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As Curve Flattening Accelerates, Morgan Stanley Goes All In, Tells Clients To Bet Against Fat Tails
The2s10s has plumbed fresh new lows: - the most levered trade in the history of the world (the curve steepener for the uninitiated) is now the most abhorred. The amount of neg P&L incurred here over the past 2 months is just staggering. After hitting an all time of 290bps in March, the 2s10s has collapsed by over 20% in the last three months. And as the leverage associated with this trade is second to none, the impact of this collapse is magnified hundreds of times, not to mention that the money banks charge for mortgages (if anyone wanted these to begin with) and credit cards is marginally so much lower that Q2 and certainly Q3 bank profitability will be very badly impaired.
Which is why we were eagerly anticipating the one firm which has been the biggest defendant of the steepener trade to come out with its "double or nothing" all-in on the economic rebound which is critical for this bearish flattening to terminate. Today, we got our wish. As expected, Morgan Stanley's Jim Caron throws the kitchen sink into the bull case, and this time also pitches the "no fat tails" trade - the same trade that worked miracles for Boaz Weinstein and Merrill Lynch. Alas, with MS clients sick and tired of losing money, almost as much as Goldman's FX clients, this could be too little too late. Furthermore, with trite claims such as "no ‘double-dip’, We expect growth in China to slow but expect a soft landing, No deflation in 2H10, Policy rates to remain lower for longer, Europe to muddle along, and solvency risks in 2H10 overstated" it may be difficult for MS to find the last standing greatest fool out there. As for pitching the "Iron Butterfly" to said fool, good luck. But it sure sounds cool.
Here is Caron telling the burning theater not to panic:
2H10 will be about managing market uncertainty and risk premiums. We believe risk premiums will remain elevated but with one caveat; that risk premiums are not all created equal. From a strategic perspective this means that we need a framework to discern which risk premiums we want to sell and which ones we want to buy. This will be the key to profiting in 2H10. Our approach in 2H10 will be to sell risk premiums and earn carry via buying highquality spread products and capitalizing on roll down while simultaneously buying risk premiums to protect against tail risks. Our thesis is that economic stability in 2H10 is an underpriced risk. We make several core assumptions for this view and they are as follows:
- We are optimistic about 2H10 recovery, no ‘double-dip’. We expect global GDP to run at 4.8% in 2010. Implicitly, this means that we are neither in the double-dip camp n
or are we in the deflation camp. We are biased for UST 10y yields to rise by year-end (Exhibit 1).
- We expect growth in China to slow but expect a soft landing. China’s decision to revalue its currency to stronger levels supports our 2H10 recovery case as it is bullish for risky assets because i) it reduces risk premiums stemming from fear of a Sino-US trade war, ii) it reduces probability of aggressive policy tightening or heavy-handed credit controls, and iii) it increases the probability for further revaluation over time. This will minimize any disruptive influence on the AXJ region and the global economy. We still see emerging markets as the engine of world growth at 7.3% with China growth alone running at 11% in 2010.
- No deflation in 2H10. Our base case for global CPI is 3.3% in 2010. This argues for a steady rise in risky assets and yields. The ‘risk-off’ trade for slower global growth and deflation is overdone in our view and is set to normalize back to levels set earlier this year and perhaps even reach higher levels (Exhibit 2). This will reflate yields to higher levels in 2H10.
- Policy rates to remain lower for longer. Monetary policy will become more synchronized in 2H10 because financial conditions are such that central banks will keep rates lower for longer. This is mainly true for developed markets, which is why we maintain our curve steepening bias, particularly in forward space. We expect the steepening mainly to be from the 5y point on out. Inside of 5yr, curves may be stable to flatter.
- Europe to muddle along, solvency risks in 2H10 overstated. We do not believe that conditions in Europe will worsen to a severity that sends shock waves of contagion throughout the financial system. Contrary to consensus, we believe that solvency criteria for peripheral Europe are better than many think. In 2H10 we expect the crisis of confidence in Europe to subside, and this will likely reinvigorate risk appetite.
- Better entry points for risk at start of 2H10 will entice buyers, we believe. The entry point for risk is much better at the start of 2H10 than it was at the start of this year. We started this year with tighter spreads, yields at their peaks and at the steepest levels for curves. Currently, a lot is already in the price and many consensus trades have been cleaned up. This means that tail risks today also include a sharp rise in risky assets and higher yields, not just a decline.
- Buying back tail risks is central to our strategy. US rate volatility is the cheapest across asset classes globally and is therefore where we want to buy our tail risks (Exhibit 3).
And the obligatory mea culpa: after all, who could have possibly imagined that the entire "recovery" was built on a rickety house of cards held together by promises, change and $5 trillion in fiscal and monetary stimuli.
It is true that we experienced a more severe setback than expected when sovereign risk conditions increased in April and May. However, market risk conditions have stabilized as measured by the stability in USD funding levels. A key metric we use to gauge financial contagion is Libor-OIS spreads . By this metric we see that risks are elevated but stable. This stability makes us optimistic that the dominant underlying forces of global growth will reassert themselves and risk appetites may return to where they were in April when yields and equities peaked. Conversely, if this spread widens, then it signals a risk to our stable growth outlook.
So even though Morgan Stanley has been dead wrong so far, it is about time, literally, it was correct. After all, teh mean reversion must happen... eventually.
It's About Time, Literally
We take a stand in 2H10 and forecast that Europe will muddle along with regard to solvency issues and sovereign risks. This means that we advocate selling risk premiums and earning carry while buying back tail risks. We recognize there are many strong counter-arguments and have sympathy for that view. But that argument is missing one important component and that’s timeframe. It's about time, literally.
Europe can remain solvent for longer than those betting against it. Although it is not our base case, it may be right that the culmination of risks in Europe end up in the break-up of the EU along with many sovereign defaults. But when will it happen? Those who have a bearish view can’t seem to answer this question, and from an investment perspective we can’t ignore time as a variable. As we see it, from an interest coverage point of view, Europe can cover the interest payments on their bonds for a long time. Eurozone coupon payments are historically very low, averaging about 3.5%, and their interest payments as a percentage of Eurozone GDP is ~3%. They have long-term funding of their debt that averages a lengthyseven years. Perhaps more importantly, their interest payments as a percentage of government revenues are about 7%. So, Europe starts from a very strong point from which they can stave off solvency concerns for a long time to come, buying critical time to repair their crisis of confidence and allow for fiscal austerity to be put in place. Don’t misunderstand; to be sure there are many risks in Europe. But this is what makes us think that the rise in risk premiums for Europe might be overdone.
So just because you got anihilated once following MS' advice, here is why you should do so all over again. Only this time, MS believes that collecting pennies in front of an out of control rollercoaster is a surefire way to recoup all those steepener losses.
The Long Put: Talk is cheap but the put is not. Those who take the other side of this view are essentially long a put option betting on a decline in asset values, but one that is hard to value. The premium they pay for being underweight risk is measured by forgone relative returns. In other words, talking about an EU demise is cheap, but holding that position is not.
Like any other option, there are a few key ingredients to its valuation: the strike, time to expiry and volatility. In this case, the underlying is peripheral Europe and the strike is their relative yield or spread to Germany. Yields have risen and spreads have widened, so the strike location looks better now than it did at the start of the year. The unknowns are the implied volatility and time to expiry (i.e., when the demise in peripherals might actually occur). Not having all the information makes this put option hard to value, and the cost of owning this option is expensive unless peripheral Europe implodes in the very near future.
To be certain, we are not saying that adding risk in peripheral Europe or other risky assets or playing for a reflation trade amid better expectations for global growth are good trades to do just because the entry point looks better. That misses the point. Instead, we are saying that one should have some exposures to being short these risk premiums while at the same time buying back some of the tail risks. Clearly, the expense of this hedge may limit potential returns, but we feel this type of approach produces a higher quality of returns. As more information becomes available in the coming months, investors can reserve the right to up the ante on their short risk premium exposures or they can reduce it. Essentially, we need to acknowledge that one of the tail risks is that risky assets improve quickly, not just decline. Since US rate volatility is the cheapest across asset classes, we recommend buying back tail risks in this space.
So in conclusion: once again, from the beginning, this time with feeling and even more other people's money.
Conclusion. Where we differ from consensus is that we are more optimistic about 2H10 global growth and believe in an asset reflation trade. We are not in the double-dip deflation camp. Key to our view is that European sovereigns muddle along and the high level of risk premiums assigned to them declines. This will allow forces associated with a global recovery, such as rising risky asset prices, higher yields and steeper curves, to reassert themselves. This view is not without risk, so we recommend that one buys back tail risks and right-sizes exposure to existing market conditions. The bottom line is that we think the probability for economic stability and a recovery in risky assets in underpriced. Our bias is to gain exposure to such a recovery while hedging tail risks.
Sigh.
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Tails, bitchez
Tyler - no comments about the melt-down in GLD?
yeah, wtf is going on? just hit 1200.30
I would imagine there are a ton of buy orders at 1200. I got impatient and ordered some at 1210. Oh well.
Well remember he posted a chart showing the giant commercial short position in gold a few days ago. That was a warning sign of the correction in price, in my opinion.
It's not exactly a targetted attack on gold. Look at the price of oil - as if that makes any sense at all?
AUDJPY CADJPY anyone...cmon... this is deflation- simple as that
Gold will win in a deflationary war. I am not certain if it will make you rich - but will certainly preserve capital.
purchasing power
Liquidation maybe taking hold right now. I remember mid to late 2008 when everything that looked halfway decent was slaughtered. Now it is obvious why. I try to keep my head on straight in this environment and not be too bearish but believe we will see another episode of liquidation happen at some point that spirals out of control.
hearsay has it as europe dumping gold trying to get more liquidity in banks
Something bad is afoot.
That's not part of today's agenda.
Come on, it was funny, especially since Tyler put out an article on gold maybe 5 milliseconds after I posted this.
As for pitching the "Iron Butterfly" to said fool, good luck. But it sure sounds cool.
I prefer the "Iron Lotus"
http://www.youtube.com/watch?v=1weVp4S8IFc
People are getting away with explaining the market on a technicality. If someone was to say, "I do not expect a double dip" they would be correct in not expecting a double dip, because there is no double dip.
This is what we call a depression. And no Mr. Krugman, we do not want another STIMULUS.
I hear from friends in institutional-level VC funds that they are seeing lots of inflows. I'm guessing big money types (family offices, institutional managers) are using the direct route for risk allocations and bypassing equity exchanges completely.
lots is relative...maybe compared to last year (anything seems like lots compared to nothing), certainly not an industry-wide phenomenon
You may of course be right. I'm just thinking out loud here. With the exchanges so fucked up, for now and for the foreseeable future, risk allocations are going to have to go somewhere else. I'm guessing that investors will increasingly seek ways to put their money to work that don't leave it so exposed to mainstream exchange risk. I'm wondering what that will look like (now is when that kid is supposed to come in with his "gold bitchez" post).
Gold LOL.
"As for pitching the "Iron Butterfly" to said fool, good luck. But it sure sounds cool"
In the Garden of Eden, baby!
I don't know what these guys are smoking but I want some.
Gold Prices during the crisis. Retraced a whole bunch during the 2008 lows.
http://www.goldprice.org/gold-price-history.html#2_year_gold_price
I too agree that gold could have a nice pullback as the liquidity crises hits, as margin clerks look for something to liquidate. But when the SHTF you won't be able to buy the physical. Unless it gets really, really bad and then no one will care about your shiny yellow metal. I'm long gold now for that medium-bad scenario.
more than liquidity... deflation its a bitch
"Gold Prices during the crisis. Retraced a whole bunch during the 2008 lows."
And if not for TARP and the lending desk at the FED and FASB accounting rules that made it possible for "mark-to-fantasy" where would gold have been at the end of 08?
Higher gold prices = inflation.
Lower gold prices = deflation.
Up and down gold prices = uncertainty.
LOL. No deflation but another 25% haircut for home prices, declinging wages, and increasing costs of living for the average Schmuck.
I wish I lived in a world with a purple sky where unicorns paint rainbows and drop skittles when they poop.
"Europe can remain solvent longer than those better against it." There were many laughable comments in this piece but the hubris of this one gets me. I think there are a lot of people that sense Keynesianism is coming to an end, but believe that they can time the top at just the right moment. 2011 tax hikes, austerity, etc. - where's this magical growth come from? I was sitting in a meeting with a MS PWM and was disagreeing with his firm's bullish stance, to which he simply responded "you have to trust the quality of our research". It took everything not to remind him of MSREF V, VI, RMBS, Mitsubishi UFJ, etc. I had to be polite...
"you have to trust the quality of our research".
that's funny one. great insight - thanks.
traderjoe
+1
"There were many laughable comments in this piece but the hubris of this one gets me. I think there are a lot of people that sense Keynesianism is coming to an end, but believe that they can time the top at just the right moment. 2011 tax hikes, austerity, etc. "
nicely said Joe
i'm not a FI trader so I have to ask: what is the typical leverage used on this steepener trade? also, have we seen the short covering start in earnest yet and how can we tell when it does? (other than a plummeting 10 year).
Finally, where in the holy hell did MS get a +4.8% GDP number for 2H10?!? The rest of planet is (finally) figuring out that the 3.5% they all expected is too high and these knuckleheads are at 4.8%????
TD awesome post, baby!
Lucky me being short 2/10 for months...:=))) Time to go long as MS advice sounds just fine with me. But hey, I am not a crowd follower...
MS
"Conclusion. Where we differ from consensus is that we are more optimistic about 2H10 global growth and believe in an asset reflation trade. We are not in the double-dip deflation camp. Key to our view is that European sovereigns muddle along and the high level of risk premiums assigned to them declines. This will allow forces associated with a global recovery, such as rising risky asset prices, higher yields and steeper curves, to reassert themselves. This view is not without risk, so we recommend that one buys back tail risks and right-sizes exposure to existing market conditions. The bottom line is that we think the probability for economic stability and a recovery in risky assets in underpriced. Our bias is to gain exposure to such a recovery while hedging tail risks."
___
You can't make this shit up if you tried.
Here, here, Muir.
I've never understood the "muddle along" idea or even the "new normal" etc. There's too much debt and debt service to simply have a flat economy. There was an exit velocity needed, and we didn't make it. As a lender, you want both the interest payment and the principal payment. You don't buy sovereigns for anything but safety. If you get the sense that the likelihood of a restructuring is growing and you're not a European bank needing to maintain your marks - you sell and don't loan further. Which then creates the liquidity/solvency crisis.
Tyler, your graphs are still not rendering correctly -- covered up by the blue side bar on the right.
That is not TD's graphs. That is your browser. In FF 3.6.6 everything looks in the pink.
Rosie's note last night (happy Canada Day to all y'all--what great timing, off Thur, gotta be off Fri, weekend, U.S. off Monday) went through entire curve flattening and coming down onto zero.
- Ned
This guy is nuts!! He's essentially suggesting to whatever few clients he has left that they should pay MS a huge amount of money to structure a complex short put position which may yield a few pennies but risks bankrupting them in the fairly likely event that another EU country goes into default mode!!!
No, this guy is not nuts! His buddies are taking the other side of the trade <g>. He will then be paid off in champagne, whores, and suitcases of cash.
Sad but probably true.
Caron changed his rates call for the third time this year; now conceding to deflationary forces estimating 10y could hit 2.75%. He is still stubborn though as he views it will close the year at 3.5%.
200 basis points off his start of year, paradigm-shift call of 5.5%. NBD.
It is amazing how you can just feel the desperation oozing out of this report. The more desperate a company gets the more you wonder about its viability.
Although, I don't really think there will be a breakup of the EU or eurozone simply because it provides no economic benefit.
... buy all the stuff we and our cartel affiliates are selling, how does that sound? and we will sell you some puts at a very high price to hedge your risk--ok thnkx.
If I knew where to get it I would load up on OOM CMBX and MCDX puts just for the sake of it. You cant lose much [just a premium] but can profit on a $ basis a shitload if those widen [and they will]
Certainly a lot of details like that to take into consideration. Thanks windows vps | cheap vps | cheap hosting | forex vps