MarketsMuse Editorial Note: Below is extract from Oct 1 edition of macro-strategy commentary courtesy of Rareview Macro LLC’s daily publication “Sight Beyond Sight”..We often profile this content from macro strategy expert and author Neil Azous, simply because since we first started following SBS commentary, it has become one of those most highly-regarded independent research pieces subscribed to by more than a few of the “sharpest knives in the drawer.”
“….One simple way to measure the market impact of the growing pro-democracy protests in Hong Kong is to look at future assumptions for corporate dividend streams.
Specifically, we are watching the HSCEI Dividend Point Index Futures (symbol: DHCZ5) that trade on the Hong Kong Futures Exchange.
Because most of the “terminal outcome” is already in the price of the futures contract, based on the modeling of expected dividend payouts, the front-month futures contract should generally show the most acute reaction to a fast-developing live event. Put another way, the “gap risk” is much higher at the front versus the back of the futures curve.
Now, to be fair, this product is generally used by regional investors with $50-300 million in AUM as the futures are not liquid enough for the larger players. However, the fact that smaller is at times synonymous for “weaker hands” highlights that the local and small player is not yet really concerned by the protests. And what that tells us is that the possible contagion from these protests is actually lower than most people think, at least for today.
The second observation of note last night is that it is very difficult to tell if the unwind in the emerging markets, carry trade and commodities has ended. While everyone has their favorite proxy, the fact is that the majority of instruments that investors watch are trading two-sided and both sides of a loss or gain are largely capped to 5-10 basis points. It is still too early to make the call for a pause, consolidation or reversal in these themes, especially as the US Dollar is once again making a new high at the index level today. Our best description is simply that the rate of change in the clearing process has slowed a fair amount, at least for today. To come to this conclusion, we simply reviewed the price action in the following way:
1. Four currencies in the Fragile Five Balance of Payment (BoP) countries: S. African Rand (ZAR), Indonesia Rupiah (IDR), Turkish Lira (TRY), and Brazil (BRL). Three are stronger relative to the USD, albeit only marginally, and Brazil does not trade overnight – unless you happen to have a personal appointment with a broker willing to trade unhedged.
2. Two strongholds: India Rupee (INR) and Korean Won (KRW). Both are weaker relative to the USD, albeit marginally.
3. Commodities & Financials. Australian Dollar (AUD) and the big four local banks. AUD is stronger relative to the USD and an equal weighted index of the big four banks is +1%.
Finally, the Euro currency crosses are in focus following the inflation data from the Eurozone.
The debate that has taken place following the release of that data is, to us, very interesting.
On one side, some analysts are suggesting that the headline CPI was actually at 0.254% unrounded. To some that suggests we were to closer to dropping to 0.2% than most paid forecasters believe and that combined with the weaker CPI Core YoY number at +0.7% (vs. 0.9% expected) suggests this was a genuinely weak release, especially given the slightly better German regional and national inflation data released yesterday.
On the other side of the debate are those who actually do their homework. They suggest that after looking at the Eurostat official press release they only calculate the estimate to 1 decimal place. So there isn’t an unrounded number until the final reading.
We do not have time this morning to validate who is right or wrong. What is important to recognize is that the weak price action in the Euro crosses suggests that the trajectory of the CPI is in line with wanted to round the number down today.
What this means is that the professional community is changing its perception, albeit incrementally, ahead of Thursday’s European Central Bank (ECB) meeting. The simple fact is that this is a further sign of increasing disinflationary pressures. The medium term inflation expectations (5y-5y break-evens) are now at the lows. All that does is increases the risks of the Euro area entering into deflation.
The key point here is that President Mario Draghi was previously able to rely on the resilience of core inflation to argue deflation was not a big deal, and that made him reluctant to expand the ECB’s balance sheet. After today’s data his calculus is likely to change and that means there is a greater chance of balance sheet expansion, even if it is just incremental from what was conveyed to us in previous meetings. The Euro has to re-price even easier monetary policy ahead of Thursday’s meeting, and there is little question it is already doing so.
The worst aspect of this is that many in the professional community are going to miss out on this positive PnL event. Why? Because they did not listen to us for the last two months and once again got greedy using exotic option structures.
We have continuously advocated that investors who went long on the US Dollar should only use outright delta positions and that being cute in portfolio construction during a short-to-medium-term thematic switch would lead to lagging performance or in some cases missing out altogether.
Well some in the professional community did precisely that, as they underestimated the degree of a move during thematic switches.
We are hearing that a lot of bearish Euro option structures were leveraged using Reverse Knock Out Option (RKO) and they were “knocked out” today as the EUR/USD dropped below 1.2650 and 1.2600.
We apologize in advance if we are repeating ourselves. But as our audience continues to diversify globally it is prudent to give a brief explanation to those that are less savvy at using derivatives.
A reverse knock out (RKO) is a European vanilla option with an American barrier. The barrier can only be hit (knocking out, or terminating, the option) as the option moves into the money or gains value.
You define the barrier for a:
a. Call option (also known as an up and out call) above the underlying asset and strike.
b. Put option (also known as a down and out put) below the underlying asset and strike. (Current)
If during the option’s lifetime the barrier:
a. Is not hit, the payout is that of the underlying vanilla option. However, the maximum payout is limited by the barrier, whereas a regular vanilla option has unlimited potential payout.
b. Is hit, the underlying option is knocked out and there is no payout. (Current)
Because the move has been bigger, more sudden and more sustained than many thought likely, a lot of professionals are extremely frustrated. The key point here is that they got the core view right, but then lost their positions (and positive PnL along the way) as they got knocked out. Even worse, since this is still a core theme, they have little choice but to add back short positions at the lower end of the range. That is painful, period.
This continuous cycle by portfolio managers beholden to a low volatility mandate and use of exotic options structures to leverage their risk capital is not only a prime example of greed, but it is also why some argue that the long US Dollar positioning is not as stretched as many think because so many of these exotic derivatives exist.
For us we just don’t understand why, when a theme like this comes around just a couple of times a year, someone sells a knock out for pennies. Not only did they collect nothing to get some additional leverage but the amount of brainpower exhausted along the way far outweighs the gain. Still, that is a digression.
Our View:
The culmination of three months of work is coming to fruition.
The accumulation of risk by the professional community has reached a level where any marginal increase in volatility or disruption in the funding markets can easily lead to a corrective scenario in risk assets.
Put another way, if we were to use a scale of 1-10, with 10 being the most amount of risk deployed, we are at the upper end right now. Judging by the outsized positive performance in September, an educated guess is that the macro strategy has the most risk deployed this year to start the fourth quarter tomorrow.
While prices might adjust in some of these core US Dollar strategies later today, the reality is that the pushback to take profits or hedge will be high. After all, this will be a positive mark in their books to end the third quarter. There is no reason to fight this today and that is fine. This strategy has been taken to the woodshed and left for the dead in many cases. It is okay to give them a day in the sun.
For us, we will remain very focused on the short-to-medium-term switches underway globally.
Last Friday marked a number of key technical closes on a “weekly” basis. Today, the same observation will be made for both a “monthly” and “quarterly” close.
Historically, this technical confirmation is powerful for a variety of reasons.
Firstly, the US Dollar will have made a short and medium-term turn in most models and long-term turn in some. What that means is anything that is trend based – momentum driven or pattern recognition – will likely see a medium-term adjustment. We have highlighted many times in these pages that these systematic strategies make up ~25% of all hedge fund AUM and deploy the most leverage.
Secondly, if the US Dollar and Japanese Yen were the major funding currencies in the world to pay for high yield assets (i.e. the carry trade) then the US Dollar will have to be replaced incrementally. That means the Euro and Swiss Franc, countries that have or will soon have negative interest rates, will have to take the baton from the US Dollar. To suggest that this has already occurred in any meaningful way, given QE has not ended and rates have not actually risen in the US, would be misguided. If you don’t believe us feel free to call any corporation and ask them what they are currently using for their liability to manage their FX portfolio.
The list could go on but the point is that this thought process will extend across many other assets as well.
Our favorite example of markets suffering from a stronger US Dollar thematic changeover is Gold. The Gold spot price (symbol: XAU) is now at ~$1207 versus $1201.64 on December 31, 2013. Not only will it close on the low to end the third quarter today but it is likely to trade negative on the year shortly. That is important to recognize because last year Gold lost its number one marketing tool when it closed negative on the year – closing positive for 12 years in a row. That would lead some to begin to speculate that Gold will close negative for the second year in a row and that is enough to test the resolve of the long base which has sold very little on the way down this year.
All in all, while we still have many of the same concerns we highlighted yesterday we are managing to look past the quarter-end noise, and focus much more so on the intermediate term themes and asset switching that will drive the markets into the end of the year. So should other investors, since there are still plenty of gains to be had for those who get it right.
Sight Beyond Sight is a subscription-based, daily macro-strategy viewpoint authored by Neil Azous and published by Rareview Macro LLC. Subscribers include a unique assortment of leading hedge funds and Tier 1 investment managers. 10-day free trial subscriptions are available without the need to supply credit card information. For additional information, please visit www.rareviewmacro.com