Tuesday, May 02, 2006

Trading the most likely outcome

No trades today, but thought I'd muse on what trades are out there that
I should be putting on. Lets look at interest-rates:

So the market finally priced in higher rates. I've had this view for a
long time, but didn't seem to profit as much from it as I should have.
So where to position from here, now rates are considerably higher? Well,
what is happening? Global interest rates are going up. No doubting that.
Japan has ended quantitative easing, and looks set to raise rates from
zero at some point. China just raised rates a touch, to 5.80% I think,
which seems intuitively low for an economy motoring along at 10%+. The
US has raised rates from 1% to 4.75% and will go to 5% next month, and
the FED is then looking like it will pause while it waits and sees how
the data unfolds for a while. And the UK hiked a couple of years ago
from 3.50% to 4.75%, and had to cut back to 4.50% last year as they
choked the economy a bit at 4.75%.

The fact the UK had to ease rates after a few hikes when they hiked
1.25% from the lows is interesting. Is this a precursor to other
economies? The FED hiking too far too fast is not the scenario that I've
bought into before, as I think the US economy is very flexible and can
absorb 5% rates in its stride. However, now that an increasing portion
of home purchases there have been done using mortgages linked to
front-end rates, unlike the traditional 30y mortgage where rates are
linked to the long-end and don't reset higher, this could force the
economy to slow down quicker than it would have otherwise. I have read
that about a third of mortgages now are ARMs (Adjustable Rate Mortgages,
like the UK where its set off short-term rates), so hiking from 1% to 5%
could bring out a pretty horrible outcome for some owners when their
repayments shoot up. Maybe we could see an extended period of 5% rates
then, with the market even pricing in rate cuts at some point? In that
case, I need to be careful of my $ short versus £, if £ were to rise.
And I need to think about shorting the Dollar generally in that
scenario, but only if rates elsewhere are to rise aggressively.

So how high can UK/EURO/JAPAN rates get? Well, I am not a fan of
monetary union, and think the whole EURO project is very unstable as
monetary policy cannot be aligned with fiscal policy on a
country-by-country basis to control the economy/inflation etc. Just look
at Ireland, where they screwed the rest of Europe by cutting corporate
taxes to 10% and so brought on a massive economic bubble. That economy
sure needs slowing down. But then you're stuck with idiots like the
French and Italians who refuse to restructure fiscal policies while they
have a chance, and so have rigid, inflexible economies destined to have
high unemployment, falling FDI and be uncompetitive with the rest of the
world. Just look at the student riots because they want a job for life,
they just do not understand how beneficial the free market can be for
them. And then you have Germany, which I like more, and think they are
slowly reforming. They have strong but fragmented banking markets which
will benefit from consolidation, and a powerful export base helped by
technological prowess and a talented workforce. With a bit more reform,
they can remain the powerhouse of Europe.

So growth will be mixed in the Eurozone. With 10y Bund yields at 4%,
what's the answer? This one is tough. Markets are pricing in the ECB
quickly getting to 3.50% (they are at 2.50% just now), and then they
will be virtually done. It seems to me that money-supply growth in the
Eurozone is out of control, inflation has been above the ECB target for
years, so that tells me they aren't that bothered about inflation and
will be slow to react, so surely that means having steepeners on in
rates? I will have a look at shorting Bund futures versus buying some
shorter EURIBOR contracts, maybe say buying 1 year out EURIBOR, so with
the average life on Bunds being 7-8 years I think, I'll have a 1y-8y
steepener on. That seems to make sense. If Treasuries can get to 5.10%
and Gilts to 4.70%, no reason for Bunds to remain down at 4.00%.

So if they FED is done for a while and the ECB are going on a slow but
extended rate hike cycle, I have to buy EUR vs USD. I just don't
intuitively like it, but that is all I can take away from what I have
written. I'll start in small, put in some limits and increase the size
if it starts going my way. I'll take a look at this over the weekend
though before I put anything on.

And as for the UK...well, I think the key here is in Government
policies. It seems pretty clear that the are pursuing socialist
policies, increasing taxes and putting burning more cash on the NHS and
the schools, and the main thing Labour care about is remaining in power,
and not the long-term health of the UK. This has meant unemployment has
been creeping up despite low rates, and will end up keeping rates lower
than they otherwise would. I also think it will ultimately hold back the
stock market also. I also always have a preference to be short bank
equities in the UK, as I think unsecured loan defaults will pick up, and
the mortgage market is very competitive. I am surprised by just how much
money the banks make, and think the profit growth must come to an end
sooner rather than later. But UK bank stocks seem to have a tendency to
go on surges, and so I want to be careful and convinced before I short
them. I'll take a further look into these stocks. And I'll remain short
the pound. And I may consider buying some Short Sterling contracts,
maybe late 2007, if I come to the view that rate cuts will be happening.
These contracts are pricing in over 5% interest rates for next year, so
could be some good upside in those.

That'll do for now. I'll be having a close look at the summaries from
this, and potentially put these trades on. Any comments appreciated!


Anonymous Anonymous said...

I'm impressed with your site, very nice graphics!

17 May, 2006 07:29  
Anonymous Anonymous said...

Very pretty design! Keep up the good work. Thanks.

17 May, 2006 12:57  

Post a Comment

Links to this post:

Create a Link

<< Home