So yet one more twist and turn in the fate of Greece caught the mkt short Euro. PAIN has certainly been the word this week and TGIF never more true. Asia certainly looked like they had had enough with tight ish range but still nowhere near JPY with its sub 20 pips!
So today looks like mkt will buy dips sub 1.4200 and sell moves above 1.4400 but that looks too rich with 1.4325 the first hurdle. It still will be all about headline trading and orderbook positioning.
On IFO this morning we look for 113.2 (street 113.4) a small decline.
Orderbook
Eur-Well stops higher 1.4260 to 1.4295 then sellers follow until 1.4330. mixed above here with sellers waiting again 1.4390-1.4435. Below buyers control from 1.4210 to 1.4075.
Jpy-pretty much sellers all the way up from 80.60 to 82.00 with just a couple of small stops on the way. Downside stops build 80.35 to 80.20 then buyers follow down to 79.60. Here familiar stops wait.
Gbp-Thin and mixed above to 1.6100 where sellers get upper hand to 1.6170. Below same story thin and mixed with buyers in charge finally below 1.5880.
Macro Backdrop: Are Bonds a Good Hedge for a Further Risk Sell-Off?
We’ve been bearish risk assets and bullish bonds for a while. The end of QE2 has been one factor behind our view. Much weaker economic data, especially in the US and relative to consensus expectations, has been another.[1][1] Since a recent peak in early May, global equities (MSCI ACWI Local) are now down about 7% (Slide 2, LHS). We think the correction in stocks and other risk assets still has further to run, which is reflected in our global macro portfolio in trades such as short SPX, long V2X and short WTI.
However, for long-only funds or investors who are inclined to fade recent weakness, one question we have been asked recently is whether bonds are still a good hedge to a long risk portfolio. Core G10 bond yields have already fallen sharply since early April (Slide 2, RHS) and recent price action suggests that bonds may have become less sensitive to bad news. Perhaps this is because rates seem to track movements in economic surprises more closely than equities (Slide 3), and have therefore priced much of the deterioration in the macro data already.
Looking more closely across the US curve, it does seem that the magnitude of the move down in front end rates (e.g. 2y UST) has been more in line with the US ESI than the declines in longer term rates (Slide 4).[2][2] To be sure, 30y yields have rallied by as much as 2y – and hence long 30y trades have been more profitable than at the front end. But this parallel shift down in the curve contrasts with the aggressive bull flattening witnessed in the middle of last year (Slide 5).
One reason the Treasury curve hasn’t flattened more could be due to fears over the fiscal situation in the US itself (dithering over the debt ceiling and little sign of progress on longer term sustainability issues). In our baseline view we have downplayed these factors, but if they were to become more central, then clearly bonds would not be an effective hedge for risk portfolios. However, we suspect that if things were to turn really ugly, then this would probably show up first in a sharp drop in the US dollar – long-dated, low-delta USD shorts are probably better tail risk hedges.
Nevertheless, absent the macro data suddenly turning much better, it’s hard to escape the conclusion that longer dated bonds are likely to find support at these levels, even if a strong rally from here may require another leg down in risk assets. In terms of potential levels, it has been our view that UST 30y yields could hit 4.0% during this rally. A drop in yields to this level over the next few months would generate about 4-5% profit. A move of this order of magnitude seems plausible if equities were to fall another 5-10%.
What are the risks to a bond hedge if, as most economists expect, the macro data does improve in H2? Well, the loss on the hedge could be around 8% (assuming the hedge is held until year end) if 30y yields were to retreat back to the early 2011 high of nearly 4.8%. (In fact, Citi’s rate strategy team is forecasting a 30y yield of 4.5% at year end.) Compare this to a potential 17% total return if global equities were to rally in H2 and hit Citi’s global equity strategy team’s year-end target of 380 on MSCI ACWI.
Thus, under these scenarios, longer dated bonds still seem like a decent hedge to a long equity portfolio.
Rates
It is evident from the discussion above that we think bonds will still perform decently in the near term. But after recently taking profits on a long UST long bond futures position, we are staying on the sidelines in core G10 duration trades for now. This is mainly because we think the next big moves are more likely to be further corrections in equity and commodity markets and we don’t find it compelling to add an even more bearish risk tilt to our portfolio at present. The one rates trade in our portfolio is a forward 2s5s flattener in USD swaps. We think this could do well if the market continues to price out Fed hikes even further into the future.
Otherwise, one trade on our radar screen is to fade the rally in front end EUR rates, although our rationale here would be to hedge other (bearish risk) trades in our portfolio – we doubt that the recent downtrend in EUR rates will reverse sharply anytime soon. In fact, for several months we have been arguing that the market had overshot to the upside on the degree and pace of tightening by the ECB despite persistently bearish talk by Trichet and other ECB officials. Downwards revisions in growth expectations, growing periphery tensions and weaker financial conditions (i.e. corrections in risk assets) were all likely to be hurdles to sustained monetary tightening.
But with 2y EUR swap rates now 45bp off their highs from just 2 months ago (Slide 6), we suspect the rally could run out of steam. The level of 2y EONIA swaps is even much lower, such that the market is now pricing only a little more than one 25bp rate hike in the next 12m (Slide 7). To be sure, given the volatility in EONIA rates under the ECB’s non-standard liquidity procedures (Slide 8), it is tricky backing out implied policy moves. Nevertheless, it does seem unlikely that the market will price out tightening completely in the next year unless the growth outlook or periphery situation deteriorates much more significantly.
FX
We hear a constant refrain from FX investors: markets are too choppy to trade and returns too hard to find/ hold on to. We have sympathy but obviously hope this does not last. In part, this may reflect a reduction in holding period by hedge funds but another factor is likely to be the ongoing impact of Reserve Managers.
The latter are still essentially heavily overweight USD (Slide 9) and use periods of DXY strength to diversify into other currencies. But this process tends to obscure market reactions to fundamentals and may occasionally lead to erroneous conclusions about market drivers (e.g. that investors really believed in the first half of the week that the Greece problem was resolved).
We remain short EUR/USD believing that risk aversion is rising, commodity prices are falling (Slide 10) and that the Fed is on hold (Slide 11, LHS)[3][3]. These are all normally bullish USD drivers. Furthermore, futures data still indicate that short term players are short USD (Slide 11, RHS). Meanwhile, sharply lower oil prices will likely further delay/ stretch out market expectations about ECB hikes (although, as discussed above, front end yields have already declined). In turn, this will maintain the correlation between oil prices and EUR/USD via a further easing in rate differentials (Slide 12).
As for the periphery crisis, we remain on the bearish end of the spectrum but clearly headline and event risk will buffet EUR/USD in both directions. For us, Spain, not Greece, is the key as the existing bail out mechanisms probably can’t cope with the consolidated debt of Spain’s sovereign, local governments and banks. So Spanish yields are what we continue to watch for the EUR. So far, they are just about holding in ranges (Slide 13, LHS). However, if yields rise in Spain this is usually a EUR negative (Slide 13, RHS).
Putting many of these influences together, our markets based model for EUR/USD currently suggests the downside target should be around 1.35 (Slide 14).
Elsewhere in FX:
· We are still short EUR/CHF and now target 1.17 (Slide 15) but are lowering our stop to 1.214 to protect profits as we approach the lower end of the channel
· We are still long GBP vs. a 50:50 USD and EUR basket. Originally supposed to benefit from faster tightening by the BoE MPC than the markets expected, we have instead in recent months seen all the tightening priced out and, this week, talk of a UK QE2 has surfaced. Despite this, sterling was remarkably stable until recently, perhaps a sign of underlying value. In recent days, however, GBP is breaking from the channel (Slide 16) so we are very nervous that persistent accommodation of inflation by the Bank of England is finally overwhelming the GBP. Our stop is about 1% weaker from current levels
· We remain short USD/CNY on the view that high Chinese inflation will mean further monetary tightening and, eventually, FX appreciation ahead of forwards. However, as we have highlighted before, if the USD rallies across the board short term, few EM currencies will be immune and, anyway, Chinese policymakers typically stabilise USD/CNY when DXY rallies. As such, this has to be considered a more strategic and medium term trade
Equities
We still think the next leg to risk assets will be lower, as discussed above, and we have been expressing this bearish bias via several trades in our macro portfolio. A simple regression of the de-trended S&P 500 index (vs. 100day moving average) on changes in our GRAMI risk aversion metric shows that (no surprise here!) the two are correlated, and even more so this year (Slide 17, LHS). Although current market pricing seems fair, we think a further bout of risk aversion could propel our GRAMI to the 1.25 level seen last year around the Greek crisis (Slide 17 RHS), which according to our regression would suggest around 5-10% further downside to equities.
We have extensively focused on the fundamental rationale to be short risk in previous weeks. However, the technical pictures in equities does not seem too healthy either:
Small cap stocks are still underperforming their large cap counterparts, something usually associated with risk off (Slide 18, LHS)
Cyclical stocks have also continued to underperform defensives sectors, with the broad index lagging the move lower (Slide 18, RHS). When we last saw the market lag cyclical-defensive rotation in late 2007, SPX fell further even after cyclicals started to outperform
The put/call ratio for S&P 500 has been rising again lately, a sign the market is gearing up downside protection, but could still have further to run (Slide 19, LHS)
The percentage of S&P 500 member stocks trading above their long-term moving average has also declined but could fall much lower (Slide 19, RHS)
In our macro portfolio we continue to be short S&P 500 futures and long implied equity volatility via V2X futures.
In addition, this week we entered a new cross-market RV trade via call options, by going long AUD/CHF vs. short S&P 500. As Slide 20 shows, AUD/CHF is highly correlated to risk assets, and indeed has been for over a decade. Recently, however, AUD/CHF has severely underperformed, opening up a gap in this historical relationship. Year-to-date, the S&P 500 is up about 2% whereas AUD/CHF has sold off by nearly 8%. Surely if, against our short term expectations, risk assets rally, AUD/CHF has a lot of scope for catching up. As such, our trade can be seen as a partial hedge to our bearish risk portfolio.
Furthermore, due to high carry and net take-in, we think P&L outcomes seem skewed for this trade, with most scenarios making money, even if spot AUD/CHF doesn’t move much. In particular, if AUD and SPX both sell off, the trade makes money based on positive take-in. Scenarios where this trade won’t work (e.g. a strong rally in equities with no, or even the opposite, reaction in FX) seem very unlikely in our view.
Credit
We have been short OATs vs. other EMU AAAs since last September. The rationale behind the trade has been our long-standing view that France’s longer term fiscal position looked the most vulnerable amongst core countries and that OATs would underperform amidst any sharper escalation in the periphery crisis. OATs have indeed underperformed over the past several days with the present heightened uncertainty over the Greek situation and rising risk aversion. As Slide 21 shows, the OAT-Core spread has been positively correlated with French bank CDS spreads and our risk aversion indicator, GRAMI.
Corporate spreads in both the US and Europe have come under widening pressure since early May (Slide 22). Even so, we expect corporate spreads to continue to widen along with a broader sell-off in risk assets. Our credit strategy team’s latest investor survey suggests that positioning is still stretched even if longs have been slightly reduced (Slide 23, LHS). In other words, there has been no real capitulation in the cash market yet, which does not bode well for cash spreads if risk aversion rises more sharply.
Also from the latest credit survey, it seems that positioning in EUR high yield is relatively stretched compared to the US (Slide 23, RHS). European high yield could therefore be in for a period of underperformance. In CDS, iTraxx Xover has widened significantly along with CDX HY in recent weeks. Going forward, we may even see Xover starting to underperform.
Commodities
Commodity prices broke key support levels yesterday (663 on S&P GSCI). We remain bearish. Slide 24 shows that the sharp uptrend in commodity prices that coincided with the August 2010 announcement of QE2 in the US has ended and in its place a top formation is forming and, at best, prices are now moving sideways. This is a repeat of what happened as QE1 drew to a close (Slide 25, LHS).
We think this highlights how much commodity markets have recently become investor-driven markets rather than end-user driven. For example, the correlation of commodities with other risk assets, like equities, is much higher over the past two years than over the whole of the period of the outperformance of commodities which began around the turn of the century (Slide 25, RHS).[4][4] With non-commercial long positions in commodity futures still huge, we think any increase in generalised risk aversion leaves commodities in aggregate vulnerable.[5][5] As we saw in 2008, when speculators unwind long positions, commodity prices can fall exceptionally sharply whatever the long term story may be in demand/ supply terms (Slide 26). For this reason, we retain a tactical short in WTI crude oil via August futures, where we look for $80/bl (on CL1) by Q4.
Elsewhere in commodity space:
We retain a Dec11 140-180 Brent call spread (i.e. way OTM) on a “just-in-case” basis given continuing tensions in North African and Middle East countries. A major unexpected supply disruption could cause a spike in prices and weaken risk appetite in other markets. As such, our short oil position would clearly suffer (even though risk more generally is unlikely to rally in this event)
We remain long platinum and palladium versus gold, a trade we consider likely to underperform while risk appetite is impaired. However, like the AUD/CHF vs. SPX idea mentioned in the equity section above, the performance of these metals has become detached from overall risk asset trends. Investors who expect a risk rally imminently should consider this trade over direct buying of stocks (Slide 27)
Citigroup Global Markets Limited