http://www.reuters.com/article/idUSTRE6234TA20100305
A second senior Federal Reserve official on Thursday joined the ranks of those doubting whether the Fed should continue to commit to hold rates exceptionally low for an extended period, a sign pressures are building to drop the wording.
The curve continues to flatten. The 2-year yield is 86 bps and the 10-year yield is 3.61 bps, so the 2s-10s spread is now 275 bps. The dollar continues to strengthen against the yen: USD/JPY is now 89.24.
http://www.bloomberg.com/apps/news?pid=20601068&sid=alAMN_KVoQ6M
Initial jobless applications fell by 29,000 to 469,000 in the week ended Feb. 27, in line with the median forecast of economists surveyed by Bloomberg News, Labor Department figures showed today in Washington. The number of people receiving unemployment insurance decreased to the lowest level in a year, while those receiving extended benefits climbed.
So far, my trade ideas are performing well. 2-year notes now yield 86 bps and 10-year notes now yield 364 bps, so 2s-10s has flattened to 278 bps (I recommended a 2s-10s flattener at 282 bps). Two days ago, I wrote that I thought that 2-year yields would go higher. 2-year notes were yielding 81 bps two days ago and now they yield 86 bps. I wrote a bullish post on USD/JPY yesterday when the exchange rate was at 88.72; now USD has strengthened vs. JPY to 89.01. Two and three days ago, I highlighted the improving employment picture (“Firms Move Gingerly to Rescind Salary Cuts” and “The unemployment rate is starting to turn”).
Today’s initial claims report is worth paying attention to, but tomorrow’s nonfarm payrolls report is more important. I think we will see further confirmation of an improving employment picture, but this is by no means assured. A weak payrolls number could easily turn my winning trade ideas into losers. However, 2s-10s, 2s, and USD/JPY are at such extreme levels that even if tomorrow proves to be a bad day for my trade ideas, I feel confident that they will pay off eventually.
Greece decides on 4.8 billion euros in extra measures
Greece’s cabinet on Wednesday decided to take extra austerity measures totaling 4.8 billion euros ($6.49 billion) to ensure it meets key fiscal targets this year, a government source said.
“Measures which will yield 4.8 billion euros have been decided,” the government official who took part in the cabinet meeting said. “Half will be from spending cuts and another 50 percent from tax increases.”
The measures include an increase of value-added tax by 2 percentage points to 21 percent and trimming public sector salary bonuses by 30 percent, the source said.
We should see an unwind of flight-to-Treasuries soon.
Let’s examine USD/JPY in terms of 1) valuation, 2) carry, and 3) momentum.
1) http://fx.sauder.ubc.ca/PPP.html shows the yen to be overvalued relative to the dollar by about 30%.
2) There is no significant difference between USD and JPY overnight interest rates, so USD/JPY is basically carry-neutral. However, the Treasury and JGB yield curves indicate that the market expects the Fed to be much more aggressive than the Bank of Japan in hiking rates.
| Treasury | JGB | |
|---|---|---|
| 1-Year | 0.29% | 0.12% |
| 2-Year | 0.80% | 0.16% |
| 10-Year | 3.61% | 1.30% |
| 30-Year | 4.57% | 2.32% |
Long USD/JPY positions should have positive carry within a year or two.
3) Regarding momentum, the attached image tells the story: the dollar has been in a multi-year downtrend vs. the yen. It has been nearly three years since USD/JPY peaked at 124.09 (FRED daily closing values), so yen strengthening may have run its course.
USD/JPY
I am bullish on USD/JPY (bearish on yen). Right now, USD/JPY is at 88.72. I think we will see USD/JPY above 93 within six months. YCS (UltraShort Yen ProShares) closed at 19.31 today.
Recommendation: buy USD/JPY or YCS.
I think 2-year notes yields will go higher (2-year note prices will go lower).
Right now, 2-year notes yield 81 bps. I think we’ll see 2-year note yields rise at least 20 bps within six months.
Recommendation: short 2-year notes (or sell 2-year note futures).
More signs of a recovery:
http://online.wsj.com/article/SB10001424052748703940704575089571513055554.html
With unemployment at 9.7%, executives are also betting they can keep employees motivated and productive without boosting wages. In the past 12 months, average hourly earnings have risen 2%; in January, earnings rose 0.2%.
Thirteen percent of companies cut pay between late 2008 and October 2009, and 29% of those planned to rescind the cuts in the following 12 months, according to an October survey of 875 human-resources employees by the HR association WorldatWork. About 15% said the pay cuts were permanent.
This article provides a good summary of the three main drivers of currency movements:
There have typically been three overarching strategies for trading the currency markets: carry, momentum and valuation. While carry is based on yield, momentum is based on currencies’ trends over time and uses past movements in price to predict future moves. Valuation looks at the currency’s actual value versus the fair value based on purchasing power parity (PPP), a theory which holds that price levels should be roughly equivalent in developed countries.
[Originally posted on Feb 15, 2010 at the Heck.com Forum]
A friend e-mailed me the following:
i know it may be already late but I feel that EUR still has a long way to go down. Do you think it’s a good bet to short it against dollar at least temporary? If instability persists in Europe, volatility will go up and people will take money out of stock market and may temporary invest in US bonds.
I agree that the Euro has room to drop more. To address this issue we need to consider a) purchasing power parity, b) interest rate differentials, c) and risk aversion. To address the issue of whether it is a good idea to short EUR/USD, we need to consider catalysts for Euro depreciation.
In terms of purchasing power parity (PPP), the Euro is still somewhat overvalued – see http://fx.sauder.ubc.ca/PPP.html and http://www.oanda.com/currency/big-mac-index. The latter suggests that fair value for EUR/USD should be about 1/0.93 = 1.075. PPP usually produces terrible short-term predictions (we often find that “overvalued” currencies continue to appreciate and “undervalued” currencies continue to depreciate), but I think it is still useful as a rough guide to value. See http://www.econbrowser.com/archives/2006/03/the_dollar_and_1.html for a PPP success story:
Comment by jim miller:
I used to make my living forecasting exchange rates. I found PPP to be very helpful. Back in 1994 I predicted the Mexican peso devaluation six months before the event. The convincing factors were watching some Mexican friends visit us in New York and go shopping-they said the savings were enough to pay for the trip. We also visited Mexico and the local prices-in dollar terms-were very expensive. It was obvious the peso was over-valued. So it was just a matter of time.
PPP is helpful in working with annual budgets, longer term financial planning,etc. It’s of no use to a foreign exchange trader. For those folks a long-term investment is a three-day weekend.
Short-term OECD currency movements tend to be driven by carry trades. When there is appetite for risk, traders borrow or sell lower yielding currencies to buy higher yielding currencies. In periods of risk aversion, this is reversed. The reason that I use the qualifier “OECD” is that government bonds in these countries usually have very little credit risk, so higher interest rates tend to be a reflection of expectations for robust economic growth rather than credit problems. With Greece, of course, the story is different.
10 and 30-year Bund yields are 3.2% and 3.94% vs. 3.69% and 4.65% for 10 and 30-year Treasuries, so USD has the advantage in terms of carry (or expected future carry). At the moment, there is not much difference between U.S. overnight rates and German overnight rates, but the difference in term structures indicates a market expectation that the Fed will be more active in raising rates in the future than the the ECB.
Finally, is there a catalyst for Euro depreciation? Yes, the problems with Club Med provide a catalyst. Some people have pointed out that Greece has a very small economy (economic output about half the size of Illinois), so it seems like it doesn’t make sense that tiny Greece might put the common currency of the entire Eurozone at risk. But maybe the Euro was overvalued to begin with, and this is just the kick that starts the ball rolling.
Unfortunately, this only scratches the surface. We should also discuss the fiscal problems of the U.S., the U.S. trade deficit with the Eurozone (if the Euro is overvalued, why are we running a trade deficit with the Euro area?), etc.
Furthermore, it is tricky to manage the risk of short positions – this should be done with stop losses or put options, and both have problems. I think the Euro will continue to depreciate, but I am unsure about the timing – and to make money on the short side, you need to get both right. Should you short EUR/USD? Even though I think the Euro will continue to depreciate, I can’t give you a straight answer to this because of the timing issue. However, if instead you were already long the Euro, I would recommend selling some.
Update: Right now (March 1, 2010), EUR/USD is at 1.3557.
[This was originally posted on Feb 9, 2010 at the Heck.com Forum. The forum is still visible right now, but I plan to phase it out after I re-post the forum content on this blog.]
I think this might be a good time to put on 2s-10s flatteners. The curve is very steep (282 bps difference between 2s and 10s) and I think we are at the start of a regime shift (old regime: expectations of a V-shaped recovery, new regime: PIIGS, post-Fed quantitative easing).
A friend replied:
You may be right. Normally, going back over many years, curve steepness tracks interest rate (e.g. swaption implied) volatility. Currently the relationship is dislocated: the curve is too steep relative to the level of interest rate volatility. If history and theory are any guide, I would expect the relationship to revert back eventually — i.e. either the curve to flatten or interest rate volatility to increase (and given current levels, I would expect the former). And flatteners have the benefit of positive roll, which means one can potentially make money on both the carry and the reversion.
Update: Right now (March 1, 2010), the difference between 10-year yields and 2-year yields is 280 bps, so the curve has flattened slightly.