I am an ardent believer of the trading axiom that “if everyone knows something, then no one knows anything.” Too many times I have seen the market do the exact opposite of what everyone believed “had to happen.”
Although I struggle with the problem of fading way too many moves, I have always made my really big money putting trades on at points where consensus was firmly against me.
Therefore part of my daily routine is to continually ask myself; what is the market is expecting and where might consensus be wrong? If I can find points where participants are overly confident of an outcome occurring, then I can enter the trade with a favourable risk reward profile. I might still be wrong, but hopefully the fact that the market had largely priced in that outcome, it doesn’t cost me too much.
I think that we are currently in one of those periods where participants are “sure” of an outcome that is not nearly as certain as they have priced in.
The investing community is convinced that the global economy is rolling over and that there is very little chance that economic growth or inflation will meaningfully pick up in the coming quarters. We see this manifest itself in the form of lower bond market yields, flatter yield curves, a move from emerging markets to developed markets and a selling of commodity currencies.
Here is the chart of the US Two Year Treasury yield. The yield has been going straight down over the last couple of months.
US Two Year Treasury Yield</a> </div>
And it is not just in the US, here is the German Two Year Yield – again with a move lower over the last couple of months.
German Two Year Yield</a> </div>
The Yield Curve has flattened. Here is the 5/30 Year US Treasury Spread:
US 5/30 Treasury Yield Curve Spread</a> </div>
The curve widened quite aggressively last fall, but since then, it has flattened back to levels last seen in the midst of the summer budget crisis debacle.
Yesterday I spoke about the recent move out of Emerging Markets into developed markets, but I didn’t talk about the damage being done to the commodity currencies. These currencies have been beaten up as world economic growth forecasts have been slashed. The best example is the Australian Dollar:
Australian Dollar</a> </div>
The markets have become convinced that economic growth is to be found nowhere on the horizon. When I read through my research feed, I am shocked at how few analysts think that there is a chance for outsized growth in the coming year or two.
I am not convinced that they are wrong, but I certainly assign a much higher probability to that possibility than the consensus.
There is no doubt that we have suffered through an economic hiccup of late. Have a look at the PMI index:
PMI Index takes a dip</a> </div>
I know it is fashionable to make fun of the fact that many bullish analysts are blaming shortfalls on the weather. I saw one of the more popular pro-doom financial websites even went as far to claim that January was one of the warmest on record, so therefore all the excuses about weather were bullshit. This is disingenuous logic. The West Coast had one of the hottest January’s on record, so it made the country average much warmer than usual. But the fact that San Francisco was 80 degrees didn’t make up for the fact that Atlanta was below freezing and covered in a sheet of ice. The warmer weather didn’t add very much economic activity, but the colder weather sure did hamper it.
I am by no means claiming that the economy is not stalling. I understand that the odds actually favour that outcome.
But I am claiming that the market has become convinced of this fact, and I am not ready to concede that point yet.
The possibility that the weather did indeed greatly affect the economy over the last couple of months is much higher than the market is pricing. And if the weather did play a big role, then the economic snap back is going to be all the greater as the demand will have been pent up.
If over the next couple of months the economy revives, many market participants are going to be caught extremely flat footed and the moves in financial markets are going to be outsized.
At this point you might be willing to concede that the market has priced in a continued economic deterioration, but you will say that this is for good reason – there has been no signs anywhere of a significant economic uptick. This has been one of the slowest recoveries on record and it indeed appears that the developed economies have hit the dreaded “pushing on a string” point. The authorities are unable to create demand and the money they push into the system just sits idly by as excess reserves in the banking system.
Well, I believe that we have finally bottomed in terms of the ever decreasing money velocity and that we are about to see an uptick in inflation.
Wouldn’t it be perfect irony if at the point where the vast majority of market participants have given up ever worrying about inflation, it actually returns?
During the last year, the inflationists have been completely discredited. Whereas a few years ago the popular wisdom was that the Fed’s massive balance sheet expansion was going to cause runaway inflation, it has now been replaced with a manic belief that the Fed cannot create inflation.
I don’t believe for a second that the Fed cannot create inflation. At the end of the day, if they have a desire to create inflation, they can do it. They simply have to print with enough determination to change expectations.
We have not had inflation because the private sector’s paying down of credit has outweighed the Fed’s creation of credit. However, that is changing.
For the first time in a long time, we actually had households taking out credit! I am not judging whether this is prudent or not – debating the wisdom of encouraging this behaviour is not going to help you trade. Rightly or wrongly, it is occurring and you need to position accordingly.
Household credit – YoY change</a> </div>
Ever since the 2008 credit crisis, households have been steadily paying down credit – resulting in the negative rate you see on this graph between 2008 and 2013.
However, it has now pushed higher and is finally positive. That means that money velocity should be increasing.
And let’s not forget how much the Fed has pushed onto the banks’ balance sheet over the last few years.
Bank Excess Reserves</a> </div>
If the velocity of money finally stops going down, then the potential for an explosive move higher is frightening.
M2 Velocity</a> </div>
The Fed has stuffed money into the system for the last five years. It has not created inflation because credit was being destroyed in the private sector, which lowered the velocity of money and the Fed’s stimulus was merely parked into the banking system. But that might be changing.
And if it is, then the surprises in the economy and inflation are going to be dramatic and outsized.
I understand that the economy looks shaky and that it does indeed look like it is rolling over, but I think this offers you a great opportunity to put on trades that expect just the opposite. Tomorrow I will talk about why the best way to profit from this is probably not by buying stocks, but instead by shorting bonds and buying real assets.
**Things that I am watching
The Chinese are allowing their currency to weaken again**
Over the last coupe of weeks the Chinese have allowed their currency to weaken again.
Chinese CNY – (higher means weaker Yuan)</a> </div>
I am not yet sure what this means, but my first guess is that the Chinese authorities are not allowing the shadow banking system to contract and have instead decided to alleviate the recent crunch with a massive liquidity injection. This has caused the currency to fall.
If this is indeed the case, it will be one more reason to expect more inflation in the future.
Short US 5 Year Treasury Futures. I expect the Fed to continue to withdraw stimulus aggressively. Conviction 3
Short US 2 Year Treasury Futures. I think the downside is a move from 31 bps to 25 while the upside is a move up to 50 bps. Conviction 4
Short Euro. Added to this trade into the recent rally. Conviction 5
Short Nasdaq 100 futures, short Eurostoxx futures, and short Nikkei futures. I entered the trade last Wednesday with idea that the Fed is going to taper until something breaks and that the bulls are pushing their luck. Conviction 4. No stops for now
Short European stocks via ESTX50 index vs Long S&P 500. I continue to believe that the ECB is too tight relative to the Fed and the BoJ, and that this will translate into relative weakness of European equities. Conviction 5
Short Yen. Establish short Yen last week. Now I will sit tight and wait. Conviction 4
Short JGB futures. I can’t call myself a macro trader without this widow maker on the sheets. Small position for now, but will add aggressively at the first sign it is working. Conviction level: 2. No stop.
Long Yen volatility. I believe we are entering a period of increased volatility for the FX pair. Conviction: 3
Long 30 year US treasury volatility. Swapping half of this position into Yen volatility. Conviction 2
Long various deferred crude oil futures contracts. I own a variety of different expiries in years from December 2014 all the way to December 2020. Conviction level: 5. No hard stop.
Long precious metals smorgasbord. Long gold, silver and platinum futures. I also believe that the closed end ETFs (CEF.A CN Equity or PHYS US Equity) which are now trading at discounts versus years of trading at a premium are a good way to play this idea. Conviction level: 5. Using the year end lows as a stop for half the position.
Long grains. Long deferred corn, wheat and soybean futures. Although this trade has not worked at all, I really like it long term. Conviction level:6. No stop period.
Long Ithaca Energy IAE CN Equity. See previous posts. Conviction level: 5
Long Input Capital INP CN Equity. I have not yet written this up, but I really like this story. More to come in coming days. Conviction level: 5