abob's fundies journal

I posted this elsewhere in FF, but thought I would stick it here as well, with a few extra comments....for posterity!

The question was what explains the sudden spike like price action in the majors (rapid USD sell-off) from around 15:45 today. I haven't been watching the market all day, but my explanation is that we saw a temporary capitulation of the carry trade as the market woke up to the idea that risks to the CHF and JPY may be to the upside from here on.


The SNB came out pro CHF today:

"Fundamental factors still speak for the franc,", the SNB said.

"These include low inflation by international comparison and the increasing current account surpluses and improving public finances."

"We monitor the development of the franc exchange rate closely, because a weaker franc makes our imports more expensive,"

...so they could do with a stronger currency, and this is built in to their forecasts. Indeed the long-term trend is one gradual of CHF appreciation.

Japanese officials on the yen:

"I see no reason for a further deterioration in the yen given the strength in the Japanese economy," Hiroshi Watanabe, Japan's vice minister for international affairs

Finance Minister Koji Omi: `It's important that foreign exchange rates move in a stable manner, reflecting fundamentals of economies,'' ``We will keep closely monitoring currency moves and take appropriate actions if needed.''
The comments are from BB and Reuters. They fit with the idea that the carry trade fell out of bed today, at least from the perspective of the funding currencies...(we have seen significant JPY and CHF strength against both USD and EUR). With respect to the yen in particular, I agree that actual intervention is unlikely, but it looks like the authorities are starting to cap the upside risks to USD/JPY and EUR/JPY. Because the fundamentals line up with JPY appreciation, it may not make sense for funds to fight the cbk rhetoric for the sake of it.

Oh, how I am starting to love the yen.

My working hypothesis when trading is that high yield trades with attractive accretive properties are also prone to sharp sell-offs, hence getting around the idea that they offer a free-lunch to the investing public.

If the above interpretation is correct, and the USD has indeed sold-off due to its high-yielding properties, then the intraday sell-off in USD/CAD may not be justified (the yield differential is not sufficient to make it a good carry candidate). Current price is 1.1270.

Readers will know I like the USD vs the CAD as well.

Sink me! I've had my fingers burned recently with long USD trades. But I am still here, just.

And so I continue:

I think cable has peaked (currently 1.9085), based on the price action and fundamentals. Short-term fundamental drivers work in one of six ways, in my mind. In order of GBP/USD bullishness:

1) mkt expects higher UK rates, mkt expects lower US rates = very GBP/USD positive
2) mkt expects higher UK rates, mkt expects flat US rates = moderately GBP/USD positive
3) mkt expects higher UK rates, mkt expects higher US rates = GBP/USD neutral
4) mkt expects lower UK rates, mkt expects lower US rates = GBP/USD neutral
5) mkt expects lower UK rates, mkt expects flat US rates = moderately GBP/USD negative
6) mkt expects lower UK rates, mkt expects higher US rates = very GBP/USD negative

It's quite clear scenario 1 has been the dominant theme over the past week or so. This is the most bullish scenario for cable. My faith is that this situation cannot and will not last. Add in the fact that cable really struggles to hold above 1.90 for any sustained period of time and you have a nice bearish play to consider.

I think the short cable trade is attractive with a tight-stop at 1.9150. A non-farm payrolls release could easily put a spanner in the works; which makes me think this strategy has a slightly less than 50% chance of surviving through the week. If it makes it throught the NFP though, I would look to take profit some 250-300 pips below, based on current conditions.

: )

I missed out the permutations that involve flat UK rate expectations, but you get the general idea.

The New York Times has a story titled 'Gambling Against the Dollar', that describes how the USD bears, including the author, have been caught on the wrong side of the trade. The focus is on Robert Rubin:

Whatever the outcome, a decline in the dollar will probably be part of it. That’s why Mr. Rubin made his bet. But the dollar didn’t cooperate. While no longer at the highs it reached in 2002, it has stayed strong. Mr. Rubin ended up losing more than $1 million (which, certainly, he can afford) before getting out of the currency market.

My favourite part of the article is:

Throughout his career — as an arbitrage trader at Goldman, as the Treasury secretary who led the 1995 bailout of Mexico — he has argued that decisions should not be judged solely on the outcome. Somebody could do a perfectly good job of weighing the relevant risks, make a call that maximizes the chances of success and still not succeed, because the world is a messy, unpredictable place.

I believe it pays to acknowledge the power of chance not just in the markets, but also in everyday life. Chance is everywhere.

saved! by the skin of my teeth (what a weird phrase!!!)

I think today's payroll data is very significant because of where market sentiment was positioned. Here is my take:

The USD had sold off on a batch of data that signalled the economy was well and truly in the middle of a soft patch. That the soft patch was coming was not a surprise. What seemed to have got the market jittery was the extent of the softness, that suggested the US may face a more prolonged period of soft growth than just the fourth quarter. This was reflected in a weaker USD and lower yields. The housing market was easing quite fast, and while this hadn't yet filtered through to the consumer, it looked like US households faced headwinds from all directions and would eventually have concede to these obstacles and button up their wallets. Simply put, the perception seemed to be that we were dangerously close to the tipping point, just before the economy slides in to recession.

I believe the latest data has the potential to be pivotal because it takes a step away from this tipping point. The report is close to positive on all fronts, although some perma-bears are hissing and poohing that the numbers are meaningless (I suppose that's what you do when the content doesn't support your thesis?). Anyway, the consumer remains resilient. The data may not be sufficient for the major bears on the economy (Roubini, Ritholtz, Rosenberg of MLynch) to throw in the towel, but in my eyes it is powerful evidence that the US economy is holding up reasonably well.

...and so it is that I remain USD bullish, especially against the GBP and CAD.

The pound has been trading lower since the open today, and now it looks like the weaker than expected manufacturing production is lending some impetus to the move. We are 200 pips away from the stop-loss, which I think gives the position some decent breathing space and more than perhaps more than a 50% chance of survival. It's only 130pips in the profit right now - because I think the odds a sustained move above 1.90 are slim, I would be looking to hold the position for a while.

Thursday will be interesting for sterling. A rate hike from the BoE is priced in, but the accompanying BoE statement has potential to upset some expectations ahead of next week's BoE Inflation Report.

Since I started trading, I don't think I have ever traded GBP/USD from the long side. Something is a miss!

Earlier CAD positions have beens stopped out due to the tight placing of my stop orders....I must learn how be a little less greedy on any given trade. I still see good scope for a higher USD/CAD before the year end, looking at 1.15 or above based on current conditions.

If I can find the time I will post an interesting analysis on cable's seasonality in December and January.

Hi abob,
let me tell you that your analysis gave me a lot and I'm really thankful.
Don't want to bother with stupid questions, but as you mention CAD do you think that the new fiscal policy towards trusts recently proposed will have any significant effect on forex ?
Thanks for everything and please excuse my intromission.
QG

Hi QuestionGuy, it's good to see my scribbling is of some use, and very few questions are stupid. I've done a little bit of research on the CAD income trust tax issue because it is a big issue:

Quick Background

CN Finance Minister Flaherty sprung a surprise on everyone when he announced last week that the tax advantage of income trusts would be phased out by 2011 for existing trusts and new trusts would only get one year worth of benefit. The fear was that the government was on track to lose a chunk of tax revenue because some big Canadian companies were thinking of converting into these trusts. I think these trusts comprise around 10% of the TSX; anyway, the announcement created the biggest one day fall in the market in more than two years, with around CN$24bn in value wiped out.

I think the net implications of the tax, if it comes in to law (Merrill Lynch put the odds of this at 80%), are significant and CAD negative:

Implications

* My first thought is that the price drop in the trusts should be a 'one-off', and my second thought is that a sell-off of this magnitude inevitably creates bargains. This is a story that Bloomberg has picked up; many commodity companies are set up as income trusts, and this sudden drop in value has created a family of potential bargain buys for foreign corporates. The commodity sector is in a take-over frenzy and these M&A flows in to Canada would be CAD positive. Indeed, the TSX has already bounced back a little, perhaps with this take-over idea acting as driving factor.

However, I believe this impact is heavily negated by the following negatives:

* The CAD strength over the last 5 years has taken place against a backdrop of relative fiscal prudence from the government (after many years of profligacy). This current shock tactic from the Finance Minister is an effort to protect these efforts, but it has the potential to back-fire if domestic Canadian companies are taken over by foreign corporates. It's shooting yourself in the foot. I'm not sure this will happen, but the incentives are skewed in this direction.

* Political risk: This move by the Finance Minister was totally unexpected, with Bill Holland, the CEO of the CI Financial Income Fund, calling it "a bizarre, Third-World policy". I consider this type of event to be of the 'low probability, high cost' type of risk, and would not expect a modern government to shock the market in this way. I'm not saying the policy is good or bad in its objectives. I just think the communication of it was very poor. An event of this magnitude has to heighten the political risk factor for currency investors. Indeed, ABN reports: 'The Canadian daily newspapers have been littered with stories of retirees who had lost in some instances $100,000 or more in a single day along with quotes from long-standing Conservative Party voters who swore that they would never again vote for the Conservative Party.'

* Importantly, we know the fortunes of the CAD seem to be tied up with the TSX, so the net fall in the index can be argued to be a CN negative. A key question is how much of the income trust component is owned by foreigners and how much of this portion will now be repatriated to these investors home-countries. This percentage is not known but ABN presents the following grid to give an idea of how much CAD will be sold in different cases of % foreign ownership and different levels of repatriation:

http://i33.photobucket.com/albums/d5...etrustgrid.jpg

ABN also reminds us of the laws on foreign ownership: By statute, non-residents are not allowed to own more than 50%. Anecdotal evidence suggests that non-resident holdings are likely somewhere between 25-40% of $200bn and that these holdings are more concentrated in the energy sector.

ABN don't believe the impact on CAD will be significant, because of the potential offsetting impact of inward M&A flows and the fact that on a monthly basis, the repatriation of the foreign component may not be that great.

* I believe the ABN analysis stops too early. First, I can't estimate the percentage of foreign ownership but can imagine it to be fairly high because foreign investors have been able to pick up significantly higher yield due to the tax benefit, relative to other assets. Second, I believe these outflows wouldn't be spread evenly all the way to 2011, but would expect them to be front-loaded, especially if in the context of weakening CAD$. More importantly, there is much greater scope for Canadian funds to invest abroad now that they stand to lose their home advantage. A reversal of this home-bias from Canadian pension funds and the like could see significant CAD-ive outflows over time. I believe this could be the greatest impact on CAD, well outweighing any M&A inflows (which are one-offs).

Thanks abob, you really make me think.
I thought it was an important issue, look forward to reach one day your depth (and speed) of reasoning on these subjects.
QG

hai abob... thanks for ur nice info... I'm newbie...

can I get some info on GBPUSD & EURUSD... hope can learn from U...

Thanks

Here is something on cable and eur/usd that you may find insightful:

For the past 5 years, HSBC has produced research looking at seasonality in the pound. If you look at the monthly data you will see a tendency for the currency to rise in the month of December, and then fall in January, with some regularity.

In their Dec 2005 analysis HSBC comments: Whatever your view on the market the analysis suggests that there is again the risk that cable will move higher in December due to this flow. If it were to follow the path of the past five years it would rise around 3% during the month. Once there, it offers an opportunity to sell it for a January retracement.

http://i33.photobucket.com/albums/d5...dJaneffect.jpg

Very interesting indeed (it rose 9 out of 10 times through to 2004!), but is the opportunity real and is it being arbitraged away? HSBC comment that 'As this phenomenon is becoming more well known the rise last year was a more subdued 0.4%. This year we have had many requests for an update of this analysis, which may signal a wider anticipation of the effect, and a lower probability of it working.' I also think the role of chance needs to be considered. 9/10 is a very powerful and the odds of this occurring through chance alone are slim, but it is possible. If you took all the major currency pairs and looked at their histories, you would find occassional sequential positive or negative runs in certain months by chance alone. Also, if you flick a coin enough times, you can easily get 7 or 8 heads out of 10 tosses, but this is random. Just something to be aware of.

And is there any justifiable rational for the seasonality. HSBC make a decent case: 'The sterling move is due to the repatriation of UK based overseas corporate dollar earning from the US (see below for more detail), and this would suggest the move should be in cable and not a generic sterling move.' They note 'that around half of all FTSE350 companies have a December reporting season. This means that these companies need to repatriate profits made in the US by December and hedge their balance sheets.' and 'It is also important to get the flows in the context of total FTSE350 earnings. Roughly half of all FTSE350 earnings are derived from overseas operations. Of that, roughly half derive from the US; implying the US is responsible for a quarter of all FTSE350 earnings.


http://i33.photobucket.com/albums/d5...dJaneffect.jpg

So, even though the pound doesn't exhibit strong seasonality on a trade-weighted basis, there seems to be some rational for cable to move higher in December based on repatriated dollar flows. But, in the context of the global FX mkt, are these flows significant enough to impact cable? HSBC say 'the corporate flow is not a short-term flow that is likely to be reversible. These types of flow tend to influence the market to a great extent (than spec flows)' and that 'On average the open interest is roughly 33% lower in cable during December. Thus the seasonal flow impacts take place at a time of reduced liquidity and hence the price action is greater than at other times through out the year.'

All in all though, it looks a reasonable case is made and supported by the logic. I am a little cautious as I have looked at seasonality before and just couldn't buy in to the idea it hook, line and sinker, because many of the rises in cable have taken place against a back drop of a weakening USD and we all know that cable's fortunes are tightly tied to EUR/USD (they have a very strong correlation). I think the case would have been a great deal stronger if if cable has risen in these months against a backdrop of a strenghtening USD. Still, to emphasise, on balance and despite my notes of caution, the data does not favour short cable trades through December...there is no getting away from that.

Quotes from from the HSBC Dec 2005 Currency Outlook.

A couple of charts supporting my last point re general USD weakness:

http://i33.photobucket.com/albums/d5...r/eurusdQ4.jpg

http://i33.photobucket.com/albums/d5...4histogram.jpg

The charts are from some old DK research, in which DK finds a seasonal year-end rally pattern in EUR/USD. Nevertheless, the evidence for seasonality in cable (see above article) is clearly stronger than it is for EUR/USD.

Its all food for thought.

http://www.pimco.com/PIMCO_US.Site/Images/n_iheader.gif

Here is the new article from PIMCO analysts on the USD. It follows the traditional bearish angle.

For many months I have enjoyed the comments on the fundamentals at Dismally.com. Now it is gone. Anyone know what happened?

Lou

Hi, abobtrader, the depth of your knowledge is impressive; thank you for sharing.

hi abob's ..how do you get so much time to write so many articel...hats off..its simpley fantastic..

If i make it to vegas ..i will make my first bet on black..

Im doing carry trade at the moment on NZDJPY and NZDAUD to offset in another account and so far from past month it is going ok as the margin required is only 13 USD and i only require couple of month to recover my investment. carry with a year in mind for profit should be ok..if one is less greedy..but who knows we never know when the market turns around and say howdy..give me the pips back