There is an old adage that they never ring a bell at the top. But there should be another one that describes how difficult it is to forecast market movements in the middle and bottom as well.
Very rarely does the market simply lay it out on a platter for you to simply enjoy the meal. And if it is that easy, then it is most likely much more dangerous than you would ever guess.
However, we seem to be an especially difficult period with many cross currents pulling from different directions.
We have geopolitical worries with Russia’s invasion of Crimea, a stumbling of the Chinese miracle which may or may not be the start of something more ominous, the apparent failure of Japan’s aggressive monetary policy to kick start their economy, an ECB which seems determined to choke the struggling European economy, the hangover from a dramatic overbuilding in the commodity countries and finally, the Fed’s attempt to wean the economy off QE. This is all occurring with a backdrop of ever increasing debt levels and paradoxically, zero (or very low) interest rates in many countries. And finally, just to make the game all the more interesting, almost all asset classes are more than fully priced, with investors faced with a difficult decision of zero real returns on safe assets or venturing out the risk curve.
In this environment we have thousands of hedge funds all with the ability to quickly arbitrage inefficiencies or (more likely) to stampede into momentum trades in an attempt to pick up any extra return available. I recently read someone describe the current situation as a bunch of hedge funds standing around in a circle shooting at the target. I think this is a great analogy and it reaffirms my desire to stay away from any trades that are too popular with the hedge funds.
All these factors contribute to a market that often moves in strange counter intuitive ways. For example, last year the Fed and the BoJ had embarked in the two biggest QE programs in history. Yet gold suffered its worst year in a decade. This year the Fed is winding down the QE3 program and talking somewhat hawkishly, yet gold has rallied.
As a trader, all you can do is try to stay one step ahead of the crowd and continually ask yourself what is priced in and where is the surprise going to come from. Then patiently wait for the opportunities.
And I believe that one of those opportunities presented itself yesterday with the flattening of the US 5/30 year treasury spread. The bond market has finally woken up to the fact that the Fed is way more hawkish than the street has expected. I have been banging this drum for a while, and it finally seems to have sunk in. The Fed is going to taper (and then eventually tighten) until something breaks. The only question is when will something break?
The market believes that the economy cannot stand on its own feet. Although the bond market is now correctly recognizing that the Fed is going to continually withdraw stimulus, the fact that the 5/30 year spread has collapsed demonstrates a belief that the economy will roll back over without inflation ever becoming a problem. Investors are demanding more yield for 5 year bonds due to the realization that the Fed is more hawkish than previously believed, yet they are willing to move out the curve due to a belief that inflation will stay contained.
Here is the 5 year Treasury yield:
US 5 Year Treasury Yield</a> </div></p>
Contrast this to the action in the 30 year Treasury yield:
US 30 Year Treasury Yield</a> </div></p>
These divergent moves have caused the 5/30 spread to collapse:
US 5/30 Treasury yield spread</a> </div></p>
Although I agree with the market’s assessment that 5 year rates should head higher, I think investors that are chasing 30 year product at 3.56% are being foolish.
The market is obsessed with the Fed’s inability to create inflation. The idea that the Fed might overshoot is so far removed from their mindset that the moment that the Fed shows any hints of hawkishness, the curve completely collapses.
And here comes my big disagreement with the market. I think that before this is all through the Fed will be dramatically behind the curve. Right now the fact that the yield curve is flattening is forecasting the exact opposite situation. The market believes that the Fed be able to control inflation.
I think that eventually we will reach a situation where inflation is rising dramatically, and due to the high level of indebtedness, the Fed will be extremely reluctant to impose the necessary conditions to choke off the inflation. This will only fuel more inflation.
Now don’t bother telling me that about how the Fed is powerless to create inflation and how deflation is the real worry. Yes, I know all about the consensus forecast. But ask yourself if through the history of man if inflation or deflation is the more common occurrence. And think about the high level of government indebtedness and then ask yourself if you have ever known a politician to take the hard difficult way out. For those that want to bet on deflation, I say go right ahead, I will take the other side of your trade. If you are right, I will owe you the minuscule real yield that Treasuries are earning. However, if you are wrong and inflation gets out of control, then you are going to be spectacularly wrong.
Given that I think the Fed will eventually find themselves behind the curve, I expect the curve to hit record steepness. Therefore I am willing to start accumulating steepener trades. Yesterday I bought the 5/30 year spread, and will add to it as it goes lower.
I recognize that this logic is at odds with my statement that the Fed will continue tapering until something breaks. I just don’t think anything will break in the short run. I think that Fed has pushed a massive amount of stimulus into the sytem and the worry will eventually move towards the Fed having overshot, instead of the current worry that they are withdrawing prematurely.
I realize I am catching a falling knife, but this is a long term trade and this is just the start of the position.
Things that I an watching
Carl Icahn: I don’t just play a jerk on TV – I am also one in real life!
I was watching this interesting piece on Bloomberg TV about New York City elites’ desire to live at 15 Central Park West.
It is filled with a veritable who’s who of NYC stars and financial tycoons. Sting, Denzel Washington, Sandy Weil and Lloyd Blankfein all have apartments in the building.
There are 37 hedge fund managers who call 15 CPW home and collectively they manage over $437 billion dollars. Obviously the competition to impress each other with the biggest best apartment in this building must run pretty high.
Which brings me to my favourite blow hard hedge fund manager Carl Icahn. Of course Carl also needs to have a place at 15 CPW. But merely buying a unit off the rack is not good enough if you are someone with Carl’s ego. No, Carl wanted to combine two penthouse apartments to make the second biggest unit in the building. But apart from having a ego so large that makes it difficult for Carl to get his head through most doorways, he is also one of those guys who has to negotiate and beat you up on price each and every time. I guess his ego doesn’t want to see anyone but himself win.
Well, as he was busy beating up the developer on the price of his $45 million apartment, Third Point hedge fund manager Dan Loeb simply wandered in and took out the offering. Carl was livid for losing his precious status apartment. According to the fellow in the Bloomberg interview, Carl let loose on one of the developers an “epically profane tirade – dropping f bombs like he was a B52 over Vietnam in 1968.” Wow! Carl – I guess that jerk you play on CNBC is not simply a persona for the camera. Seriously? You try to chisel the developer and while you are nickel and dimeing, another hedge fund manager beats you at your own game, but you aren’t classy enough to simply say well done? You my friend are a hypocrite and a pain in the ass that I will glad to see out of the media limelight. You epitomize everything that is wrong with the 1% (actually the 0.001%).
UPDATE: New position. Bought the 5/30 year steepener. Will add to the position in the 160s.
Short CAD. Will add through 1.12. Stop 1.09. Conviction 4
Buy TIPS short TLT spread through long dated options. Conviction 3
Short 10 Year US Treasury Futures with half of position married to out of the money calls Conviction 4
Short US 5 Year Treasury Futures. I expect the Fed to continue to withdraw stimulus aggressively. Conviction 2
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 3
Short Mar and June 2016 Eurodollar vs long equivalent BAX futures. Conviction 3
Long March 2014 VIX Futures. Conviction 2.
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