macro thoughts dec 31, 2014
TRANSCRIPT
Macro Thoughts December 31, 2014 Keith Grindlay
OUT WITH THE NEW IN WITH THE OLD! After a decade of anticipating BRIC and European economic revolutions, in 2015, will global economies again depend on the US consumer?
Macro Thoughts’ view and analysis of global economies, since 2008, has consistently been focused on the Demand side, rather than the Supply side, and suggested that 2014 could be a year of optimism for the all-‐important US Consumer, but that there was a need for commentators to be realistic. Central bankers, economists, strategists, governments, banks’ CEOs, policy makers and anyone who forecast US rates at 3.5% to 4% by the end of the year, should have reconsidered their forecasts and assessments of global economies and reached the conclusion that the economic world is not as close to pre-‐2008 as they thought. The CRB Index and oil and energy prices have fallen. Few commentators forecast oil at sub-‐$60 a barrel, yet the theme of oversupply and citing strong PMIs as a sign of recovery should have finally been put aside.
Macro Thoughts’ half year review, entitled ‘There is Supply, but there is no Demand’, continued to stress there was still a need for this to be recognised, despite the improvement of US Non Farm Payrolls, which was trending above 200k monthly averages, to take advantage of one of the best ever performing years for bond market returns.
Macro Thoughts December 31, 2013: “To maintain the progress, central bankers, governments, markets and economists must not get carried away with the idea that the patient has recovered, but must realise the (cash) drip still needs to be turned off; then, 2014 can be the year of hope. If this can be achieved without yields spiking higher, Payrolls can continue the trend they ended 2013 with and if higher inventories are met by demand, stability can then become recovery….”
“As the increase in GDP can largely be attributed to inventories and since the employment Participation Rate remains at record lows, is it reasonable or realistic to expect the US Consumer to have the Demand to meet the Supply and make 2014 the year Americans ‘Never Had it So Good’??”
At the end of 2013, it was felt that both the UK and US had stabilised their economies, but would need to raise rates early in the year, or the window of opportunity could close on each central bank. Macro Thoughts’ GDP expectations for both were 3%, but it was felt that data would weaken in the second half of the year and, therefore, the Fed and BOE needed to act.
It was felt that the European economy was falling into deflation, caused by the record high level of unemployment, and this would lead to the ECB needing to cut rates to negative.
In China, the new leadership of Li and Xi have begun a 10 year plan to end corruption and move away from being regarded as the global manufacturer, leading to a more consumer driven economy and Macro Thoughts, therefore, expected the Chinese economy to continue to slow. To reflect this, Macro Thoughts expected economies that depended on trade with China to suffer. Although the RBA and the majority of commentators were forecasting higher rates for Australia, Macro Thoughts expected that, by the end of the year, there would be a need for the RBA to reassess, to reflect the weakness, and to re-‐price for rate cuts.
By the end of Q1 2015, the ECB will be en-‐route to QE, the BOE may be expected to have down graded the economy again in its February Inflation Report, China may have been forced into more
stimulus, Russia will be dealing with stagnation and the US will be closer to raising rates, despite weaker data.
CORRELATION OF INVETORIES WITH US NON-‐FARM PAYROLLS (Bloomberg)
The way in which 2008 was a game-‐changer should be recognised; the credit tap was turned off, US consumers moved from spenders to savers and Japanese households are no longer savers. Europe's problems can be linked back to German unification and its high unemployment is creating disinflation. Russian sanctions are driving Moscow to make the same decisions as they did in 1998. In summary, whilst the first dominoes were toppled in 2008 with subprime, some of the last pieces are only just falling.
At the beginning of each of the past six years, markets and economists have been ‘bulled-‐up’ by an expectancy of a sharp improvement in the economy and a sharp rise of interest rates but each year has disappointed.
This time, however, 2015 may become a defining year, making it very difficult and volatile to trade: one way or another, in 12 months time, the world will be a different place. The US should have started to raise rates (starting in June), the ECB should be some way down the road with its policies (and there may by then be fewer EU members), China will have had another year to redefine its
economy, the UK may suffer some payback for the perceived strength of its economy over the past two years and Russia will have fought to control chronic stagflation. Australia may have cut rates a couple of times and those who fund in USD will have had to make some tough decisions.
The US consumer used to be the driver of global growth, but foreclosures, lost pensions (because of the fall in stock markets), job losses and the hardship that was endured after the crash, will linger long in the memory and this has caused a profound change in the savings rate.
For decades, the US savings rate rarely increased above $450bn, but 2008 changed everything. Pensions, homes and jobs were lost, and the memory of all this is now entrenched for the US consumer, so that while the Japanese savings rate has turned negative, the US saving rate has expanded. For this reason, inflation has been kept subdued, despite trillions of dollars of US QE being injected, but this has meant that the demand of the US consumer, once the driver of global growth, could no longer be relied on to support the supply of the rest of the world.
US SAVINGS RATE IN USD BILLIONSS (Bloomberg)
Macro Thoughts has consistently argued that the only way to turn economic stability into recovery, allowing the US to come off intensive care, was for the price of oil to be below $85 for a significant period of time, as it was the only way to repair disposable incomes and confidence, as there is little incentive for wage growth. This would also help to stabilise the rest of the world that is in desperate need of help, because, throughout, policymakers have been far too far behind the curve with their decisions and, even in a deflationary environment, there are those with significant influence that still consider inflation as the greater threat.
As a result of lower oil prices, global growth in 2015 is likely to be underestimated, while at the same time, it may finally be recognised that disinflation took hold a while ago and, in many economies, including China and Europe, is turning into deflation. Deflation even has the potential to develop in unlikely countries, such as Australia and New Zealand. Therefore, there is even more reason to
differentiate between demand and supply, not worrying about higher GDP, as disinflation could become structural outside the US.
The nature of US employment, being inflated by part time workers, has created a more immediate reaction to inventory build-‐ups in NFP and PMIs. For the US, ISM and PMI Manufacturing data has been positive throughout 2014, trending from a low of 51.3 to a high of 59, despite weather and other issues that impacted on factories. Lower shipping and labour costs have benefited the US, which has managed to retain and bring back manufacturing from abroad and lower oil prices will continue to encourage ‘Made In the USA’, as part of a drive for self-‐sufficiency that began in 2009. This change is to the detriment of the rest of the world, which will have to adapt, accordingly.
The crash of 2008 caused two fundamental changes in the US that policy makers and economists need to recognise when considering data and making decisions; the savings rate has become hugely inflated in comparison to then (and this has kept inflation low, despite QE), and the level of self-‐employed and part-‐time workers has distorted the perception of full employment, so that comparing the pre-‐2008 unemployment figure of 4.4% with the post-‐2008 figure of 5.75% should not be seen as a reasonable comparison; therefore, when considering ‘normalised rates’ for Fed funds, reference to pre-‐2008 levels should also be reassessed -‐ there is now a ‘new normal’.
There is a school of thought that suggests higher stock markets reflect stronger economies, but it was highlighted in recent Macro Thoughts that, when Boeing and the like invest so heavily in buy-‐backs and dividend increases, CAPEX suffers, whilst there is a continued whine concerning the lack of skilled workers. No matter what the geopolitical implications, low oil prices will have a greater impact than negative interest rates on disposable incomes, giving confidence back to consumers and, hopefully, enough confidence to finally turn corporates to CAPEX, rather than investing in stock markets and, in that way, proper employment can grow.
Fearing a shock similar to 1994, the Federal Reserve’s Janet Yellen spent much 2014 telling markets and consumers to be prepared for higher Fed Funds rates; yet, since 1994, US rates have been falling and in both 2013 and 2014 US 10 year rates failed to retrace more than 23%, (Fibonacci). US Treasury yields in 2014 almost retraced the entire move up in rates priced in 2013, falling 1% against many expectations set by forecasters 12 months ago. For economists that have chosen to follow the trend of supply rather than demand for rates forecasts, this has been a challenging year.
This has left Yellen with a difficult path for 2015. The task to raise rates was set by Bernanke, when he announced tapering as the end-‐game; even then, the aim was to get rates back to some kind of normality. Williams and Lacker will move the ‘Dove-‐meter’ down a few notches, with rate hikers Plosser and Fisher losing votes; nonetheless, the new voters have already made it apparent that they are in line with the majority, looking at mid-‐year to raise rates. There was no doubt that the Fed’s rate projections were going to be reduced at the last meeting, largely because of global conditions and presumably in anticipation of a further reduction in the new year, influenced by the new voters.
More than 6 years of sub-‐1% interest rates and, now, cheaper oil, is having an impact on consumers, already being seen in improved Retail Sales, though Christmas falling at the end of the week may reduce the average of Christmas sales. The long period between December pay cheques and January credit card bills having to be settled, means that any payback will come in the new year; therefore, the strength (or weakness) of Christmas spending and the net impact won’t be fully known until as late as February.
Though falling oil prices should have the desired effect on consumers, there may also be a benefit to savers, and there is an ironic twist in Libors. Libor settlements were originally set for cash lending and one of its original functions was partly due to the oil industry. It is estimated that US energy companies hold between 10% and 13% of US higher rate bonds; therefore, any reduction in income could result in a reduction of purchases and may lead to slightly higher long end rates. However, the short term target for US 10year generic yields is still 2% with a flatter curve and consumers may find that, rather than spend, they will continue to feel compelled to hold on to their cash. US savers have been a significant driving force of low inflation; the trend higher in the US savings rate is a singular phenomenon that needs to be recognised for its change since 2008 and is potentially structural. The subprime crash didn’t just result in foreclosures; US savers pre-‐2008 were happy to hold so much on deposit, had an appetite for stock markets and hadn’t lost their pensions in investments. This will mean that perceptions of what is normal for rates will have to change.
For some time, the US housing market has been generally slowing, but until the end of the summer the largest cities had been relatively unaffected. The Case Schiller survey of the largest 20 cities had shown positive growth in all cities by half year, but in October, half showed price declines, including New York, Washington and Denver.
Cities in America have gone bust; municipal debt and the stability of the financial system in the US is still in question. According to the Fed, US banks had an annual shortfall of $100bn in liquid assets in September and the enormous concern of municipal debt cannot continue to be ignored. In Detroit, a bankruptcy hearing in September had little impact on markets, despite being an issue as great as the government’s fiscal debt problem, which shut government buildings in 2013 and was part of the reason the Fed still haven’t raised rates. Potentially 100,000 bond holders (including pension funds) may have to face up to default and bear the cost, while the city is allowed to hold on to its art collection. With US banks underfunded and waiting to be repaid, it will be hard for cities to obtain any fresh credit. Developments during 2015 will have to be taken into account by the Fed, yet there has been little acknowledgment so far. Not yet on the radar, but will be by the end of 2015, is the Presidential election due in 2016. The timing for Obama’s re-‐election could not have been better for him, and at one point the 2016 election even looked a certainty for the Democrats, but as the election gets nearer, especially when the candidates are known, markets will refocus on the politics and fiscal condition of the US.
Early indications are that two political clans are set to clash, the Clintons in the Blue Democratic corner and the Bushes in the Red Republican corner. These are truly big-‐gun families of US politics and it is rare to have such a face-‐off of the like, making the outcome extremely difficult to forecast. In a recent survey in the US for the most influential people alive, Bill Clinton and George W Bush featured in the top five men and Hillary Clinton was the top woman.
With so many different permutations, economic trends and possibly the greatest geopolitical risks since 1939, as well as being on the edge of significant economic changes, 2015 looks to be one of the more challenging years, and the potential for a new medium trend move for US 10years should be expected to begin in 2015.
US 10Y SWAPS ARE EXPECTED TO START A NEW MEDIUM TERM TREND IN 2015 (Bloomberg)
Global GDP figures have been boosted by trade and wholesale inventories, which was apparent in 2013 Q4 data; while the UK economy benefitted from foreign investment in property, the ECB was continually fighting within itself, leaving it well behind the curve with policy action, (Macro Thoughts had forecast negative rates by then), China struggled to maintain 7.5% growth while in transition, oil was over $100 a barrel and there were geopolitical risks in the Middle East and Russia.
During a challenging year for many, Macro Thoughts’ performance of recommended trades for 2014 has been very pleasing (attached), but this wasn’t due to a crystal ball. It was felt in Q4 2013 that not enough attention was being paid to the lack of demand, with too much focus being placed on supply. This, and several other major issues, created uncertainty, so, for this reason, Macro Thoughts felt there was a danger of getting excited over long-‐end yields, even before the end of tapering, and that the year’s range for US 10years would be 3.25% to 2.50%, lower than the majority of forecasts. It was also felt that the Fed and the Bank of England should have already been in rate hike mode, as the window of opportunity would not be open for long.
With this view in mind, Macro Thoughts was at odds with a Fixed Income market that was setting up record short positions in expectation of higher rates, despite evidence as early as January that yields were not holding above 3%. Rates were down to Macro Thoughts’ expected lows for the year by May, at 2½%, and headed even lower (moving averages for 50, 100 and 200 day crossed lower in May).
Non Farm Payrolls were setting a higher tone, having adjusted for the bad weather, while many questioned growth for the same reason. But the bad weather had its positives, as it allowed inventories to be drawn down, therefore, employment would continue to maintain strength. GDP expectations were also revised lower, but this meant a more realistic approach and recognition that higher rates, to the degree that had been anticipated, would slow an economy.
The demand for Puts, even before the first Non-‐Farm Payroll release, was so extreme that, even without knowing the data, the risk/reward pointed to Call buying, so that when the data was strong (though weaker than expected), short positions were already questionable and many of the issues are still as important and relevant now as they were for Macro Thoughts then. The same warnings 12 months later are again pertinent and lessons should have been learnt from last year, so that this year, markets may have a less aggressive bearish tone to start with; ironic, given the Federal Reserve looks set to move rates higher for the first time since the summer of 2006.
There is a need to recognise that long term interest rates have been trending lower for decades, so that while the Fed has the intention to raise rates, the net result could end with a flat yield curve, with the curve 2y to 10y beyond 1.37% and potentially as flat as 1%.
Curve flattening has been a theme Macro Thoughts has followed since the beginning of the year, initially recommending trading UK 5y10y from a flattening bias, both in swaps and in swaptions, at 0.90%, reaching 0.50% by August. Such a trade needs to be managed for carry and roll, so on several occasions part profits were taken on the way, re-‐engaging positions to optimise profits. It was again recommended to re-‐enter the position, once the spread was established below 0.50% (currently 0.415). While both the US and UK can see flatter curves, (UK 5y10y could turn inverse eventually), the two economies have different issues to contend with in 2015.
UK5Y10Y CURVE FLATTENING STARTED AT THE BEGINNING ON 2014 IS CONTINUING (Bloomberg)
Currencies are expected to be at the forefront of central banks’ thoughts, as negative cash flows, especially for countries with high deficits, may suffer from the strength of the USD. The first 6 months of 2013 saw record levels of Sovereign Eurobond issuance, but this dried up completely in the second half when Bernanke announced Tapering midyear. The fear of higher longer term US rates failed to be realised in 2014, and this has helped save many high deficit / high issuance countries. As the Fed look to raise rates, cheaper issuance will become more uncertain if medium
and longer term rates rise too sharply, but this should not deter Eurodollar issuance, as central banks should be happy to be delivered USD.
There has been a school of thought that suggests weakening a currency will bring about recovery. Japan, China, Europe and Australia are pursuing policies of devaluing, but this becomes a two-‐edged sword, as the percentage needed to devalue to grab a few crumbs of dwindling exports is very high, and the more a country needs to devalue, the less the benefit of cheaper oil.
This is an important factor for the UK, who have benefited from the strength in Sterling by encouraging foreign investment. Against consensus in 2012, Macro Thoughts warned against weakening the currency, even though at the time UK Clearers were announcing in national newspapers that Cable needed to reach 1.45 and lower. For the UK this was an ‘old school’ pre-‐2008 ill-‐advised notion, as the UK needed investment. Once Carney was set to take over from King as head of the MPC, new more aggressive fiscal and monetary policies were introduced, cutting corporation tax and releasing funds for lending. It was natural to expect that some of these funds would go to the wrong areas of the economy, but it was not lost on Carney that UK consumer confidence depends on steady or higher property prices and once the trend was set to the point that a bubble was brewing, he and Osborne tightened conditions. This immediately impacted on prices and sales, but this should not be feared.
UK 10YEAR SWAPS HEADING TP 1.75% (Bloomberg)
Few have been more bearish on the UK economy than Macro Thoughts and therefore few took Macro Thoughts’ forecast for 10 year UK yields returning to 2% seriously. Macro Thoughts has been consistently concerned by over optimism and the failure to differentiate between investment and the flight to a safe haven. Cameron, Osborne and Carney moved policy towards increased investment 2 years ago, cutting corporation tax, increasing lending and allowing buy-‐to let businesses to grow. This encouraged FDI, but not into industry and manufacturing, as the cash inflow was placed in property. Far Eastern cash released by domestic sellers in reaction to tax changes, joined Russian, Middle Eastern and European buyers of London properties. Entering election year
with an economy that is recognisably weaker, with a significant danger of negative equity for those encouraged to buy over the past 2 years, will put pressure on employment, (estate agents, surveyors, solicitors, builders and removers), which has been boosted by recent developments in property.
The UK needed to take advantage of its positive position by boosting investment into manufacturing and industry, diversifying away from R&D and construction/property, to create long term stability for the future, but the targeting of the financial industry, too much ‘red tape’ and the continued purge on banks has had limited success so far. The government has also failed to successfully tackle the deficit, which is greater than expected, 6% of economic output, despite the inflows, and one of the surprises for many will be the low level of tax receipts, as well as foreign investment receipts, which reflects a truer picture of employment and incomes. These numbers will be made clearer next year, as part of a ‘more rounded and comprehensive basis for assessing changes in economic wellbeing’, with additional data to assess household disposable incomes, using GDP, net disposable and household incomes (per head).
More discerning shopping also reflects tighter purse strings and Macro Thoughts has used the BRC Shop Price Index as a measure over the past 18 months, noting that prices have been trending lower since Q2 2011, falling below zero in Q3 2012, to the current lows of -‐1.90%. This data reflects lower prices, even before Lidl and Aldi arrived as competitors to UK supermarkets, and reflects a trend of underlying everyday household disinflation, stripping out the student fees, travel costs and energy company price increases, which have clouded the fact that the UK has seen disinflation for some time. Cheaper oil and food prices, the late arrival of colder weather, as well as early sales, should give UK consumers some confidence to have spent over Christmas and this may already be reflected in stronger Retail Sales data recently. Credit card bills will arrive in January, therefore, some payback can be expected in February, once the bill are paid, in time for the February inflation report, which should again be forced to downgrade staff projections, potentially delaying base rate hikes for another three months, against a backdrop of a general election.
BRC SHOP PRICE INDEX HAS BEEN FALLING SINCE 2011 (Bloomberg)
Trades such as receiving GBP1y1y (1.4350) and 2y2y (2.1650) in swaps (and Swaptions), which closed in November at 1.375 and 2.07 have been recommended during the second half of 2014. Both positions looked to take advantage of the steep UK swap curve using the roll down of carry/roll, (GBP6m1y had been priced at around 1.085 when the trades were recommended). Being a more strategic trade with the carry and roll, these trades have been preferred to trading a strip of futures or using options for this short end part of the curve while using the crossing of 50, 100 and 200 day moving averages to gauge entry levels.
UK unemployment in 2014 has been impacted by the change to welfare benefits, as well as a record level of self-‐employed, notably in the older age groups. This may create the same problems that the US has, finding skilled and experienced workers, who have moved out to new industries or set up businesses themselves. The UK needs to invest in its own younger generation to develop for the future, while remembering that the skills of the older generation can only be passed down through experience. It is disappointing, therefore, to hear CEOs complain of the lack of skill levels and experience, having already made redundant older and experienced workers. Over the next 12 months, the UK government is committed to cutting the red tape of small companies and start-‐ups, so the trend of self-‐employment should be set to continue.
It is as if the analysis that the chronic levels of unemployment will remain for another 10 years means governments, the EU and the ECB don’t have to face the facts now and that time will solve the problem. Consistently, the ECB have fudged decisions so as to pass policies, appeasing members aligned to BUBA, still targeting inflation. Until the last 6 months, unemployment has been largely neglected by policy makers throughout Europe, with no coordinated policy of job creation, while the central bank has been more concerned with the level of interest rates for sovereign debt, than targeting the real economy. The Juncker plan, on the face of it, should encourage better private investment and, therefore, job creation, but the size of the leveraging, expecting Eur20bn to generate Eur300bn of projects, is optimistic.
Believing cutting rates by 0.15% would make any difference to an economy that had lived on borrowed time for a decade shows how hopelessly the ECB underestimated the gravity of the situation, not just in Med Europe but also in France, while at the same time they failed to recognise the slowdown in Germany or the negative impact from changes in China.
Total European Manufacturing PMIs have hovered above 50, but only just. The improved price of oil and ECB policy catch-‐up, using QE and TLTRO, should encourage manufacturer confidence and hopefully lead to improved employment conditions.
There are still questions over the effect QE will have and the poor timing of the first two TLTROs, (September’s just prior to October’s bank stress test results and December’s just before the year end), will cloud the ECB’s judgement at their January 22nd meeting; the third TLTRO, which should be unhindered, isn’t until March 5th, but having moved on from stress tests, banks should be in a position to favour increased lending.
Draghi is, however, committed to QE, with the intention of doubling the size of the ECB’s balance sheet to EUR3tn, comparable with 2012, adding to the purchases of ABS and covered bonds. There have been suggestions that the ECB will base purchases on the strength of credit ratings, suggesting they may only be willing to buy the higher grade paper; this would have a very detrimental effect on
markets that have pushed Italian 10 year auction yields below 2% for the first time and Spanish yields to 1.635, record lows. Once all the policies are fully employed, it will be down to European governments to take responsibility, though they will have their own agendas to concentrate on, with a number of elections due in 2015, including those of Spain, Portugal, Greece and the UK.
Draghi has been given a lot of credit for turning yields lower when he threatened OMT. At that time, Macro Thoughts favoured the introduction of a Eurobond that could be anonymously issued to cover 50% of a government’s annual debt, would have made QE a lot more palatable and easier to manage and would have had a direct impact on lending costs. Ironically, the end result has been that by purchasing bonds, the ECB in effect is now creating a Eurobond, based around the capital key (based on each national central bank’s percentage contribution to the Euro).
Voting system changes within the ECB and extended intervals between meetings, from monthly to six-‐weekly, should make final decision-‐making easier. In future, Germany, Spain, France, Italy and Netherlands will share 4 voting rights, while the rest (14, including Lithuania) will share 11 votes, with each national central bank taking turns.
It will take the first quarter of 2015 before any true analysis can be made and volatility should remain subdued, with Bund volatility moving lower, to 3.50% -‐ 5.5%, down from 2014’s range, barring geopolitical risks from Greece and Russia, which are not insignificant and can be expected to put added pressure on the Euro.
The solution to Greece’s debt and deficit issues has never been achieved, despite some effort and the pressure from Troika. Having accepted the country into the Euro, it was up to Greece to change its culture to enable it to adapt, while benefiting from the single currency. In failing to do so, they are jeopardising their membership and, if that happens, a precedent will have been set, even before a possible UK referendum. The impact could be more far-‐reaching, although in the long run it is very unlikely that others will follow; while Greece may be an issue for now (or at least until the general election due on January 25th), France may create a greater long-‐term problem.
As Draghi announced the intention to introduce QE, markets rushed to buy into yields, making some spreads levels bewildering. Buying Czech 10year bonds at yields lower than Germany made little sense, as Czech data is stronger, Germany has a better credit rating and better carry/roll. Czech
yields traded like a runaway train, racing downhill in an effort to catch the German train, but the excited momentum carried it too far and the Czech train sped past the station at which it should logically have stopped.
GERMAN AND CZECH YIELDS (Bloomberg)
Many commentators have underestimated the abrupt slowdown in China and therefore underestimated the effect this would have on Germany, and in many ways this has yet to play out. Germany can adapt to change, redirecting trade to the US and improving parts of Europe; France, however, doesn’t have the same flexibility. While headlines may highlight that the UK economy has overtaken France in size, in reality over the past two years the divergence of both nations has been considerable. High taxes in France have forced property owners to move across the channel, helping to inflate London and southeast England house prices, while property prices in France have generally fallen. French Manufacturing PMIs fell back below 50 in May, despite lower rates and subsidies and unemployment is at record levels (ILO Unemployment rate reaching 10.4%), and this has led to credit rating downgrades.
Despite having its credit rating downgraded and a sizeable issuance calendar expected in 2015, markets have been happy to buy French bonds, regardless of the attraction of Netherland and German Bonds, as well as the performance of Spain (which should have a reduced funding requirement next year). Japanese pension funds are said to have been keen buyers, helping push yields as low as 0.83%, just 0.15bp above AAA rated Netherland and 0.28bp above Germany.
To reflect lower European rates, Macro Thoughts recommended a long duration position in Netherland 10 years, initiated in May at 1.78% and closed in December at 0.78%, as well as Spain 5 years (July, SPGB 1.0 01/20) opened in June while it was a small issuance (but expected to become benchmark) at 1.55%. The long in 5year Spain should be carried over into the new year (revalued at 0.85), as it should continue to benefit from QE expectations.
Relative Value trades were mainly based on tight, flattening curve positions in Spain and Italy or x-‐market trades that included France/Austria and Sweden/France. While these have made money, it
has been disappointing that France (which was downgraded again in December) has outperformed Netherland largely because of significant buying of French bonds by Japanese pension funds as part of a drive to buy foreign assets while devaluing the JPY.
Japan’s problems have continued, despite devaluing the currency by around 20 big figures (58%) over 2 years and the re-‐election of Prime Minister Shinzo Abe suggests that, while the jury is still out on the final outcome, at least something is being done to address two decades of deflation. There has been a structural change in Japan that has turned the saving rate to negative, something that would have been unthinkable 5 years ago.
The problem with assessing the results of Abenomics is not knowing what would have been. As the world economy contracts, any policy that involves devaluing the currency has risks and it also increases the cost of importing oil and gas and, having moved away from nuclear energy after the tsunami, Japan is even more susceptible to price fluctuation, so that while costs have come lower, the full benefits have not been felt. Japan also has a demographic problem that is getting worse, as many young Japanese are emigrating, leaving an aging and retired population that needs funding and as its deficit continues to widen, downgrades can be expected in 2015. In an effort to address deficit issues, taxes have been raised.
Abe may have regretted the decision to raise Sales Tax in April, which hurt consumers more than many had anticipated, and this should push the next rise a long way into the future. Japan has one of the highest corporation tax levels of the major economies, so it has been surprising to Macro Thoughts throughout the year that Abe didn’t reduce corporation tax as early as June. This would have offset some of the sales tax, by encouraging companies to increase wages and would also have helped the performance of the Nikkei. Instead, Abe chose to devalue the currency further (a cut in corporation tax will push the Nikkei higher and may have strengthened the currency).
Following the success seen in the UK, more countries can be expected to follow suit by reducing corporation tax and Japan is now expected to cut theirs by April, from 34.6% to 32.1%, and another cut will follow in 2016, to 31.3%.
The cut in corporation tax can be expected to slow the rate of descent for the JPY. Macro Thoughts first sold JPY as part of a theme to buy GBP (circa 124.50) in 2012, happy to take 9 big figure profits, but naively neglecting to see the full extent of what was to become a 60 big figure move, retracing 50% of the move from 251 in 2007 to 117 in 2011. Abe now has to play out his policies to the full, and as any success has been at best limited, further devaluation in 2015 can be expected, targeting 140 against the USD and 200 against STG.
Japan will also have to address the growing competition from China, which is also turning inward to self sufficiency. The new political initiative that is being driven by Xi and Li has taken many commentators by surprise because of the abrupt changes that are being made. Current policies aimed at cleaning up corruption, addressing property prices and creating an environment that encourages foreign investment in the long term should help create a period of low inflation and sustainable growth globally, but in the short term this is reducing growth and trade.
China will play an important part in global developments geopolitically and economically that will be far reaching and could reshape many economies. Despite the fall in oil prices that should help
maintain growth in 2015, since 2009 the Chinese economy has been contracting and there are signs of significant problems in the real economy. For an economy built on manufacturing, to have PMIs contracting should normally be ringing alarm bells. House prices in all major cities are falling, which is needed for affordability, while rural areas are suffering from a chronic shortage of modernisation. Policy makers are targeting these issues and appear to have the contraction under control, with further policies expected to continue to aim at slowing the descent rather than preventing it.
Although many commentators have looked to China and BRIC nations to drive global economies, and to be a place for investment outperformance, Macro Thoughts, over the past two years, has been aware that changes are needed to prevent an uncontrollable situation ending with a deeper recession.
When the PBOC announced GDP growth of 7½%, with a stalling economy, it was clear that some kind of economic stimulus would be coming, as without it growth would be nearer (or below) 7%. The PBOC have forecast 7.1% GDP for 2015, but following back-‐to-‐back monthly growth figures well below 7%, this again looks doubtful; therefore, further stimulus including more rate cuts will be needed. Growth below 7.5% compares with recessions of 2003 and 2008, so holding above 7% should be seen as reflecting stress levels of the past.
China needs to go through these changes to prevent domestic unrest and help spread the wealth of the richest 8% of the population to the other 92%. There is a need to update industry, cut debt and shadow banking and improve farm efficiency. Despite becoming the world’s largest exporter last year, its economy produces less than $10,000 per person, compared to the US, which is 5 times greater.
China is cleaning up its bond market and opening up its foreign exchange market and therefore has the potential to become one of the largest financial centres in the world, but to do this it needs to gain the confidence of the rest of the world. The problem is it is alienating itself with oil agreements with Russia, disputes in Hong Kong and direct conflict with Japan.
These conflicts and economic changes are having a negative impact on many economies, including Australia’s, which has tried to adapt to lower commodity prices while dealing with an influx of property buyers from China, Singapore and Hong Kong.
The RBA is very good at assessing China and regularly reflects a truer picture than actual data coming out of Beijing. It has, however, gravely underestimated the slowdown of the rest of the world and overestimated the price of Iron Ore, estimating Aud$94 average price for 2014 and 2015 (at the time Macro Thoughts questioned their forecasts). By reflecting China’s expected slowdown, Macro Thoughts has over the past 3 years traded Australian assets with the view of a weakening economy. Unlike many central banks that use currency devaluation out of choice, the RBA needs to maintain pressure on the Aud$. It was therefore not difficult to predict weakness in May 2013 (50, 100 and 200 day moving averages crossing) and again in September and October in 2014.
It was also recommended in November to receive 2 and 3 year Australian bonds, targeting generic yields of 2.44% for entry, partially taking profits at 2.20% and holding a balance to target 2% and below (end of year revaluation is 2.13%).
AUSTRALIA 3 YEAR YIELDS ARE NOW TRADING TO PRICE A RATE CUT IN 2015 (Bloomberg)
Lower commodity prices, especially milk prices, are also impacting on New Zealand, who raised rates in 2014. At times of global downturns, New Zealand property prices tend to out perform, because the nomadic nature of New Zealanders becomes restricted by higher global unemployment, resulting in many native New Zealanders returning home. New Zealand has also benefited over the past decade from film making, which has helped to open up its tourist industry. Nevertheless, farming, especially dairy farming, remains a significant industry and milk prices have been coming down. Twelve months ago, corruption in China’s milk industry created fears for baby milk, enough for new mothers to buy directly from abroad, forcing milk prices, generally, higher. After a clean up campaign that led to a number of arrests and harsh sentencing, China is now again able to better meet its own demand and so the inflated price of New Zealand milk has contracted.
While the RBNZ may not wish to cut rates, it has less room to make further increases. Growth should remain strong, despite saying they are pausing, while its deficit is doubtful to return to a surplus by 2015 as the Government have expected and is unlikely to until 2016 at the earliest.
Macro Thoughts expects the NZD to trade below 0.70 during 2015 and, though it is a smaller market, may have a strong carry incentive for long positions in bonds.
India and Indonesia should be the brighter spots for investment, purely because they are led by well informed and well regarded central bank governors and because they have the room and ability to make changes that will improve their economies. Compared to China, India’s manufacturing is underperforming, yet there are state of the art factories from European companies that can compete globally. There is a need for India to deregulate and lose its fear. Over recent years, there have been promises to open up the supply chain that would have improved efficiency and increased domestic wealth, but there has been a fear that foreign companies may become too dominant.
India and Indonesia will both need foreign investment increases in the coming years, but with China’s move to a more consumer driven economy, both have the opportunity to pick up market
share. India’s Modi has shown he has the ability to make bold and immediate decisions and, with the right backing from the government, the potential for India over the next decade cannot be underestimated; therefore, long term growth of 5.5% is very achievable for 2014, and higher for 2015, as long as the currency doesn’t suffer from a sharp rise in the USD, and with inflation likely to be around 5.75% to 5.5% helped by lower oil prices, rate cuts can be expected by mid 2015.
Though some may have found trading in 2014 challenging, there have been some significant trends that have resulted in fixed income markets having one of their best years for returns. Macro Thoughts anticipates a more difficult year for trading in 2015.
During 2015, it is expected by Macro Thoughts that carry and roll trades will increase in importance for bond and forex portfolio performance. European RV will become more relevant than outright duration, while many Emerging Market economies, with high deficits especially dependant on USD for funding, may diversify.
In 2014, having had the view that markets were over expectant on rates, Macro Thoughts needed to be patient; however, between March and May many of the trades that were on the ‘scratchy pad’ reached levels to enter trades. Macro Thoughts’ range for US10y at the beginning of the year was 3.25% to 2.50%, but by the end of Q1 it was clear that 30 year yields were trending lower, moving averages crossed in April and once 3.40% was broken, 3% was a target.
It was also apparent by then that European duration trades were better performing in Spain and Netherland, rather than Italy and Germany, and tactically selling Italy to buy Spain throughout the year became a constant theme.
Macro Thoughts, at the end of 2013, had forecast European rates being cut to negative to encourage banks to lend and to loosen CAPEX. For the first half of the year Receiving 3m and 6m 1y swaps and swaptions would benefit from the carry, while being positioned for rate cuts.
Though being one of the few bulls for UK rates, there was a need to be patient. There were a couple of false moves, so the first half of the year was difficult to trade. One of the first trades of the year was a flattener for 5y10y at 90bp. Though against consensus and carry, it was felt the trend would match the view should rates be hiked, while expecting weaker data later in the year.
Strategy trade performance for 2014 follows.
Keith Grindlay MFM 00 44 207 862 0407 Mobile 07787 508161 [email protected] [email protected]
Disclaimer Macro Thoughts are a commentary, not investment research or advice – they are for information only and should be regarded as unregulated by the Financial Conduct Authority. While several people have my agreement to forward Macro Thoughts, I would appreciate being contacted first.
!Open!Recommended!Trades!Include: ENTRY P/L!taken!&!Comments REVALJul@02 B!SPGB!1.40!01/20 1.55 0.85Nov@21 Swap!curve!2y5y10y!fwd!3&6m 33 Rec!5Y 0.28 TRADE!12Nov@21 Swap/Swaption!Rec!9m5y!ref!0.5725 0.5725 ATM!575K!/!stk!0.485!360k! 0.46 TRADE!12Nov@27 AUD!Rec!swaps!ref!genric!2!and!3!y!2.44 2.44 p/profit!reference!2.20 2.13 TRADE!13Dec@03 Sonia/US!OIS!1y1y!&!2y2y 0.490 1y1y!5/6bp!!!!2y2y!54/55bp!!!!p/prft!0.39 0.36 TRADE14Dec@09 UK!5Y10Y!swaps!flattener 0.460 0.41 TRADE!15
Dec$12 Buy*Spain*5y*(SPGB*3.75*10/18) 2.85 profit*of*1.085bp*taken*July*'14Jan$21 S*IRISH*4.5*18*B*Spain*3.75*18*5y 61 !58!&!56Jan$21 S*IRISH*4.5*18*B*Port*4.45*18*5y 1.92 1.86!!&!1.9Jan$21 S*IRISH*4.5*18*B*UKT*1.25*18*5y $10 (+)5!!!(@)9Jan$24 SELL*PERIPH*BUY*CORE EM!HIT!SP/GER!SPD!1.79Jan$29 BUY*Finland*10Y* 1.85 5bpFeb$11 BUY*Portugal*10y*PGB*5.65*2/24 4.97 2bpFeb$18 BUY*FRTR1*19***SELL*RAGB*1.15*18* 27 19.5bpApr$01 BTPBTP4.25*19**BTP*3.75*3/21 53 1bpApr$03 SPGB*FLY1*3.75*18*V*2.75*15*&*5.5*21 22/23 2.5bpApr$03 SPGB*FLY*3.3*16*V*4*15*&*5.5*17 12 3bpApr$03 UKT*FLY*4.25*27*V*5*25*&*6*28 21 22bpApr$25 BUY*France*10y*FRTR*2.25*24 2.00 10bpApr$25 BUY*Sweden*10y*SGB1.5*11/23 2.00 10bpApr$30 PGB*Buy*4.75*19*Sell*5.65*2/24 1.15 3bpMay$12 Buy*Nether**07/24* 1.78 14bp!&!100bp!May$19 Buy*Belg*2.6*24 1.92 12bpMay$22 Buy*Spain*(1/2)*SPGB3.8*04/24 3.04 28bpJun$02 Sell*FRTR*2.25*24 1.76 1bpJun$25 Fly*UKT1*17/UKT5*25/UKT3.25*44 72.00 8.75bpJul$02 B*SGB*4.25*19**/*S*RAGB*1.95*19 43 8bpJul@02 B!SPGB!1.40!01/20 1.55 0.85Jul$24 SPGB3.75'18*/1.4*'20*/*4.85'20 24 4bpJul$24 SPGB3.75'18/3.75'18/1.4'20 24 2bpJul$24 SPGB1.40*01/20 1.360 31bpAug$21 S*BTP4.25*09/19**B*BTP3.75*03/21 46/48 17bpAug$27 S*SPGB5.85*01/22*B*SPGB4.4*10/23 43/45 13bpNov$05 B*NTH*47*S*FRA*45*alternative*rv*tds 47.66(MID) 10bp!or!7.5bpNov$05 B*NTH33**S*FRA*35 42.5*(MID) 10bp!or!7.5bp
Date Trade( Entry Closed(at Reval PnL2014
Jan(06 GBP-5y10y-flattener- 90/89 p/p--81.5,-add-86,--p/p-65,-close-61 50bpJan(13 Eur-3m1y-.32-Receiver 0.055 9cJan(14 US-3m30y-4.20/4.35/4.50-payer 15 5cJan(15 UK1y1y-rec-s/s-1.00 15/17c 9cJan(21 EUR-2y5y10y 25 11bpJan(22 UK-Eur2y-spread- 37bp 7bpJan(22 UK-Eur2y-spread- 50bp P/Profit-55 7bpJan(25 GBP-5y10y-vol-spread 15 5y-2.16--P.80-/-10y-P-1.025 13Jan(25 GBP-5y10y-strad-vol-spd-2.17--2.955 80 5y-1.60--10y-240--(.80 12.5bpFeb(05 S-RX-strang-/-B-swaption-strad 25-&-77 S142/146-ay-25-B2.18-1y10y-.77 12(&(79Feb(26 Eur-1x2-.45/.65-1y1y rec-10k+2k 5kMar(06 US-Payer-6m1y-0.40/0.60-red-.395 0.06c 2cMar(07 Eur-3m1y-Rec-0.33-ref-0.34 0.34 13bpMar(11 Rec-Eur3m10y--1.93 1.94 1.855-and-1.63 20bpMar(11 Eur3m10y-Rec-1.75/1.60/1.50 .18c 42cMar(17 Rec-UK1y1y-1.27-s/s 1.27 6cMar(21 Rec-EUR-2y2y-s/s----- 1.20 55bpMar(26 Rec-Eur6m1y-Pay-US-6m1y 0.12 10.5bpMay(09 Eur-6m10y30y-swaps--steep 0.54 spot-0.64-mids 11bpMay(09 Eur-3m10y30y-swaption--steep flat Ref-buy10y-rec-sell-30y-rec CMay(28 UK1y1y-B-Rec-1.35-/-S-pay-1.65- 1.48-ref 18bpJun(06 US-5Y5Y 1.765 1.815 5bpJun(05 Rec-Eur-1y3y- 0.685 part-profit-7bp 32.5bpJul(07 US-2y5y-fwd-3m-swap-flattener 1.140 P/PROFIT-1.05-bal-stopped-at-entry 9bpJul(15 US-B2Y1Y-S3Y1Y-STRADDLE-SPD 30/32BP PREM-100-&-130-VOL-90-&-99.75 5bpAug(13 UK5Y10Y-STEEP 50 10bpAug(13 UK1Y1Y-REC- 1.575 .65bpAug(13 UK1Y1Y-REC-(1X21.40/1.20-COST-0) 0.000 Sw-Rec-1.575-(S'tion-1.40/1.20-1x2-cost-0) 20cSep(15 US2Y5Y10Y-FWD-6M-(IMM) 0.38 0.5bp TRADE-1-Sep(26 UK-1y10-Swaption-Rec-stike-2.25 2.76/75(84c 2.67-94c-&-2.415--2.495c-&-2.285-2.56 9bp(C10c(& TRADE2Oct(14 US6M-10Y30Y-Steepener 52.3 10bpNov(04 UK1Y1Y-REC--1.43 1.430 rec-1.435-or-s'tion-1.35/1.05-rec-sprd-13.5c 32bp TRADE-9Nov(04 UK2Y2Y-REC--2.16 2.160 40bp TRADE-9NovC21 Swap(curve(2y5y10y(fwd(3&6m 33 28 TRADE(12NovC21 Swap/Swaption(Rec(9m5y(ref(0.5725 0.5725ATM(575K(/(stk(0.485(360k((prem(rev(strike(.485(570k(ATM(850K0.46 TRADE(12NovC27 AUD(Rec(swaps(ref(genric(2(and(3(y(2.44 2.44 p(profit(2.20 2.13 TRADE(13DecC03 Sonia/US(OIS(1y1y(&(2y2y 0.490 1y1y(5/6bp((((((((((2y2y(54/55bp 0.36 TRADE14DecC09 UK(5Y10Y(swaps(flattener 0.460 0.41 TRADE(15