Thursday, September 11, 2014

When will the profit-taking come?

One of the sad realities that Neil highlighted in his recent guest piece was the propensity of markets to take profits swiftly whenever there is a decent move.  Part of this is of course a function of the aimless nature of macro in a zero interest rate world; part of it is also a function of the "five minute macro" mentality that so many punters embrace (willingly or unwillingly) as a function of their risk management framework.  No doubt some of it is also the various "puts" sold by central banks which tend to push assets back towards some mean.

Regardless, at a charity golf outing on Monday Macro Man heard several anecdotes of profits being taken in the euro after a whopping 3.5 big figure move.  Of course, 3 days is a full market cycle in 5minutemacroland, and positions have no doubt been subsequently re-added.  Yet with major event risks looming, Macro Man cannot shake the sad idea that a deeper bout of profit-taking might be in the offing.

Sterling, for example, is following the precedent of CAD in 1995 almost to a T, weakening to its lowest level several days before the referendum, then drifting slowly higher.  Yesterday's poll result obviously gave cable a kickstart higher;  with that weekend gap looming at the time of writing, what odds that we close it before the referendum just to screw everyone who sold last weekend's poll result?

Eurodollars, meanwhile, continue to dribble lower on the back of the SF Fed research paper released the other day.  Macro Man regards that as little more than doublespeak- a regional Fed research department doesn't necessarily speak for its regional President, let alone the FOMC as a whole.   Just ask the freshwater economists in Minnesota, who were eventually sacked by that notorious monetary smackhead Kocherlakota for disagreeing with him!

Anyhow, the usual-suspect contracts are now at levels that have generally held over the summer.  EDZ5, for example, has much liked it below 98.90, except for one brief foray that ended with the Fed's blase policy announcement on July 30.

In the "good old days" of 5 years ago, of course, when you saw a trend emerging you hopped on it and added as it went your way.  Obviously, in a mean reverting world that's not the greatest idea...especially when everyone else is taking profits.  Of course, there's the rare exception to the rule (USD/JPY in 2012-13, for example), which perhaps unsurprisingly have been prime sources of macro returns when they occur.

Nevertheless, it's been a good run over the past six weeks, and with the Scottish vote and the Fed in the pipeline, it would be surprising to see those with profits not cash in at least a few of their chips. As always, the trick is to figure which trends have been noise and which are set to continue.  For choice, Macro Man likes Z5/Z6 steepeners in EDs, and prefers USD/JPY to cable....

Tuesday, September 09, 2014

Ending the cult of loss aversion in global macro

With macro markets finally starting to percolate nicely, the following is a guest post by friend-of-the-blog Neil Azous of Rareview Macro.  Neil's piece reflects many of the conversations that Macro Man has had with friends the industry, and was originally published here.

The 2008 financial crisis exposed institutional money managers to a range of risks for which they were not prepared. Some of these were market risks, in which the value of their investments declined more than they had previously imagined possible. Some of these were liquidity risks, in which still-viable strategies gated their funds, thereby preventing investors from getting their money out. Finally, some of these were operational risks, in which the demise of Lehman Brothers and the Madoff scandal highlighted the importance of factors such as accounting, compliance, and infrastructure, as well as just performance when it came to choosing a fund.

In the wake of a traumatic loss, whether it is financial or personal, it is just human nature to overcompensate to make sure the experience is not repeated. But while that is understandable, it is rarely the best response. And so it has proved for many hedge fund investors over the past few years. While one could argue that each of the investor responses highlighted above has damaged investment performance, this article will focus on one specific issue:  the cult of loss aversion in global macro investing.

Although some global macro funds performed strongly during the financial crisis, others were caught up in the maelstrom.  As a result, while the strategy attracted strong inflows in 2009-2010, enthusiasm was tempered to a degree by the realization that an idiosyncratic macro investment would not automatically guarantee a hedge against generalized market stress. At the same time, the recipients of these inflows were keen to maintain their larger asset bases and the fees associated with them. This has become a particularly important factor over the last several years as conventional strategies have performed strongly, and with investors demanding positive returns in macro regardless of the underlying market and policy dynamics.

The result has been a concentration of assets under management (AUM) amongst a few very large funds, many of which fetishize loss avoidance over all other factors in trade selection and risk management. Of course, risk management is an important part of any robust investment process.  However, in modern macro investing the cult of loss aversion is becoming counterproductive given the fundamental and market outlook.

These days, most macro managers can be more accurately described as ‘hedged’ than ‘absolutely discretionary return’ investors. When legendary traders such as George Soros or Stanley Druckenmiller were making a name for themselves in the British Pound or Equities (yes, he was long a lot of them) they did not have a “hedge” against those positions because they truly believed in them. Sadly, very few macro managers have this level of conviction these days. They are too worried about taking a loss rather than a making huge profit.

In a world of many independent opportunities and a widely-dispersed asset base, it is completely rational for firms to use tight trade- and portfolio-level stop losses, because with rare exceptions (such as during times of acute market volatility) each stop loss decision has little bearing on the behavior of the market as a whole. Unfortunately, this does not describe the current state of the market.

Thanks to the static monetary policies operating in many major economies, there are relatively few independent investment opportunities with sufficient market liquidity to absorb a thematic allocation from a large global macro fund. As a result, the few such trades that do exist very quickly become over-crowded, particularly by the few large funds that dominate the AUM base of the strategy. Unfortunately, this leads to paranoia and a fear of loss rather than a healthy balance between risk taking and risk management.

When the markets do move, portfolio managers are incentivized to take profits or reduce risk very quickly. Why? Because macro investing has become a game of musical chairs, where investors need to make sure they are not the one caught out when the music stops. Those on the right side of the market, aware that most of the past five years have been characterized by range trading in foreign exchange and fixed income, move to ensure that they do not drawdown their investment gains. Those with losing positions, on the other hand, do not feel able to view markets through a value prism, and instead worry about the possibility of hitting their modest loss thresholds, and thus closing out positions at disadvantageous levels. Consequently, the de facto “macro” time horizon has been compressed into a few hours to a few weeks, leaving relatively few able to capitalize on the thematic gains that have traditionally characterized the strategy.

Although generating a 10%-12% gross return should not be a particularly hard target in an environment where risk parity funds have produced 20%+ annualized gains over the last few years, the current focus on loss avoidance above all else has condemned the macro strategy to a performance that is mediocre at best.  If a portfolio manager is unable to weather a 5% drawdown without having his risk allocation cut or eliminated, how is he to participate in the type of trades that generate double digit returns? The answer is he cannot. Unfortunately, what is individually rational (i.e. cutting risk quickly to avoid hitting drawdown limits) has proven to be collectively irrational as the industry careens from stop-loss to stop-loss.

This negative feedback loop has provided even more incentive for investors to allocate elsewhere, and very often to managers dedicated solely to one asset class, including funds that are far less focused on loss aversion or a metric like a Sharpe Ratio. Remember, investors can market returns. They cannot market a Sharpe Ratio.

It is ironic that the macro strategy has lost its way considering the opportunity for out-performance from some of the big themes of the last four years – long Equities (yes that is a macro investment), long Interest Rates, long Credit, and short Volatility – was very large. These were strategies that in previous cycles made big profits for the macro managers who got them right.

They can do so again. That is why the call right now should be to re-think how investors look at risk. What investors should demand from their managers is a return to old-school macro investing, where themes are given time to play out, portfolio turnover is significantly reduced, and more focus is placed on absolute returns at the expense of fetishizing drawdown limitation.

At the very least, investors should take a look at the macro managers that have evolved post the Global Financial Crisis. A new breed of portfolio managers are emerging who  are “risk conscious” and use their expertise in derivative products to add both edge and control to concentrated investing. True, their absolute AUM pales in comparison, and certain strategies may have liquidity constraints in terms of scale, but it is becoming easy to identify this group of “risk conscious" managers from those simply focused on loss aversion.

Additionally, the sector needs another George Soros, who generated 25%+ returns year after year, with a Sharpe Ratio lower than a diversified US 60/40 benchmark. How was that done? By believing in his themes and betting big. Otherwise, it is just a matter of time before investors realize their collective actions have squeezed the risk appetite out of managers and left the global macro landscape without an edge.

Should such a change occur, there are plenty of thoughtful managers who will again reap significant benefits for investors.  Recall that the so-called golden age of macro investing featured concentrated positions, higher volatility, and a somewhat lower Sharpe ratio.  However, it also offered excellent diversification against a portfolio of risky assets and generated large absolute returns.

Until then, we can only hope that current circumstances are not merely incentivizing those with the best marketing pitch  and the quickest trigger finger, but instead rewarding the truly talented while weaning out the less skilled….the way Darwin meant it.

Monday, September 08, 2014

Sweating Scotland

Way back in April,  when Macro Man mused about the then-distant Scottish independence referendum, he suggested that sterling should eventually be priced with a risk premium in the run-up to the vote.

At the time, of course, it seemed like the issue was largely a talking point for FX salesfolk to drum up business, given that market focus was squarely upon other issues such as Carney, the Fed, Europe, etc etc.  To be sure, sterling has fallen quite sharply against the dollar, though given the relative stability in EUR/GBP much of that was a dollar issue rather than a sterling one.

Today, however, there can be no doubt that markets have noticed the Scottish issue, as weekend polls put the independence supporters in the lead, with now a scant ten days to go before the vote.  A quick glance at 1 month cable vols suggests that the market was not prepared for this at all:

 (chart courtesy of BAML)

From Macro Man's perch, this is the panic that you are probably supposed to start fading, if only in dribs and drabs.   Short sterling has rallied back to levels not seen in nearly a year, and the vol chart above tells you that people have panicked a wee bit.

Perhaps you don't want to do your full ticket now, but providing a bit of liquidity in times of uncertainty can often reap handsome rewards.

There are so many issues still to be resolved, even if the Yes vote goes through, that it's difficult to trade on anything but emotion, such is the dearth of facts on such key issues as:

* What currency will Scotland use?  They seem to think sterling, the government seems to think not.   (Hint: if you have any Scottish fivers, best spend them this week while they're still legal tender.)

* Will Scotland be admitted to the EU?   Not if they use sterling, according to Olli Rehn.

* What portion of UK debt will Scotland assume?   None, if they don;t use sterling, according to Alex Salmond.

*  Will Scotland keep the queen as head of state, or dredge up some descendent of Bonny Prince Charlie to assume the throne?   Or will it become a republic?

* If Scotland votes Yes, what does this mean for the UK general election next May?   Will Scottish precincts vote/count?  What then happens when Scotland leaves the UK?  Do those MPs get ejected from Westminster, possibly bringing down a government?   Anything that keeps Mr. Bean Ed Milliband away from Downing Street will likely be taken positively be markets.

In the meantime, markets can merely watch the polls and sweat on the Jocks' decision.   Decisions taken in panic, however, are unlikely to be rewarded in the fullness of time.

Friday, September 05, 2014

0 for 1

Well, Macro Man whiffed on the ECB about as badly as he could have.  Not only did they announce an ABS program (the inevitable leak did occur right as yesterday's post went to press!), but for some reason they decided to cut the key rates by another 10 bps.

Now, you know as well as your author does that there is not a single individual or institution in Europe that would say, "Well, at 0.15% I wasn't sure if I could afford the loan, but now at 0.05% I am ready to rock'n'roll, baby!"  On the other hand, there may well be banks that would say, "Well, we could take out x in the TLTRO, and it will only cost us 10 bps to park it until we find someone to lend it to.   Wait, it now will cost us 20 bps?  Hmmm...maybe we should cut our bid by use paying more to sit on cash than we do to borrow it."

Of course, perhaps the real reason for the rate cut was to submarine the euro.  If so, Dr. Aghi's plan worked admirably, with EUR/USD evidently sustaining its largest single day decline in three years.  Now, there has been some querying as to whether the euro's decline might make the Fed uneasy, thereby altering the monetary policy outlook.  

Colour Macro Man sceptical.  Just yesterday, the US announced a trade deficit of $40 billion, which while being more than your author has in his sofa cushions, is pretty modest by the standards of the US.  The magnitude of the moves observed so far are pretty miniscule in the grand scheme of things (USD/JPY is unched since December 31); given that the US is still a relatively closed economy, the trade weighted exchange rate would have to move a hell of a lot more before it began to impact the models in any significant way. 

Obviously, for the US to cry foul at someone else's monetary policy undermining their exchange rate would be the height of hypocrisy, but somehow that doesn't feel like a particularly strong factor in favour of the argument.

Today of course is payroll day, with all the associated noise and fanfare.   For what it's worth, Macro Man's payroll model anticipates a slightly lower than expected result of 210k jobs, versus the consensus of 228k.   On the face of it, that might prove to be a slight disappointment.

However, yesterday's price action (as well as some of the macro returns for August) would appear to validate the poll result that punters are gunning for a stronger dollar.  As long as today's figure isn't abjectly weak (and with data of this dubious quality, that's by no means a given), one would have to think that the trend would continue- there would be strong arguments for a lower EUR/USD and higher USD/JPY on each side of the equation.  Insofar as FX over the last few years has largely been an exercise in sifting through turds to find the least repellant sample, finding a compelling fundamental support for a trend move in G10 FX is like a welcome breath of fresh air.

Price action will be key.  There are a lot of shops still underwater, and if this is the big trend for the end of the year, there shouldn't be much by way of pullbacks.  The Abenomics trade in 2012/early 2013 didn't let anyone in and punished the profit takers.   That's the way macro used to be, but the last few years have bred bad habits.   Macro Man is very curious indeed to see which way the pennydrops after this figure.

Thursday, September 04, 2014

What now, Dr. Aghi?

Hard as it is to believe, it's already been three months since the latest of Mario Draghi's game-changing announcements.  Say what you will about the man, but he's not afraid to move the needle.  (Of course, the fact that a repeated series of game-changers has been required says something that's perhaps a bit less flattering.....)

In the interim, financial markets have performed more or less as Signor Draghi might have hoped.  The euro is lower more or less across the board, which must come as a relief given  his recent concerns over the exchange rate.   Government bonds have of course ripped, with Bunds at one point tacking on a full 10 points in futures terms; German cash ten year yields are now less than half of what they were a year ago.  The only disappointing asset class has been equities, though between the Ukraine conflict and Espirito Santo they've faced headwinds that the other asset classes have not.

So what now, Dr. Aghi?  You have James Bond (or at least his German cousin, Jakob Bund) right where you want him.   Will you press the button that buries him forever, or give us a lot of pretty words to describe your unnecessarily complicated scheme, thereby giving him time to escape from your clutches when your back is turned?

Past form certainly indicates the latter.   To be sure, the growth and inflation forecasts look likely to be nudged lower yet again.  All else being equal, this would provide cover for a further policy shift.     However, it's not clear to Macro Man what another deposit rate cut would accomplish; after all, money market rates have plummeted over the last few months, and it is not in any way certain that trying to shunt EONIA solidly into negative territory is going to have a positive impact on the banking system.   Indeed, it's easy to construct an argument that it would be a net negative..   At the same time, with the first TLTRO just around the corner, there is a jolt of liquidity stimulus coming down the pipeline.

While it is possible that the work on an ABS program has been progressing more quickly than expected behind the scenes, the realpolitik  of European policymaking is such that we almost certainly would have had some major leaks if such a program were around the corner.  As such, Macro Man expects Draghi to live up to his alter ego's Bond-villain stereotype and do a lot of talking but not much doing today.

What will it mean for markets?   According to Macro Man's little EUR/USD model, the euro has overshot modestly to the downside.   A correction of a couple of cents wouldn't go amiss, though it would probably need a weak payroll number to return the pair to its "fair value" of 1.3400.  (Macro Man is still trying to get the full dataset to populate his charts.)  If it gets there, one might credibly expect an orderly queue of sellers looking to establish/add to shorts.  Macro Man has to admit that he'd be tempted to join them.....

Tuesday, September 02, 2014

On your marks, get set, go

Well, the race to the finish has started, and the early evidence is that it's going to form.   Last week's survey provided an overwhelming consensus that long dollars as QE ends is the way to go, and sure enough the buck is soaring against most other currencies thus far this week.

Long equities are also a clear favourite, though whether that's by default or because of ECB stimulus or US growth is anyone's guess.   The perceived investment outlook for fixed income is more mixed, though interest is pretty clearly skimpy compared to the enthusiasm for FX and equity trades.

This week will of course provide a dose of signal via the ECB meeting and Friday's payroll report.  For choice, Macro Man expects the ECB to provide a by-now de rigeur downgrade of its growth and inflation forecasts but stop short of announcing any new policy measures.   After all, the first TLTRO is slated for allocation later this month, and hey- why not see how that goes before making any further decisions.    Given the term structure of European rates, it is surely legitimate to question exactly how much more monetary policy can be expected to accomplish. 

On an 'unchanged' ECB, the euro would presumably stage a small rally.  Will that produce a wall of supply or a raft of stops?  The result will tell us something about market positioning and risk appetite.  Of course, another strong NFP number would presumably encourage a further wave of dollar demand, so it's probably not the week for the "run tight stops and hope to get lucky" strategy that seems to dominate macro these days.

Of course, with four months still to go, this year, it's not how you start but how you finish.  In that vein, punters will be keen not to pull a 'Devon Loch', particularly after such a challenging year....

Friday, August 29, 2014

The race to the finish

Apologies for the lack of postings this week but Macro Man felt curiously uninspired by the ongoing rally in all manner of assets.  Big-figureitis is a well-known behavioural phenomenon, and now that we've traded SPX2K it will be interesting to see if profit-takers emerge.

Of course, with the end of the summer upon us (the Macro Boys are already back in school), following next Monday's Labor Day holiday it seems reasonable to expect trading desks to be fully staffed full of well-rested punters looking to make their years.  Indeed, it's become something of a depressingly familiar phenomenon in the macro space for traders to scuffle for the first eight months of the year before throwing a bunch of risk at the market from September onwards to snatch victory from the jaws of defeat.  Strangely, "put it all on black to recover your year" seems to be absent from most marketing materials....

This year, the first eight months have been unusually challenging; from the moment the market opened on Jan 2, many punters have been underwater thanks to sharp reversals in last December's favourite trades.

This naturally leads Macro Man to wonder where markets are likely to allocate risk over the next few months in 2014's version of the race to the finish line.  Naturally, he has his own suspicions, but he's curious what the informed readership of this space make of things.   With the Fed outlook likely to come under particular scrutiny, there is of course no guarantee that the market pricing of the past few months will predict future pricing.

So what say you, readers?  Please fill in the survey below.   Obviously the answers are necessarily simple, so if you have a theme or specific trade that is not listed, click on 'other' and fill in the blank.   If the form is working properly, respondents should be able to view the results.

EDIT:   You can see the results here.