Rainbow Connection

After reading a top notch piece of research from Nomura’s Nick Firoozye (Mythbusters – “LSD” Leverage, Shorting, Derivatives can be reasonable) and a few too many bourbons I decided to emulate the Team Macro Man financial cover song format. For background on this sort of trade see @matt_levine here. Hat tip @MBlockRhino who stuck the song in my head. Apologies to Jim Henson, Paul Williams, Kenny Ascher, and Kermit.

Why aren’t there so many trades of our rainbows?
And who’s on the other side
Rainbow are options
With many inclusions
And risks Monte Carlos hide

So we’ve been told
And some choose believe it
These products should trade OTC
Someday we’ll find it
The rainbow connection
the lovers, the dreamers, and me

Who said that every risk
Could be priced and answered
When cleared by a CCP?
Somebody thought of that
And someone believed it
And look what it’s done to me

What’s so amazing
That keeps the Fed gazing
And what do they think they might see
Someday we’ll find it
The rainbow connection
The lovers, the dreamers, and me

All of us under its spell, we know that it’s probably magic

Have you been half asleep?
And have you heard voices?
I’ve heard them calling my name;
Is this the sweet sound
That called the young traders?
The voice might be one and the same

I’ve heard it too many times to ignore it
We’re providing liquidity
Someday we’ll find it
The rainbow connection
The lovers, the dreamers, and me

Where’s the Slack?

Don't worry, Strickland was wrong too

This June, the Fed’s most reactionary member, and noted hand talking enthusiast, James Bullard gave what I found to be one of the most reasonable presentation on FOMC policy in years.  It was titled ‘How Far Is the FOMC from Its Goals?’ and if you have not seen it please do give it a look here. In it he outlined a simple formula to quantify how close the Fed is to threading the needle on policy based on absolute distances from the inflation and unemployment targets levels.

The data from that presentation was from April.  I thought it worthwhile to update it since, for reasons I do not understand, the market is currently pricing Fed Funds rate hikes even further out today than they were then.

The Fed is currently closer to its dual mandate targets than 89% of the historical data and closer than any point in since 2004. This is a noted improvement from June when it was closer than 75% of readings.

It is important to recognize that when your target has multiple inputs and data is constantly in flux you are not likely to be precisely at your target often.  As a matter of fact, the Fed has not hit both targets in any month since 1960 when they started the PCE index.

The Fed targets are symmetrical so it is worth remembering when economists like Krugman, Stevenson, & Wolfers point out the Fed is “missing on both mandates” today, that it strictly a function of their political viewpoints.  The Fed is always missing the mandates but the goal is to set the best policy for 6-12 months from now.

In all previous examples the Fed has changed course on rates within three months of being this close to targets, which is one of the many reasons I maintain the view I’ve expressed for the past 20 months.  First hike Q1 2015 and continuing at 200 bps a year.

My Ten Commandments for Finance Twitter

"Fucking cool it chief!" - Moses

I am a noted admirer of rules and have recently fielded some requests for my rules of engagement on twitter after a tweet from my friend @munilass. I am sure these are not ideal for everyone but for me, as a private account with only opt in interaction and a rather specific industry focus, they have proven valuable. The rules are ever growing but here are the top ten that stuck out.

  1. Do not send traffic to bad content. If you do, you are paying for more of it.
  2. Avoid tweeting about topics where you lack expertise and unfollow those who regularly do. Credit on this thought process goes to Ray Dalio for “Ask yourself whether you have earned the right to have an opinion.”
  3. Do not complain about the stream. You chose that content and it is your fault if it sucks.
  4. Limit your number of follows to a level that you can reasonably read.
  5. Do not subtweet. It is cowardly and wastes everyone else’s time due to lack of context.
  6. Do not use straw man arguments to prove a point. Address thesis directly with whoever presented it.
  7. Do not feed the trolls. If you engage those lunatics you are the problem.
  8. RTs are endorsements.
  9. Block someone every day. Trust me this will save you some outrage.
  10. Keep your stream dynamic. Cut dead wood and add new voices, this medium cannot be stagnant.

Though I’m a man with a passion for rules, the trick with these and all others, is possessing an understanding and knowing when to break them.

The Greatest Trade Ever

A few weeks back Bob Treue the president and founder of Barnegat Fund Management was kind enough to upload his November 2010 presentation at Oxford University. Here he explains at length and answers questions about his 2008 TIPS trade which became famous thanks to an academic paper and some coverage from the FT and Barrons.

I personally believe this was the greatest trade of all time. The trade idea itself was a rather straightforward arb opportunity brought about by the massive imbalances that arose during the period directly after the Lehman bankruptcy, but what made it extraordinary was the actual ability to execute.

The keys to the trade, as outlined here, were holding at least 50% of the fund in cash and equivalents as collateral for margin calls during periods of increased vol, selecting and educating a client base that was comfortable with the risks and rewards of a relative value fixed income fund, and hoodwinking desks like mine by negotiating the best ISDAs possible during times when dealers were less concerned about risk management.

Since it only had 25 views when I found it I thought it would be criminal not to share it. Enjoy.

Claims Rule Everything Around Me C.R.E.A.M.

Last week Bloomberg’s Michael McKee was interviewing one of my favorite economists, Neil Dutta of Renaissance Macro, and asked him whether he thought initial jobless claim deserved such a wide following or if it might be an overrated indicator. I was pleased to hear Dutta confirm its importance.

If anything this data point is underrated. It is hard data so it is not reliant on estimates (excepting rare examples like California last year when a state fails to correctly collect it). It is released with a six day lag so it’s about as close as one can get to real time. It is subject to an extremely low level of revisions. However, unlike numbers like NFP, durable goods, retail sales, or industrial production it rarely results in market volatility upon its release.

The lack of an upward trend in claims is why I stuck by my guns over the recent data weakness being an entirely weather related phenomenon. My charts below are a testament as to why it is unquestionably the best indicator of the domestic economy.

Let’s start with a comparison to another labor metric: Claims 4WMA (white) vs. Unemployment (orage).

One more labor metric: Claims 4WMA inverted (white) vs. NFP (orange) with recessions shaded red. Claims offers a far less noisy data set.

Overall economic growth: Claims 4WMA inverted (green) vs. GDP growth year over year (blue).

Soft manufacturing data: Claims 4WMA inverted (red) vs. US PMI (blue)

Hard manufacturing data: 4WMA inverted (orange) vs. US auto assemblies (white) with recessions shaded in red.

Sentiment data: Claims 4WMA inverted (green) vs. Consumer Confidence (white)

And the ultimate sentiment indicator: Claims inverted (green) vs. SPX (orange)

Fisher on Tapering

Over the past few days we have seen a relatively minor selloff in domestic risk assets. A 4% swing peak to trough in equities is not exactly earth shattering, but the onset complacency and lack of volatility in the past year amplified at least the vocal reaction to the move. This coupled with a few mixed economic signals has some under the impression that the Fed might alter its tapering path for QE.

With inflation currently picking up, unemployment significantly below Fed projections, and GDP growth significantly above them, I think the easier case is for more tapering not less. These projections are already so cautiously off the mark that the January unemployment rate is likely to breach the 2014 year end central tendency. That’s an estimate made last month.

Projections which will need to be need to be drastically altered in hawkish directions below.

This situation reminded me of a quote by Dallas Fed President Richard Fisher from his remarks on January 14th. Though clearly the most hawkish member of the Fed, he is a voting member this year, and I found this insight important especially as to why their focus on long term real economic trends is of a great deal more importance than noisy short term market reactions.

“Were a stock market correction to ensue while I have the vote, I would not flinch from supporting continued reductions in the size of our asset purchases, as long as the real economy is growing, cyclical unemployment is declining and demand-driven deflation remains a small tail risk, I would vote for continued reductions in our asset purchases, with an eye toward eliminating them entirely at the earliest practicable date.”

I am confident that as long as the dual mandates of inflation and unemployment are moving in the right direction this, extremely competent, Fed will continue along the path of policy normalization.

Full disclosure I’m a short duration all over town.

Richard Koo on Tapering

In a note this week Nomura Research Institute’s famed chief economist Richard Koo laid out his case for the Fed to start tapering as soon as possible. Most of it focused on liquidity, recent labor market improvement, benign inflation, and the current pace of economic growth through his ever insightful balance sheet recession lens. Most of these factors have been debated to their fullest extent by every research team in finance, and with industrial production and CPI as the only significant data points left before the FOMC meeting, there is little to change any views from that angle.

What stuck out to me was his “personal standpoint” argument. This is especially worth noting because he recently met with both Bernanke and Yellen to discuss monetary policy and presented his case for normalizing policy. As an aside the aforementioned presentation, which I was lucky enough to see later in the month, included one of my favorite chart’s of the year.

Since I did not see any of the usual suspects write up his most recent note I have shared the relevant section directly below.

(A)n objective view of the situation suggests that now—when forward guidance is still in effect and inflation is subdued—is the time to act in order to prevent a premature rise in interest rates under tapering. For that reason, I suspect many FOMC members are arguing that now is the time to make the announcement.

December tapering would benefit both Bernanke and Yellen
A December tapering would also be beneficial from a personal standpoint for both the current Fed chairman and his successor nominee. As the man responsible for launching quantitative easing, Mr. Bernanke would no doubt like to set a course for the normalization of monetary policy before his term expires.

I suspect he began talking about tapering in May because he wanted to at least put things in motion before his term expired at the end of January. Then, even if the US economy fell into a quantitative easing “trap” during the process of normalizing policy, he would be able to avoid the criticism that he had started QE but left the cleanup to his successor.

Decision by Bernanke would make it easier for everyone else
Ms. Yellen, meanwhile, has strong dovish credentials, and if that was the basis for her nomination by the Obama administration, I think it would be difficult for her to announce a tapering immediately after becoming Fed chair.

For the first few months, at least, it would be better for her to spend time preparing everyone psychologically for the next step given her dovish reputation in the markets and the administration. But this would delay the start of tapering and could push the Fed behind the curve, possibly leading to an undesirable rise in long-term rates.

Her job, therefore, would be made much easier if Mr. Bernanke were able to set a new course for the Fed before stepping down.

In short, if a decision has to be made in the near future, it would be easier for all concerned if Mr. Bernanke were to make it before his term expires.

Dutch again: The parameters for policy normalization have been in place for some time now, and I agree that it is both important and would be far easier for Bernanke to make the call.

Negative Ghost Rider, the pattern is full

This post is little more than a victory lap so please feel free to stop reading now.

Something strange happened yesterday. In the morning I was looking through data from the past two debt ceiling clusterfucks trying to think of an ideal way to structure a trade for a potential impasse. Having remembered that the US sovereign CDS curve had some wild fluctuations the last two times I focused on another possible flare up on the front end. This is a rather illiquid little backwater and a truly useless market for anyone actually trying to hedge risk on a treasury portfolio, but it’s a fun spot for doing some punting.

As it stood this morning 1y CDS were at 13bps with a 6bp spread on the bid ask and 5y CDS were at 24bps with a 4bp bid ask spread. Both of these levels were significantly below their (short) historic averages.

Since I can’t trade these in my PA, my desk doesn’t actively take risk in these instruments, and our clients don’t particularly care for small illiquid trades I thought I would share my thoughts on twitter.

I was happy that a number of people thought it was an interesting trade and got a few follow ups on the matter but most people just thought it was a halfway funny joke about Top Gun.

Then at the end of the day I was going through my pricing rundowns and I saw that this happened.

1y CDS had shot up by 45bps since the morning. Upon further examination I noticed that the aforementioned 1-5y spread went from 11bps to an all time record of -28bps. As shown below this is a 5.9 standard deviation event, and if you believe that derivative pricing follows a normal distribution this is something that should be seen once in every 300 million observations.*

And here’s the one day change for the curve.

I am going to run with the assumption that I just happened to have timed this recommendation perfectly, but I will hold out an inkling of hope that just maybe someone who reads my tweets banged this level and moved the market.

*If you think illiquid derivatives follow normal distribution patterns you should stay away from them, as well as any other assets that might prove too complicated for you.

A Few Thoughts on Domestic Inflation

Yesterday a far more talented sell sider than myself @barnejek in a discussion on the relentless rise in US real rates over the past two months sparked this post at BI and it lead to continued discussion on twitter and a few more posts about the recent fall in inflation rates. I took a few issues with it and received many questions so it’s far too much for twitter.

First and foremost the tweet makes no sense because inflation in the US has been stubbornly low for the past two decades, so unless you think it’s going lower from these current depressed, generationally low, levels saying goodbye to inflation is ridiculous. If however, that is your actual opinion please reach out in the comment section I would be thrilled to enter a swap to that effect.

Here are US benchmark real rates and their ramp up since April. I’ve been saying for the past seven months that short 5y TIPS was the best trade on the planet as they had all the overvalued characteristics of USTs but with positive carry. I still like the trade but the recent run up in the inflation expectation component of it looks overdone. As such I find it hard to see inflation going any lower from here.

Here’s the benchmark breakevens where the move has been just as staggering, the two year most notably is off 114bps.

US inflation levels are quite low. PPI leveled off last month but CPI and PCE both surprised to the downside. Luckily, this trend looks to have reversed last month.

Inflation will be supported by the recent climb in wages which were the input most severely impacted by the payroll tax increase. If I had to peg the soft inflation from the spring to one thing, that would be it.

It is important to look at wages coupled with consumer credit which was also continued to expand.

The most stable of the bunch core PCE has a good long term track record with the 5y UST, where the recent rise in yield points to upward pressure.

Last month’s CPI reading looked like a fluke to anyone who follows it.

The reading was inconsistent with the data from PriceStats (formerly the billion prices project) where prices have been rising for weeks.

Case-Shiler showing CPI should face continued pressure from rising home prices and rent equivalents.

Lastly to show just how overdone the move in short term inflation expectations has become here’s crude oil charted against the 2y breakeven. Since it factors so heavily into both consumer and producer inflation it has had a great predictive factor.

That said, my base case if for inflation rates moving significantly closer to the Fed target of 2% over the next 6-9 months.

Three Bearish Charts for Equities

First off let let the record show that equities are by no means my area of expertise, but I thought this was worth sharing and too long for twitter.

This week three of my favorite correlations for US equities in different risk areas ended up significantly disconnected from the levels where the SPX is currently trading. Because of this I decided to enter into a short term risk reversal on Thursday.

Economic risk: SPX has lined up very well initial jobless claims for the past 5+ years but has recently overshot by quite a bit

High quality risk: the BAML Global Financial Stress Index, which attempts to measure stress in areas such as solvency and liquidity, price momentum, and short term volatility. This is the first time it has broken significantly below equities in over two years.

Low quality risk: the Markit CDX North America High Yield Index tracks CDS for 100 non investment grade debt issuers. This has been an extremely tight relationship and was the straw that broke the camel’s back for me.

It might be worth keeping an eye out for a minor correction.