ALPHA SOURCES

OCTOBER 30, 2017

 ALPHA SOURCES
SPREAD EM
O ne of the more enjoyable
aspects of being an independent
macroeconomic researcherat least
for a geek like meis the road trips
when you get to speak to clients and
prospects. Sure, you see more airport
lounges and hotel rooms than you need
to. But there is no better way to gauge
the zeitgeist than to spend a week in
meetings with portfolio managers and
asset allocators. I have done just that
in New York, and I sense a cautious
optimism that the positive trend in
equities and credit and the economy will
continue for a bit longer.
In my capacity as a Eurozone
economist, my central message to
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the wardens of our capital was that
the European economy is just fine.
But I also spent time floating the
following proposition: Monetary
policy divergence is back with a
vengeance, and macro traders will
make, or lose, their money on this
theme in the next 12 months.
The ECB and the BOJ recently have
signalled to markets that they will be
stuck with negative interest rates for
a while. Meanwhile, the the Fed is
on the move, a point highlighted by
Fridays robust advance Q3 GDP report,
which suggests that growth in the U.S.
economy was a punchy 3% annualised,
despite a drag from two hurricanes.
 ALPHA SOURCES

LETS MAKE THIS EASY The two charts below attempt to

The simple version of this story provide evidence for this idea. The
assumes a continuation of the trend we first chart shows that increased rate
have been accustomed to since 2014. divergence between the EZ & Japan
The short-term yield spread between and the U.S. imply that the rebound
the U.S. and the Eurozone/Japan on a year-over-year basisin the euro
recently reached a multi-year high. And and yen against the dollar should
if you take central banks at their word, reverse soon. The most recent price
it is set to go higher. action suggests the tide is turning in
If thats your assumption, the trade favour of this trade. The second chart
in U.S. rates is straightforward. You shows the same spread alongside the
should be short front-end U.S. notes. relative equity performance of EZ and
If you think the Fed is doing real Japanese markets. It mirrors the result
damage to the economy, you should in the first; the widening interest rate
combine this with a long 10-year bet. differential suggests that equities in
If you believe in Trumpflation, though, Europe and Japan should outperform.
a short 10-year position is the way to An important detail here is that if
go. In the Eurozone and Japan, you these charts are right, the equity trade
should arguably do nothing, although by definition requires a currency hedge
peripheral bonds in the EZ look nice in a to work. So we should be looking at
world where the ECB is going nowhere. inflows into currency-hedged ETFs for
A further widening of the spread signs that investors are taking this
has implications for other asset trade. The iShares HEZU and HEWJ and
classes too. All things equal, it Wisdomtrees HEDJ and DXJ could be
should translate into a weaker euro interesting. In both cases equities in the
and yen against the dollar, as well euro area and Japan already are flexing
as outperformance of equities in their muscles, indicating that investors
the Eurozone and Japan. are on the move.

fig. 01 / King dollar to ride again? fig. 02 / Should equity investors look beyond the U.S?

EZ & Japan* two-year yields less U.S. two-year yields, % (Left) EZ & Japan* two-year yields less U.S. two-year yields, % (Left)
EUR & JPY nominal exchange index**, (Right) MSCI EU ex-UK and Japan less U.S.**, inverted, (Right)
1.0 120 1.0 40

0.5 110 0.5

60
0.0 0.0
100
-0.5 -0.5 80
90
-1.0 -1.0
80 100
-1.5 -1.5
70
-2.0 -2.0 120
60
-2.5 * Equally weighted. -2.5
140
-3.0
** 2010=100, a lower value means a 50 -3.0 * Equally weighted.
weaker JPY and EUR against the dollar. ** 2010=100, equally weighted.
-3.5 40 -3.5 160
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FADE THE SPREAD WIDENER The alternative is to assume that the

For those who are sceptical that U.S. bond market is back in the driving
global bond spreads can widen further, seat, pulling European and Japanese
the options are two-fold. You can fade rates higher. In the Eurozone, a two-
the trend in the U.S. by betting on lower year yield of -0.7% in an economy
front-end rates. Or you fade in the growing above trend, and where QE
Japan/EZ by betting that rates here will is being dialled down is an accident
be dragged higher as the Fed moves, waiting to happen. Similarly on the long
and/or that either the ECB and the BOJ end bund yields at 0.4% look ridiculous.
make a hawkish turn. Even after a sizeable move higher, they
A bet that the Fed will kick back from would still be considered low.
the table is at odds with macroeconomic The problem is two-fold, though. The
data, but it will have contrarian traders ECB has slammed rate expectations by
on alert. The first chart below that promising to keep rates at their present
speculative shorts on the U.S. 2-year level until after QE has ended. This
note are stretched. implies a depo-rate at -0.4% until the
The obvious risk is that the middle of 2019, at least. Also, the euro
Donald throws a curveball and area runs a big current account surplus,
appoints a Fed chair with a creating a wave of excess savings eager
radically more dovish persuasion to seek yield abroad.
than Yellen. Even if the outcome is a In Japan, you have to decide whether
Fed that gradually lifts rates next year, Kuroda is serious in defending his price
I reckon it would still be worth a big target on the 10y. A BOJ targeting
short-term move down in U.S. front-end 0% on the long-end in a world
rates. The other most likely catalyst where U.S. rates are moving higher
would be a swoon in stock markets. is a world where USDJPY goes to
As I said last week, though, it would the moon. To fade this, you need to
probably have to be a big one. bet against the BOJ.

fig. 03 / About those U.S. rate hikes fig. 04 / A free short in Europe?

COT positioning, Z-score U.S. two-year notes, no. of contracts Denmark, Sweden and Switzerland, two-year yield, %*
Eurozone, benchmark two-year yield, %**
4 * In standard deviations above/below median 6
based on data going back to 1999
3 * GDP Weighted.
5
** French and German benchmark.
2
4
1
3
0
2
-1
1
-2
0
-3

-4 Do you fell lucky? -1

-5 -2
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JUST TELL ME WHAT TO DO
Its all well and good for me to lay out
the menu for you, but which is the best
course? As much as I like to fade the
grind higher in U.S. rates, I also think
it is slightly too easy. If the 2s5s invert
I will change my view, but a u-turn by
the Fed would be a movie we have seen
before. The stock market trips, which
spooks the FOMC and in any case, the
federales realise that hiking in a world
of negative rates and external surpluses
in Japan and Europe is futile.
The alternative is that accelerating
expansions in Europe and Japan drag
their rates higher. The most likely
catalyst is that the ECB or the BOJ are
forced into a more constructive stance
on the economy. It would, in turn, limit
the recycling of their external surpluses
abroad. In this environment, it would
be easier for U.S. rates to drag EZ and
Japanese yields higher. It would be
akin to the late-cycle story 2006
and 2007 where all global central
banksalbeit from different
starting pointswere on a path of
normalisation. It didnt end well.
fig. 05 / The death of a champion fig. 06 / and the rise of a new one
General Electric less S&P 500, y/y%*
700
60
600
40
500
20
400
0
300
-20
200
-40 100
-60 0
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THE AMAZON SINGULARITY
Equity markets are joyfully oblivious
to any idea of a regime change. As of
Friday, the MSCI World was up nearly
15% on the year and volatility has
stayed pinned to the floor. In addition,
the high-flying tech sector continues to
crush all resistance. Fridays price action
in big guns such as Amazon, Microsoft
and Google is a case point. As long as
this trend persists, investors who have
cast their lot with passive index-tracking
investment vehicles will do well.
Active managers, however, face a
more treacherous situation. Outside
the comforting world of 45-degree
lines in tech, some erstwhile
household equity names are being
destroyed. The best example probably
is General Electric. The first chart below
shows the trailing relative return of GE
vis-a-vis the S&P 500; it has never
been worse. The second chart caps the
comparison by showing a relative price
index of GE and Amazon. Every cycle
has winners and losers I guess, but you
do have to wonder how much further
this tech singularity can persist.
Amazon less General Electric $ price index, 2010=100
99 00 01 02 03 04 05 06 07 09 10 11 12 13 14 15 16 17