Has Britain finally cornered itself?

After a week of travelling I came back to see that Moody’s has finally pulled the trigger on the country where I currently reside. This is such a non-story that it feels stupid to even mention but I suppose it will be making headlines for a little while longer. And this is a very good thing.

Before I start, however, I would like to thank the British government for conducting a massive social experiment, which will be used in decades to come as a proof that a tight fiscal/loose monetary policy mix does not work in an environment of a liquidity trap. We sort of knew that from the theory anyway but now we have plenty of data to base that on.

Secondly, I will be referring to my favourite IS/LM model. If you want to read more about it, a very good tutorial can be found here.

So… Let’s assume for a second that the Osborne/Cameron duo is capable of taking a stop-loss on their policy. I know it is a heroic assumption when discussing any politicians but why not…

When looking at record low cost of borrowing, a severely depressed economy and a central bank that does not even pretend anymore to be independent or targeting inflation the recipe should probably be to spend more. In the standard IS/LM model an increase in government spending over taxes (i.e. boosting the deficit) pushes the IS curve to the right. Thus, both the output level and the level of interest rate will increase. Consequently, the exchange rate should appreciate as capital flows to the country in question. This in turn leads to widening of the trade deficit. Ideally, the government would want the Bank of England to step in and limit the increase in interest rates (a.k.a. QE) so that the currency does not appreciate. And, as I mentioned before, the BoE is more than willing to do so.

Let’s now have a look at the situation from another angle. I have been going through he Bank of England’s quarterly reports in reference to trade (which can be found here) and I have found two interesting charts. The first one looks at episodes of rapid moves in the British pound and the impact on the trade balance:


The relationship is pretty strong, which is why many people are calling for debasing of the sterling, particularly after G20 gave a pale-green light to such activities for countries, which are effectively in a liquidity trap.

The second chart shows why debasing of the sterling makes an awful lot of sense. It shows two measures of the International Investment Position – the standard one (i.e. with FDIs at book value) and what I would call a “market” one (i.e. with FDIs at market value).


You can see that the UK is looking quite a bit better if you take into account the actual values of FDIs. I would suggest that the recent rally in global equity prices has at least kept the blue line in the positive territory. This essentially means that GBP devaluation not only boosts the terms of trade but also makes the UK richer. Not very many countries are in such a pleasant situation (think of many emerging economies with significant external debt).

Again, weakening of the sterling does seem to be a very appealing strategy for the authorities. There is, however, one important problem – GBP devaluation is unlikely to bring extra revenues to the government and could actually make the fiscal position a bit worse. Here’s why – devaluing one’s currency and narrowing of a current account deficit means that the country’s savings are increasing in relative terms to investments. Granted, this may well have to happen considering a huge stock of private debt but this is not desirable from the growth point of view. On top of that, the J-curve effect dictates that the initial impact of currency devaluation will be actually adverse.

What I am trying to say is that while GBP devaluation has a lot of positive sides, it will probably not work on its own because it will further depress domestic demand thus putting a strain of public finances.

Therefore, I do believe that Britain has finally cornered itself into a situation where there is overwhelming evidence that Mr Osborne should really start spending. He should also assume that Mr Carney will not let that spending lead to appreciation of Real Effective Exchange Rate (a bit more on that mechanism in one of my previous posts entitled “Be careful what you target or am I in the right church?“). That is to say that the Bank of England will keep nominal and real rates very low. In my opinion this is the only rational way of the situation that we’re currently in. Then again, I am assuming the impossible here, i.e. that the politicians know what the stop-loss is.

How to trade this? I don’t normally trade anything related to the UK (except GBP/PLN) but I would assume that any sell-offs in Gilts should be used as an opportunity to buy. As far as the sterling is concerned, the fact that exports outside of the eurozone are now bigger than to the eurozone, EUR/GBP is a cross that doesn’t make that much sense. I would very much prefer the cable, or better yet selling the sterling against EM currencies as this is where the adjustment in trade balances will have to come from.


Guessing the volatility

When you look at celebrity analysts and investors of late, you will have to conclude that we’re dealing with confirmation bias of horrendous proportions.
It is very easy to be permanently bullish, particularly in the equity business and the bears have it tough because in order to be remembered they need to be good at timing. Or at least they have to be able to survive with their call in the media for an extended period. A good example of the former is Mr Paulson and his one-trick subprime pony. As far as the latter is concerned you don’t need to look past Nouriel Roubini who called a completely different crisis (remember the US current account and twin deficits?) a long time before it never-happened and yet has somehow been enshrined as a guru. Sure, there are people who called it right and for right reasons but they’re less present in the media because they are honest enough to admit that sometimes your views are actually going to be a bit more boring than “the end is nigh, sell everything”.
I must say that forecasting bearish scenarios is remarkably tempting. Not only can you stand out in a crowd but the potential payout is humongous. I think many people at some level admire Nassim Taleb despite the fact that he’s ability to make money trading has been grossly exaggerated, to be polite.
So every now and then we hear people who call “wolf” and hope that they 1) appear prudent and 2) cheaply expose themselves to a significant tail risk (which in this case should be called a “tail chance”).
Why am I writing about this? Well, because I’m sick and tired of people pointing out how ridiculously low the VIX is. Yes, the VIX is very low and stable but it has nothing to do with the market perception of risk. Believe me, everyone is aware that this thing can blow and crucify markets. The VIX is low because it gives you carry.
If you’ve ever been trained in the theory of options you may recall the gamma-theta trade-off. This basically means that you own the right to capitalise on movement in the underlying variable and you pay for this right with theta, i.e. time decay. Thus, selling options is simply yet another way of getting carry. I know many of you will find it pretty basic but I still believe it needs stressing.
USTs are probably too expensive, all medium-term risks considered. But so what? Shorting them with cost you a fortune. Same with VIX. Yes, it severely understates the risks but the cost of holding it is not negligible. In fact, it is even higher than just paying for implied volatility. I would argue it’s double that because opportunity cost of buying the VIX is… selling it!
The same applies to FX options and any other instrument. We are in an environment where you have to have pretty damn good reasons not to be in carry-positive trades. At the end of the day fund managers charge, say, 1% and every day that passes by without them clocking the carry brings them closer to dreaded outflows. Unless of course they time their shorts well but for that you really need a little more than “this stuff is at all time lows”.
My (relatively short) experience in the market suggests that on aggregate buying options doesn’t pay off. Otherwise bank option desks would’ve ceased to exist by now. This is very similar to buying car insurance – as a society we get screwed (see insurance companies’ profits) but there’s always a guy who had his car stolen and cashed out.
Don’t get me wrong, I’m not calling for being engaged in mindless carry trades. In fact I’ve been spending most of the time lately trying to figure out smart shorts (hence my recent focus on linkers). Buying VIX is definitely not one of them even if it eventually covers one lucky analyst in glory.
Oh yes, didn’t I say I envy all those guys mentioned at the beginning…?

PS. I am in some obscure place on the continent so can’t really do much charting. Will improve that from next week onwards.

Be careful what you target or am I in the right church?

So the G20 damp squib is behind us and while many commentators will say that it has given a “pale green” light for the likes of the BoJ to keep devaluing their currencies, I think the whole discussion is somewhat flawed.
Here’s why.
Devaluing one’s way out of trouble seems to be a very convenient solution to most crises. It’s as if producing and selling stuff to other nations was the ultimate reason to live. But devaluation can have many different forms, which some people find confusing.
To explain that let’s actually look at something that hasn’t been discussed for a while, i.e. revaluations and real convergence. It is quite common sense that small, open economies tend to converge to income levels of their richer trade partners. The mechanism usually works through significant inflow of know-how followed by a boost in productivity, particularly in the tradable goods segment. Subsequently, the Balassa-Samuelson effect kicks in and we have a generalised increase in the price level. Usually this is accompanied by appreciation of the currency. Both those factors – higher inflation and a stronger currency – lead to appreciation of the Real Effective Exchange Rate. We have seen such a mechanism in a lot of emerging economies, e.g. in Central and Eastern Europe after the EU entry in 2004.
Note that the two factors at play (nominal exchange rate and inflation) are interchangeable and work together to balance the system. In other words, if for some reason inflation in the country in question is artificially depressed, the nominal exchange rate will move more.
Now let’s go back to devaluations. There are two broad reasons why a country would like to weaken its currency:
1) to boost exports,
2) to increase the money supply.
This distinction matters because without that how could we explain behaviour of such countries as Japan, Switzerland, Czech Republic or Israel? These economies have traditionally excelled at exports due to superior growth rates in productivity in the tradable goods sector. Yet, those countries have engaged in significant operations in the foreign exchange market in recent years (or threatened to do so). Note, however, that in each and every case it was preceded by bringing interest rates close to zero. Therefore, we should conclude that FX operations were just an extension of monetary policy after traditional ways (i.e. interest rate cuts) have been depleted. As a result, saying that these central bank have engaged in currency wars is pretty daft, in my opinion.
Now, there is a group of countries, which probably would like to see their currencies weaken to improve the competitiveness. However, if this is an objective then we must discuss the real exchange rate. And the standard economic theory dictates that it can only be done via increase in government savings.
Let’s take the most recent example of a country, which seems to be trying to pursue such a goal. The Central Bank of the Republic of Turkey has been stressing the importance of the REER lately. They even outright threatened that they would intervene in the FX market should the 120 level be broken. There is a fundamental flaw in this logic, though.
To start with, Turkey is a country with a very high current account deficit, which basically means that its domestic savings are relatively low. By extension, consumption is fairly high thus keeping inflation rather elevated. In such an environment, selling the lira (TRY) makes very little sense as it will most likely boost inflation even further, offsetting the paper (aka nominal) gains. This brings us to a paradox that higher inflation leads to higher REER thus necessitating monetary policy easing. In my home country of Poland we have a saying that “they can hear a bell toll, they just don’t know at which church”. Similarly here – the CBRT has correctly identified the problem of having to boost competitiveness but they have chosen a dangerous approach.
Instead, the government should increase its savings even more than it already has to bring total domestic savings higher, thus increasing competitiveness. This way, it can avoid persistently high inflation and current account deficits.
This is not to say that such a recipe is great for everyone. It would’ve been good for, say, Spain before the crisis but now the focus should be more on the nominal side of the equation. Such examples could be multiplied.
But what I’m trying to say is beware of people talking about currency wars any time they see a central bank intervening in the FX market because you will miss the important distinction between the nominal and the real sides of things.
And policymakers, be careful what you target because you can end up at a wrong church.

PS. I wrote this post on “yet another on time Ryanair flight” so there are no links or anything. I will try to update those tomorrow with a few interesting articles on the subject.

Inflation volatility or which bond markets to avoid

As promised, a quick word about inflation linkers in emerging markets.

While in most cases, the path of inflation in the coming 3-6 months is pretty much given; many economies are a completely different level of their respective inflation rates. Importantly, volatility of inflation rates also differs wildly. Take the following chart as and example. It shows the relationship between average inflation since the beginning of 2005 (so around 100 observations) and the standard deviation of CPI in the same time-frame.


As you can see, there is a group of emerging economies which have achieved a relatively low level of inflation (the circled part of the chart) but they have had mixed success in terms of staying close to the average. Arguably, Israel, Malaysia and Poland are the best in this field.

As you move to countries with higher average inflation rates, standard deviation tends to rise. However, note that we are talking here in percentage points, as opposed to normalised values. In other words, we say that Poland is “better” than Turkey just because it has had a lower average and a lower standard deviation. However, if you normalised standard deviation by dividing it by the average you will see that Turkey has been much closer to its average than Poland. We will use that in a minute.

The chart below combines the approach of the volatility in inflation rates (i.e. standard deviation divided by the average) with the distance of the latest CPI print from respective central banks’ targets (note that for some countries I had to make assumptions as their central banks are not inflation targeters).


In this chart we see, for example, that South Africa is 1.2pp above the 4.5% target (mid-point of the 3-6% SARB range) and  that standard deviation of CPI prints since 2005 has been around 40% of the average (which was 6.1%).

How to trade this? Someone could ask what the point of looking at such a chart is. Well, as worries about inflation resurface along with some acceleration in growth rates, investors will be willing to bet that some emerging economies could have their inflation rates moving up fast. At the same time, the central banks would have to respond. Therefore, I think that what we’re looking for is countries, which

  1. currently have inflation below (or close to) the central bank’s target
  2. have experienced significant volatility of inflation prints in the past.

In those economies you should consider looking at inflation linkers or shorting nominal bonds.

When using such a comparison, Chile stands out as a good candidate with low current inflation and high inflation volatility. Similarly, Israel has a history of quite rapid moves in inflation rates and we also can be reasonably sure that the output gap there is insignificant. Finally, Poland is looking at rapid declines in inflation rates at the moment, mathematically increasing odds of a rebound in the second half of the year and indeed in 2014.

There are also many caveats to this approach but I have found it to be a useful starting point when trying to play a global inflation / disinflation theme.

Misinterpreting the UST sell-off

In my previous post I briefly mentioned the cliche, which is the sell-off in US Treasuries and how many people treat it as the biggest impending risk to their portfolios.

This subject has been recently explored by the IIF in its regular update on capital flows to emerging economies (pdf here). In Box 2 on page 7 you can find an analysis of what happened back in 1994 and let’s just say it isn’t a pleasant read. Many conclude that considering that foreign positioning in EM bond markets is considerably higher, any move in the US curve will be a calamity. Historical evidence makes it difficult to argue with this view but I think some people have not really thought through the whole mechanism.

Consider the following example. In recent days I had a “priviledge” of interviewing a few analysts. When asked about the general market direction they all replied that they were bullish now and bearish later. This is by the way the standard response of a sell-side credit analyst who wants to get his clients to buy but also to sound prudent and risk averse. I was tempted to cut those conversations short very quickly but eventually decided to explore motives of such a novel recommendation. So I asked what would be the trigger for the said bearishness “later”. The answer was the same – a sell-off in USTs and ensuing outflows from emerging markets. I managed to resist quoting Homer Simpson (“Doh!”) and started digging deeper. Note that people I spoke to had an important piece of evidence at their hands, i.e. the recent outflows from hard currency EM debt as reported by the EPFR.

When asked about what sort of levels in USTs they had in mind, the replies varied between 2.30 and 2.50 for the 10yr. Now, let’s stop and think a little about what this really means. The chart below shows the current UST curve along with the 1yr forward one.


As you can see, the market is pricing in a shift up of the UST curve by around 27bp in the 10y. In other words, this means that if you sell the 10y bond here and the yield doesn’t go up by at least 28bp in the next twelve months, you effectively lose money. The forward curve is the quickest and the simplest approximation of the carry of the position. You don’t just have to guess the direction but you also have to beat the forwards.

Disclaimer for geeks: I know that simply subtracting 10y yield from the 1y forward is not exactly the same thing as a carry but it will have to do for the purpose of this post.

If you think that 10y US yields will sell-off by 30bp or so then guess what – the market is already pricing that in and nothing spectacular has happened (yet!). Oh and also, in 2011 the difference between the 1y forward 10y yield and spot 10y yield was at times as high as 50bp.

In my opinion, if 10y yields in the US increase by 30-50bp in the next twelve months or so it will be one of the best things that can happen to emerging markets debt. I strongly believe that such a scenario would lead to further tightening of EM-DM spreads because:

  • it will mean that the world economy has actually picked up but not sufficiently to bring about significant inflationary pressures
  • the US economy will have accelerated but not sufficiently to remove the acommodation or end QE
  • problems in the eurozone would remain contained (if we get a return to the acute phase of the EMU issues, don’t count on the spike in US yields!).

The market is perfectly capable of dealing with a slow increase in US yields. Also, everyone is very well aware of this risk so talking about it is a moot point.

How to trade this? Contrary to what may seem from this post, I am actually quite concerned about a sell-off in USTs, mainly because of the convexity effect related to mortgage papers. It is totally conceivable that one day a huge flow goes through the market and the said 28bp happens in a few hours rather than a year, like the market implies. Therefore, I still think that investors need to be careful about duration in emerging markets, particularly the ones where you see some signs of activity picking up. I would very much rather own short duration debt of high yielding countries (think 3y Ghana) than long duration debt of low yielding countries (think Poland). That being said, given the technical position of many funds, my base case scenario is that a US-induced sell-off in EM debt will be a good opportunity to go long.

Finally, I believe that investors should selectively look for inflation linkers in emerging markets but this is a story for the next post… Meanwhile, check out this recent story from Bloomberg: Bond Traders Whip CPI Angst as India to Hungary Cut Rates.

Those boring oil prices

Econbrowser ran a post entitled “Dude, where’s my cheap gas?“. It has a few interesting charts indicating that it will take some time before the shale gas/oil revolution impacts prices at the pumps. I think there could be a bit more into that story and quite soon, too.

The chart below shows the spread between Brent and WTI oil prices.


This has stayed elevated for quite some time and for various reasons and it seems to me that the market is no longer paying attention to why this is actually happening. Many have been citing he Middle East turmoil as one of the reasons. While this is certainly a factor, why would we see that only in Brent prices? Firstly, Brent and the Middle East blend are not exactly substitutes. Secondly, we are not seeing that risk in any other market (have a look at the Israeli shekel or forward points in USD/SAR in Saudi Arabia). Finally, there is tons of new supply coming from Iraq and some African nations, replacing the lost output from Iran. In short, I don’t find the whole Middle East hypothesis plausible.

So if it’s not supply disruptions/changes then maybe it’s demand? If you go through the Chinese data (and seasonally adjust them), you will find that the dynamics is pretty decent. Moreover, for years everyone has been talking about Chinese urbanisation, which inevitably brings more demand for fuels (think of it as the copper-oil spread). We can’t be certain how far advanced in the process we are but things are progressing in the direction of less investments and more consumption.

Meanwhile, the world is fixated on declines in inflation, which are about to happen or are already happening. Have a look at the momentum in US core inflation (below, annualised rates).


There is almost nothing worrying about this picture unless of course you are a firm believer in the “what goes down, must go up” theory. In all likelihood the US inflation picture will not change in the coming months, particularly in the core. But what about the rest of the world?

Let’s not forget that vast majority of economies have experienced a significant drop in potential growth rates over the last couple of years. This means that any increase in growth could lead to inflation sooner than we think. Sure, many will say that it’s not just the growth rate that matters and we need to close the output gap first but the worry is that the world where productivity is on the decline any growth acceleration could be inflationary. Add to that a sustained supply shock and you have a recipe for a pretty decent repricing of interest rate expectations.

Now, I don’t mean to sound alarmist about inflation and I would not call myself a vivid supporter of people who call for repetition of the Weimar Republic (yes, Ambrose Evans-Pritchard, I’m talking about you…). But the prevailing way of thinking is that many countries will not need to hike interest rates for longer than you would normally expect simply because the additional carry would strengthen their currencies. This is particularly the case in emerging markets. The same emerging markets, for which the growth consensus remains pretty bullish…

Where does this leave us? Improving leading indicators, lower potential GDP growth rates, reduced productivity growth and possibly quite persistent upward trend in oil prices. For me these are crucial reasons to worry about bond markets in many (emerging) economies. In my mind they are certainly more valid than the US Treasury sell-off cliche, which dominates media and analysis.

How to trade this? Find a country with a significant trade deficit and improving growth outlook (e.g. Turkey) and be defensive there. Also, look for activist central banks (e.g. Israel) and be aware that those guys can and will move very quickly. Additionally, if you need to own bonds, go for short duration in higher yielders (such as Russia or Brazil). Finally, think if it doesn’t make sense to switch out of suppliers or industrial materials into energy producers – this could be a very long term trend, unless of course someone comes up with a car that runs on water. And by the way, I would like to wish that last bit to all of you (unless you’re a Russian oligarch).

Very efficient markets

As I was browsing through my bookmarks, I found this very old article from The Economist: Dismal science, dismal sentence. This, surreal at first glance, court case still comes back to me when anyone mentions the Efficient Markets Hypothesis.

In recent days two blogs that I like to read posted about the subject (The Money Illusion and Noahpinion). Both posts are well worth a read as they provide a few nice examples, which at face value are actually quite compelling.

But the problem with this theory is not so much its assumptions or implications but the way it has been tested. The most common tests include plotting performance of a large sample of portfolio managers against the performance of the stock index and concluding that – after accounting for management fees – the community does not beat the index. This obviously is very convenient for the guys at Vanguard etc but at the same time it is very illogical.

Let’s take an example of a market where we have only ten investors. All of them will be trading between themselves and if you think of it – there will be equal amount of longs and shorts in the market. Therefore, it is not difficult to conclude that these investors will on average have the same return as the market itself. When I think of it like that, it reminds me (in some aspects) of the Heisenberg’s Uncertainty principle. In physics, by measuring properties you change them. In finance, the measurement and the property in question are exactly the same thing. To cut the long story short, people trying to prove the Efficient Markets Hypothesis invariably arrive at the conclusion that the market cannot beat itself. Big deal!

This is not to say that the market is inefficient. I find it to be efficient most of the time (even if it stops me out). That said there are a lot of people who really take the EMH to the extreme, just like the judge in the article from the Economist. They conclude that there is no point giving anyone money to manage as the cost will definitely make it suboptimal to buying an index.

I don’t directly manage money but I know a lot of people who do. And the most impressive individuals, who happen to have pretty high Sharpe ratios and limited drawdowns  all have similar characteristics. Firstly, they don’t start the day with “it’s going to be a risk-on day, let’s buy 200m AUD”. This Coffey-esque approach to investing is both ridiculous and pathetic. Instead, they usually have a whole bunch of uncorrelated trades and quite rigorous risk management. Directional, Hail-Mary trades are very seldom and fully controlled. These guys tend to beat the market.

Actually, scratch that last sentence. They don’t beat the market. They generate returns which are not depending on the market direction. Therefore, comparing them to returns achieved by the broad market is pointless.

So while the EMH is quite compelling and serves as a good baseline for analysis, testing it and drawing conclusions about performance of the aggregate industry is very much self-contradicting.