Can’t fade, won’t chase

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…?

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Just do as I say, don’t do as I do

One of the oh-so-many unintended consequences of what we’ve seen in the market for the last five years is the widespread belief that no matter what happens policy makers are in almost full control of the events. Moreover, we seem to be more willing to take their word for granted rather than analyse what they’re actually doing (which reminds me of this old Genesis song, hence also the title of the post).

Think of it.

• If the US growth numbers turn sour, who do we think can come to save the day? Either the government with the fiscal package or, more recently, the Fed with some sort of money printing magic wand.
• When a eurozone country gets into trouble, all the research says “if only the Troika was there to help them” or “if only Mario Draghi was not on vacation and said something about whatever it takes”.
• Similarly, if the day of reckoning comes in India after years of screwing up the fiscal situation and very little progress on boosting competitiveness to sort out the current account (yes, that does matter), all we want is the RBI to tighten the liquidity situation to go back to normal.
• Or when Turkey pushes the current account deficit and short term external debt to levels previously unseen in the emerging markets universe, simultaneously pumping up credit growth to very high levels and keeping negative real rates, all the JP Morgan research wishes for is for Governor Basci to sound hawkish to make it all go away. Indeed, they hiked the upper end of the interest rates corridor today and people are very happy even though it really means nothing.
• In Egypt where the fiscal situation is completely unsustainable and people are rioting at the time when FX reserves are being depleted at a Formula I pace, many people think that the Gulf states or the IMF or some other Santa Claus can come and save the day with a simple loan. If only the government asked for it…
• Finally, when the Governor of the National Bank of Poland categorically says that policy easing has finished at 2.5% and that he is sending a strong signal to the economy that the worst is over and therefore the economy can grow again, the market immediately takes it as a gospel even though it does sound an awful lot like my favourite Baron Munchhausen.

Trust me, I do have many more examples of when we either wish for or treat policy makers’ decisions as the ultimate solutions. Whereas if you think of it, many times it is a very twisted logic, which a friendly portfolio manager summarised as “when we turn left, a road to the left will appear”.

It didn’t use to be like this. Our faith in policy makers’ ability to reverse the course of the market has proven correct in many cases (see whatever it takes) but I think that oftentimes it’s just a reflection of the laziness of the market. After all, it’s much easier to buy bonds in Slovenia or Italy because the ECB says it will defend them rather than to look into the fundamentals. Or it’s much easier to buy the Turkish lira because the CBRT says it is hawkish rather than to think whether it’s actually true (NB it most definitely isn’t, in my opinion).

I am not denying the fact that the policy makers control developments in the very short term no matter how much you disagree with them but we need to be very careful when extrapolating that. I strongly believe that there are still things which are beyond fixing and that sometimes it really is too late. The following points are not necessarily things I am convinced about but I think you can make such counterarguments to the propositions I presented above:

• Fed saving the day – what if the US is in the classical liquidity trap in which case without a strong fiscal stimulus you will get nowhere via QE?
• Draghi doing whatever it takes – what if the EMU debt is actually not sustainable, in which case it’s just a matter of time before dominoes start falling? (ok, I actually don’t really agree with this one but Nouriel, Nassim and Zero would probably make that point; Also, “Zero” is the first name of Mr Hedge, right?).
• RBI saving the rupee by squeezing front end rates to 8% – what if the awful policy mix of the recent years actually requires long term yields to increase considerably to attract any sort of interest from international investors?
• CBRT rescuing the lira – what if we are ahead of a proper old-school funding crisis in which case the current account deficit will need to be closed in a disorderly fashion triggering a massive increase in interest rates and a huge recession?
• Egypt bail out – what if the cost of saving Egypt is too high for anyone to bear and the country actually is unable to sustainably fund the fiscal deficit, particularly in the local market?
• Poland recovering – what if the excessively tight monetary and fiscal policies have durably lowered the potential growth rate in Poland turning it into a country more resembling the Czech Republic (i.e. with very high savings rate and no domestic demand)?

Some of those things sound less plausible than others but I guess the message is that don’t let the policy makers whisper the reality and pull the wool over your eyes. Granted, they can and should impact your trading decisions in the short-run but if the brightest and best-paid minds working in the financial industry are having problems with forecasting what is going to happen in the marketplace then how can you assume that people who – for the most part – are politicians constantly make the best possible decisions?

Dude, where’s my potential?

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:

1. the reduction in the level, volatility and inflation persistence (ok, ok, that’s just an “idem per idem” argument)
2. the fact that the various episodes of price adjustments have not resulted in second round effects
3. the anchoring of expectations inflation, and
4. 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.

As I was thinking of the whole concept of potential growth rates in emerging economies I came across this very good article from Valor via Brazilian Bubble: Brazil’s Central Bank is in search of lost credibility. I don’t necessarily agree with everything that’s been said there but have a look at this paragraph:

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.

I can see where the Copom is coming from. Inflation remains of paramount importance in Brazil, to the point that they publish data to second decimals, as if it had any macroeconomic implications. I am not sure whether hiking rates will be the correct decision but I wanted to point out what can happen to an emerging economy if potential growth rates decline. If the economy has been showing “subpar growth over the last two years” and inflation is surging then maybe it wasn’t “subpar growth” after all?

There are of course positive examples, too. Turkey is one of them (although not very recently). I have not been in agreement with their recent policies and I think they’re throwing their undisputed success in fighting inflation to the wind but if we go a bit further back, we will see at least two episodes of a durable decline in the inflation rate. Both occurred after periods of significant economic hardship – first at the beginning of the millennium and then after the 2006 crisis. Now, Turkey had a grand opportunity to durably lower inflation after the 2008/09 global crisis but the central bank instead decided to focus on micromanaging pretty much every element of the economy. The reason I mention that is all three episodes of a shock to let’s call it “normal” level of inflation were used by the central bank to slash rates dramatically. In this respect, the CBRT recognised that the economy has become less inflationary. However, it remains to be seen whether its most recent response to global events is correct. In other words, the risk the CBRT is running is that it assumes that potential growth rates is higher than it actually is. It worked in the first two instances but that may be because they were driven by local developments (rather than the global crisis like in 2008/09). If the CBRT is not lucky this time, events could necessitate a similar approach to the Copom.

How to trade this? There seem to have been two approaches to monetary policies in recent years in emerging markets. On the one hand, we have seen activist central banks such as BCB or CBRT which have actively engaged in currency wars etc. They seem to be operating under the assumption that they need to counter whatever it is that Fed/ECB/BoJ conjure. I would call that “externally driven monetary policy”. On the other side of the spectrum you have the likes of Poland or Mexico, which – while acknowledging the impact of external developments – have maintained their reaction functions roughly unchanged. The latter group is beginning to realise that their economies are developing considerably slower than they could and so chances are that last week’s rate decisions are not the last surprises they have for us. As such money market curves should steepen there. The former group is to some extent the opposite. They are either like Brazil coming to the conclusion that inflation is becoming an issue despite slow growth. Or, like Turkey, they keep playing with fire pretending that the economy is still not strong enough to push inflation higher. One should be very careful being long duration in those, in my opinion.

* 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.

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.