We live in a finite world. Finite land, finite water, and resources, and a finite life. But sometimes our patience is stretched out to infinity -or close to it. We, financial experts, and ordinary fishermen, both share the need for patience. It comes as a tough achievement, because, as Franz Kafka once suggested, long waits (he mentioned eternity) can be exasperating, “surtout vers la fin“.
Ever since Alan Greenspan started to use his monetary tool box in order to conduct and conform market behavior (October 1987), valuation has mattered less and less, and financial markets have been morphing into casinos. Monetary aggregate levels and their growth, interest rate suppression (financial repression, and the consequential quest for yield), and the Fed’s valuation model (based on the infamous “ERP”) have fully taken a front seat. It’s now been nearly a decade since these three drivers for financial pricing became the only game in town.
It is indeed a brave new world. The world where equity prices can float comfortably above the 2.3 times price to sales ratio level (US), and while at it, brush off any inconvenient events. Like Brexit, a two-year negative growth spell in profits, or an increase in the debt/EBITDA ratio for NFC’s, that ought to affect the WACC seriously, and valuation correspondingly. Impressive -to say the least.
And it does look like a Fisherian permanently high plateau at first sight. Monetary policy tools have successfully suppressed volatility, driven markets the CB’s way, and helped improve consumer confidence. Yet, stubbornly, I still don’t buy the idea that you can indulge in ordinary “long-only” asset management, in this seemingly placid environment. Financial markets are the shakiest house of cards I can remember in 30+ years of trading.
Fortunately or not, depending on your point of view, all actions come at a cost, and nothing lasts forever. After years of monetary abuse, out in the open for everybody else to see, the true nature of the so-called “monetary policy tools” has been revealed. The essence of the much fantasized and overhyped, CB monetary toolbox, is, after all, a cosmetic kit, with lots of lipstick, mascara, eye shadow, or rouge. The functional, basic health of the underlying financial system, or the economy, is unaffected by all those skin creams, lipstick, and even Botox of late.
I find it remarkable that CB’s got away so easily, doing no more than plain cosmetic manipulation, for so long -as mesmerized investors watched in awe what CB’s were apparently able to do. They did well at deceit, and their success has provided them with an invincibility aura that has kept them alive against all odds. In the meantime, we feast on supply side neglect. Nobody wants to streamline and update our productive capacities, Schumpeterian creative destruction costs votes. Votes are, literally, all that counts in politics.
Needless to say, I have been gradually running out of patience. Thankfully, not out of other people’s money. Not that past results protect you for long. We all have to remain humble, or else the market will do it for us. No, no problem with humility to report, but I am running real short of patience by now. Still some more left, but not much. I can’t wait to move on to a new phase in the solution of our global economic problems. One in which the use of Botox is forbidden. One in which I can cease to represent the Perma bear script. I’m fed up with the role. It’s boring!
We might be very close to the end. Witchcraft is “out”, as soon as the general public gets acquainted with the underlying bag of tricks. Sooner or later, somebody finds out there is no magic in what they are doing. Investors are currently dawning on the fact that Central Bankers are not the “magic people” they themselves think they are. Playing their missionary role, in the Common Knowledge game, becomes a lot more complicated from then onward. Go ask Janet.
What has changed in financial markets over the last couple of months? Two things. First, Investor perception of Central Bank’s capability to keep these Botox treated markets looking pretty enough. Second, the degree of conviction of Keynesian priests in the efficacy of what they are doing.
Nothing else has changed substantially -hey, I think I know what you’re thinking now. What about debt and leverage? Well, sadly, the underlying health of the financial system is largely irrelevant for as long as we have the CB’s back. In the meantime, debt has, of course, kept growing exponentially, and the global economy looks anything but healthy. Everybody knows that! Still, being more of the same, this perception is not really a game changer. We got used to talking debt in trillions, and it hardly bothers us anymore.
The big deal is that we are continuously encountering casual, anecdotal, or even verbal evidence that points in the direction of naive CB priests and followers also experiencing some doubts on the power of CB makeup. And, together with the dumb, run of the mill investor prototype, some high profile individuals keep voicing it louder by the day. Theresa May’s speech on causality between QE and inequality took me off guard. How dare she doubt the efficacy of Mark Carney’s and Mervyn King’s policy moves! Surprisingly enough, she might turn out be the “Margaret Thatcher” her country needs to come out of this mess. That was brave Theresa!
The change of heart that I talked about last month, is no longer subtle, or self-restrained. Even the ECB has belatedly spoken twice, supporting this new line of thought -all but confirming the previous Fed and BOJ turnaround. To state it loud and clear once again: this looks like the end of the road for more NIRP, and a decisive bar raising for more QE. Last month I said I was tentative about it. I am now positive that this is the case -for the time being.
Following this change of paradigm, markets have also moved somewhat, towards the scenario I envisaged as the most likely. The main risk of an investment strategy based on no more NIRP/QE, and a gradual phasing out (tapering in Fed-speak) of any printing still taking place, is a desperate last minute panic that takes them all to the trenches (printers) -in a last-ditch, final attempt to regain control.
And they will probably do just that, it is only a matter of timing the event. As I said back in February (“One more print to come, maybe a lot more“), I hope they hold on until the end, and keep that last print, as the ultimate untapped resource, in order to preclude a global ATM network crash. But that is, undeniably, a low confidence call.
CB’s will have to hold on to their actual stance, and the pressure to let go will be unbearable. They will do their best to uphold markets with some jawboning, and lots of POMO intervention. They have proved beyond doubt that they are good at that. Should this fail (it is, all things equal, a matter of time) they will be confronted with their last option. If they are trigger-happy and concede early to more “nirping” and printing, one more blow off top is to be expected. In fact, it would be a second round of the”March-September 2016″, fresh money and credit-driven surge in financial assets. A highly correlated upswing in financial risk pricing for both duration and equity risk.
It would only buy time -once again. But it would be extremely painful for shorts. Of course, the next outburst of equity pricing exuberance would most likely be ephemeral. We would, for sure, get less bang for the buck than the last time. But it would suffice to put some tenacious shorts out of business. We have to remain flexible in our approach because politburos are now confused and shaky. Only POMO desks are messing around trying to prop up prices of relevant assets. They will, later on, become desperate -and presumptively unpredictable.
I did get it right in January, when I called for a dull, sideways year, in currency trading. Only the USD/JPY cross has provided some relevant price swings. Nine months later, I think that is about to change.
The first “leit motiv” in currency positioning for the rest of the year, is, what I have reiterated for the last two years: USD strength. The USD is potentially strong in most crosses and is only being held back by an implicit agreement between central banks to prevent its appreciation. A USD appreciation works as a global tightening. That is something nobody needs/wants right now. It is one thing not to print more, and another one altogether, to allow for global monetary tightening.
Hence, this currency features a heavy dose of makeup embedded in current levels of pricing. Against renminbi, yen, or the euro. But the forces that push the USD up (global scarcity, cleanest dirty shirt, interest rate differential support) cannot be ignored. Summing it all up, no need to gear up on dollar longs, but shorting the USD is calling for a possible disaster. If you are to own something, my point of view is that you have to be long USD.
USDJPY has gone all the way from the 80 level (that inspired a post called “junk yen“, dated May 2014), to the 125 level (that warranted a cheap status for the yen, regardless of the country’s problems). From a brutally expensive yen to an outstandingly cheap currency in only a matter of months! Not far from Sterling volatility after all. We are now (at 104), after a substantial retracement of the last move, somewhere close to fair value. It is, in the short run, a game of flows. Repatriation flows on risk-off, and weakness whenever the Japanese spur their unhedged investment abroad. And hedging does not come cheap for Japanese companies with assets in USD.
In the EURUSD pair, 1.10 is a politically agreed line in the sand that we are possibly breaking right now. Further appreciation of the USD increases the commercial deficit of the US versus Europe and adds to the perception of a wobbly euro. It is in both sides’ interest to keep it where it was (1.10 to 1.1450 levels). Nevertheless, the pressure to break towards 1.05, or even parity, subsists. It is a realistic scenario, sustained by a probability well above that of a tail risk.
USDCNH is where the most interesting action is taking place. The pair to watch. Nothing is 100% foolproof in financial markets, but going long this pair (shorting CNH) offers excellent risk reward. You have to pick your entry point carefully (PBOC alternates on and off periods) and watch the cross currency swap curve, and the Shibor pricing, even more closely than the actual pricing of the pair. The chances of CNH sustained strength, are remote, and your only worry is beating the cost of the swap. It doesn’t get any better than this when cherry picking a trade.
One last mention for my mistaken call on the EURSEK pair. The Rikjsbank has effectively managed to impose a market price comfortably above the 9.50 level. There are even working to counteract some depreciation tendencies above 9.70! I was plain wrong about the inability of the Rijskbank to get away with those levels. Having said that, I find current levels an extraordinary mispricing of their currency. They have gone much further than begging their neighbors for some aggregate demand.
The US has finally listed them as one of the countries to watch -as likely currency manipulators. That is as far as the US will go to voice that they are manipulating their currency. Politics always adds a twist to otherwise obvious conclusions.
We have to wait on this pair until the timing is right. If you do your homework (select the appropriate fundamentals), everything that is underpriced will go up again. But the timing can kill you, particularly in a NIRP environment.
Bond duration, and credit risk.
Long duration has been the all-weather paradigmatic trade for the last 35 years. Ever since the 1981 Volcker high in USD interest rates, these have inexorably trended down -obviously with some volatility along the way. What’s more, for the last decade or so, and regardless of the equity bubble, long duration bond prices have been the best performing asset class. Equities made the headlines -but long duration bonds were the money making instrument behind the curtains.
The trade is overcrowded and overextended, and it is obvious to all that current prices make no sense. But bondholders felt they were well supported by CB’s up until the last “change of heart”. If there is to be no more “nirping” and printing, who will forcefully buy long bonds at current yields?
The Ice Age thesis (A. Edwards) sustains that there is still substantial downside in long term rates (at least in USD rates). With all due respect to a great thinker, I am not that sure. Certainly, any way you cut it (hours worked growth, or productivity improvement supported growth) the economy is not going to grow healthily in the foreseeable future. That weighs on interest rates, taking the Wicksellian rate down. On the other side, I feel that on a flow of funds approach, QE buying, and short-term rate suppression, have been too crucial. If we turn off the main spigot, who’s left to buy? Long bond free float is way too high for pension funds and insurance companies. They need CB help to keep rates at this level!
I think current long bond prices are not equilibrium prices -even considering the fact that the economy will not grow significantly before a major reset. The consequence is likely to be some bear steepening of the curve if CB’s withdraw from their actual printing and “nirping” activities. At the very least in Japan and Europe. Ten and thirty-year treasuries did not sink deeply below the zero real interest rate level. They have a better chance of being spared in the sell-off.
Credit risk is something I am not ready to discuss. Actual spreads over mid-swap are something akin to picking up pennies in front of a steamroller. The next default cycle will be vicious. I will take spreads near the mid-swap rate for the term of choice, and live with less. Frugality is good for you. Some of my calls are bound to be wrong, and I can handle that. But I would commit suicide if debt imploded, and I was caught in credit risk driven loses.
I will not bore anybody with more of the same. Maybe I have to recycle and improve my ability as an economist. I concede I am totally unable to understand how on earth actual pricing is going to be maintained without heavy printing, “nirping”, or increasing credit aggregates. Steve Keen has reiterated the point that it is not the amount of incremental credit that counts, but the rate of growth related to growth itself (second derivative). Without substantial and incremental money growth globally, the system stops working. Just like that. We are credit and money printing junkies.
Prices will not float without heavy monetary support. So the main thing to consider is wide monetary aggregate growth. It doesn’t really matter much if we are talking high powered (in the past) bank reserves, or just broader concepts of True money supply (TMS for the US) or Total social financing (TSF for China). It’s all about money flow, and the search for yield. There is no such thing as a price discovery process.
Being short or not, to a greater or lesser degree, is an option. Long only portfolios, or ETF holding in your portfolio, is not. At least not for me.
And of course, all these concepts are tough. It’s hard to keep focused and avoid panicky buying and selling at every turn of events. You think a strategy, you do your risk management properly, and you hope for the best. Doing something that simple, I am now up 6.50% for the year (in two tranches, 4.30% until the 16th of September and 2.20% return from then onward, with a new investment vehicle). Nothing to brag about, I know. But is has been a tough year for us global macro players. I hope to live to see better times to invest.