The last few weeks have been frustrating as our core trades have struggled to make any real progress. Equity markets remain stuck in quite a tight range, as have core bond yields. When price moves are very muted, it’s difficult to make money regardless of whether you are bullish or bearish. There has been a little bit more volatility in FX and commodities. However, the continued weakness in the Dollar does not yet sit well with our thoughts that a low could start to be carved out soon.

The current low volatility environment has been well documented, and so we won’t dwell too much on this. However, either the current low volatility environment morphs into a higher volatility environment (as has happened many times in history), or markets continue their merry way higher. We can think of many reasons why markets should see a price correction coincident with an increase in volatility. However, the only reason to expect higher prices is a combination of continued investor complacency, and fear of missing out, encouraging participants to extend the trend that that has been apparent since late last year.

Or, let’s think about this another way. A few weeks ago, a strategist at Citi opined that investors have pretty much given up on fundamental analysis, and we think it’s hard to disagree that thought. And if investors aren’t giving much weight to fundamental analysis, then either they are simply hunkering down in a buy and hold approach, or they are resorting to technical or market analysis. Frankly, if investors are resorting more and more to technical analysis, then we are entering a circular feedback loop. If prices go higher, then investors will buy, reinforcing the uptrend. If prices go lower, then investors will sell, reinforcing the downtrend. Has every active investor now simply become a momentum investor, with the buy and hold gang assuming that central banks have their backs? We fear the answer is yes.

Our frustration with markets turns to incredulity when it comes to short dated European/German government bonds. We can understand why regulated European entities that have to meet capital requirements will hold negative yielding bonds. With the ECB deposit rate at minus -40 basis points, and EUR60 billion per month of QE, these entities have been forced to hold assets that guarantee a loss if held to redemption. But with banks able to deposit cash with the ECB at the deposit rate, why would anyone buy 2 year German Government bonds with a yield below the ECB’s deposit rate?

Chart 1 – German 2 year bond yield with ECB deposit rate and balance sheet

Chart 1 is an updated chart we showed a few weeks ago, showing the 2 year German bond yield along with the ECB’s deposit rate and balance sheet. It is clear that it was only the advent of QE that forced 2 year bond yields below the deposit rate. And between 2016 and early this year, perhaps investors thought it only a matter of time before the ECB lowered the deposit rate further into negative territory. Perhaps they thought that simmering political uncertainty ahead of elections meant there was still a tiny risk that the Euro Area would break up in some fashion. Perhaps with the removal of the EUR/CHF floor by the Swiss National Bank in January 2015, buying short dated German assets was more attractive to some compared to Swiss Franc assets.

Whatever the reasoning, it seems to us that these issues are a lot less relevant today, and furthermore, the next step from the ECB will be to announce a further reduction in their QE programme starting in early 2018. Indeed, when Draghi hinted at the end of June that Euro Area reflationary forces were gaining some traction, the yield on the 2 year German bond rose 18 basis points in a matter of days, from -0.73% to -0.55%. Over the last 9 weeks, that yield move has been completely unwound, and is back at -0.73% as we head into the ECB meeting in less than two weeks.

Chart 2 – 2 year German bond future with 14 day moving average and open interest

Chart two shows the price of the German 2 year bond future which is obviously the inverse of yield. As can be seen, the price trend since late June has been very persistent, but what has captured our interest is the relatively large increase in open interest (shown in the lower panel) to the highest in 6 years. This is a clear sign that it is new long positions driving the price higher, and in our opinion, anyone buying at the current price is simply a momentum investor, almost blind to the fundamental backdrop and the fact that she/he is buying an asset with a yield of minus 0.73%.

In another sign of a continuing or growing disconnect, and again picking upon Europe, we look at the continued strength of the Euro as being a bit overdone. The chart below shows the EUR/USD exchange rate alongside the difference between 5 year US and German bond yields. Although the exchange rate can move around from undervalued to overvalued, the correlation between the two usually remains quite tight. This began to change in May and seems to have completely broken down since July. Even on Friday when neither Yellen nor Draghi talked about monetary policy in their Jackson Hole speeches, the Euro rallied as each spoke, gaining over 1% for the day.

Chart 3 – EURUSD exchange rate and 5 year bond differential

Now there are some extraordinarily large players in the FX market, such as sovereign wealth funds and central bank reserve managers, and perhaps what we are seeing is large currency shifts by one or two of these guys. However, the Euro was the only major currency to make a new multi-month high against the Dollar last week. Yes, the Scandinavian currencies did too, but Sterling, Swiss Franc, Canadian Dollar, Japanese Yen and the Aussie and Kiwi Dollars all remained lower than the low of a few weeks ago. Is this more mixed price action a sign that the multi-month period of Dollar weakness is close to ending?

For European assets, we think the ECB meeting in two weeks’ time is important. We think that Draghi will be more forthcoming on future QE plans, even if he doesn’t have the final details. Our bet is that his rhetoric will be enough to halt the rise in short dated German bond prices. However, Draghi will also be keen to remain as dovish as possible, hoping to emulate the dovish hikes that the Fed have delivered this year. We also think that he is somewhat unhappy about the recent strength in the Euro, and perhaps he will somehow make mention of this, even though the ECB does not directly target the exchange rate. Now, we may be fitting our narrative here to justify our bearish view on both the German 2 year bond and the Euro, but it is not inconceivable that both can go down at the same time, especially if markets suddenly wake up to fact that not only are both the Fed and the ECB tightening monetary policy, but the Fed may well be doing so on both the balance sheet and the interest rate front.

So, as we have been saying for a few weeks, we think that a larger shift is either beginning in markets (i.e. developed equity markets have not made any progress over the last two to three months or so) or is just around the corner (i.e. a relatively large bounce starting in the US Dollar). Upcoming central bank meetings may well be very important to this scenario. Of course, we could well be wrong, but with equity markets stuck in a fairly narrow range, something has to give at some point, and we think that point is relatively soon.

Summary of trade ideas highlighted in our weekly commentaries

Just one change this week, with a new S&P 500 put option bought. The tenor of this option is longer than the option we bought a few weeks ago, thereby giving us a little more time for the trade to work. Of course, longer dated options also cost a bit more, and so we have to be careful that we don’t sit on this position as the value decays. We may well trade some of the associated hedge in order to both manage risk and our bottom line profit/loss, and there is a good chance that we will not hold the option until final maturity.

	RMG Trade Idea Summary – Initial Notional Portfolio of US$5 million
	OPEN TRADES
Trade Date	Trade	Entry Price	Stop Loss Level	Loss to stop Local Curr	Loss to Stop US Dollar	Bps Risk to Stop	Last Price		Open P/(L)%	Open P/(L) Local Curr		Open P/(L) US Dollar
26/07/17	Short 100 Contracts  Sept Schatz	112.03	112.3	-27000	-32130	64.3	112.22		-0.17%	-19000		-22610
15/08/17	Long 300 November VIX 16/24 Call Spread	0.97	0	-29100	-29100	58.2	1		3.09%	900		900
23/08/17	Long 20 Contracts S&P 500 November 2350 Puts	29.2	0	-58400	-58400	116.8	28.3		-3.08%	-1800		-1800
	Unrealised Totals				-$119,630							-$23,510
	CLOSED TRADES
Trade Date	Trade	Entry Price	Stop Loss Level	Trade Closed	Close Price	Realised P/L		US Dollar P/(L)			Last Price	Open P/(L)
14/07/17	Long 10 Contracts Sept Cocoa	1892		04/08/17	2047.7	8.2%		15570.00
14/07/17	Long 10 Contracts Sept Cocoa	1892		01/08/17	2068	9.3%		17600.00
14/07/17	Long 20 Contracts Oct Sugar	14.099		04/08/17	14.174	0.5%		1680.00
14/07/17	Long 10 Contracts Sept Coffee	132.10		04/08/17	139.4	5.5%		27375.00
19/07/17	Long 20 Contracts Sept Cocoa	1943.10		28/07/17	2035	4.7%		18380
19/07/17	Long 20 Contracts Oct Sugar	14.42		01/08/17	15.0245	4.2%		13540.80
20/07/17	Long 10 Contracts Sept Coffee	136.175		01/08/17	138.65	1.8%		9281.25
09/08/17	Long 10 Contracts December Gold	1274.4		14/08/17	1287.4	1.0%		13000.00
02/08/17	Long 40 SPX Sept 2400 Puts	12.7		14/08/17	12.3	-3.1%		-1600.00
Cumulative Closed Profit/(Loss)								$114,827.05

This is not meant to be a model portfolio and it is not meant to constitute any investment advice. This is purely a way of keeping track of specific trade ideas that we highlight in our weekly investment commentaries. These ideas will consist of the more important or higher conviction ideas that we implement in our multi asset macro fund. We have chosen to have a notional starting portfolio value of US$5 million; the reason being that we can also illustrate how much risk we are taking on each trade as well as keeping a cumulative track of how our main trade ideas are performing. This is a notional portfolio only and does not represent any portfolios that we manage. However, for the sake of clarity and consistency, we do put these trades into our multi-asset macro portfolio alongside other trades that we do not make apparent here. The prices we show in the table above are the prices we transact at for our macro fund, not including any trading expenses.

 

Stewart Richardson
RMG Wealth Management