week and it seems set to escalate in September. Aside from events in Syria and behavioral factors such as September being the worst month for US stocks, there are a variety of macro developments that could heighten market instability.

Fed Tapering

The most dominant issue over the summer has been speculation surrounding the Federal Reserve’s tapering of its monthly $85 billion asset purchases. The consensus among economists is for tapering to begin in September after the Fed concludes its meeting on the 18th, but that is not yet a certainty. Between now and then US economic data will be scrutinized, and possibly overreacted to by markets, as analysts try to gauge the mindset of Fed officials. Better-than-expected data is likely to boost expectations of Fed tapering in September, while weak data could influence the central bank to refrain from a reduction.

Debt Ceiling

The return of Congress will also bring drama as the issue of the $16.69 trillion US debt ceiling must be addressed. The US Treasury warned on Monday that it will reach its borrowing limit in mid-October, earlier than many analysts had expected. But for the limit to be raised, Republicans want significant new spending cuts and constrictions on Obamacare. President Obama said he will not negotiate on the debt limit, while House speaker John Boehner stoked the flames this week by saying he is ready for “a whale of a fight”.

It was initially hoped that agreement could be achieved without the type of last-minute wrangling in August 2011 that resulted in the downgrade of US debt and stock market sell-offs. The US budget deficit has decreased significantly, with the Congressional Budget Office forecasting $642 billion for 2013, which will likely equate to 4% of GDP, down from 2009 when the deficit was $1.4 trillion or 10.1%. But the recent rhetoric implies that despite budgetary and economic improvements the upcoming negotiations could be just as fractious as two years ago.

Eurozone Politics

Europe is also set for political anxiety. German elections take place on September 22nd and the outcome is significant given that current chancellor Angela Merkel is effectively the eurozone leader. The upcoming elections resulted in a quiet summer for the eurozone, but the calm is not indicative of looming threats.

Strong German performance saw the eurozone economy grow in Q2 but this followed six quarters of contraction. There is still no lasting solution to the region’s problems. Little has been done regarding bank reform while Greece, Cyprus, and Portugal will need additional financial aid later this year. Moreover, Italian bond yields have jumped recently as an imminent vote on whether to expel former prime minister Silvio Berlusconi from parliament may threaten the stability of the coalition government.

Angela Merkel’s approval ratings in Germany are high and she will likely be re-elected to lead a coalition, but celebrations will be muted by thoughts of the eurozone periphery.

Japan: Pillars of Abenomics

The Japanese government has been meeting with economists and business leaders this week to gauge opinion on whether a series of planned sales tax hikes should be implemented. Last year it was agreed that sales tax would rise to 8% from 5% next April and then to 10% in October 2015. The tax hike is necessary to ease the government debt burden, helping to pay for the aging population’s welfare costs. But now the government is trying to ascertain if the economy is strong enough to handle the tax increases. Economic data will be watched carefully before prime minister Shinzo Abe makes the final decision, expected before October 7th.

Implementing the tax hikes would be a sign that Japan is serious about enacting structural reforms, in effect the “third pillar of Abenomics”, following on from the previous two measures of renewed fiscal stimulus and aggressive monetary easing. If Abe reneges on the tax hikes he risks casting doubt on whether his government is committed to reducing public debt, which is projected to reach 230% of GDP by 2014. Japan needs to address its finances to avoid potential ratings downgrades; an outcome that could result in a sharp Japanese bond sell-off. Given that Japan’s financial institutions hold significant amounts of government debt, a spike in bond yields will result in severe losses for the banking sector.

VIX Volatility

Earlier in August the VIX, a gauge of the market’s expectation of future volatility based on the premium for S&P 500 options, was trading near six-year lows. However, the VIX has historically been a very imperfect measure of future market volatility. Still, the financial media regularly referenced how the low VIX or “fear gauge” reading implied that investors were anticipating low volatility over the next 30 days. But what most outlets didn’t report was a significant rise in the volume of VIX calls; options that are profitable if the VIX index rises. So while the VIX was at relatively low levels, the buying of options to protect against a rise in the VIX was rising sharply, and ignored by much of the media.

In effect, many investors were positioning for future volatility, even if this was not reflected in the VIX price. This is an example of the disconnect that can exist between markets and the dangers of reading too much into a single measurement. It brings to mind the Malayan proverb: Don't think there are no crocodiles because the water is calm.

Sunday 25 August 2013

MacroWatcher: Weekly Analysis

August is one of the most popular vacation periods, but few expected the Nasdaq to take a three hour holiday on Thursday. The shutdown was blamed on a technical glitch, and the blame lies squarely with Nasdaq software unlike previous outages in 1987 and 1994 when the group accused squirrels of tampering with power lines. Regardless, the incident serves as a reminder that no matter how much technology changes, market challenges remain the same.

Market Recap: August 19th-23rd

The most notable moves on the week were in emerging market currencies as the anticipated tapering of the Federal Reserve’s QE3 monthly bond purchases saw investors buy back US dollars. The Brazilian real, Indian rupee and Indonesian rupiah all fell to notable lows on expectations of an end to cheap liquidity. While minutes from the Fed’s July meeting contained few surprises, they reinforced perceptions that members are “comfortable” with Chairman Ben Bernanke’s plan to reduce the $85bn-a-month bond buying later this year if the US economy continues to improve. Some officials called for tapering to begin in September while others want to wait for more data.

Bonds fluctuated through the week, with the US Treasury 10-year yield touching a two-year high above 2.93% Thursday before reversing lower on Friday. Stock markets were choppy, lacking direction on an absence of significant US economic releases. European data was generally upbeat, particularly UK and German GDP, while an unexpected expansion in Chinese manufacturing provided some optimism of stability in the world’s second largest economy.

Fed Tapering

The Federal Reserve Bank of New York conducted a survey of 21 primary dealers last week and found that most believe the Fed will start its tapering in September, with reduced bond-buying of $15bn per month. The dealers also expect the Fed to keep interest rates on hold until 2015. Despite all the nervousness surrounding the tapering, a $15bn reduction would still make the Fed’s monthly purchases larger than when QE3 was first announced in September last year [the program was unveiled at $40bn per month and increased to $85bn in December].

Moreover, an analysis from two economists at the San Francisco Fed asserted that the effects of large-scale bond-buying “depend greatly on the Fed’s guidance that short-term interest rates would remain low for an extended period” and that “interest rate forward guidance probably has greater effects than signals about the amount of assets purchased.” Yet even if the economic impact of tapering is negligible, don’t expect markets to react with much efficiency.

Emerging Markets Drama

The BRIC [Brazil, Russia, India, China] emerging markets are getting caught in a perfect storm of negative sentiment. Expectations of higher US rates, a reduction in cheap financing, falling commodity prices and country specific issues are combining to lead some commentators to warn of an “emerging market crisis”. Such statements seem excessive. Unlike in the late 1990s, exchange rates are more flexible today and reserve holdings are far greater. During the 1997-98 currency crises global reserves were $76bn; today Bloomberg data shows BRIC currency reserves alone are $4.4tr.

Markets settled down late last week as Brazil launched a $60bn currency intervention program and India pledged to cut its current account deficit [imports > exports] and will consider a sovereign bond issuance. Recent moves imply a correction rather than impending crisis, but that shouldn’t mask some of the problems facing the BRICs. Most notably, Brazil and Russia are overly reliant on commodity markets, Indian inflation is escalating and China’s banks are overleveraged. Hopefully recents events may spur the BRICs to reform their long-held protectionist policies and large state sectors.

Eurozone Recovery

Positive sentiment in Europe was aided by eurozone purchasing manager indices that showed expansion in manufacturing and services. Encouragingly, the periphery economies showed improvement. Yet periphery bond yields failed to continue their downward trend, generally finishing higher on the week likely due to thin markets and decreased risk appetite spurred by the emerging markets sell-off.

German bund yields maintained their ascent, touching a 17-month high near 1.94%, a knock-on effect of the Fed’s expected tapering and an improving eurozone outlook. While it has been a quiet summer on the political front, the governments of the periphery nations remain under intense pressure and there is still much work to do in reducing debt burdens and increasing funding for Greece, Portugal and Cyprus.

China Stabilizing

Chinese PMI manufacturing data suprised to the upside, rising to a four-month high. This followed on from upbeat July data, easing some “hard landing” slowdown concerns. The PMI sub-indices also showed increased domestic demand, a key goal of the Chinese government as evidenced by last month’s “fine-tuning” policies of tax cuts for small companies and new funding for transport infrastructure.

Yet rising house prices are a burgeoning problem. For July, prices rose 6.7% year-on-year, up from 6.1% in June according to data obtained by the Wall Street Journal. Higher prices have been aided by a sharp increase in lending in the first half of 2013 and a relaxation of strict controls on home purchases in some cities, particularly Wenzhou which has suffered from China’s exports slowdown.

“Real World” Analogy 

Trading analogies are pretty common, but I didn’t expect to be thinking of one while attending a mixed martial arts event in Boston last weekend. Halfway through one of the bouts a Brazilian fighter, who was on his back, grabbed the leg of his standing American opponent. Using his weight to hook himself around the American’s leg, the Brazilian attempted a painful-looking knee-lock hold.

While instinct would be to resist the move and attempt to remain on one’s feet, the American did something different. Even though it was a situation the American hadn’t wanted, or expected, to be in, he didn’t resist the submission attempt. Instead, he relaxed his body, allowing himself to be dragged to the ground, going along with his opponent’s momentum. By keeping his leg muscles relaxed, and aided by copious amounts of sweat, the American used the momentum to roll out of the Brazilian’s grip and managed to reverse the move into a hold of his own.

The American fighter typified the discipline of a good macro trader. He didn’t forecast the Brazilian’s knee-lock attempt, but was nimble enough to adapt and didn’t try to go against the strong momentum. Ultimately he took advantage of the Brazilian’s attack. Similarly, a trader should know when not to fight against markets, even if he doesn’t agree with the fundamentals behind a strong move. Markets will go where they want to go, sometimes irrespective of logic. Unforeseen situations will arise and a macro trader must be able to recognize when his views are out of sync while simultaneously adapting to market conditions to profit from strong momentum. But if all else fails, just like the American fighter was assisted by sweat in his escape, traders will do well to stay in liquid markets.