The world has stepped on a monetary brake. And I don’t think it will end well. Continue reading
I have previously been saying that it would appear that the global cycle is turning (growth wise). Or at least so the consensus has it. On the one hand, this should feel exciting. After all, we will be finally able to do the opposite of whatever it was that we have been doing during the cycle that is allegedly ending. On the other hand, however, it is obviously terribly difficult to catch the right moment to do so (some will tell you this is when you should use options but unlike some fat-tail loving people I actually find options pretty expensive, for the most part. But I digress).
Let me give you two examples.
Firstly, there are strong indications that the fixed income is in the bear market. And modus operandi in any bear market is to sell into any rallies. So, we should simply be short any bonds and/or paid in rates. And I am generally on board with this strategy, except it is so remarkably costly. Curves are exceptionally steep and going short bonds means that we have to be prepared for oftentimes monstrous roll-down working against us. You think US 10y ends the year at 3.40-3.50%? Well, I have bad news for you – this means you should actually buy them! This was completely different when yields were falling. Sure, there always were more or less significant pullbacks but the carry was always with you. I had a look at the attribution of 2013 P&L from J.P. Morgan’s GBI-EM Global Diversified index today. Turns out that if you put your money into EM debt last year and kept it, you would’ve lost 6.33% due to the change in price (i.e. yield going up) but you would’ve made 6.31% (sic!) in coupons. Almost flat in the annus horribilis for EM debt! On top of that of course you would’ve lost 9% on the FX but that’s beside the point.
Making money in the fixed income bear market is remarkably difficult: even if you get the broad macro story spot on, you really need to catch small moves and close the position quickly. You don’t want to chase the market after it’s sold off but you won’t fade the move either as it goes against the big trend.
The second example I wanted to give is the USD/EM story. Let’s assume for a second that the USD will appreciate from here on in. I don’t particularly subscribe to that view but clearly the first days of 2014 have challenged me quite a bit. The broad USD strengthening is usually consistent with poor performance of EMFX. And boy, there are plenty of reasons to be short some emerging currencies! For example, those of you who follow me on twitter (@barnejek) may have noticed I haven’t been particularly appreciative of the behaviour of the Central Bank of the Republic of Turkey. To quote one of my friends, from the macroeconomic point of view Turkey does appear to be an “unmitigated disaster”. The recent move in USD/TRY is not only consistent with the global USD strengthening but also completely in line with the fundamentals (and no, politics is just a side show). Unless the central bank starts hiking interest rates, I don’t see that trend changing anytime soon.
So basically even with short periods of global risk-on, fading the move in USD/TRY is out of the question (for me). But at the same time, we cannot neglect that the move in the lira over the last few weeks has been eye-watering and putting a new position on here is brave especially that it costs not insignificant carry. It’s ok if you’ve had it on because there’s a significant P&L cushion behind you but then I am of the opinion that it really doesn’t matter what a particular position has done – I think one needs to constantly reassess all positions and if you have something that you wouldn’t necessarily put on at any given point in time if you hadn’t had it, just close it! *2 minute interlude to re-read that last sentence to see what I actually had in mind*
But I didn’t mean to make this post about Turkey and how screwed up the balance of payments situation and short term external… (see? I wanted to do it again :-).
All in all, it is very unfortunate that genuine intellectual excitement of something possibly changing quite dramatically is coupled by immense frustration of not being able to put all the trades one would feel comfortable with. I can’t fade the moves, but won’t chase them either. Or was it vice versa…?
The phrase “this time is different” doesn’t usually spark very positive reactions. But I don’t care because there’s one thing about the market these days that makes me think that something is strange when compared to previous bond market sell-offs.
If you follow me on twitter you will have noticed that lately I have been talking a lot about asset swaps (ASW). This is a pretty technical concept but I will try to be as straightforward as possible.
If you are still reading this then you probably know that in the fixed income market we have two broad groups of instruments – cash bonds and swaps. In theory, their yields (prices) should be moving more or less in a parallel fashion because they are interest rates instruments. In other words, you can bet on interest rates going lower by either buying bonds or receiving interest rate swaps (IRS). The difference between those two instruments is called the asset swap and it tends to move for the following main reasons:
- Buying bonds requires balance sheet and IRS is an off-balance sheet instrument.
- Buying government bonds creates exposure against the issuer (sovereign) while IRS is a contract between two counterparties (e.g. banks).
- Supply of bonds is limited while IRS can be created out of thin air.
- Government bonds are a stream of cash flows (coupons) while IRS is an exchange of fixed against floating rate (e.g. LIBOR).
I have learnt to pay a close attention to moves in ASWs, just like I very closely monitor moves in cross currency basis because they can reveal pretty significant market developments. An ASW can tighten, i.e. bond outperforms the swap (e.g. bond yields drops by 10bp and IRS for the same maturity by 7bp) or widen. In core markets, tightening of ASW has been historically connected with higher aversion to risk. When problems arise, investors would very much rather own, say, US Treasuries than have a contract with a bank to exchange some cash flows. Chart below shows the 10y ASW (the higher the number, the more expensive the bond vs swap) in the US against the EMBIG spread. As you can see, the correlation is pretty significant.
Now, what happens in developed markets does not usually work the same way in emerging markets. Indeed, periods of risk aversion were generally associated with significant widening of ASW in emerging markets. The rationale is simple – let’s dump emerging bonds because the credit risk is going up. Having an interest exposure via a swap with JP Morgan becomes more valuable than buying government bonds of governments of Mexico, Hungary or Malaysia. Simple heuristic.
And this brings me to the “this time is different” proposition. As you may have noticed we are experiencing the end of days for government bond markets. Well, we’re not really but people like Bill Gross want to make you think like that. EPFR data is showing significant outflows from bond funds investing in emerging government bond markets. The last time we saw such big outflows was in September 2011. However, unlike in September 2011 when ASW totally exploded, in the recent weeks EM ASWs have actually tightened and considerably so. Just to give you an example – ASW in the 10y segment of the South African government bonds are at the tightest level they’ve ever been. South Africa – the country whose economy is in a downfall, whose currency has sold off dramatically and where the social tensions are at levels unseen in years. To be sure, the bonds have sold off too but nowhere near as much as IRS.
I can find a few explanations for that but the most important conclusion is that real money investors (so asset managers rather than hedge funds) have not been selling government bond markets to a large extent. They have sold some and shifted others to more defensive places, they probably hedged their currency exposures but they have not sold their bonds. Why? Perhaps because they don’t believe Bill Gross, thinking the scare will pass (this argument seems to be supported by Pawel Morski in one of his latest posts). Or perhaps because they know the market is not able to absorb the potential flow anyway.
At the same time, the hedge funds seem to be willing to exploit the recent change in the global mood and are pushing IRS higher. This then stops out model accounts (CTAs, aka the scum of the earth), which had been running humongous receiver positions in bellies of various curves assuming the Fed would stay put forever (or at least 3-5 years). Meanwhile, it seems like the tide has turned a bit and the convexity of the US curve is shifting. That’s why I was pointing out earlier today this tweet from Business Insider’s Matt Boesler:
5yrs haven’t traded this cheap on the 2s5s10s since October 2011 twitter.com/boes_/status/3…
— Matthew B (@boes_) June 7, 2013
All in all, I don’t want to make this post too technical but this is the first EM bond “crisis” since I have been in the industry when local bonds in emerging markets have so far been outperforming IRS and ASW have been tightening. And while I think I understand the reasons behind that this is not a sustainable situation, in my opinion. In fact, I strongly believe that something has to give – either the real money guys are in a denial or the hedge funds have jumped on the tapering bandwagon too early. Either way, the EM curves are pricing something that is almost impossible to come true, in my view.
I have given a friend a task lately to come up with a consistent theory explaining recent moves in markets. I said it could be a conspiracy theory, a preposterous theory or any-other-theory as long as it provides a consistent explanation of recent moves. His reply was “people are selling what they were very long of” but then he reflected and said that it wouldn’t be consistent with the equity rally.
While I do not aspire to give you a comprehensive explanation, I think I have one that at least I feel comfortable with. But let’s start with a snapshot of what’s going on:
- USTs are selling off.
- Inflation keeps surprising to the downside.
- USD is not really rallying (except against the yen).
- US equities are generally supported.
- Credit is wider but not spectacularly so.
- Implied vols are creeping higher.
- EM bonds are under tremendous pressure and currencies are weakening.
- Commodities had come off but have sort-of stabilised lately.
Now, it may well be the case that we’re simply experiencing a risk-off period, although I’m not sure equity and commodities markets would agree with that fully. Neither is the UST sell-off the first thing that springs to mind when discussing the dreaded risk-off.
A theory, which is a bit closer to my heart is what Paul Krugman put in his blog today but again the USD is not really rallying. Alternatively, stuff like the Mexican peso shouldn’t be under so much pressure in such a scenario, I reckon.
I see two main forces driving the market at the moment. The first one is the Bank of Japan. In my post Eddie Vedder and the Japanese carry from April 13 (USD/JPY approaching 100 ) I was being skeptical about the whole concept of yen being used to fund stuff elsewhere saying that the Japanese will probably find plenty of opportunities locally if they believe in Abenomics. However, I did also say that if anything they’d go for bonds in the US, which are looking considerably better than other global bonds on a currency-hedged basis. Similarly, if a Japanese investor wants to bet on the yen decline, then they should keep it simple and do USD/JPY rather than, say, AUD/JPY. And this is a very important point because whenever USDJPY jumps 1%, it pushes the USD index higher by almost 0.15%, thus creating the impression that the risk is off because the USD strengthens. Therefore, the previous correlation of “yen lower, risk higher” does not work like a charm anymore.
But then, if it’s just a localised intervention in USD/JPY, which has very little to do with the fundamentals in the US of A then perhaps it is safe to assume that some investors have been skewing their own USD index by buying a bit more USD against the JPY and selling the greenback against the EUR? I will explain in a second why.
A global bond investor, which has a WGBI index as a benchmark (that’s representative of around 3-4trn USD in AUM) has 23 countries to choose from. These include the bond behemoths like US, Germany, Japan or Italy but also smaller markets, mostly in Europe. And the way this investor looks at the world at the moment is as follows.
- She just heard from Ben Bernanke that the Fed might start limiting bond purchases. Granted, this will still be an expansion of the balance sheet but at a slower pace. The investor in question will be reassured that this is not a policy mistake but rather the response to recent data when, e.g. looking at the tax receipts data (chart below):
The chart shows the annual rate of receipts of the federal government. Not only have we surpassed the pre-crisis highs in terms of revenues but also corporate income taxes are looking very healthy. And no, they are below the 2007 highs not because Apple is avoiding taxes or something but because there is a lot of tax credits originating from the crisis to work through.
- The investor then looks at emerging markets (Mexico, Poland, Malaysia and South Africa are representing EMs in the WGBI index) and thinks that there is no way these are going to withstand the UST sell-off. Anyone who thinks otherwise is in a dreamworld in my opinion. There’s also the argument of positioning, which is very heavy.
- Then the investor looks at her global growth/inflation forecasts and sees this big black hole between the Urals and the Atlantic Ocean, which is at a brink of deflation and already in a recession. As much as such a scenario for Europe would’ve been considered a disaster 2-3 years ago, it is now a fact of life. Please see my post Systemic ain’t what it used to be for a more detailed explanation. Suffice to say that if you have reasons to believe Bernanke when he says he will “taper” then you also should believe Mario Draghi when he says that he is prepared to do whatever it takes.
- Meanwhile, there is a significant risk of a currency war breaking out in Asia. Yesterday the Japanese told their Korean colleagues to go and… do something about the won rather than whine over the yen depreciation. Not exactly a fantastic environment for investing in bonds over there, either.
- So if you are a fixed-income dedicated investor then there’s really pretty much one place to be – European debt markets. To be sure, trends change and it can be reversed but if you believe in the global growth/reflation trade then probably shorting BTPs or SPGBs is not the first thing to do. In fact, under such a scenario I can very much imagine peripheral spreads tightening massively, particularly in Italy, which has now officially ceased to be a fiscal troublemaker.
- In such a scenario EUR rallies, EGBs outperform and emerging markets closely tied to the EU (Poland, Hungary etc.) perform better than those linked to the US (Mexico). All that has indeed taken place.
I would like to spend a second on the EUR here. In one of my recent discussions with long-term investors an interesting theme started taking shape – what if Europe is about to experience what Japan had experienced in the last two decades but in a very short period of time, say 1-2 years? The current account is very positive, the appetite for debt is relatively strong and domestic demand will stay very sluggish but at the same the ECB won’t go “full monty” on printing. Unless it is forced to do so, of course, like it recently happened in Japan. What if the balance of payments forces coupled by the fact that virtually every major trading partner of the Eurozone is printing money push EUR to some ridiculously high levels before the pressure on the ECB is so strong that it can’t resist it anymore? So yes, the EUR would eventually crash but there would be a lot of stop losses beforehand.
I will be very honest – I am really struggling to get a good feel on the market at the moment. There are bond markets that I still like a lot, e.g. Italy, CEE or Russia but I think one needs to have something to offset the long rates exposure (my suggestion – Turkey). I generally think emerging markets in the EU should outperform Latam and Asia due to proximity to the deflationary vortex but moves have been quite brutal there, too. On the FX, if what I wrote is correct then the theme from the beginning of the year, i.e. being long EUR/MXN, EUR/RUB or EUR/MYR should work out really nicely.
And yes, I know this post would’ve been nice to have two weeks ago but this is what I make of it all anyway.
Just like everyone else in the financial markets over the last week or so I have become the world-famous specialist on Japanese flows (!)*. I have heard a lot of more or less plausible stories and when I was trying to digest all the noise, I couldn’t help but think about “Nothing As It Seems” by Pearl Jam:
Occupations overthrown, a whisper through a megaphone
It’s nothing as it seems, the little that he needs, it’s home
The little that he sees, is nothing he concedes, it’s home
And all that he frees, a little bittersweet, it’s home
It’s nothing as it seems, the little that you see, it’s home…
I am not certain what is going to happen with the wall of money that is seemingly coming from Japan, but I know that there’s a remarkable amount of superficial analysis, which I would like to comment on.
1. The Japanese carry trade will continue as the BoJ prints more.
According to estimates by Daiwa net issuance of JGBs after stripping BoJ purchases will be -26trn yen. This is around 5% of GDP, which is a pretty monstrous amount. This naturally makes people’s imagination go into overdrive, particularly as we’re talking about the country with decent carry-trading history. But there is one problem with such an approach. Carry trade was Japan’s response to the lack of returns in the local market. Bond yields have been ridiculously low and the stock exchange was still suffering as zombie-banks kept dragging it (and the economy) lower. Now, do you think this situation has not changed even a bit? We may be agreeing or disagreeing with what the BoJ is doing but investors (particularly retail) could be excused for e.g. thinking that the Nikkei will double this year. This is particularly the case as what the BoJ seems to have orchestrated is a fantastic opportunity for the Japanese banks to cash in on their available-for-sale JGB portfolios. So answer yourself this question – is it so entirely obvious that Mrs Watanabe continues buying AUDJPY (annual yield of 3.2%), ZARJPY (annual yield 5.4%) or MXNJPY (annual yield 4%)? Granted, these and many other currencies will continue to constitute a very important part of the Japanese investment portfolio but pretending that the investment backdrop in Japan has not changed is naive in my opinion.
2. The big yen move has only just begun.
Currently various forecasters are trying to come up with the most bearish view for the yen. I have already seen 120/USD but admittedly I do not pay much attention to that stuff. But try to think who has so far made money on the yen debasement? If you don’t know then try to get a hold of the HSBC hedge fund report to see that the vast majority of macro funds have caught at least a part of this move. And because selling the yen is seemingly such a no-brainer**, not being in the trade is a big career-risk for many. In some sense, macro hedge funds cannot afford to miss another leg in the yen move (if there is one). But in the greater scheme of things this is just noise. Don’t forget that the Japanese economy has just become at least 30% cheaper. And we are talking about a bunch of historically deadly innovative companies who have managed to keep their place in the global market place against all odds.
Goldman has recently produced a study showing that the country with the most similar exports composition to Japan’s is… Germany. It is already very much visible it the underperformance of the DAX, in my opinion. Personally I prefer Mercedes over Toyota but at a 25% discount I know I would change my mind.
My thinking is as follows: if this yen depreciation and the crowding out of the Japanese banks from the JGB market is persistent then Japan has every chance to become the champion of the global trade again. And if so, why on earth would I be buying GBPJPY or AUDJPY?
Let me give you another example: If you have been selling the yen and buying the South African rand consistently in the last five years then only last week did you break even on your average spot level. Sure, you got some coupons in between but it cannot be ruled out that investors who have been buying the ZAR against the JPY will just take this as an opportunity to close the position after being bailed out by the BoJ.
3. Banks will invest abroad.
This bit I find preposterous. I have mentioned above that banks may have just been given a lifeline by the BoJ and they will be able to off-load their available for-sale portfolios at a significant profit. What they do with the cash next is anyone’s guess but banks are not really in the business of punting on currency markets with their balance sheets. Believe it or not but even when GS recommends buying EURUSD, it’s not like Goldman’s treasury shifts all its money to Europe. Banks operate in the “LIBOR+” world. They are happy to take exposure to foreign bonds but it is usually done on an asset swap basis. Below are a few bonds that I just looked up on Bloomberg and how they compare when swapped to JPY.
- T 2 02/15/23 78bp
- SAGB6.75 03/31/21 #R208 68bp
- MBONO6.5 06/09/22 68bp
- POLGB 4 10/25/23 10bp
- TURKGB8.5 09/14/22 36bp
As you can see those differences are not huge and definitely not big enough to make emerging markets irresistible. Additionally, there’s a perverse effect of what’s been going on in the JGB market lately. The chart below shows a crude calculation of VaR for 10y JGB futures since 2000.
A chart of the yield volatility is looking even scarier, which – paradoxically – could bring the Japanese banks into a risk-reduction mode as no one can bear such wild swings of the profit and loss account. And adding Brazilian assets to the portfolio doesn’t help much.
4. Asset managers, insurance companies and pension funds will invest abroad.
Yes they will. The same way as they have in the past. Well, maybe with a bit bigger size but it’s far from being certain at the moment. If it’s the yen weakness they’re after then I suppose buying the USD will do (without adding an extra layer of volatility between the USD and some other currency). And if they don’t think the yen weakens much from here then why would they accelerate foreign buying in the first place?
This brings us to the last point I would like to make. As much as in previous years the Japanese investments abroad were driven by expectations of superior returns outside of the country, we are now talking about the expected yen weakness. In my opinion this changes the structure of investors taking advantage of the move and I believe that it will be the foreigners shorting the yen, rather than the locals. This, at least in the near term, makes it a tactical, rather than a structural trade.
So these were my views on the whole situation. I don’t have any concrete recommendations this time but I just don’t like how one-sided the discussion has become. And if I’m wrong then… well… listening to Eddie Vedder while writing this post definitely made it worth my while.
* not sure how to stress that I am being ironic, but I have noticed that subtitled movies on Sky have (!) at the end of sarcastic sentences.
** I have always thought that no-brainers are for people without brains but somehow this definition hasn’t become mainstream.
As a big fan of IS/LM, I have always admired Paul Krugman. He obviously knows his stuff but more importantly he has held his stance throughout the crisis and has done it in a very convincing way. This will definitely be remembered.
However, I sometimes have issues with what he says and these issues are proportional to the distance between him and the subject in question. While his views on Iceland were pretty much in line with what I think, I’ve been under the impression that he oversimplified things by conveniently ignoring the fact that there is a lot of cash trapped there, which will remain a big problem for many years to come. But this is nothing compared to what in my view is a completely misguided and superficial analysis of the Baltics. The fundamental difference between what he says and what I think is that for me just because a country that used to run significant excesses before the crisis has not returned to the previous level of output is by no means a proof of a failure of local policies. I would argue that a lot of pre-crisis GDP was, in effect, phantom and should not be treated as a benchmark. Additionally, countries like Lithuania are an example that internal devaluation can work well, which you can see looking at a rapid growth in productivity in recent years. And no, I don’t care that a lot of that has happened through reductions in employment. Not because I’m a heartless liberal but because a lot of the pre-crisis employment should not have happened in the first place. The same situation could be observed in Latvia and yet prof. Krugman keeps waving the GDP chart saying how ridiculous the policies have been.
But I wasn’t going to write about the Baltics. Today I read Paul Krugman’s latest post entitled Poland Is Not Yet Lost. The mention of Latvia aside, there is nothing in this post that would be factually incorrect – Poland did have a “nice” global recession and the zloty was an efficient corrective mechanism in 2009 and after.
However, the problem with his post is that it discusses an absolutely irrelevant issue of Poland joining the EMU. Sure, the Polish authorities have been quite vocal mentioning that in recent months but in my strong opinion it has nothing to do with the actual intention.
What’s the reason then? Polish bonds. After a spectacular rally in 2012, yields on POLGBs reached record low levels and the curve flattened dramatically as the NBP stayed way behind the curve. At the same time, standard valuation metrices like eg asset swaps or carry have become extremely tight. To the point that without assuming a paradigm shift or without classifying Poland as a safe haven it was difficult to justify further strong purchases. “Expensive” was the word most commonly used at the turn of the year. The Finance Ministry, which by the way holds a Ph.D. in public relations, realised that too and was frantically looking for a way to portray POLGBs as “still attractive”. And they quickly found one, ie the spread to Bund, which is hovering above 200bp. But in order for people to start looking at this spread they had to give them a reason. Joining the EMU was one. And believe me, this has been quite successful judging by how many requests I get about this spread these days.
Talk is cheap and Poland knows about it so if saying that eventually the zloty will be converted into € can bring us some flows then why not? Especially that there hasn’t been any commitment regarding the date or no indication on how on Earth Poland will meet the Maastricht criteria. But I guess this is a much simpler strategy of communication than trying to explain how the budget will cope with the first drop in consumption in almost 20 years or what does it mean that the budget deficit is already at 60% of the full-year plan after only two months. I guess it’s good there’s Hungary (and now Slovenia) next door who will always attract eager sellers, eh?
But coming back to prof. Krugman, I realise that my credentials are nowhere near his. Heck, I’m not even writing this under my own name. Still, I think in cases like Latvia or Poland, he lets his ideology run before the analysis of what actually is going on.
Last week was pretty eventful in terms of central banking. Obviously, the folk from the ECB grabbed a lot of headlines with their relative optimism but they are not the only ones trying to “whisper the reality”.
Meanwhile, two important emerging markets central banks decided to cut rates last week. And dramatically so. First, the National Bank of Poland decided to reconcile the market split between a 25bp cut and a no-change decision by… slashing rates by 50bp*. Two days later, the Banxico decided to do a similar thing, also exceeding the market expectations. Now how is that possible? Two central banks, which historically have been quite hawkish and have kept rates generally high have suddenly decided to get adventurous?
Let’s start with the NBP. Today the central bank revealed the details of its latest macroeconomic projections (a neat presentation can be accessed here). I found this chart quite interesting:
It shows two things. Firstly, according to the NBP models, potential growth rate has declined to below 3% from close to 6% before the crisis. Secondly, the lost output is so huge that the central bank expects the output gap to remain wide open at least until the end of 2015. In theory, that means at least two more years of zero underlying inflation pressures (caveat: see the Intermission section that follows). This is bold.
Intermission: Here I need to remind you of a significant distinction between potential output and potential growth rate. Have a look at the chart again – expected growth will exceed potential growth rate already at the beginning of 2015 (which by the way is pretty far off!). Only since then will the negative green bars start becoming smaller, reflecting the catching up with the lost potential. I don’t have a definitive answer to that but it is not entirely obvious that underlying inflation can start going up with green bars in the negative territory.
Now let’s move to Banxico. In the statement following the last meeting the central bank enumerated “structural advances” which have been made in recent years (translation here). They include:
- the reduction in the level, volatility and inflation persistence (ok, ok, that’s just an “idem per idem” argument)
- the fact that the various episodes of price adjustments have not resulted in second round effects
- the anchoring of expectations inflation, and
- the significant decline in inflation risk premium.
Of course Banxico is trying to make a big success out of it by saying that it has fostered an environment with less economic uncertainty. And good for them but someone cynical could say that this simply means that the economy has lost a significant part of its potential growth rate. I am not questioning the decision itself – I actually think the Mexicans did the right thing – but wider ramifications of it could eventually lead to even lower rates than now. Same as in Poland.
Now, Brazil is not in a crisis, despite the fact that GDP has been showing subpar growth over the last two years and is on its way to perhaps the third year of such a situation. Despite that, everything indicates that the Copom is preparing to raise the Selic rate, repeating the standard reaction of a past that everybody thought had been left behind.
* Despite huge temptation, I will not dwell on how ridiculous the communications policy of the Poles is. After two months of becoming increasingly more hawkish and suggesting a pause, they decided to cut more than expected to show that they’re done. I did not lose money on that so it’s not my grief speaking but I really believe this is the worst Monetary Policy Council among the mainstream emerging countries.
One of the basic ideas of investing in emerging markets is that whatever it is you are going to make by holding EM assets will be boosted by the currency return. For the most part, currencies in emerging markets have beaten their respective forwards. To take a real life example, you can today sell USDZAR 1y forward at almost 9.50 expecting the spot to fix much below that in 1 year’s time. Sure, sometimes you would get hosed (particularly on the rand) but in principle it has been a winning strategy over the longer term. Just see never-ending EM bullish comments from Mark Mobius or Jim O’Neill. Happy days, at least for them…
Such a phenomenon has a strong backing in the macroeconomic theory, which tells us that countries experiencing higher growth rates should see their real effective exchange rates appreciating. Of course this will happen through a combination of nominal appreciation and higher inflation but as long as the particular USD/EM cross doesn’t go up, investors should be happy.
But carry is not only about beating the forward in the FX market. There used to be a much powerful, yet less known set of transactions aimed at generating carry. I am talking about buying short term debt issued by emerging markets and funding it in the FX swap market. This transaction used to be loved by banks – they would use their cheap USDs, convert them to an emerging currency in an FX swap and buy the debt, mostly up to 1y maturity. This had three key benefits to emerging markets:
- provided a steady supply of hard currencies to the economy (financing of the current account deficit),
- increased the demand for government debt (financing of the fiscal deficit),
- was pretty stable as banks could withstand a lot of volatility by keeping assets in hold-to-maturity portfolios.
If you think of it, the first two points must have significantly contributed to superior growth rates in many emerging economies, thus enabling the “beat the forward” crowd make money.
Interestingly, right after the financial crisis of 2008/2009, this activity increased. Banks suddenly got access to super cheap funding from monetary authorities and the Basel committee had not woken up yet to throw new regulations and capital/liquidity requirements. At the same time, cross-currency basis widened considerably. This meant that “some currencies are more equal than others“. Or put differently, as much as before the crisis the Mexican peso or the Polish zloty would be trading at par with the USD in the money market, having the dollars right after the most acute phase of the financial crisis passed was a huge advantage. Banks (and some hedge funds via a structure called Total Return Swap) made a lot of money on that. A LOT…
But then the access to USDs became so universal that the greenback ceased to trade at such a premium and, of course, the new regulations came making it exceptionally difficult to use banks’ balance sheets for carry trades in emerging markets. But fair enough, maybe this sort of money-making method should not really be used by banks.
There are, however, pretty wide implications. I have already hinted that the described activity of banks was one of the important reasons why EM growth (and consequently currencies) outperformed. Also recall that the funding achieved by emerging economies had been pretty stable until the changes came. So with this in mind, does it still make sense to talk about carry trades in emerging economies?
I did a quick exercise analysing how long it takes to wipe out the quarterly carry in Mexico and South Africa (I have chosen them at random). I basically looked at average daily depreciation over the course of a month and compared that to the quarterly carry. In both ZAR and MXN I got a similar result, i.e. 2.6 days. Imagine buying the rand and the peso for the carry on Monday morning because you think carry trades will perform. By the time you return from lunch on Wednesday your quarterly carry could be wiped out. Puts things in perspective, doesn’t it?
How to trade this? I know I have committed to giving some trading clues after my posts but here a better question to ask is how NOT to trade this. It may sound like a cliche but seriously, if someone tells you to buy a currency “because the carry is good”, just show them the door. Secondly, I would caution against assuming that volatility will increase as people get stopped out on carry positions in emerging markets more often. The sad truth may be that as much as many FX-focused banks would hate it, speculative activity in EMFX could remain quite low, in which case it will be economic cycles determining exchange rates. And trends are usually associated with low implied volatility…
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
- currently have inflation below (or close to) the central bank’s target
- 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.
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.