Carry Trade

"There is a big flight to quality," warns one trader as the spread between interest rate swaps (implicitly bank risk) and government bonds soared to a record high. This "crisis gauge" flashing red is also followed by 3 month SHIBOR (short-dated interbank lending rates) surging to an 8-month high. China's CDS have jumped 30bps since the Fed taper and as Bloomberg reports that billionaire investors like George Soros and Bill Gross have drawn uncomfortable parallels between the situation in China now and the US before 2008 (when this crisis gauge was key in spotting the carnage to come). Simply put, the banks don't trust each other...

For the second night in a row, China, and specifically its currency rate which saw the Yuan weaken once more, preoccupied investors - and certainly those who had bet on endless strenghtening of the Chinese currency - however this time it appeared more "priced in, and after trading as low as 2000, the SHCOMP managed to close modestly green, which however is more than can be said about the Nikkei which ended the session down 0.5%. Still, the USDJPY was firmly supported by the 102.00 "fundamental" fair value barrier and as a result equity futures, which had to reallign from tracking the AUDUSD to the old faithful Yen carry, have been propped up once more and are set to open at all time highs. If equities fail to breach the record barrier for the third time in a row and a selloff ensues after the open in deja vu trading, it will be time to watch out below if only purely for technical reasons.

The last 7 days have seen the unstoppable 'sure-thing' one-way bet of the decade appreciation trend of the Chinese Yuan reverse. In fact, the 0.95% sell-off is the largest since 1994 (bigger than the post-Lehman move) suggesting there is clear evidence that the PBOC is intervening. The fact that this is occurring with relatively stable liquidity rates (short-term repo remains low) further strengthens the case that China just entered the currency wars per se as SocGen notes, intending to discourage arbitrage inflows. For the Chinese authorities, who do not care about the level of their stock market (since ownership is so low), and specifically want to tame a real-estate bubble, this intentional weakening is clearly aimed at trade - exports (and maintaining growth) as they transition through their reforms. The question is, what happens when the sure-thing carry-trade goes away?

Many are confused this morning at the exuberance in US equities after dismal data and a bond market that is barely budging. Of course, the answer lies deep in the fun-durr-mentals of the JPY carry trade... but this time it's different as it would appear a note from BofA proclaiming "it's time to buy AUD" coincided perfectly with a ramp in AUDJPY and thus - new all-time highs in stocks...

Asian equities are trading lower across the board on the back of some negative credit stories from China. Shanghai Securities News noted that ICBC and some other banks have curbed loans to developers in sectors such as steel and cement. Slower gains in home property prices in China’s tier 1 cities are also not helping sentiment. Beijing and Shenzhen prices rose 0.4% in January, which looks to be the slowest monthly gain since October 2012 according to Bloomberg. Elsewhere there are reports that a property developer in Hangzhou (Tier 2 city in China) is reducing its unit prices by 19%. Our property analysts noted that given the strong gains seen in Tier-1 and some bigger Tier-2 cities in 2013, a slowdown or negative trends in price growth should not be a surprise. Nevertheless, it has been a very weak day for Chinese and HK markets with the Shanghai Composite and the Hang Seng indices down -2.0% and -1.2% lower as we type. Across the region, bourses in Japan and Korea are down -1.0% and -0.6%, respectively.

Sometimes you just have to sit back, look at some charts, and say WTF...

This week saw the continuation of the "bad news is good news" theme as one economic report after another came in far below expectations. The question remains whether it is actually all just a function of the weather? Of course, there is something inherently wrong with driving asset prices higher based on hopes that a weaker economy will keep the Fed's "liquidity fix" flowing to drug addicted Wall Street traders. Under that theory, we should be rooting for an outright "depression" to double our portfolio values. But, when put into that context, it suddenly doesn't make much sense. Yet that is the world in which we live in...for now. Therefore, as we wind down the week on this "options expiry" Friday, here is a list of things to think about over the weekend.

Step aside long-time hedge fund hotel darlings Apple and AIG, and make room for...

The die has been cast, and it appears that the world is finally on the path to the great "carry-trade unwind" endgame. If so, this is what it will look like...

The last week or two appeared to be dominated by hope that the transitory weakness in data was weather-related, the recovery was all good, and that the Fed would un-taper to give it a helping hand just in case... Today's FOMC minutes made it clear the latter was not the case and today's macro data made it clear this weakness is not just the weather. With US macro data at six-month lows, the last 2 days saw credit and equity protection markets well bid - even as underlying stocks surged back to unchanged on the year. However, between Fed talking-heads and the FOMC minutes, hope faded... stocks tumbled, credit widened, Treasury yields surged higher, the USD jumped, and precious metals were slammed into the red on the week. Volume - surprise surprise - was the highest in over a week.

Stocks are confused. The FOMC Minutes, which clarified that a) taper is on (no matter what almost), and b) forward guidance has been replaced by some fluffy words; have sent the USD higher, bond yields higher, and precious metals lower in 'classic' un-taper unwind mode. Stocks are holding (for now) as the USD strength (and implicit JPY weakness) is supporting US equities via the idiocy of the carry trade. VIX remains well bid and credit markets are blowing wider.

“Guidance” is the new organizing credo of US financial life with Janet Yellen officially installed as the new Wizard of Oz at the Federal Reserve. Guidance refers to periodic cryptic utterances made by the Wizard in staged appearances before congress or in the “minutes” (i.e. transcribed notes) from meetings of the Fed’s Open Market Committee. The cryptic utterances don’t necessarily have any bearing on reality, but are issued with the hope that they will be mistaken for it, especially by managers in the financial markets where assets are priced and traded. 

While the only fun-durr-mentals that matter appear to be global central bank liquidity injections (and thus the level of leverage entrusted to the JPY carry trade), the crowd is swayed by truthisms and "common knowledge" memes that recovery is here, that things are improving, that earnings are 'solid', that markets are still cheap, and that historical analogs are different this time. However, with monetary policy at a turning point, we also appear (fundamentally and technically) to be at "the inflection point from self-reinforcing speculation to fragile instability."

So far the overnight session has been a replica of yesterday, with the all important carry trade once again fizzling overnight during Japan trading hours, and dipping as low at 101.60 before staging a modest rebound to the 101.8 level. We expect the "invisible" 102.000 USDJPY tractor beam to be again engaged shortly and provide market support and/or levitate stocks higher as the now standard selling in Japan, buying in the US trade pattern repeats. On the other hand, US equity futures appear to have decoupled from the pure carry trade, and instead latched on to USD weakness and EUR strength following European Q4 GDP data, which came at 0.3% on expectations of 0.2%, up from 0.1%. Considering the constant adjustments to the European definition of GDP, at this point Mongolia would have been able to demonstrate growth if it was in Europe (but apparently not Greece which once again missed GDP expectations with Q4 GDP of -2.6% vs Exp. -2.0%). Expect ES and USDJPY to recouple shortly, as they always do - the only question if the recoupling will take place lower or higher.

Trust is gone and credit is going and debt is sitting between a rock and a hard place with its grubby hands pressed together, praying that it will be forgiven, forgotten, or overlooked a little while longer. By the way, the reason trust and credit are gone is because oil is no longer cheap and world economies can’t grow anymore. They can’t afford to run the day-to-day operations of a techno-industrial society. They can only pretend to afford it. The stock markets are mere scorecards for players who can only lie and cheat now to keep the game going. Somewhere beyond all the legerdemain and fraud, however, there remains a real world that is not going away. We just don’t know what it will look like when the smog of fraud clears.