abob's fundies journal

The following portfolio comprises my favourite trades for 2006. The portfolio is a long-term portfolio, reflecting my view on the state of the world and on some particular stocks. The only active management of the portfolio will be when I take profit or when I close trades if they hit their theoretical stop-loss levels.

ABOB Portfolio 2006

Commodities
Short gold (June) 564.1 (stop 655)
Short WTI July oil 67.55 (stop 80)
Short copper (HG Comex) 2.0390 (stop 2.5390)
Short silver (July) 9.227 (stop 12.5)
Short platinum (July) 1054.1 (stop 1400)
Long coffee (July) 124.20 (stop 100)

Equity
Long Nikkei 15805.95 (stop 13,000)
Long S&P 1280.68 (stop 10,000)
Long Microsoft 27.05 (stop 18.00)
Long Alexon 228.00 (stop 150)
Short Google 466.27 (stop 600)
Short Starbucks 31.18 (stop 40)
Short Apple 84.20 (stop 110)

Fixed income
Short German bund 3.27% (stop 2.8%)

FX
Short EUR/SEK 9.323 (stop 9.55)
Short NZD/USD 0.6905 (stop 0.74)

For the sake of simplicity, I assume the equity at risk for each trade is equal, where total risk is the spot price minus the stop-loss level. Please note, these are not necessarily real money trades. Let's see how this portfolio fares. I will post updates at the end of each quarter and when there are changes to the portfolio.

: )


For the record, in the real money world, I am long the Nikkei following the Livedoor fallout, short NZD.USD and very small short cable. Depending on how these turn out, my next positional investments would be in commodities from the short side.

This blog article is not FX related but may be relevant for investors of sterling, FTSE or UK bonds

The Financial Times is today running a very interesting piece on long-term gilt yields. Following a surge in demand for long dated debt, real yields in 50 year UK government paper have plummeted. The nominal rate yesterday fell to a low of just 3.48%, while the rate on 50-year inflation-linked paper fell to 0.38%. When I look across at the JGB market in Japan I often ask "how can investors justify buying such a low yielding investment?" I now find myself asking the same question of the UK market.


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The main culprit behind this buying of overpriced debt appears to be pension funds. Corporates' pension accounts are woefully underfunded and in an asset-liability matching exercise, pension funds are buying up more and more long-term paper.

The low yield problem may be compounded by several additional factors: (1) Yield curves are generally inverting across the developed globe. (2) Long dated paper in the UK is in short supply - the government only recently re-introduced 50 year debt to the market. The market is screaming for more liquidity. (3) The FT make the interesting point that as pension funds buy more and more long-dated paper, so yields are pushed down. Because these yields also act as discount rates in the pension funds' liability calculations, an effect of lower yields is that the pension funds' liabilities grow in size (in present value terms). This, in turn, means the pension funds must buy even bonds to match the ever growing liability. More bond buying pushed yields lower still, and so the cycle continues.

Point 3 is the most worrying. It makes logical sense and if this effect outweighs the effect of rising bond prices boosting the asset side of the pension funds' balance sheet, then this may suggest the market has got itself in a circuitous trap.

I believe the problem will not persist as real yields at existing levels simply do not provide sufficient reward for the risk; we are talking about a 50 year tenure! At the same time, if the self-fulfilling prophecy component of the low yield conundrum puzzle is a real phenomenon then it is not unreasonable to hypothesise that the unwinding of this situation could also be self-fulfilling: as investors start to sell bonds, so yields will begin to rise and pension liabilities will shrink in present value terms. Less liabilities means less bonds need to be bought to match, and so the cycle will continue, pushing rates higher and higher.

If I had the capability I would much rather be a seller of 50 year inflation-linked paper than a buyer.

As a side note, if I was a pension fund manager, I wouldn't be buying this long dated paper at these levels. It may be heretic but I would be piling in to the FTSE. Would you rather by stocks, with a long-term real return of around 6% (conservative), or government paper with a real yield of 0.38%?

: )

Abobtrader

damn, I seem to be on the short side of everything !

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Uncertain times in the market seem to be accompanied by freak events in the UK. The night before the stock market crash of 1987, the UK was hit by a freak storm that wreaked havoc across the country. Last Friday, a disorientated whale was discovered swimming up the Thames River in London, the first time in recorded history. As the whale swam past the financial district of Canary Wharf the market was being hit by a whirlwind of cross currents: fresh threats from Bin Laden, escalating concern over Iran's nuclear ambitions and the announcement that Iran was moving its assets from the West to avoid having them frozen by the authorities, high oil prices that were moving more off sentiment than fundamentals, higher volatility in gold, and further follow through of the equity market weakness that followed the Livedoor scandal and earnings disappointments from some of the big hitting corporates. In the opening session in Asia following after the weekend, oil has moved above $69 and the Nikkei is down another 2%. Importantly, we have also seen an explosion of USD weakness (the FX market is usually fairly quiet in the Asian session). EUR/USD has burst through the 1.2275 region and cable is above 1.78 at the time of writing. The madness is continuing.

Like the whale I feel disorientated. I have just finished reading Practical Speculation by Victor Niederhoffer and I am reminded that equity markets perform strongly in the long-term. Perhaps I should be thinking of this recent dip as a buying opportunity. Indeed, on Vic's 'Daily Speculations' site, he talks of bringing out the canes and of how previous episodes of similar weakness have been tended to be followed by gains (instead of just talking in anecdotes Vic admirably counts and quantifies whenever possible). If it wasn't for high oil prices I would be confident in bringing out my cane and buying equities. But I am young. Indeed, I do not have a cane, though I may need one very soon.

I will be going long the Nikkei tomorrow morning, and perhaps buying some Woolworths and Invensys shares, but at the same time I may be selling Google and Apple. I am already long the FTSE. If the pound is still above 1.78 I may be seller of cable in small size and may also buy EUR/GBP to get some immunity to EUR/USD. I just can't see why the pound has been such a strong performer of late. I will post my real money positions on-line at the end of the day. My positions are counter-trend. In this sense I am always fighting. It can be draining.

Unfortunately the whale died during the rescue operation. It was disorientated and found itself in unchartered waters. It stopped feeding. For new investors such as myself, the events and volatility of late has also created a feeling of disorientation. I see opportunities but the new landscape is beset with increased risk. Aggression in position taking will be constrained by these new uncertainties, lest I end up as the whale.

: )

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The dollar bears sure like to come out at Davos. Here are some quotes from George Soros:

"When you reach the point where interest rates might be turning around, then the dollar might become more vulnerable''

"I personally think that the recovery in the dollar has probably reached its peak but it doesn't mean that the dollar is about to fall"

I am a great fan of Soros and have just got a hold his book, The Alchemy of Finance. I'll report on this book later. On the dollar, his view appears to be far less bearish than what we heard from Buffet and Gates during the previous Davos get together (after which the USD rallied considerably), though Soros has been a USD bear for several years now.

I readily admit that I am less willing to come to the defence of the USD bulls these days, even as I, myself, remain a low conviction USD bull (versus GBP and NZD). There is no getting away from the fact that last year saw the USD move from being a funding currency to a potential high yielder as interest rates were raised at every possible opportunity. And from where we stand, I find it easier to make the case for the ECB to hike over and above what is currently priced-in, than I do for the Fed. If the cyclical and structural story is USD negative what's with my moderate USD optimism versus NZD and GBP. Unlike, the euro area, I believe rates in the UK and New Zealand are more likely to move lower than higher, perhaps more so than is priced in. Also, I don't believe the USD is in an equilibrium position but that it is slightly too cheap to fair value, and that the market view is skewed in favour of a weaker USD (a contrarian indicator?).

Forces are pushing and pulling in both directions. Frankly, I see more opportunity in equity markets and commodity markets than I do in the fx market. I know I have trained myself to trade the USD from the long side when the opportunity presents itself, but I should stop doing this soon as the ground appears increasingly shaky. (I had a dream last night that the USD fell off a cliff edge, and that the public lost all faith in the currency.)

Don Quixote and the markets

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I've just finished the first part of the excellent Don Quixote (new translation by Edith Grossman). I found the following quotes to have application to my trading endeavours.

On Don Quixote and his state of mind: 'In short, our gentleman became so caught up in reading that he spend his nights reading from dusk til dawn and his days reading from sunrise to sunset, and so with too little sleep and too much reading his brains dried up, causing him to lose his mind. His fantasy filled with everything he had read in his books, enchantments as well as combats, battles, challenges, wounds, courtings, loves, torments, and other impossible foolishness, and he became so convinced in his imagination of the truth of all the countless and grandiloquent and false inventions he read that for him no history in the world was truer.'

How often we fill our heads with so much of the swill that is written on financial markets. It is easy to lose ourselves in the chat boards on the internet, on the articles and books on how to be make millions from nothing, on the benefits of technical analysis, and on and on. We are chasing hope. Our brains risk drying up from all this nonsense; the portion of writings that are truly useful is surely drowned out by all the repetitive nonsense that permeates our world, offering false hope through deception.

Sancho Panza to Don Quixote: 'And what's clear to me in all this is that in the long run, these adventures we're looking for will bring us so many misadventures that we won't know our right foot from our left. And the better and smarter thing, to the best of my poor understanding, would be for us to go back home now that it's harvesttime, and tend to our own affairs, and stop going from pillar to post and from bad to worse, as they say.'

I have often had this feeling of turning back, fearing that in the long-run I will be proven wrong; that the combination of market efficiency and broker commissions would erode my capital and my will. This feeling was greatest after my earlier misadventures, when I had just started trading. In these early days I was least sure about my view on the efficiency of markets. Now, I am more confident that the markets are not always efficient, and am more confident of my decision to trade with the passing of each day.

Don Quixote to Sancho Panza: 'You should know Sancho, that a man is not worth more than any other if he does not do more than any other. All these squalls to which we have been subjected are signs that the weather will soon improve and things will go well for us, because it is not possible for the bad or the good to endure forever; from this it follows that since the bad has lasted so long a time, the good is close at hand.'

This quote reminded me of the mean reversion in financial markets, that perhaps it is best not to go long at the high of the day, week, month, or year. It can be beneficial to trade the other way, or at least to wait for a pull-back to get in at a better price. This happens more often than not. The quote is also useful to remember when your portfolio is going through a bad patch, although it should not be used a cover for failing to investigate why it is that things are going bad.

the last two quotes speak for themselves:

Lotario to Anselmo: 'Remember that if a man seeks the impossible, the possible may justly be denied him.'

and lastly '...let the man who dares more than his strength allows suffer in silence...

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After completing the excellent Soros on Soros, I was eager to read The Alchemy of Finance. My verdict is that the book is brilliant and unparallelled, but it sure had its flaws. I was surprised to find The Alchemy of Finance to be written in a completely different style to Soros on Soros. It is extremely dense, perhaps unnecessarily complicated, and as I have come to expect of Soros, The Alchemy ventured well beyond 'reading the mind of the market' - with sections on the free market versus regulation, the inherent instability of the financial system, and proposals for a global central bank. Oh, and as I had a pretty old copy of the book, I didn't have the benefit of the new foreword by Paul Tudor Jones or of the new preface, which gives a nice heads up on the theory of reflexivity. Because of this, I was blown away as Soros ploughed head first in to his philosophy, reflexivity, and how it related to the financial markets. It made my head hurt. The book is very tough going, and is definitely not something you can read while watching MTV (trust me).

Now the good bits. Soros is a genius and is arguably the most successful investor of all time and this book seems to provide a genuine insight into his thought process. Soros first explains his theory of reflexivity- his name for a situation where there is a feedback loop between the thinking participants (eg the market, providers of credit etc) and the situation in which they are involved (eg: investing in the market, lending etc). For example, the decision to lend money affects the future creditworthiness of the debtor; and investing in markets can create price moves which then alter investor perceptions - this is an ingredient in the generation of boom-bust cycles. I'm sure Soros says that his theory of reflexivity gives him an 'edge', but I found his synthesis of macro events to be on a level that very few people can likely reproduce and maybe this is his edge - he just seems to be operating on a higher level to the majority of the market.

My favourite part of the book is Soros' real-time trading experiment, where Soros explains his thought process and investment decisions in real-time in a diary format. He gives a break down of his portfolio as he progresses. This section is what makes the book worthwhile. You get to understand and appreciate Soros' thought process, which is pretty advanced. Naturally, you need to have some understanding of economics to understand this stuff, but it really is gold.

What surprised me most was how often Soros changed his portfolio positions. I always had him down as a Buffet type of investor, assuming that apart from the occasional opportunistic trade he would take very long-term bets. He does seem to do this, but he also trades on a much more frequent basis, constantly testing his hypothesis and getting feedback from the market. I'll admit I was initially thrown back by the fact that his macro hypothesis seemed to be long-term in nature while his investment decisions were of a shorter duration. It all clicked when Soros said that trading was not about getting your economic predictions right but that it was about anticipating what thesis the market was adopting.

I highly recommend this book for all macro traders.

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PS - If you want to know more about Soros theory and its application, the chapter on reflexivity and the stock market is freely available here.

I know this isn't purely fx related but if you have a view on the commodity mkt, this has implication for AUD, NZD and CAD. I am small short CAD vs USD and short NZD/USD.

All the best

Abobtrader

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I have commented that when commodities hit the mainstream as a potentially solid investment idea, that may be read as a sign that the market has reached its peak. The following paragraph is from a Reuters story, published earlier today:

'Commodities are becoming a mainstream asset class with investors, who for years regarded them as too risky. Now robust global economic growth, especially strong demand from China, and decades of underinvestment in oil refineries, mines, and transportation infrastructure, have created shortages in many raw materials and bottlenecks getting them to market. Key commodity price indexes have soared to levels not seen in a quarter century. Many economists and money managers believe that the commodities boom will be long-lasting. Some have taken to calling it a "supercycle." Many investors are looking to get involved, either to speculate with short-term trades, or to diversify portfolios with more long-term commodity exposure. '

The piece provided links to stories with the following titles (selective):
Fund flows into commodities exceed expectations
UK, Irish pension funds turn to commodities
New retail gold funds seen here to stay
Commodities bull run could last 15 years
UK's Dawnay Day launches new commodity index fund
Commodity index fund makes debut on Amex
INTERVIEW-It's a different world now in commodities
INTERVIEW-Demand for commodity funds to rise-Japan's Okato
INTERVIEW-Commodities boom has years to run

I have limited market experience but from what I have seen and from what I have read, I have come to believe that whenever a particular sector or market is hotly in favour, it is best to stay away, despite what may appear to be be a compelling logic to join the party. This is particularly true for retail investors. If we look back to recent history, to just before the tech bubble blew up, record amounts were flowing in to funds (unit trusts, mutual funds, ISA's etc) as private investors believed that we were in a new era and that these stocks would serve as useful vehicles for medium or long-term investments. Many individual investors bought at or near the top and failed to sell on the way down, losing a large chunk of change. The investor universe is made up of many types of buyers and sellers: seed capital providers, venture capitalists, private equity funds, mutual funds, pension managers, funds of funds, and retail investors. I believe that by the time a trend (usually based on a fundamental development) filters through to the retail investor, then it is time to start questioning its sustainability. The poor retail investor is often last to the party.

Unlike equity markets, which have an upward drift, commodity markets do not exhibit such a bias. Because of this, I believe that retail investors, pension funds and the like, who have recently moved in to this space, are investing in a market with skewed risk-return. Many commodity have already climbed several hundred percent over the past five years, and while prices could remain high due to the China effect, I wouldn't like to make medium term or long term investments at these levels. Indeed, as a short-term proposition I am a seller (I exited my long sugar trade and am short gold and copper). I am not ruling out further gains in the near term because the trends are strong and money is moving in to the sector, but if you look at historic price charts of the commodities you will see that kinds of high prices we are witnessing are rarely sustained. As such, I believe the retail investor is once again may be being sold a raw deal and could well end up as grist for the mill. At present I believe the commodity markets are suitable for market timers but not for the buy-and-hold crowd.

Reading that Reuters story today has me thinking that while we are far from euphoria experienced during the internet bubble, the tech boom was a very different phenomenon in that the internet was far more pervasive and so grabbed more media attention. Lower barriers to entry mean't more companies were launching and this also created a greater buzz factor. This means I don't have a very good yardstick to assess a peak in public interest in the commodity market, but I think we may be close to that point. I'm betting the good news is in the price.

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I have again decided to book profit on my real money short NZD/USD trade, at the current price of 0.6720. I entered the trade at 0.6750 and added again at around 0.6800.

My profit is modest but after looking at my portfolio, I realised the over-riding theme was bearish commodities. While I believe NZD should head lower on fundamental grounds, this trade is also strongly related to commodities and I need to reduce my concentration. I am exiting the trade with a view to get back in at better levels, accepting that I may never get to see these 'better levels'. Nevertheless I am satisfied as I have effectively swapped this trade for a pure commodity trade (short copper and short gold), where I have greater conviction and which has proven more rewarding.

Morgan Stanley make the case for why NZD/USD may remain stubbornly high despite compelling economic logic for depreciation. Here are some of the interesting points the MS note makes on factors that will affect the timing of a NZD sell-off:

- MS believe "triggers for a move from NZD are driven by ‘nominal’ factors coming from the supply of capital flowing into New Zealand, rather than the economic fundamentals in New Zealand. It is likely that prospective ECB and BoJ policy shifts and expectations of these changes will be more important drivers of NZD." MS note the high level of Uridashi and Eurokiwi bonds that will mature over the next couple of years, making relative policy that much more important. I diverge in opinion here, but only slightly. Whereas MS think the pace of NZD depreciation may be highly dependent on the pace of tightening by the BoJ and ECB, I believe we may be fast approaching the conditions for a perfect storm in NZD, with evidence of slowdown in NZD compounded by signs of a robust US economy (retail sales, NFP and belief in continued strength from the monetary US authorities under Bernanke, who I perceive to add a slightly more hawkish tilt to Fed policy than was otherwise the case). I believe BoJ policy is important but as rates are unlikely to move up at an aggressive pace in Japan so the demand for kiwi assets from Ms Watanabe should remain fairly strong, though once the rout starts it may not stop. Regarding the ECB I believe ECB interest rates are a significant issue but I maintain that all eyes should be on the US - I think ECB policy is generally subordinate to Fed policy when it comes the fx market, though I'll readily admit that I haven't looked at the eurokiwi bond issuance issue in great detail.

- MS have NZD/USD overvalued by 15% on a fair value basis. They note 'if NZD does start to
move south, it is likely to undershoot its fair value, making the potential cumulative depreciation substantial'.

- On the fundamentals, MS note the current account deficit of 8%, foreign indebtedness of 81% of GDP (triple the US level), a slowing housing market, and negative net exports.

- On the issue of foreign debt, MS make the point that we may see fresh issuance replacing the maturing debt, but the question of how much new issuance we will see is an open one.

- They note a 'fixation on nominal yield differentials' which may be serving to keep NZD at these high levels. If investors were to shift their focus to real-yields, NZD would likely come under greater pressure (inflation is higher than Japan, Euro area and US).

- MS also note that commodity prices remain high, noting that according to their estimates '
1% increase in the Commodity Research Bureau’s spot commodity price is associated with an
increase of 1.03% in NZD/JPY and a 1.296% in NZD/USD'.

Overall then, more reasons to sell the kiwi. Although I no longer have a position in the kiwi, and even though the high carry is a bit of a thorn in the side of the short traders, I remain bearish and continue to believe the patient will be rewarded.

I believe that most traders would prefer to be long a currency position that receives interest, rather than suffering the slow burn of paying out the interest rate differential every day. However, I am of the view that the straight forward fx carry trade is often mistaken as a trade that offers somewhat of a free lunch; when the carry trade is in favour being long the high yielding currencies seems the obvious thing to do. The benefit is two-fold; you earn interest on a daily basis and you benefit from capial gains as funds flow to the high yielders, creating currency appreciation. It seems to make so much sense. Conversely, it can be very painful to be short the high yielders when carry is in vogue.

That said, surely this free lunch is 'too obvious'? I don't rule out the possible existence of a slight edge in being long the paying currencies, but I fear that the the widespread perception is misguided and view the the perceived benefit to be largely illusory. My main concerns are:

- It's not always obvious when the carry trade is the dominant theme in the market.

- While we know that uncovered-interest rate parity does not hold over time, perhaps there are other risks involved in playing currencies from a carry perspective. In one sense you could argue that rates of return reflect risk (this is the basic idea behind all financial investments), so maybe the higher yielders are more risky in terms of volatility? I believe this is true, but I also think that this risk may not be evident in simple standard deviations and in the more obvious measures of volatility. I believe the higher returning currencies are inherently more risky on the downside; that is, while these currencies may creep higher over time, I perceive greater risk of sudden and steep corrections. This is evident in the price action in USD/JPY, where the bias for sharp moves seems to be skewed to the downside (this was evident in the price action earlier this week, and can be seen in previous periods if you look at charts going back several years). Likewise, the Icelandic krona, which yields a very attractive 10.75%, plummeted over 9% in two days this week, with the FT reporting 'for traders who had borrowed in euros, the krona's sharp slide wiped out more that a year's worth of carry trade profits in one fell swoop.' My theory is similar to that posed by others as an explanation for the existence of the equity risk premium. I think it is valid and it could be relatively easily tested by those who are inclined.

- Trading a basket of high yielding currencies enables traders to offset some of the directional exposure, especially if some of the pairs have negative correlations. My concern here is that you are generally reducing your interest pick-up as you reduce the directional exposure of your basket. This is the trade-off, the payment for a less directionally exposed basket. More worrying is the problem of dymanic correlations, which means your perceived hedged exposures could be illusory. FX correlations change rapidly over time, and if the carry theme falls out of favour the risk is that wholesale selling of the high yielders means that your entire basket could suddenly become strongly correlated. In a stable environment, the correlations will stand up, but when it really counts, the relationships could break down for the worse.

- Lastly, given the volatility of currencies, it is worth bearing in mind that a) the gains from the interest rate differential can be wiped out very easily, and related to this a) you could suffer large drawdowns by pursuing a pure high yield strategy.

I am not saying the carry trade is a fools game, but I think it requires a very cautious approach with an appreciation for history. It is not in the nature of market does not offer up free gifts in such an explicit manner.

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The ECB yesterday raised interest rates to 2.5%. Upward revisions to its growth and inflation projections pushed the euro higher by a big figure as the market re-appraised a more hawkish than expected ECB. Market expectations are for two more 25bp rate hikes this year, which would take the policy rate to 3.0%.

My view on interest rate cycles in broadly in line with the market. I believe: the Fed is approaching the end of the tightening cycle; the ECB still has some way to go; the RBNZ is close to monetary easing; and the BoE is at the end of the hiking cycle (while we could see another hike from the BoE I perceive a slightly higher risk of a cut). Having a view in line with the market does not imply that there are no trading opportunities to be had. I am negative on NZD vs EUR and USD, neutral to slightly bullish on on the USD versus the EUR, and would be negative on GBP in the high 1.70's. With respect to the yen, it is clear the economy is recovering and that the ultra loose monetary policy will come to an end. However, I am not sure the yen follows rate differentials as explicitly as other currencies.

These directional views can be explained by the fact that I strongly believe in cycles; for the countries that are close to monetary easing, I expect the economic data to start surprising on the downside (on aggregate). Similarly, for the ECB, where the tightening process is arguably in its early stages and the economy is displaying signs of growth, I believe euro area data will have a tendency to surprise on the upside (see today's strong euro area services pmi). It is worth bearing in mind that the ECB (and previously the Bundesbank) has a very strong aversion to high inflation, arguably more so than other central banks.

This view is about as long-term as it gets. It is the kind of big picture that frames one's trading strategies. Within this picture, I would take positions based on signs of excess in either direction, on evidence of shifting sentiment, on detection of economic changes that either support or reject my views, and on signals emitted from the other financial markets (bonds, equities and commodities).


: )

mmm, do I ever stop writing about interest rates ?

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I have recently been thinking about the idea of a neutral rate of interest. In theory, the neutral rate of interest is the level where inflation is stable and output is growing at its potential. I believe the idea is valid in theory but that it is very tricky in practise. This is my simple explanation for why the neutral rate changes over time.

Say, the neutral rate is calculated at 5.0% for the Fed funds rate. There is an economic crisis and the Fed drops the Fed funds rate to an extraordinarily low 1.0% for a sustained period of time. Borrowers switch to the low rate, and new borrowers take on debt at this new rate. Because rates are held at this low level for a long period, the level of debt accumulated at these low rates is considerable. Then, as the economy recover the Fed funds rate moves to 4.5% over the period of some two years. 4.5% is moderate in historical terms and is arguably low relative to the level of inflation and growth. However, what has has actually happened as rates have climbed from 1.0% to 4.5% is that the interest rate bill for a large chunk of the population has gone up by over 300%. The effect is quite as pronounced as the example suggests because mortgage rates wouldn't have gone up by such a large amount in percentage terms, but it does serve to illustrate the fact that potential pain that borrowers would face could be considerable, and would be much higher than if the Fed funds rate had only fallen to 3% before climbing back up.

This idea, that the neutral rate of interest is at least in part a function of where have the nominal rate itself has moved to, and for how long it has spent there, is something to think about when looking at the Fed funds rate, the ECB in its new more aggressive phase, and the when analysing the BoJ, which has effectively had a zero interest rate policy for several years.

Non-manufacturing ISM
Never before have I seen such a response in EUR/USD to the services ISM data. This data is usually ignored by the market; not only is it a relatively new index but it is inherently difficult to measure the non-manufacturing part of the economy (despite its increasing importance) and the numbers can be pretty volatile. It is quite likely the market centered on the employment index component of the ISM data, which rose to 58.2 from 51.1 in January (50 is the 'no-change' level). Because there is a reasonable correlation with the NFP, such a strong reading bodes well for next week's NFP number. Nevertheless, its not all roses. First, you could argue that the Jan employment number of 51.1 was somewhat of an aberration, as December and November had readings of 56.9 and 56.7 respectively. Also, at the same time as the ISM number, we the University of Michigan consumer confidence data was released, showing a pull back of 5.5 points to 86.7.

By the end of the day, the USD had mostly retraced, but the extent of the initial response may be telling us that there is a major tug of war in the market's perception of monetary policy. The ECB is turning more hawkish, but has the market been underestimating scope for Fed tightening? There is some talk of a Fed funds rate of 5.5% (Lehmans). This game has been going on for quite a while now and has kept EUR/USD locked in a relatively tight range. I am happy with my broadly agnostic view on the pair.

US Treasury research
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Today also saw the US Treasury launch the first of a series of research papers, which look like they could make for interesting reading.

The first paper looks at petrodollars and global imbalances and is only 7 pages in length. The authors make the salient point that between 2002 and 2005, the oil import bill of the United States increased by a whopping $104bn as the price of oil sky-rocketed. The current account deficit widened by $284bn over this period.

Japan jitters but all is well


Last night's market response to the ending of Japan's policy of quantitative easing left me scratching my head, thinking 'What does this all mean for my long Nikkei position in the main Portfolio?'

I have always believed that the BoJ/MoF would only very gradually tighten monetary policy, and that this should create a positive environment for Japanese equities. Indeed, Fukui's comments that "Interest rates will stay at zero for a while, then move to extremely low levels before being adjusted according to economic conditions", confirmed this and gave me confidence in my trade. Indeed, the Nikkei posted a 2.6 percent increase overnight. The signal from the bond market (lower yields) was also comforting, but I just couldn't figure out why the yen appreciated significantly. Were yen traders out of tune with the equity and bond markets in expecting more aggressive tightening ahead? Was the equity market rally a knee jerk reaction before a sharp decline? This divergence had me puzzled for a short while, but I am happy to report that the yen seems to have come around to thinking of the wider market and has ended the session on a weaker note.

When Japan will put an end to it's zero interest rate policy (ZIRP) is any one's guess, but so long as the authorities keep signalling a cautious approach, and provided inflation remains contained, I am happy with the long Nikkei trade. What I am less happy with is the timing of my entry: I went long at Nikkei 16585 on 31 Jan. This was my first ever attempt at a trend following trade. I am slowly realising that trend following does not fit in with my trading personality.

Note - I will review my portfolio positions at the end of the quarter.

I normally pop over to David Andrew Taylor's site (Dismally.com) for timely comments and charts of specific economic data releases. Today, however, there are a series of events points I would like to briefly comment on. Below, I discuss today's current account report, the retail trade data, Trichet's comments, the Medley report, and a pattern in the EUR/USD intra-day price action. These are all interesting, but I believe they point to little more than a continuation of the status quo; that is to say I expect more range bound trading in EUR/USD for the time being.



Medley nonsense? At least one currency trader cited a Medley report, as a reason for EUR/USD appreciation. According to Reuters, the report suggested that the Fed will increase rates a further 25bp to 4.75%, but beyond that it is uncertain. I find the idea that Medley reports move the market difficult to believe. I don't have any experience with the company, but from the reports I have read, they seem overly sensational and short on substance. I am dubious about the real quality of their content, as they often quote high ranking officials, who of course they can't name (perhaps because they are so high up...or so low down?). While the folks at Medley likely have some very good contacts in Washington, what can they really tell us about the Fed that we don't know already? Despite my reservations, the market seems to believe Medley can provide special insight.

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Patterns in EUR/USD: This may of interest to day traders. I've noticed that when a currency appears to be making some kind of obvious pattern, the announcement of economic data often can create a great deal of volatility but then, quite often, the spot rate settles back into completing the original pattern. Today's price action in EUR/USD is a perfect illustration. Before 13:30 (time of current account and retail data), EUR/USD appeared to be appreciating in a kind of horse-shoe pattern. The data created some volatility but after about half an hour, the pattern was firmly back on track. Is this an example of a pocket of predictability in an otherwise predictable market. It could be tested for with the right data set.

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- Another record US current account number: This data came out at the same time as the retail sales data, and showed a deterioration beyond consensus expectations. A Q4 deficit of $224.9bn takes the 2005 total to a record $804.9bn, equating to 6.4% of GDP.

The chart below (from the BEA) shows the trend for an ever worsening deficit:
http://i33.photobucket.com/albums/d5...ntbeaSmall.jpgWhat really stands out in the above chart is the pace at which imports have outstripped exports over recent years (in $ terms). Indeed, we are close to the point where exports would have to rise by twice as much as imports just to keep the trade balance stable.

All else being equal, the USD would need to depreciate by a great deal just to stabilise the deficit. In my view, this is not the solution to the problem. While a weaker dollar may help to some extent, I expect the problem to be addressed on many fronts; an improved relative growth outlook (stronger demand from Japan and the Eurozone, versus the US), lower oil prices reducing the oil import bill, and an increase in the US savings rate resulting from higher interest rates and a slowing housing market. While I expect these factors to play a role in helping to stall the pace of widening of the deficit, it is difficult to envisage the trend reversing any time soon.

Indeed, whatever the many possible causes of the current account deficit, there is no getting away from the fact that the significant increase in claims of US assets (see chart below) poses a growing threat to the USD.

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Right now, interest rate expectations are getting somewhat of a second wind, and these cyclical positives seem to be lending some support to the greenback; this effect is clearly over-riding the structural negatives for the time being. We are not there yet, but when the end of the hiking cycle is firmly in sight, I believe the dollar will depreciate as its loses this cyclical support.

The next phase would perhaps be an accelerated USD depreciation resulting from both structural and cyclical USD negatives. In this scenario, investors would pay greater attention to the deficit problem and seriously question the extent to which foreign investors will be willing to finance the burgeoning deficit, especially against an environment of declining yields (if the market starts to factor in rate cuts). We are very far from this point in the cycle, but it is a possibility to consider.

Following today's current account data, tomorrow's TIC data may receive higher than usual market interest.

- Weak but strong US retail sales: The headline number for February came in worse than expected at -1.3% m/m, though the ex-autos number was in line with the consensus at -0.4% m/m. The USD didn't sell off immediately, because there was an offsetting, upward revision to the January data and taking a wider perspective, the trend in retail sales remains healthy (year-on-year growth in retail sales is 6.5% for the headline and even higher for the ex-autos series (8.8%). It is not unusual to see a strong negative number in the monthly series after a bumper month, and this 'give-back' is what we saw in today's data. I don't profess to have any insight on the future path of this important series, but I would expect a moderation in retail sales growth in line with evidence of a slowing housing market, further Fed increases, and the Fed tightening which has already taken place (monetary policy can take over a year to be fully felt in the real economy).

- Trichet comments: As a reminder of the upside risk to interest rates in the Eurozone, Trichet was today quoted as having made the following comments in an interview with a La Tribune, the French newspaper:

"Our monetary policy is accommodating"

"We have real short-term interest rates that are very close to zero, nominal short-term interest rates are the lowest in the euro area since the Second World War,"

"All observers have understood that we will do everything that is necessary to maintain price stability and they grant us their trust. This confidence is our most precious asset."

"When you have interest rates close to zero in real terms, when you have the lowest rates that a major central bank has ever employed since World War Two, you are exercising an accommodating monetary policy,"

These comments remind us that even in a pure cyclical battle, there is no clear winner in the EUR/USD tug-of-war. No doubt, EUR/USD will sooner or later break out of the tight range that it has been stuck in over the past few months, but I am not about to place my money on the direction of the move. On balance, I am moderately bullish EUR/USD but the contrarian in me keeps on looking at the heavy skew of forecasts for USD depreciation as a contrarian signal. One course of action would be to trade small range bets around a recent mean in EUR/USD, with a view to jump on any break-out in a big way (fundamentals permitting).

An autopsy of my kiwi positions reveals particularly poor decision making:

Since late last year I have been very bearish on the kiwi. On December 16 of 2005, I wrote a piece on NZD/USD, titled 'Kiwi to the Slaughter'. I entered a real money short just north of 0.700. My reasoning was based on a host of fundamental arguments which suggested a medium term position could be very profitable. After just a few days, the NZD fell rapidly, and I took profit, with a view to re-enter the trade at a more favourable level. On Jan 3, I got back into the position at a good price. (On Jan 17th I added a short NZD/USD position to my theoretical long-term portfolio, which I still hold). I booked a small profit (real money) on Feb 16, saying that while I remained bearish on the kiwi, I was even more bearish on commodities and that I had decided to reallocate my capital to short commodity trades. I then went on to give a host of reasons why I thought 'we may be fast approaching the conditions for a perfect storm in NZD'.

http://photos1.blogger.com/blogger/5...rch%202006.jpg
You can see from the chart on the left, that NZD has indeed fallen of a cliff edge. Despite all my reasoning as to why this would happen and why I thought risks were skewed in favour of short positions, I was too smart for my own good and tried to time the trade, jumping in and out of my position every few weeks. I saw this as the most rewarding macro trade out there, and yet I didn't have the position on when it mattered. Never have I been so right and so wrong at the same time.

The biggest problem was that there was a large disconnect between the time horizons of my fundamental rationale (medium term: 3-12 months) and my actual position taking (short term: trading every few weeks). I'm sure greed played a role here. Another point that becomes evident with hindsight is that I exited this trade to go short commodities, but the latter position was largely based on my view of the price action. I believe prices have overshot fundamentals in the commodity world, but my fundamental arguments for why commodity prices should fall are nowhere near as robust as my views on the kiwi. Perhaps, the flaw in my personality is that while my macro thinking is suited to medium or long-term position taking, I often feel that I need to be involved in the market and that I am forgoing profit by not trading. I need to have more patience and more conviction in my views.

This year has not been so wonderful. Nevertheless, we keep learning and we soldier on.

I previously suggested that the supposed 'free lunch' provided by carry trades may be largely illusory and that the additional return likely comes bundled with higher risks. While I haven't tested this theory, I believe one of the risks is a higher than usual probability of a steep reversal of the position in question.

This has been borne out in the sudden unwinding of two big carry trades. In recent weeks, the kiwi has fallen by over 10%. Japanese holders of kiwi bonds (urisdashis) are exposed to the NZD/JPY exchange rate and recent investors must be smarting, with currency losses wiping out the interest rate advantage, and then some. A currency on the other side of the world, in Iceland, has also met with a similar fate. As the chart below shows, the krona has also fallen of a cliff edge. Contributing to the depreciation were the following: negative reports from Merrill Lynch, and Danske bank; a downgrade from the ratings agencies; a refusal of international banks to roll over the debt of the major Icelandic banks; and investor concerns of a sharp economic slowdown set against a backdrop of a country with a current account deficit of 16% of GDP. All good reasons to sell the currency.

Chart: EUR/ISK

http://photos1.blogger.com/blogger/5...320/eurisk.jpgBoth of these sell-offs can be argued to be related to the gradual removal of global liquidity that is likely taking place right now, with the Icelandic krona in particular acting as a touch paper for a sell-off of other risky currencies, but the reasons behind the move are not relevant to my theory. Also, it is interesting to note that Iceland is expected to raise its interest rate tomorrow, perhaps by as much as 50bps. Even though the depreciation of the currency - which has an inflationary impact - will likely be a key factor in deciding by how much to tighten rates, it is worth bearing in mind that the current policy rate of 10.75% has provided little compensation for recent investors who went long the currency, and that a further 50bps is unlikely to swing sentiment.

Even though I haven't rigorously tested this theory of skewed returns, it seems to hold weight. At the very least, recent events highlights the importance of not chasing 'easy money' trades with blind faith. Risks are lurking around every corner.

Note - Although uncovered-interest-rate-parity (UIP) doesn't hold when measured in the simplest sense, perhaps using risk-adjusted returns would bring the theory closer to the reality. This skewed return is also one of the many explanations put forward for the equity risk premium, but I am yet to see it in the academic research on exchange rates.

Geez, it's been a while since my last post here!

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I think I may be the only one here (surprise, surprise), but I see GBP/USD as severely stretched on the upside at 1.9010.

I appreciate the interest rate story is in favour of widening rate differentials driving EUR/USD appreciation (and by virtue of its correlation, cable) but the market really seems to have latched on to the soft US data, topped off with todays weak Philly Fed (this has a nice correlation with US ISM). With sentiment the way it is, it may not take much to create a bout of USD gains from where we stand.

Ever the contrarian, I like GBP/USD short with a stop at 1.94. On a move to 1.88 I would move the stop to break-even.

PS - The medium and long term technicals suggest I may be pissing in the wind.

Well, I just found your thread and since I am boning up on all things fundamental I shall be keeping an eye out for further postings.

Excellent, thought you'd quit posting! Read all your journal before, please keep posting, its great to see other thoughts from fundies

In the event you are actually wondering if there are readers of your journal... This post attests it. (wink) Frankly, I enjoy the read. Thank you.