On Friday investors were forced to deal with the reality that maybe the US economy is not as bad as they feared. The unemployment numbers were released and instead of job growth sagging, it jumped. According to Bloomberg economists expected 145k jobs to be created. The whisper number was even lower than that and the market forecast had a definite downward bias. When the number came in at 162k it was a big surprise. But what was even more surprising was that the Average Hourly Earnings came in at 0.4% instead of the forecasted 0.2%. The unemployment rate jumped to 6.7% from 6.6%, but that is to be expected in an improving jobs market as more participants return to the workforce looking for a job.
Although the skeptics have been bemoaning the lack of job growth and the stagnant employee earnings growth during this economic recovery, Friday’s numbers squarely contradicted this concern.
I have repeatedly emphasized that the economy was performing much better than most market participants believe. This number reinforced that view and is making many rethink their forecasts.
But although I am bullish on the economy, I am by no means bullish on the equity market. In fact, I think that the stock market bulls should be careful what they “wish” for. Given the massively overstretched valuations, I think that a strong economy that causes interest rates to rise quickly is going to provide a considerable headwind for stocks.
Maybe the market is starting to agree with me on this point. On Friday stocks gapped up into new all time highs, but were quickly sold.
S&P 500 future trading on Friday</a> </div></p>
Although I am bearish on equities because I believe that growth and interest rates are not going to be behave as well as the bulls hope, I still continue to believe that the real accident waiting to happen is in the fixed income market.
Over the last few months we have had a combination of factors that have caused the bond market to rally. Between the brutal North American winter and the slow down in emerging markets, there has been a definite pause in the global economy. At the turn of the year the US 10 year Treasury was yielding over 3%, but with these developments it has sagged to under 2.6%.
US 10 Year Treasury Yield</a> </div>
During the past 5 years since the 2008/9 credit crisis, there has been a couple of times that the economic recovery has seemed to be on the verge of becoming self reinforcing. Each time the Fed stopped their QE program and the economy rolled back downward. This time the Fed is trying to wean the economy off QE in a more gradual manner. However, markets have a terrible tendency of repeatedly extrapolating recent past history into the future.
This tendency has created a situation where markets are mistakenly continuing to believe that the economy is once again on the verge of rolling over and that the Fed will again rush in and administer a new round of QE (or at least slow down or stop the taper). It has been made worse by the fact that the weather, the emerging markets slowdown and the heightened geopolitical tensions are causing an economic pause that seems to be confirming the market’s worries.
However, this has created an opportunity for us.
I am already short bonds, but it is time to increase the bet. I think that Friday’s employment number has confirmed my belief that the market is being overly pessimistic about the economy (and also strangely sanguine about the inflation risks). As the emerging market drag hopefully alleviates and the weather returns to normal, the US economy will spring back to life and even the most grumpy economic bears will have to face the reality that the economy is not as bleak as they forecast. The Fed will quickly find themselves behind the curve as the market realizes that interest rates are much too low for this type of environment.
My one real concern is the situation in Ukraine. Although I do not think that Russia’s plans extend past Crimea, I am mindful of the fact that the situation is very unstable. It would only take one drunk Russian soldier to panic and shoot a Ukrainian by accident for the whole thing to quickly escalate in a powder keg that Putin did not foresee. I think that the potential for an accident that causes a war needs to be factored into any investment strategy.
Therefore I am worried about shorting too much fixed income without some sort of hedge in place. I am short equities, so that will naturally provide some protection. I was thinking about reducing my US futures short since my red P&L is telling me that I am wrong, but given my increased short bond exposure, I am going to leave all equity shorts in place.
This morning, I am going to short more 10s, but I am going to buy some out of the money calls to protect myself in case of a geopolitical accident. The call options are going to be fairly out of the money – June 126 calls. I will marry this new position on a 1 to 1 basis on this new leg of the trade. Hopefully the calls will expire as dust.
Buying Canadian BAX futures / short US Eurodollar futures
Although I am bullish on the US economy, I am not nearly as constructive on the Canadian economy. Now don’t get me wrong, I am not like the vast majority of hedge funds that are hysterically bearish on Canada’s prospects. No, my bearishness is much more Canadian in nature – decidedly in the middle.
I do believe that after the 2008 credit crisis Canada’s economy performed significantly better than most of the other developed nations and we mistakenly mistook our good fortune for intelligence (we began to believe that our shit didn’t smell). In doing so we have over extended ourselves. We have built too many houses, we have committed to too much mine expansion, we have created too many financial service jobs. We have done what happens in every boom – we have over expanded.
This was confirmed on Friday when Canada’s unemployment numbers did not show anywhere near the same degree of rebound as the American numbers. Economists expected the Canadian economy to create 15k jobs, but instead we lost 7k. Canada’s economy is suffering from the inevitable slowdown that follows any boom.
Hedge funds mistakenly look at Canada’s over expansion and assume that our excesses will be equal to America’s transgressions in the mid 2000s. This is where I part course with consensus. I think that we are going to under perform the US economy for some time to come, but that we are not going to plunge into the abyss.
My suspicion is that as the American economy improves, Canada’s is going to consistently lag. It will be the opposite of the last 5 years. But by no means is Canada going to collapse.
During the last 5 years Canada’s short term money market rate has been above the American equivalent:
US Dolllar LIBOR (white line) vs CAD CDOR (yellow line)</a> </div>
During the mid 2000s boom in the US, the LIBOR led the CDOR rate higher. However after the 2008 credit crash, US short term rates have been firmly stuck below Canada’s.
As the American economy improves and Canada’s languishes, this situation is going to reverse. In fact the market has already begun to anticipate this eventuality.
Here is the Canadian June 2016 BAX future versus the US June 2016 Eurodollar future:
</a>3 month Eurodollar Futures June 2016 (white line) vs BAX June 2016 (yellow line) </div></p>
The bottom panel has the spread between the two contracts. A year ago the Canadian BAX future was pricing almost 90 basis points higher. However since then this spread has narrowed down to only 33 basis points.
And for the September 2016 contracts, the spread is almost even:
3 month Eurodollar Futures Sep 2016 (white line) vs BAX Sep 2016 (yellow line)</a> </div>
These two contracts are only trading with a 6 basis point difference.
Although I am by no means early to this trade, I think this trend will continue into the future. I am therefore buying June and Sep BAX futures and shorting the equivalent Eurodollar futures.
All the hedge funds are busy shorting the Canadian dollar or leaning on our banks. I am much happier wandering into a square where they aren’t focused. Canada’s moribund economy is going to be solved with a monetary policy that remains neutral as America’s shifts to tightening. This trade will best take advantage of that outcome.
UPDATE: Short 10 Year US Treasury Futures with half of position married to out of the money calls Conviction 6
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
UPDATE: New position. Short Mar and June 2016 Eurodollar vs long equivalent BAX futures. Conviction 3
Long March 2014 VIX Futures. Conviction 2.
Long a tiny position of puts on TSLA and FB. Just for shits and giggles. Conviction 1. Stop – none: when they go to zero the market will do it for me.
Short Euro. Added to this trade into the recent rally. Conviction 4
Short Nasdaq 100 futures, short Eurostoxx futures, and short Nikkei futures. Fed is going to taper until something breaks. Conviction 3. 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 4
Short Yen. Conviction 3
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: 1. 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: 4. 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: 4. Using the year end lows as a stop for half the position.
Long grains. Long deferred corn, wheat and soybean futures. Conviction level:5. 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