To this point, I’ve largely limited my thoughts on this blog to extremely big picture events; with the occasional, harmless bit of opinion on the events of the day. The record of picking up on major themes has been quite favorable: I pointed out back in 2011 that the crisis the world is fundamentally grappling with is a currency crisis. I’ve strayed well clear of the hyperinflationistas, through my writings on quantitative easing also back in 2011. I was quite bearish about the nature of solutions being offered by Europe in September and again in October, 2011. I turned constructive on signs that internal revaluation was achieving some results in January, 2013. I also pointed to the immense power of QE3 in September 2012, while going on to warn that an exit was unlikely to be smooth, in March 2013. Finally, I expressed repeated concern by India’s deep-rooted competitiveness problem in articles in January 2013 and then again, in June 2013. Apart from blowing my own trumpet, the reason I point out all of this is because I’m about to start to blow this reasonably healthy track record by getting into more micro market movements. I am afterall, a trader, not a philosopher, a theoretician or a journalist. So, the business of actual market moves is my business – not the business of offering ‘opinions’ with a fair likelihood of relative success. How you trade your view of the world is ultimately far more important than what your view of the world is. To quote the legend himself (George Soros), “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”
So here goes the beginning of a journey of regular posts on my market parameters, where success rates drop, confused conjecture begins and clarity becomes a relatively scarce commodity. That’s the real world of trading. This is a risk management business; not merely an opinion and conjecture business. Strategic, secular views are extremely important here; but how you trade those views, and mix them with tactical calls is the secret sauce that there’s no one recipe, formula or method for. My aim here isn’t to advertise my actual trades, but simply to pen down thoughts on the dynamics driving current market action. Build broad parameters, and leave the value of this conjecture and its ‘actionability’ to the reader. With all of that out of the way, here goes. This one’s likely to be a lot longer than future posts, because of the nature of current conditions.
Emerging markets have turned center stage, both in the financial press and among policy discussions. The basic nature of the crisis is that much of the emerging world has fallen into the trap of slowing reform, widening deficits (in many cases, twin deficits) and the enabling condition for much of this has been hot money inflows; FIIs continued to pour money into emerging markets, even as the fundamentals in EMs were deteriorating. As the Fed announced its decision to taper; various carry trades seemed to reverse; and the resulting outflows created a self-perpetuating crisis. Weaker currencies led to a degree of panic for foreign investors, who saw the dollar value of any unhedged positions decline rapidly.
As is usually the case, markets have moved well ahead of EMs becoming central to the discourse; so, the issue at this point, relates to timing and how stretched markets already are, rather than simply the causes behind what has been a fairly predictable crisis.
A few notes in this regard: firstly, correlations are different across different time horizons. So, for example, over the last 6 months, the Indonesian Rupiah (brown), the Turkish Lira (orange), the Brazilian Real (green), the Indian Rupee (blue), the Thai Baht (pink) and 5-year US treasury yields (red) have been extremely correlated. But, as you stretch the time horizon on these relationships, correlations loosen. So for instance, contrast the 6-month chart below, with the 10-year chart that follows.
It’s difficult to say how long highly correlated movements across EM currencies will continue; but elevated correlations are in themselves an indicator of financial stress. At some stage; markets will again look to differentiate between countries and currencies where the problems are endemic, and others where currency adjustment itself leads to reasonable outcomes.
A couple of views on EMs that are worth a read:
1. Robin Wigglesworth of the Financial Times: “Too soon to buy unloved Emerging Markets”
2. Nopparat Chaichalearmmongkol and Warangkana Chomchuen of the Wall Street Journal: “Thailand GDP Highlights Policy Dilemma”
A longer-term structural view revolves around several competing considerations.
1. A data-centric view of country-wise trade elasticity. As imports become more expensive, and exports become cheaper; the classic view is that trade deficits should narrow. In some cases, for example, India, this hasn’t yet shown up in the data, to any significant degree. The leads and lags involved in this process, as well as externalities make it difficult to project trade elasticity. But it is true, that all things equal, weaker currencies should go some way towards fixing the underlying problem: a lack of competitiveness.
2. Not all countries in the midst of the current crisis are created equal. The trajectory of the current crisis is likely to be quite different from the 1997 Asian Financial Crisis because the countries involved have significant foreign exchange reserves. This is a short-term buffer.
3. Policy response. The signs so far aren’t great. The basic identity, (X – M) = (T – G) + (S – I) seems to have been thrown out of the window. The assumption that spending more to stimulate the economy, while simultaneously ensuring rates don’t rise is an approach that most of these countries have regurgitated, and that’s not encouraging. It undermines any progress that currency depreciation creates. Indeed, this sort of policy response is extremely dangerous.
4. Inflation dynamics: Rapid depreciations of the kind we’ve seen across EMs are quite likely to lead to renewed inflationary pressures, particularly in countries which depend on energy imports. This problem gains an additional, problematic dimension in countries which subsidize energy imports, since a weaker currency structurally creates a wider fiscal deficit in these countries.
5. Growth: last, but not the least: growth and indeed resultant confidence is often the best antidote to any economic crisis.
What this adds up to is a series of difficult policy choices and a high likelihood of policy accidents. Indeed, we’ve already seen at least one: where the RBI in India went in with hawkish measures to ‘reduce currency volatility’ but mixed it with a dovish tone on monetary policy which undermined the impact of these measures, leaving the market uncertain about the course of monetary policy and increasing the pressure on already stressed financial institutions. This is in fact, a key risk in the case of emerging markets, where policy incoherence and often, the lack of an educated political and civil society debate are facts of life.
Now, beyond these structural issues, we saw an important event on Friday, which may just set the tone for emerging market response over the near-term. Brazil announced a $60-billion intervention by the end of the year and the BRL responded by appreciating about 3.5% in Friday’s trade. Some may suggest that this is an extremely risky move, since it risks undermining central bank credibility itself; but I believe this intervention should enjoy a fair degree of success. This is primarily because the announcement is large enough for it to enjoy a degree of credibility and it came late enough for the market to be positioned with a large number of shorts. However, if US yields spike further, all bets are off.
That dynamic leads to the conclusions for short-term positioning. By short-term, I mean the next few days!
India (NIFTY): While everyone has been looking at the USD/INR relationships and making projections on the NIFTY based on this; a relationship that has more closely tracked NIFTY movements has been the one to the Japanese yen. The following chart illustrates these relationships:
Historically, recoveries on the NIFTY tend to be led by banks. Indeed, the fact that the previous rise to 6100 went hand-in-hand with a fall in banking stocks was one of the primary reasons why I was skeptical about that move.
Much like the Rupee/Yen relationship; there’s little that suggests the brief rise in the Bank NIFTY: NIFTY ratio is sustainable. But, oversold banks, the NIFTY & the BANK NIFTY rising off oversold levels on the RSI; a degree of positive divergence and indeed, the large surge in volumes in the final stages of the decline towards 5250 on the NIFTY all suggest, the shorts within the system are currently somewhat vulnerable. I’m not a believer in predicting market moves; merely in trying to position yourself in a probabilistically useful manner.
Full disclosure: I tweeted on Thursday about having picked up NIFTY August, 5400 calls @ ~35 each. I continue to hold these and cannot reasonably project how long I will maintain these positions. While my base case is to hold these till contract expiry this Thursday, I am using a loose, trailing stop.
Broadly, while short-term traders look to be positioned poorly, I expect several doses of overhead supply if indeed this market heads higher. So, at this stage, the positioning is purely tactical. Given the extremely large negative trend over the course of the August futures contract; I’m looking for a bout of short-covering if the index futures trade above 5500 for any length of time. At this stage, I’d be looking to revisit my positional bias around 5600.
On the other hand, a failure to cross ~5500 would denote weakness and may lead me to develop fresh shorts, if the inter-market action supports a greater likelihood of weak EM equity action. This would include a stronger yen to the rupee; higher 5 & 10 year US yields and a degree of domestic bond market weakness.
Lastly, the metals and mining stocks continue to look quite interesting. I did close some metals longs; and am currently in wait and watch mode. A close above 3.40 on copper is likely to lead me to open fresh longs. This is an area I’m looking at, closely. The basic thesis here is that there has been a bout of commodity strength which has taken place under the radar. The CRB Index and others appear to suggest a long-term decline may have concluded. So the technicals suggest a degree of positioning into materials stocks may make some sense. However, this is a purely price based thesis that I don’t have a larger view on. I’d need to develop an underlying reason to expect continued dollar weakness before terating this as a serious, sustainable hypothesis.
United States; Dow, S&P 500
Finally, my outlook on the Dow & S&P remains extremely cautious beyond the next couple of sessions. I hate to bring Japan into this once again, but this is another relationship I consider important and track closely:
Broadly, I don’t see too much conviction about moves above 100 on the USD/JPY or ~1700 on the S&P 500. There have been sustained signs of negative divergence on both the S&P and the USD/JPY pair and this looks and indeed ‘feels’ like a market undergoing some sort of an exhaustion process. I’d need to see a sustained move above 100 on the USD/JPY; to begin to re-consider this outlook.
Lastly, 2.80 on the 10-year looks like a pretty important level in the near-term. Trading below these levels for any considerable amount of time should be good for EM currencies. Also, keep an eye on other EM central banks following Brazil in announcing measures to use FX reserves in order to try and stabilize the currency.
That’s it for now. The main aim behind this section is to start to transfer some of my personal offline views and quite regular, but unstructured tweets to this blog. The main reason I’m doing this is to force myself to try and pen down views and to invite people to poke holes in them. This is not intended to outline specific trades. Managing risk is the skilful piece of the trading jigsaw. This is merely an attempt to create a degree of personal coherence in an ocean of randomness.