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.