Trade ideas...lets see what we can come up with

DcifrThs · #1 06-08-2007, 02:41 PM

Alright folks, i haven't seen a non individual stock based one of these yet so lets start it.

on May 20, 2007, i wrote the following as a brief summary of the overall trends in the global economy:

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well first off, I’d like to break the “economy” into asset classes and countries.

Taking global equities first, we have seen a sharp run up in stock prices worldwide. Growth has been strong and globally synchronized. For the first time ever, all OECD countries are growing simultaneously. Globalization has appeared to link the economies of the world structurally. Chinese growth has obviously been a massive driver and demand from that country does not appear to be slowing. Even if efforts to slow the economy by the govt pan out, a growth rate of 8% is still likely.

A few things have kept equity prices up. First and foremost is the massive # and amt of deals we’ve seen and continue to see. Leveraged buy outs, share buy backs, mergers, acquisitions, and the like all push ever higher on global equity prices. China may also be moving towards a bubble as the # of new accounts to buy equities has shot up at insane rates. Private equity firms are also flushed with cash. All this cash is tied to the next point, fixed income.

Global rates are very low and credit spreads are squeezed tight as a drum. These low rates, when compared to equity yields, make borrowing to purchase companies via cash & debt very attractive. We see this from corporate bond spreads and the deals being done mentioned above. Global capacity utilization at this point in the cycle would usually be getting strained and margins feeling some compression. The globalization though has flooded the world with cheap labor which has kept margins fat and capacity lower than typical at this point of the business cycle.

Emerging market debt spreads above risk free rates have also come in a great deal. At least part, if not all, of this is legitimate. Developing economies have changed the way they handle a booming commodity mkt (and thus a very large income stream for commodity exporters). Typically, those countries would actually be running current account deficits by importing a ton and financing those imports with money that would love to invest in their country given how it's doing. But this time, we see those countries running a current account surplus. This is because they are growing and using the export money to invest in their own country (and around the world, thus running a capital account deficit). Overall this is great, but spreads can’t get much tighter. Further, some commodity exporters are running CA deficits & borrowing funds from around the world to consume. This is troubling since a shock there, even if triggered by that country’s economic situation alone, would likely reverberate across emerging mkts and widen spreads.

As a result of everything above (high liquidity, high growth, global demand), commodity prices are high as well. China demands a great deal of them as does Japan, the US, & Europe.

Moving on to China. Last week (week of may 14th), they finally acknowledged that good 'ol fashioned central bank tightening is really what is needed to slow the economy down. In order to do that, they have to let their currency appreciate vs. the dollar and uncouple their monetary policy from the US (i.e. while the currency is pegged, they can’t raise rates). Otherwise, domestic inflation will rise making the peg worthless (competitiveness will fall as domestic prices rise regardless of the Yuan's level vs. trading partners). This will also help push global rates up as their massive ($1.2 TRILLION) reserves of US bonds will stop accumulating and the US 10yr rates will start to move up.

 Addendum: i would have to rethink that latter remark. US10yrs i thought would be less sensitive to economic conditions since there was so much of china's reserves pushing their prices up. recently, we saw about a 40bp upward move in rates. i think overall, the chinese have a smaller effect than i initially indicated although it is still quite big. SECOND: china has come up with a small way to bring equities down a bit by trippling the stamp tax on shares. this has cooled the market slightly, but not by enough

This slow loosening of the peg is a step in the right direction, but more is needed. China is accumulating a CA surplus far faster than it is allowing its currency to rise. It will need to purchase ever more US dollars (and thus US bonds) to keep its currency in line. So the Yuan is highly pressured to appreciate vs. the dollar.

In terms of currencies, the Yen is also near record lows (121 as of may 18th). Given the low yields in Japan, this has caused a re-appearance of the carry trade, most notably to the US & Australia. These unhedged flows are self defeating in a way and can cause a global risk aversion shock if/when it finally snaps (self defeating b/c selling yen to buy AUD/USDs assets puts more downward pressure on the Yen which makes investment in Japan even more attractive. Eventually, those fundamental economic flows will dwarf the carry trade flows causing those invested in it to repatriate at ever worse prices).

 Addendum: we now see the carry trade being even more attractive as AUS, USA, & EUR have all seen their economic prospects rise more than expected, pushing the yield differential even higher

The dollar is also very weak vs. the Euro and the Pound. This weakness, however, is warranted as the US needs to borrow ever greater amounts in order to keep financing the massive CA deficit. The figures are truly staggering and an even weaker dollar is possible so long as imports remain as high as they have been in the recent past (we’ve had some good news on this front in the past few weeks, but not enough).

In terms of the domestic economy, we saw some weak growth #s in the first quarter and a slight reduction in the inflation rate, which is still outside the fed’s “comfort zone.” The mkts are still pricing in cuts though and given the consumer confidence we’ve seen and the Chinese apparent yielding to US trade concerns (rate hike & peg movement), that/those cut/cuts isn’t looking too likely. A realization of no cuts int eh future may also put a damper on equity prices. The housing issue we have seen hasn’t dampened consumer confidence but has put a dent in growth as we saw from Q1 estimate. Overall though, the economy looks good and inflation is still a touch high. I’d think the next rate move will be a hike, not a cut. Especially since the slack in the global economy felt as a result of global low wages is reducing and wage pressures may rear their ugly head sooner than expected.

 Addendum: while growth was revised down by over 50% to 0.6% for Q1, the overall economic outlook has increased substantially as of this writing as can be seen by the pricing of fed funds futures & options. a rate hike is now much more favorably viewed and the probability priced in for a cut has been pared back a lot. 

Finally, we have low (relative to historic) mkt volatility. Any one of those de-stabilizing things mentioned above can cause this to spike as it did in February. A rise in risk aversion will hurt global asset prices across the board (save the US treasuries & gold, which has done well due to high liquidity). Increases in global rates may catch many not pricing them in off guard.

So, to wrap up, the major themes we have going on are

1) syncronized global growth as a result of highly correlated business cycles.
2) low rates/high liquidity
3) high commodity prices
4) strong emerging mkt growth that doesn't look panic/currency devaluation prone.
5) a carry trade that has a potential to destabilize the lowly volatile environment.
6) weak and weakening US dollar
7) strong US economy w/ a touch of inflationary pressure
8) low (implied/expected) volatility

In the future, I'd look for a global pull back in equities and US assets as risk premia adjust from their currently tightly squeezed position as the last leg of the cycle finally starts to come into full swing. I’d be long volatility as we are strained as it is and there are many points from which a scare could emanate.
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Now, i'd like to see what we can come up with working off that + the recent occurrances that are not taken into acct as of the time of that writing + stuff i missed/didn't include etc...

one example from another thread is the idea i had for the diff bet between silver & gold. another could be a simple short silver, short gold. so from the commodity picture, i think a trade consisting of the following would be a good place to start :

outright: short gold
diff bet: short gold spot, long gold futures

outright: short silver
diff bet: short silver spot, long silver futures

diff bet: short gold long silver (bet gold falls more than silver)

as of the writing above, i was quite strongly short US 10yrs. now that they've sold off significantly and are more realistically reflecting the interest rate environment i'd have pulled a lot back from that. i'm still slightly short in my mind though, may -15% vs. -85% a few weeks ago.

i was also neutral to short US equities. maybe at most about -10%. now i'm about neutral (0%) as they've fallen a bit to reflect the IR repricing.

sssssssssooooooooooooo, lets hear some trading ideas & discussion.

this thread should be great for anybody going into interviews any time soon.

thanks and lets get started,
Barron