USDJPY Inches Higher As Japanese Stocks Set For Longest Winning Streak In History

Yen is weaker and Japanese equity futures notably higher following a landslide election victory for Japan Prime Minister Shinzo Abe which theoretically ushers in yet more easy monetary policy. USDJPY has jumped above 114.00 in early trading, sending NKY futures up almost 1% in the pre-market.

If this equity rise holds it will mark the 15th consecutive gain for the Japanese market - breaking the 1961 record of 14 straight days to become the longest winning streak in Japanese stock market history.

Nikkei 225 is at its highest since Dec 1996.

Meanwhile, much has been made recently of the decoupling between USDJPY and the Nikkei 225

However, this chart masks a closer relationship between USDJPY and the relative performance of Japanese and US equities.

So there really is no regime shift.

What are the drivers of this persistent negative correlation between the yen and Japanese equities and which flows supported this negative correlation this year?

On Friday, JPMorgan presented three fundamental explanations to justify the link between Japanese equities and the yen.

One typical explanation is that the yen, being a major funding currency for the world, should rise in a risk-off equity environment and vice versa. But this argument is not supported by the fact that there is much lower correlation between the yen and global equities. It is also not supported by the structural break in the correlation between Japanese equities and the yen shown in the chart above. The yen was the most prominent or sole funding currency before the financial crisisof 2007/08. After the financial crisis the yen was joined by the dollar and later by the euro as funding currencies. So if anything the negative correlation between equities and the yen should have been even more negative before the financial crisis. But the opposite happened. The negative correlation only intensified after the financial crisis.

 

A second explanation, with causality running from yen to Japanese equities, is that a weaker yen has a positive impact on corporate profits inducing equity investors to buyJapanese equities and vice versa.

 

A third explanation is that Abenomics was always thought of as a combined trade for overseas investors: buy Japanese equities and sell the yen. And reverse, i.e. sell Japanese equities and buythe yen, when Abenomics wanes.

But JPM notes both of these last two explanations have a problem: why does the yen not go up as foreign investors buyJapanese equities? In principle when foreign investors buy or sell Japanese equities currency-hedged there should be no currency impact. And when foreign investors buy or sell Japanese equities currency unhedged there should be in fact a positive correlation between the yen and Japanese equities. What are the circumstances then under which we have a negative correlation between Japanese equities and the yen?

We previously presented three flow circumstances:

 

1) If a foreign investor (buyer) purchases Japanese equities currency-hedged from another foreign investor (seller) who was long yen already (i.e. the seller owned these Japanese equities currency unhedged before), the net market impact would be an up movein Japanese equities and a down move in yen.

 

2) If a foreign investor (buyer) purchases Japanese equities currency-hedged from a Japanese investor (seller) and this Japanese investor uses the proceeds to purchase foreign equities currency-unhedged, the net impact would also be an up move in Japanese equities and a down move in yen. This flow appears to have taken place since mid-September. Foreign investors were buyers of Japanese equities, at the same time as Japanese investors sold domestic equities and as Japanese investors stepped up their purchases of foreign equities. But since September, the purchases of foreign equities by Japanese investors were smaller in magnitude relative to the purchases of Japanese equities by foreign investors. So the negative impact on theyen from the former flow was more muted relative to the positive impact on Japanese equities from the latter flow.

 

 

3) Another flow example is related to dynamic hedging by existing holders of Japanese equities, Existing foreign holders of Japanese equities could have unwound previous FX hedges in response to equity price declines in recent months, even if they did not sell any Japanese equities themselves. This is because equity investors tend to dynamically adjust their FX hedges to match the size of the hedges to the value of their equity holdings. So as the price of Japanese equities goes down in local currency terms, these foreign investors cut some of their previous FX hedges, pushing the yen up in the process. The opposite flow takes place in periods of Japanese equity appreciation: existing foreign holders of Japanese equities have to increase the size of their FX hedges to match the increased equity values, pushing the yen down in the process.

This dynamic hedging flow suggests that there should be an even stronger correlation between the performance of the yen and the absolute performance of Japanese equities in local currency terms, relative to the correlation between the yen and the relative performance of Japanese vs. US or global equities. But the two charts above show that the opposite happened this year. The correlation between the yen and the relative performance of Japanese vs. US equities has been stronger than the correlation between the performance of the yen and the absolute performance of Japanese equities. This suggests the above flow stemming from dynamic hedging by foreign investors of existing Japanese equity holdings, has likely weakened this year.

So from the above three flow circumstances, it is the second one that appears to offer the best explanation of what happened since September in the Japanese equity/yen space. 

So, following the recent buying, how overweight have foreign investors become in Japanese equities?

So in all, it appears that overweights in Japan have been focused mostly among leveraged overseas investors including CTAs, making Japanese equities vulnerable to an unwind of some of these positions in the near term. Non-leveraged institutional investors or retail investors are rather neutral.

To conclude, JPMorgan finds no reason to believe that the historical negative correlation between Japanese equities and the yen has broken down. The relationship between Japanese equities and the yen has been closely aligned this year if one looks at the relative rather than the absolute performance of Japanese equities.

More recently, since September, the purchases of foreign equities by Japanese investors were smaller in magnitude relative to the purchases of Japanese equities by foreign investors. So the negative impact on the yen from the former flow was more muted relative to the positive impact on Japanese equities from the latter flow. Going forward, overseas leveraged investors present the main vulnerability for Japanese equities, in our view.

Is The Yuan About To Tumble After Friday's Shocking PBOC News? Here Is Goldman's Take

In a move that stunned China currency watchers, late on Friday (local time) Bloomberg reported that China’s central bank decided that it would remove a reserve requirement for financial institutions trading in FX forwards for clients by cutting it to zero from 20% currently. The change would take place on Monday, September 11 (it has yet to be confirmed). As a reminder, banks, funds and other financial institutions trading FX forwards for clients were required from October 2015 to set aside 20% of the past months’ sales as reserves in a move that was aimed at curbing currency speculation. Subsequently, the PBOC further punished traders, or rather shorts, by boosting short-term margin requirements on FX positions, making it virtually impossible to hold on to a short position for a long period of time.

All that changed at the end of last week, when the PBOC effectively "U-turned", and gave a green light to the same FX speculators whom it criticized (remember the Chinese anti-Soros media campaign), slammed, punished, and in some cases arrested, to now short the Yuan once more.

The reason behind the move was simple: in recent weeks the Yuan, both on and offshore, had soared far too high, to the point where Beijing was getting worried about its impact on exporters, as a separate Friday report from Reuters discussed.

On the surface, this was a brilliant solution to Beijing"s problems: it lowers the Yuan on one hand, and on the other, it is not the PBOC who is manipulating the currency, it"s the evil speculators who are "guilty", avoiding being blamed by the US for currency manipulation. Most importantly, the removal of this marginal capital control worked immediately, as the following intraday chart of Friday"s USDCNH clearly showed.  

So will this plan work, and is the Yuan set to plunge in Monday trading? We will find out soon enough, but until then, here is the explanation from Goldman"s MK Tang on what Friday"s move means, and its implications for Yuan policy, but first, here are several analyst opinions, as summarized courtesy of Bloomberg:

CIB Research (Guo Jiayi, Zhang Meng, analysts)

• Scrapping the reserve requirement indicates the PBOC is confident of the yuan’s outlook


• Given the weakening dollar and solid domestic economic environment, it’s unlikely the new rules will bring one-way expectations to exchange rates


• Indicates the PBOC wants to slow yuan appreciation and prevent a herd effect, and it opens the window for further FX regime reforms

Commerzbank (Zhou Hao, emerging-markets economist)

• Policy change underscores that depreciation pressure has largely diminished


• PBOC signals it’s again sitting opposite the market as fresh long CNY positions triggered a rapid appreciation over the past week


• Spread between CNY and CNH forwards to narrow significantly in coming months

Lianxun Securities (Li Qilin, macro researcher)

• PBOC wants to ease strong appreciation trend, which could affect exports


• Chance is limited for the yuan to continue the fast pace of strengthening of the past couple of weeks


• PBOC is likely to show a stronger hand if markets don’t take note

Mizuho Bank (Ken Cheung, strategist)

• Good time to spur hedging demand in both directions in the forwards market


• Institutions which invest in onshore bonds via the Bond Connect can thus hedge FX risks onshore


• Expects USD/CNH one-year forwards to drop, leading to narrower spread between onshore and offshore

ANZ (David Qu, markets economist)

• Change won’t significantly cut corporate FX settlements, which are largely decided by spot prices


• Demand from companies to buy dollar is rather tepid, so any future increase in forward positions should be limited


• New rule will have limited impact on spot market, where central bank “guidance” will play a bigger role


• It’s likely prohibition on net outflows in cross-border RMB pooling will be relaxed or canceled amid yuan strength

Finally, here is Goldman"s extended take:

Reported relaxation of FX hedging cost: backdrop and implications for CNY policy

Chinese media reported late last Friday (though not officially confirmed) that effective Sep 11, the PBOC would cut the reserve requirement on FX derivatives sales to 0% (from 20%), which would reduce the cost of FX hedging by importers.

We see three implications:

1. the authorities may be less concerned about outflow pressures, which appear to have dissipated following earlier episodes of likely intervention-driven CNY strength to counteract bearish sentiment;


2. it marks a possible meaningful step preparing for increased (two-way) CNY volatility in the medium term; and


3. shows the continued importance of tracking signals of policy intention (including the fixing’s “countercyclical factor”) on the near-term CNY path, which seem to point to reduced comfort with the ongoing pace of appreciation.

Main points:

We provide an overview of the FX reserve requirement, and discuss the backdrop for the reported relaxation and the likely implications for the CNY policy.

1. What is the reserve requirement (RR) on FX derivative sales?

Introduced in Sep 2015, the RR sets the amount of FX that each bank has to deposit at the PBOC (with no interest remuneration) in connection with its sales of FX derivatives (including forwards, swaps, etc.) to non-bank customers. The RR has been set at 20% of the notional value of the derivatives.

This is effectively a tariff, increasing the cost for non-bank customers to buy FX via derivatives. Its introduction was in response to strong outflow pressures at that time, part of which was driven by a large amount of FX forwards bought by non-bank customers (worth close to $80bn in August ’15, c. 3x the previous usual amount). The authorities attributed the sizable demand for FX forwards to unhealthy speculation. FX forward purchases have sharply fallen since the RR measure, to less than $20bn in Sep ’15 and less than $10bn in recent months.

Late last Friday (Sep 8), Chinese media (e.g., 21st Century Business Herald) reported that the PBOC would lower the RR to 0% effective Sep 11, although at the time of writing this has not been officially confirmed.

2. What is the recent backdrop for the reported relaxation?

Outflow has significantly slowed since the turn of the year, likely reflecting tighter capital control as well as reduced devaluation concerns. That said, in the first several months of the year, market pressures were still skewed toward net CNY sales. In this context, in May the authorities added a "countercyclical factor" to the CNY fixing mechanism, initially intended to counteract the market’s "herding" behavior that had pressured the currency weaker.

Under the new fixing rule, when the market displayed a CNY-bearish tilt (CNY close weaker than fixing), the countercyclical factor the next day would tend to push CNY fixing stronger, as we have discussed here. But such fixing guidance alone did not seem to be effective. Instead, in late May through early August, we have observed three episodes of sharp appreciation, perhaps driven by policy intervention to entrench the countercyclical factor’s credibility and negate bearish CNY sentiment.

However, more recently since mid-August, the flow pressure seems to have reversed and the CNY strength more market-driven. The August reserve reading, which implies net FX purchase by the PBOC to lean against CNY appreciation, is the first official data suggesting this shift, although we await further flow data for confirmation. The reversal of market forces likely reflects the success of the earlier episodic policy support of the CNY in changing market psychology, as well as a weak USD and better China sentiment.

3. What are the implications for the CNY policy?

The reduction of the reserve requirement on FX forwards to zero would mechanically lower the cost of outflows via derivative transactions. In terms of policy, we see the following three implications:

• The authorities have become a bit less concerned about outflow pressures. Therefore, the RR relaxation could be a precursor for incremental unwinding of other capital control measures, should the flow situation remain benign.


• A meaningful possible step preparing for increased (two-way) volatility in the CNY in the medium term. Besides reflecting higher policy tolerance for outflows, the RR relaxation has the clear effect of lowering the cost for importers to hedge their FX liability exposures. Such hedging would in turn mitigate a main negative side-effect of having a more flexible FX regime, which has long been one of the authorities’ structural policy objectives.


• As for the near-term CNY outlook, while assessing market pressures helps, interpreting policy intention is probably even more important. For instance, reserve data suggests the PBOC bought about $10bn in FX in August, only a moderate amount by China"s historical standards; it could conceivably have bought materially more to limit the CNY appreciation.[1] The fact that it didn"t seems to indicate that the authorities were comfortable with, or even desired, the strong CNY in August.


• There could be “too much of a good thing” more recently, though. We maintain our view that risk of major depreciation is limited in the run-up to the Party Congress (to start on Oct 18). That said, we believe it is useful to continue tracking policy signals for the near-term CNY intention, including the countercyclical factor. Just when bullish changes in the countercyclical factor (i.e., $/CNY fixing below CFETS model-implied) preceded policy efforts to push the currency stronger in May-July, a bearish change in this factor currently could signal a decreased policy comfort with the continued CNY appreciation. On this score, we note that the countercyclical factor in the last few days has turned more reactive to the market appreciation pressures (Exhibit 1), potentially pointing to lower propensity to accommodate much further CNY strength.

Exhibit 1: Countercyclical factor has become more reactive to the previous day’s appreciation, hinting at decreased policy comfort with further CNY strength

Ray Dalio: With Two Potential Crises, Buy Gold In Case "Things Go Badly"

It"s been a while, years in fact, but suddenly it"s gold"s time to shine again.

The yellow metal - insurance against systemic collapse, hyperinflation and infinite political stupidity - which in recent years has seen its popularity fade as the younger generation has gravitated toward the far faster moving crypto currencies - is once again back in the spotlight.

As UBS" strategist Joni Teves, who has been recommending the precious metal for a long time despite the BOJ"s relentless suppression, writes "gold bounces from recent lows in line with other safe havens amid risk-off sentiment across markets following geopolitical headlines over the past 24 hours." Below are the key considerations from today"s UBS note:

Key technical levels come into focus for gold, triggering some decent market activity in the middle of this typically quieter summer period. Geopolitical risks tend to have quite a volatile influence on prices and the immediate risk here is that $20 move from yesterday is quickly faded. Gold is holding well so far. We think the risks are somewhat skewed to the upside here, with a break of $1280 likely to attract further attention. Although speculative positions on Comex have increased in the past couple of weeks, overall levels remain lean. Subdued participation this year and lean positioning suggests that market participants would have to play catch-up on a break higher. On the flip side, this also suggests that a pullback is likely to be relatively contained. Additionally, we had previously argued that uncertainty on Fed policy expectations is likely to keep gold broadly supported, especially given downside risks to inflation. US CPI data on Friday should offer some insights; the next important signpost would be the Fed"s Economic Symposium at Jackson Hole, for further guidance on policy.

Separately, in an unexpected endorsement from the head of the world"s biggest hedge fund (excluding apple), overnight Ray Dalio said that clients should move 5% to 10% of their capital to gold as a hedge to the two biggest risk events unfolding today: the rapidly escalating North Korea crisis, and the seemingly intractible debt ceiling crisis, which as former CBO director Rudy Penner said yesterday, would likely lead to a market crash this fall. Here are the highlights from BizInsider:

... during the calm of the August vacation season, we are seeing 1) two confrontational, nationalistic and militaristic leaders playing chicken with each other, while the world is watching to see which one will be caught bluffing, or if there will be a hellacious war, and 2) the odds of Congress failing to raise the debt ceiling (leading to a technical default, a temporary government shutdown, and increased loss of faith in the effectiveness of our political system) rising. It"s hard to bet on such things one way or another, so the best that one can do is be neutral to such possibilities.

When it comes to assessing political matters (especially global geopolitics like the North Korea matter), we are very humble. We know that we don"t have a unique insight that we"d choose to bet on. We can also say that if the above things go badly, it would seem that gold (more than other safe haven assets like the dollar, yen and treasuries) would benefit, so if you don"t have 5-10% of your assets in gold as a hedge, we"d suggest you relook at this. Don"t let traditional biases, rather than an excellent analysis, stand in the way of you doing this.

And in a surprisingly humble conclusion, Dalio then says the following: "if you do have an excellent analysis of why you shouldn"t have such an allocation to gold, we"d appreciate you sharing it with us."

JPMorgan's Head Quant Doubles Down On His "Market Turmoil" Forecast: Here's Why

After getting virtually every market inflection point in 2015, and early 2016, so far 2017 has not been Marko Kolanovic"s year, whose increasingly more bearish forecasts have so far been foiled repeatedly by the market, and the same systematic traders that he periodically warns about. As a reminder, his most recent warning came last week, when he cautioned that even a modest rebound in VIX could lead to dramatic losses for vol sellers. As a reminder, here is the punchline from his latest note:

Days like May 17th and similar events "bring substantial risk for short volatility strategies. Given the low starting point of the VIX, these strategies are at risk of catastrophic losses. For some strategies, this would happen if the VIX increases from ~10 to only ~20 (not far from the historical average level for VIX). While historically such an increase never happened, we think that this time may be different and sudden increases of that magnitude are possible. One scenario would be of e.g. VIX increasing from ~10 to ~15, followed by a collapse in liquidity given the market’s knowledge that certain structures need to cover short positions.

So in light of a market that refuses to post even the smallest of drawdowns (we are not sure if the words "selling", "correction" or "crash" have been made illegal yet), has Kolanovic thrown in the towel and declared smooth seas ahead? To the contrary: in a note released late last night, he echoes warnings made recently by both Citi and BofA, and predicts that receding monetary accommodation from ECB and BOJ will likely lead to "market turmoil, and a rise in volatility and tail risks" and just in case there is some confusion, he reiterates what he said last week, namely that the "key risk of option selling programs is market crash risk."

In terms of near-term catalysts, what is Kolanovic most worried about? The same thing that Matt King warned about this week when he explained why he believes "markets will flounder as central banks try to exit" and showed the following chart:

Now it"s Kolanovic" turn to make essentially the same warning:

Equity Volatility has been suppressed by relentless supply via yield generating strategies, macro decorrelation and inflow into passive and quantitative strategies....  Risky assets have been rallying for years, and market volatility is near record lows. Valuations are high, arguably supported by low interest rates and record pace of central bank monetary expansion. However, this may change in the near future. In the US rates are rising and monetary accommodation from the ECB and BOJ is expected to recede. Medium term, this is likely to lead to market turmoil, and a rise in  volatility and tail risks.

Indeed, and by now we can only assume that the rest of the actively trading community is well aware of these very risks. And yet, stocks refuse to budge, which either confirms what Kolanovic said recently, namely that only 10% of all market decisions are made by human traders, or that as King speculated, the market is now so broken it can no longer discount the future, especially if the event to be discounted is precisely the one that broke it in the first place.

Below are some additional excerpts from Kolanovic"s latest note, explaining why he is doubling down on his "market turmoil" call:

The landscape: Volatility is low across the board

Volatility across asset classes is near all-time lows. We have written extensively about the drivers of current low volatility which we summarize below.

Current pace of the Global recovery does not warrant a high volatility regime. Global growth is tracking ~3%, with disinflationary drag receding. In the US, slow and steady growth have alleviated fears of imminent US recession and China hard landing risk has been contained by PBOC easing and large Government stimulus. Medium term, as rates in the US rise and balance sheets of global central banks recede, this positive growth narrative will likely increasingly come under pressure.

While fundamentally volatility should not be high, it is clear to us that the current macro environment does not warrant all-time low volatility either. For instance, our analyses point that in equities, implied and realized volatility may be suppressed by 4-8 points by various structural drivers.

Selling of volatility across asset classes is one of the key parts of risk premia/smart beta programs. Selling of volatility is a yield generating strategy that can be benchmarked against bond yields. The key risk of option selling programs is market crash risk. Global central banks have helped in both aspects by lowering yields and reducing crash risks, increasingly inviting strategies that sell volatility outright or implicitly.

Figure 2 below shows changes in global central banks’ assets (6-month change), and volatility of global equity markets (6-month volatility of MSCI World). One can see that in the 2007-2013 time period, central bank asset purchases leaned against major increases of market volatility and thus reduced market tail risk (see here). The current wide gap – with a near record pace of central bank balance sheet expansion (highest since 2011) and record low levels of market volatility – poses significant market risk. This risk is likely to materialize as the balance sheets of global central banks are pared in 2018 as described below.

G4 Central Banks have resorted to “unconventional” policy measures to stoke the global economy in the wake of the 2008 financial crisis. Various QE programs from the Fed, BoE, BoJ and ECB resulted in central bank balance sheets ballooning from $6Tr in 2009 to $14Tr at the end of 2016. G4 QE should expand by a further $2Tr this year. However, 2018 will mark a major shift in this dynamic according to our Economic team’s forecast, as G4 QE programs should fall off a “cliff” (Figure 2). This will notably be due to the ECB and BoJ scaling down their large scale asset purchases (by $950Bn and $500Bn, respectively), and the Fed actually shrinking the size of its UST/MBS holding (by $330Bn). Such a disengagement from central banks could facilitate disruptive market moves.

We think that the current low levels of volatility are not a new normal and will not last very long given the amount of leverage, rising rates, and the approaching reduction of central bank balance sheets. While we don’t know when the next recession will happen, every Fed hike is bringing us closer to it. Increasing allocation to hedges, specifically tail hedges, may be prudent.

One day, Marko"s magic will return. For now, however, the relentless drift higher continues.

Visualizing Average Home Prices By State - Guess Who's Paying The Most

If we were to ask you which state was "home" to the nation"s most expensive dwellings we assume you might guess the subprime capital of California or the financial mecca of New York where hedge fund billionaires shell out millions for apartments the size of middle America"s living room.  But you would be wrong. 

No, outside of Hawaii, the "swamp dwellers" of Washington D.C. are paying more for housing than any other state in the country according to the following chart from Overflow Data.

Of course, it"s not exactly "fair" to compare home prices in the urban, city center of Washington D.C. to much larger states like California that have both densely populated urban areas and far less expensive rural areas.  That said, it is somewhat telling that America"s "public servants" and their handlers can afford to spend so much on housing.

Goldman Highlights A Significant Debt-Equity Disconnect And How To Trade It

In early March, Goldman"s John Marshall looked at the firm"s proprietary macro hedging indicator and found something peculiar: investors were buying stocks and discarding protection. As Marshall said at the time, this was a reflection of "How Trump Changed the Market", and said added that "the cost of liquid long-dated hedges in equity and credit has collectively reached its lowest level in six years following the decline this week. The last time macro hedge costs were near this level across assets was in July 2015."

He then warned that "while not likely the cause of the pullback in August of 2015 (the mini-flash crash), the lack of hedges in investor portfolios likely exacerbated the sell-off."

Fast forward to today, when the most read piece of research on Goldman"s portal is the follow up piece from Marshall. Clearly, while the market has failed to sell off even modestly let along in a rerun of August 2015, Goldman has found a particularly "compelling" short-term divergence between credit and equity which it believes could lead to a quick and profitable convergence trade.

As Marhsall explains, credit has significantly outperformed equity over the past month on a risk-adjusted basis. More specifically, CDX IG 5Y has outperformed its corresponding equities by 1.8, 1.0, 1.3 and 2.0 standard deviations over the past 1, 2, 3 and 4 months, respectively. Marshall views this as an attractive entry point for relative value trades, i.e. a compression trade:

"For investors looking for a macro hedge, credit offers more attractive hedging opportunities. For investors adding to bullish positions, equity offers more attractive buying opportunities."

The divergence in question:

And even more gaping divergence: between CDX HY and corresponding stocks:

Meanwhile, an example of where the trade does not show the above divergences, is in Europe where ITRAXX and equities have traded in line.

The reason why this trade is a continuation of his observations from a month ago discussing the collapse in hedging, is that according to Marshall, based on the instruments that have outperformed the most in recent days (credit derivative products), "this is part of the broader trend of institutional investors underpricing tail risk."

This suggests that the main trade risk is that the divergence grows even bigger as investors continue to shun hedging, potentially stopping out anyone without a big enough balance sheet to eat the variation margin drawdown.

On the other hand, the upside is as follows:

we look back over the past 7 years at each time credit and equity have diverged by more than 1 standard deviation over a 1, 2 and 3-month rolling period. Divergences of this magnitude have occurred 10 times and lasted an average of 8 days. Over the subsequent 1 month, the lagging asset outperformed the leading asset by 2.5% with a standard deviation of 3.5%. Our study shows the “diverging asset” (the asset that drove the divergence) was responsible for 2/3rds of the convergence profit. This suggests that in the current divergence, hedging with credit may have a higher profit potential than long equity over the next month.

In short, buy IG and buy the corresponding equities for the upcoming compression. Alternatively, just buy IG which should account for nearly 70% of the potential upside. And, if the trade doesn"t work, just blame Trump, and not the Fed, who according to Goldman "changed the market."

How Trump Changed The Market: Goldman Explains

In the first stage of the Trump Rally (from the election to year-end), investors appeared to hedge as the market rallied. However, since the start of the new year, Goldman Sachs" proprietary macro hedging indicator has traded along with equities, suggesting that investors are buying stocks and discarding protection. As Goldman"s John Marshall and Katherine Fogertey explain, the Trump rally has changed the market - Investors Stopped Hedging.

As the Goldman duo notes, Long-dated liquid hedge costs at a multi-year low, and explains:

The cost of liquid long-dated hedges in equity and credit has collectively reached its lowest level in six years following the decline this week. The last time macro hedge costs were near this level across assets was in July 2015 (see Exhibit 1).

While not likely the cause of the pullback in August of 2015 (the mini-flash crash), the lack of hedges in investor portfolios likely exacerbated the sell-off.

Methodology for Chart above: We track the liquidity premium that investors are paying by hedging with terms that are considered more liquid in each asset. We estimate the cost of hedging with 3 year 55% OTM SPX puts and 10 year CDS protection relative to the cost of hedging with 10 year puts and 3 year CDS protection. Our CDS measure is the weighted average cost of single name CDS protection for S&P 500 companies in the weight that those companies are in the S&P 500 index.

 

How do we gauge the intensity of macro hedging?

We monitor the relative cost of hedging across the curve for SPX equity options and the CDS protection in S&P 500 names (see Exhibit 2).

Specifically, we find that when investors hedge in times of stress, they rush towards the part of the term structure which is the most liquid. In the credit market, longer dated hedges are more liquid (5+ years) relative to the options market where there is little reactivity or liquidity in 5+ year options. The relative liquidity is in short-dated equity options (3 years or less).

Hedges: 1-3 year Equity puts; 5+ year CDS protection

In times of stress, investors must be selective and buy hedges that have not already been bid up by other investors; given the lack of liquidity premium being put on some of the more popular parts of the curve, we see these highly liquid areas as unusually attractive for investors that see risk of a market pullback. Buyers of these hedges are likely to see the largest boost should there be a correlated market decline. 

As Goldman warns, our indicator is now in-line with its most complacent level in the past six years, suggesting investors are generally unhedged across both equities and credit.

Trump set to change market dynamics

Remember Fed Watchers?  It was like a market fetish - watching Sir Alan Greenspan"s every move, as a possible "hint" of interest rate policy.  Was his briefcase heavy?  Did his shoulder sag more than usual - indicating many papers in the briefcase, which means the Fed has a lot to decide?  Those were the days.. although Ben didn"t seem to have the intellectual charisma of Sir Alan, Ben Bernanke seemed to work as a robot, with no indications from his personality whatsoever, not even a twitch of his beard.  No comment about the current Fed Chair.

Trump however, seems to have changed the game - look just from today:

http://www.zerohedge.com/news/2017-01-31/biotech-stocks-slide-trump-slams-astronomical-prices-tells-drug-ceos-get-prices-down

If anyone was wondering what Trump would tell Pharma CEOs in an ad hoc meeting scheduled for 9 am today, here is the answer:

• TRUMP TO DRUG CEOS: YOU HAVE TO GET PRICES DOWN


• TRUMP ON MEDICARE, MEDICAID WE NEED PRICES WAY DOWN.  PRICING HAS BEEN ASTRONOMICAL


• TRUMP SAYS NEED TO MAKE DRUG PRODUCTS IN THE US


• TRUMP WILL OPPOSE REGS FOR SMALLER COMPANIES

Some companies are even developing strategies to monitor "The Trump Call" tweet effect:

Just in time for his inauguration, London-based fintech firm Trading.co.uk is launching an app that will generate trading alerts for shares based on comments made on social media by Donald Trump.

Keeping one eye on the U.S. President-elect’s personal Twitter feed has become a regular pastime for the fund managers and traders who invest billions of dollars daily on world stock, currency and commodity markets.

This is all well and good but what implications for the broader markets?  Such a market force has frankly, never existed.  When someone like Bill Ackman tweets, people notice.  But it won"t drop the USD Index by 1%, nor will it tank the Biotech Index, or tech.  For better or worse, the Trump tweet effect is a new force that"s changing the market dynamic - let"s say for the better, because at least it"s disruptive.  Fundamentally, short term spikes shouldn"t change anything, it"s just perception and knee jerk reaction.  Algos should be adaptable, and if you"re trading for the long term fundamental play - short term moves shouldn"t matter too.  

But this is a "visible hand" that"s never been seen in the markets before.  It"s a new risk, a new risk to hedge.  It"s possible to hedge any risk, using options, futures, insurance, and other instruments.  

On the other hand, entire strategies could be developed, just trading the Trump tweet momentum - but you"ll have to be quick!  

To learn about FX Hedging, such as Emerging Market hedging which is going to be an increasing issue in 2017 - Checkout Fortress Capital Hedging.

If you want to get started learning how markets really work, checkout some titles from the bookstore here at pleaseorderit.com

Morgan Stanley: "We Haven't Seen A Shift This Severe In Over A Decade"

While the plunge in cross-asset correlations, which as recently as last fall was at all time highs, has been duly documented in recent weeks, nowhere is it more obvious than in the following chart from Morgan Stanley which shows the firm"s global correlation index.

Morgan Stanley"s Andrew Sheets summarizes the stunning move as follows: "Regional correlations, cross-asset correlations and individual stock and FX correlations have fallen simultaneously. That"s unusual; we haven"t seen a shift this severe in over a decade" and ultimately calls it for what it is: a "crash" in correlations unlike any seen before. 

He then concedes that while "crash" is not a term used lightly adding that "our editors here at Morgan Stanley won"t let us use it without a good reason" he "struggles to think of another word to describe just how much, and how sharply, cross-asset correlations have fallen. In just four months, we have gone from a market of unusually close linkages across markets, to one with usually divergent returns."

There are three direct implications from the move:

1. Lower correlation should mean a better "macro" trading environment (since each market isn"t the "same" trade). It is a mixed blessing for diversification, lowering overall portfolio volatility, but also making hedging through "proxies" harder.


2. Lower cross-asset correlation is common in "late cycle" environments, fitting our preference for equities > credit. Meanwhile, USDKRW remains our favourite "proxy" hedge in a lower correlation world, given its linkages to several macro risks.


3. We"d expected correlations to rise again if growth data disappointed. Since lower correlation has helped to depress volatility, hedges that benefit from both correlation and vol moving benefit from unusually good pricing now. Our favourites are AUDUSD, gold and EURUSD.

Sheets then says that the sharp drop in cross-asset correlation is not a fluke. It represents a decline in correlations at each of the three key "levels" that we care about – cross-asset, crossmarket and intra-market. Our correlation indices (Exhibit 2) focus on the first two of these, while the last is an important addition.

• Cross-asset correlation (50% of our index): This refers to how closely prices in different assets are moving relative to each other (credit vs. equities, equities vs. rates, equities vs. FX, etc.). Declines here have been driven by a more ambiguous relationship of rates to equity and credit in recent months. Rates-equity correlation has been this poor only during the taper tantrum and then before that in 2006/07. The dollar has decoupled from stocks, commodities and yields, which have rallied in a rising dollar environment.


• Cross-region correlation (50% of our index): This refers to how closely prices in different regions of the same asset class are moving relative to each other (i.e., US vs. EM equities, European vs. Japanese rates, EUR vs. GBP). Declines here have been sharp as well, as monetary policy and political risks have an impact. Intra-fx correlations have also changed – notably, USDJPY correlations to a number of risk currencies have become weaker.


• Intra-market correlation: This refers to how closely prices of different securities within an index are moving (i.e., are the stocks within the S&P 500 all moving together, or not). We use different indices to measure this, which we plot in Exhibit 2.

From an economic perspective, the dramatic move is troubling because such a decline is common in "late cycle" environments, as "idiosyncratic" stories (company-specific M&A, tweets) are larger drivers than economic or earnings fears MS adds. The decline is directly linked to the lower realised volatility seen in credit and equity markets; when underlying components are moving in different directions, it is harder to get large shifts overall.

How does the transition come about? Unusually accommodative monetary policy helped to raise linkages between global asset classes. As this policy tightens, it"s reasonable that these linkages should decline. But there"s another, more "normal" force at work here: late in the cycle, we"ve often seen lower correlations.

There are several reasons for this. Deep into an expansion, higher economic confidence reduces the likelihood that many markets will panic at the same time, and means market-specific stories are often bigger drivers than the more binary question of "recession, or not?"

Sheets then points out that a correlation of this magnitude both helps and hurts investors, and notes that "Any market with diverse drivers has positives and negatives."

On the plus side, it should be a better backdrop for "macro" trading. The last six years have seen unusually bad performance of macro hedge funds relative to a 60:40 portfolio. There are several explanations, including simply that these funds have made bad calls. But it seems reasonable that it"s hard to extract alpha from macro trends when all markets are moving together. With that shifting, the backdrop should be better. Over nearly two decades, hedge fund returns have outperformed a 60/40 portfolio more often in a low correlation environment than a high correlation environment (see Exhibit 6). Lower cross-asset correlations are also good for any globally diversified portfolio, reducing its volatility all else being equal.

And then there is the question of volatility. In an amusing note earlier today, Bernstein strategist Inigo Fraser-Jenkins writes to "prepare for higher idiosyncratic stock-level volatility under a Trump presidency due to “off-the-cuff” tweeting." However, for now the risk of a volatility spike appears remote, as it appears to trail equity correlation.

Ultimately, what happens to cross-asset correlations next will depend on Trump: should his fiscal policy plan disappoint, and the market revert back to the "monetary stimulus" mindset, correlations will spike back up. On the other hand, if the status quo persists, the index may drop even more as all legacy cross-asset linkages are broken. Whether that finally results in some long overdue alpha creation for hedge funds, many of whom recently flipflopped in their outlook of trump, remains to be seen.