Steen's Chronicle: All change! Last station !A ll change

Just as I felt confident in my new macro model:  The Bermuda Triangle Economics, BTE, the world is changing – yes, I am always slow, but this recent potential macro paradigm change is interesting and can, fortunately also be explained by from the BTE view – I call the new phase: The Reality – Marginal Cost of capital normalizes

 

The concept in BTE is that the world, so far, has been kept in artificial equilibrium dictated by QE and fiscal policies which have supported the 20% of the economy which is listed and banks with access to capital and not least political favors. Premise based on a non-existent wealth effect which really is an Elite effect. (Supporting the have vs. the have not's)

 

Meanwhile the 80% of the economy, the SME's which is the productive, innovative, young and less capital intensive have been left to rot for themselves hence low innovation and high unemployment.

The lack of social discontent being explained by the fact we are the Entitlement Generation. We have no interest upsetting the government and central bank policies because more than 50 pc of the population benefit from transfer of income from the state. Proving the old game theory theorem of the individual can be rational but the sum of individuals makes their actions irrational. That is in short the BTE.

 

What would upset this equilibrium?

 

The intuitive response would be: A change of QE? That's not necessarily true – no, the truth is an increase in market volatility would dramatically hurt the false equilibrium through a bloating of VaRs (Value-at-risk models)

 

When the market gets more nervous the volatility(which is defined as the first derivative of a price move) moves from being a one way street defined by compressed risk premium, policy intervention and yield chasing combined with benign inflation to big discontinued jumps in prices.  The culprit? Abenomics!

 

JGB contract historic volatility 50 & 100 days….(Source: Bloomberg LLP)

 

 

 

For all its success in getting Nikkei higher – and until recently – USDJPY, it also dramatically increased volatility in JGB's which was certainly not intended. This increase in JGB's volatility made people like me go short USDJPY based on similar moves in history again increasing the relative volatility – this led to higher general fixed income volatility, where in the US a30 year mortgage bond yield is up 76 bps.

 

The benchmark 10yr US bond has moved so much that the world's most famous bond investor Bill Gross has lost 335 bps in his PIMCO Total Return Fund (PTTRX US Equity) from year high in April and is down 169 bps for YTD in a fund which is known for stability (Let me stress I am have big respect for Pimco and Mr. Gross and I am only using PIMCO Total Return Fund to make the point even the best investors is hurting in this move – PIMCO fund remains an outstanding outperformer over time relative to its peers)  

 

30 Year US Mortgage rate (Source: Bankrate)

 

 

Pimco's Total Return Fund

 

 

So in short, the dramatic changes to fixed income and overall market volatility probably had 70% to do with the failure of Abenomics to continue the game of QE and easy money. The reason for this as I have stated several times, is that Japan came too late to the party. They were the 8^th inning in a baseball game (total inning 9) (With Bank of England potentially being the 9^th and final inning) – when you come late in a game the pitcher is tired, the strategy needs to be changed from striking player out to preserving your lead. The market have decided that the pitches coming at the batters are slow, predictable and easy to hit meaning we could be at the end of this cycle.

 

What makes Japan's timing even worse is the fact that risk premium were extremely compressed – everyone was seeking yield and running momentum trades which led to over-reaction to downside. Look at corporate and investment yield tickers like HYG and LQD which both is down in excess of 5% from the top, so what we are seeing now is also a "normalization of risk premiums" – which is long-term very healthy – we could at best be moving towards creating "price discovery" again in the fixed income market meaning we know the price of money both in time and yield – at least in the sectors outside the control of the silly central bankers.

 

The other major trend I want to touch on which makes this move in yield  really concerning is global current account trends. I have stated a few times that the lack of recycling going forward is major issue for not only the US but certainly for all current account deficit countries: (and hence the major sell off in EMG)

 

 

The trend is clear: From 5-7% surplus' – ergo saving excess which needed to be spend on US fixed income Asia is barely having surplus and BRIC will in my estimation move to deficit inside next 12 month with Japan joining them on current account deficit side. This means the biggest institutional buyers of GOVERNMENT debt disappear – if anything they will dis-save!

 

Concerned by now?

 

You should be.

 

Finally straw,

 

Looking at the US economy the recent increase in yield has happened DESPITE no improvement in underlying data…imagine if the US economy started to slowly pick-up from these low levels of activity over the summer due to lower energy, better "feel factor", and slightly better housing market – You ready for 3% 10 YR yield and 5% mortgage rates in an economy with less than 2% real growth? Probably not, but you are not alone.

 

 

Conclusion

 

I see the next few days as potential major game changers – the bloated VaRs will make people hedge and over hedge, the normalization process of risk premiums via above plus higher real rates (higher yield + lower inflation) leads to more sell-off in trades which have "worked so far"… and increase volatility on its own.

 

I have not even mentioned the Constitutional Court Ruling in Karlsruhe which the Anglo-Saxon press and banks with their usual nativity of everything German have written off as non-event. Reading Spiegel last night I got concerned about consensus but you judge yourself. Decisive days for EURO: High Court considers ECB Bond buys

 

Positions: (Alpha)

 

Short OAT – on bond volatility and Europe QE light

Short 10 Y. Notes on above and technical break plus convexity hedging

Bought 101 USD call JPY put as insurance ……..(Higher US yield…)

Short GOLD (higher real rates…. Biggest conviction trade today)…

 

Looking to add short Crude and long USDZAR, EURPLN again.

 

Safe travels,

 

Steen

 

 

 

 

Med venlig hilsen  |  Best regards
Steen Jakobsen  |  Chief Economist

 

Saxo Bank A/S  |  Philip Heymans Allé 15  |  DK-2900 Hellerup
Phone: +45 39 77 40 00  |  Direct: +45 39 77 62 23  |  Mobile: +45 51 54 50 00

 

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