#$usdcny

[alexgurevich]

The Tale of Three Shorts: Part I

Short JPY, CNH, and NZD are three currencies positions that have been prone to elicit doubt and second guessing recently.The great JPY short (long USDJPY) initiated as early as 2010 is much discussed in my book. Through 2015 it satisfied many characteristics of a superior trade. 

Short CNH (long USDCNH) and NZD were also added to the portfolio in early 2015. Several of my blog posts discuss the favorable risk-reward of those trades, especially USDCNH. 

The common theme between these three trades is that all of them were initiated based on very solid strategic considerations and had delivered excellent profitability until recently.  Over the past several months, all of them experienced a significant draw-down and/or a pickup in volatility. And all of them had experienced a meaningful challenge to the concept of their individual superiority.

Yet in all three cases, I have chosen to stay with the trades, albeit with differentiated risk exposures. In this piece I will discuss the various considerations that ultimately lead to this decision with regards to JPY. Entering long USDJPY in the low 80’s and pyramiding it as the momentum built, I had established clear price targets; 110 in the event of a stable dollar and 120 to 125 in the event of much broader dollar strength. Price targets are to be respected and I dutifully took profits around the 120 level.  In fact, by the end of 2015 my exposure to USDJPY relative to the size of my portfolio was less than 15% of what it was at peak exposure. 

Whether it was correct to get flat or to run the residual position to see if the market would overshoot was, without the benefit of hindsight, neither here nor there. The true strategic question was what to do once the significant correction in USDJPY had occurred. 

20yr Chart of USDJPY

Based on the chart above, it is not clear whether the cyclical trend is sustained. As for the secular trend, it is more favorable for yen on a price basis and slightly more favorable for the dollar on a total return basis.

With respect to specific asset valuations, Chapter 1 of my book discusses the importance of a currency pendulum, which is propelled by economic gravity. Such gravity is often manifested by a central bank policy.

So is the recent change in USDJPY direction a sign that the pendulum has started to swing back the other way? It is important to remember that CB talk and incremental policy adjustments are more important in terms of changing sentiment than fundamental flows. 

Indeed, every speculator encouraged or discouraged by the BOJ, who sells USDJPY, is the speculator who later has to buy USDJPY. And since our time horizon is longer than that of virtually any other market player, the net long-term effect on our portfolio is minimal.

Spec JPY Positioning (CME, Non-Commercial Futures, >0 = Long JPY, Short USDJPY)

However, the actual policy does have an effect. A central bank is a monopolistic issuer of its own fiat currency. And continuous increase of supply is bound to make a product cheaper. 

The fact remains that the BOJ is continuing to buy assets and add liquidity and the FED is not. Furthermore, I see no imminent change to this situation.Thus, I find it hard to imagine that economic gravity would change against the dollar, unless the Federal Reserve policy were to change dramatically. Our long bond position should take care of such an eventuality.

For now, I regard the recent yen strength as a correction of a trend over-extension. Staying long USDJPY through such a correction has a logical implication. We are supposed to add to the position if it goes further down.

I try very hard to avoid the fallacy of trying to pick an exact “floor” for the price. If it went down to 108 there was no reason to be sure it couldn’t go to 106 (and it did!). But since our core thesis is based on policy, such price action should encourage us to increase the position rather than stop out. 

As one of the superiority tests for this trade, let us check if its opposite is a “self-defeating chicken” (strategic language from Part III of my book). We don’t know whether USDJPY has currently bottomed close to 105 or whether it could go to 103, 101, etc. But what we really care about in terms of portfolio risk management are much more extreme scenarios. For example, can USDJPY trade back to the lows of 2011? I think that is highly unlikely. Further JPY appreciation would elicit such a raging policy response from BOJ that the resulting pendulum forces may propel USDJPY to new highs. 

Some may disagree. There is an opinion that BOJ is powerless now to weaken their own currency. As I stated before, I am convinced that a CB can always devalue their fiat, as long as there is political will. People may argue if there is such a will at 110, but I assert that there WOULD BE such a will at 90. Thus as a sign of superiority USDJPY appears to have more upside than downside, as a large move to the downside creates a large opposing force.

Another superiority test is analyzing the historical pattern. What actually happens to USDJPY during US tightening cycles? This test comes back mildly encouraging. While having performed well through the 2004-2006 cycle; USDJPY fell sharply during the tightening of 1999 and started to riseonly at the last stage of the cycle in 2000.

But how can we can we tell, without the benefit of hindsight, where we are in the cycle? My preference is to remain agnostic about timing and to stick with what I know: eventually long USDJPY tends to win through the entire tightening cycle on a total return basis.  Not the strongest endorsement, but an endorsement nonetheless.

Lastly, comes the dominance test. Assuming that we like long USDJPY, we must check if there are any trades across asset classes which are strictly dominant; that is, they would perform in every case when USDJPY goes higher and possibly in some other cases?

The most natural candidate for such dominance is Nikkei. Will the Japanese stockmarket go up in every case when JPY weakens? Not entirely certain, but the likelihood is high. Furthermore, Nikkei has recently started to show signs of performing when the yen is merely stable, as opposed to falling. Dominance is not established, but suspected.

Conclusion: Long USDJPY is still an attractive trade with attributes of superiority, but it is at a risk of being dominated. Long Nikkei holds its own attraction to us (see my post from February 10th, 2016) and appears to be incrementally favored by the relationship of concurrent necessity.  Hence, USDJPY is a “hold” based on the policy support with modest tactical trading, while long Nikkei is an “accumulate” with an eye towards a significant position for the next great bull market.

Keep your minds open, and good luck!  

[alexgurevich]

Is "Short RMB" Still the Fairest of Them All?

Before August of this year, the answer was a no-brainer.  Remember, our imperative is to buy low. I have written multiple times about the Chinese currency both before and after the August 11th devaluation.

My position had been clear - given the vol market’s extremely low probability on a devaluation, "Short RMB" was a mandatory, superior risk/reward bet, but not the kind of trade on which you would want to blow all of your capital. There was no ex-ante certainty of timing or magnitude.

Now that the second wave of the move is in progress, what am I doing? In markets like USDCNH, with expensive bid-offers, there is extra value in not "fidgeting" and just running my positions.  So I am sticking with my options, which are now deep-in-the-money and are essentially outright positions.

But that has been the case for a few months. Am I going to adjust my positions? My book The Next Perfect Trade discusses the currency pendulums in the first chapter. Normally, once a major trend has launched I would be piling in, as if possessed by macro demons, and not worrying at all about not getting the "cheapest level".

I am, however, holding steady (while very substantial) positions, because long USDCNH is no longer a clearly "superior" trade according to my strategic language.

I still think it is a positive expectation trade: the devaluation is more likely to be equal or greater than projected by the market. But the question I am asking is, "are there more dominant trades out there?"

Let us disregard the scenario of re-appreciation of RMB as unlikely, and break down the market analysis into two scenarios for the next couple years:

Relatively stable or slowly depreciating RMB

Massive depreciation either because of the government's loss of control or a radical policy decision

While long USDCNH looks good in light of Chapter 1 of my book (entitled "Trend"), it has problems with Chapter 2 (“Carry”). A slow depreciation may or may not catch up to the 3.4% devaluation priced in the 1yr forward. Many of us would agree that if Scenario 1 is a given, then the trade looks mediocre.

Scenario 2 is obviously great, but I seek trades that work in the broadest range of economic outcomes. In other words, are there trades that are as good in Scenario 1, but also hold up in Scenario 2?

I have two examples:

Long US bonds, a trade which I like for reasons I've written about ad nauseam; and

Long USDKRW, which while not clearly dominant, offers a nice diversification.

With positive carry in the bonds' case and low carry in KRW case, we don't have to worry about the velocity of RMB devaluation. Both trades are likely to get a tailwind from a lower Yuan, regardless of timing. And both trades have the potential to work even with stable RMB.

One caveat with KRW and has move quite a bit already, while not having the same overwhelming secular trend and superior risk profile as the bonds.

But both trades are set to do extremely well in Scenario 2, a catastrophic devaluation.

To summarize: While I like and will keep the USDCNH trade, I see a lack of clear dominance and am concerned over awkward liquidity. I prefer to focus my risk on long US bond futures and consider diversifying into USDKRW.

Good luck.

[alexgurevich]

Central Banks Teach 2015 Trading Lesson

Arguably, the three biggest Central Bank ("CB") driven surprises so far this year:

January 15, 2015 -  SNB de-pegged the Swiss Franc, causing catastrophic revaluation.

August 11, 2015 -  PBoC suddenly devalued the RMB; a historic change in stance.

December 3rd, 2015 -  ECB dealt a disappointment to the doves causing a massive rebound in the Euro, as well as Euroland yields.

The three events listed above were particularly educational for me, as each CB action and marketresponse had its own unique impact on the portfolio given three different positioning environments:

SNB -    No significant CHF positioning into the moveo 

PBoC -  Large, specific CNH positioning in anticipation of the move

ECB -   Large portfolio positions and substantial risk exposure

The market shocks I observed and their corresponding impact on my portfolio all rang strong truth towhat I have discussed in detail in Chapter 10, “Portfolio Paralysis”, of my book, The Next Perfect Trade:

Huge optionality lies in having unencumbered capital.

I have described Portfolio Paralysis as the instance when you cannot take advantage of a sudden market dislocation because your capital is already tied up in existing positions.

Aware of my previous tendencies to be overconfident and stretch positions enough to become vulnerable to portfolio paralysis, I had introduced a discipline of limiting exposure during the "good times", when everything seems to be going my way.  Hence when the market suddenly turns I can take advantage of the dislocation and increase positions, rather than being forced to cut.

My long bonds, long dollar, long stocks portfolio had been tremendously productive through 2014 and into the first quarter of 2015. Correspondingly, I exercised some caution proceeding further into the year. Retrospectively, it was still not enough caution.

One could make an argument that I was sized correctly because I survived the vicious correction in the second quarter and was even able to incrementally add risk. Yet by June 2015, the drawdown put me uncomfortably close to the edge of the cliff. In action movies, heroes repeatedly dodge bullets or cars by a millimeter, narrowly slip under the drop-down gates or deftly defuse bombs with only seconds remaining.  I posit that in markets, as in real-life action sequences, such circumstances are a sign of failure to be in the position in the first place rather than success in getting out.  In other words, if you teeter too often on the edge - you are bound to fall off sooner or later.

How does this lesson relate to the three central bank surprises?

Going into the ECB meeting, I considered myself not to be overextended. Having said that, an important tenet of my strategy is not to reduce my core positions ahead of important data releases or policy meetings.  My rationale is that if markets were to gap in my favor, I would irrevocably lose a portion of my profits. Alternatively, if the markets were to gap against me, I would still expect to recover the money given that my long-term view is likely to be correct.

So, I took some profits on the favorable Euro move in November 2015 and was not losing any sleep over the ECB. The result, however, is self-evident:  EVERY position in the portfolio was hit, causing a multi-standard deviation loss (not that I believe in the Bell Curve probabilities). December 3rd turned out to be the single worst trading day of my career in percentage terms.  Yet, it was nowhere near the most painful or stressful day.  

In fact, I started the day at an all-time High-Water Mark with a decent amount of profits locked up. While the move was ferocious in total drawdown terms, my portfolio was under much less pressure than during the second quarter compression and other tough spots in my career.  I was able to judge this time that the ECB-related contagion and sell-off in the US Treasury Bonds was largely position driven and likely to be short-lived.  I not only held on to all my positions, but also was marginally able to increase my long bonds exposure. Even so, it felt and still feels a little too close for comfort. Importantly, caution precluded me from SIGNIFICANT increase in positions, and therefore, I didn't really take advantage of the volatility.

Now, I am not so arrogant to believe that I should make money on every instance of a violent market move. All you can hope for as an experienced trader is that the aggregate of your first buy/sell reactions puts you slightly ahead of the game over your career. A long-term trader faces a tradeoff: keep your position larger to profit more on the underlying trend and risk portfolio paralysis OR decrease risk size to have "dry powder" when the market dislocates.

There is no exact criterion for the right level of risk. But consider this: I was spot on with China,anticipating both the equities sell-off and the currency devaluation. Fearing a short-squeeze, I expressed my views via options with the intention to hold them into expiration. But options entail additional risks of failure discussed in Chapter 9, “Adding Unnecessary Complexity”, of The Next Perfect Trade. As Chinese markets were recently progressing in my direction, I explained in my October 5th blogpost, complete success was far from certain.  Indeed, due to imperfect timing and time decay on the options I have only managed to break-even on the equity trades. The currency options are deep in the black, but as I have written, the battle is far from over. Finally, the CHF de-pegging in January caught me completely by surprise.  In fact, in December 2014 I wrote about initiating a short CHFMXN position. However, my exposure to CHF had been sufficiently small and overall performance sufficiently good, that on January 15th, I experienced no hint of portfolio paralysis.  I was able to think clearly and take advantage of the panic by selling CHF. This is what I wrote on that day. By diving into the unexpected dislocation, the trade turned out to be one of my best money-makers, both in absolute terms and in terms of the ROC in 2015.

Hence, the lesson of 2015 taught by Central Banks:

During extreme market events, a clear head and free capital may often trump correct, but unwieldy positioning.

Good Luck with the Fed this week.

Image: A New Japanese 7th Grade Classroom by Angie Harms

[alexgurevich]

China Strategy Overview

I’ve been somewhat prematurely congratulated on the success of my China strategy. Indeed, I have been vocally sceptic this year about Chinese stock market and currency. And given that I ALWAYS put my money where mouth is, it is natural for my followers to assume that I making “fortunes untold” on those trades.

The reality is that the trades I have been involved in this year have been, while profitable thus far, were by no means “slam-dunks” and may yet end being in the red.

The readers of my book “The Next Perfect Trade” http://tinyurl.com/q3sdqpo have pointed out that the long USDCNH trade, for example, may not meet some of my criteria for a superior trade.

My book had been mostly completed before China came into focus. In this post, by popular demand, I will outline my approach to trading RMB and $FXI in the light of my broader strategies.

As far back as 2006, I have started to suspect that Chinese economy was a giant Ponzi Scheme destined for a collapse far more devastating than what happened to Japan in the 80’s.

To be clear: I don’t produce my own economic research, all I can do is listen to people and side with those who make more sense.

However, for years I have stayed out of betting against China, because I couldn’t formulate any bearish strategy that would fit my criteria. I’ve written before how difficult, in general, it is to be short a stock market and as for the currency - the appreciation trend had been overwhelming.

I have mentioned in my book that if you can’t a find a good trade to express a view, you may want to question the view. So despite, having a wrong view for almost a decade, I have escaped much damage by failing to find a trade fitting into my strategy.

By 2013-2014 the China troubles appeared more imminent to some experts, but my eyes were turned elsewhere. I saw tremendous value in being long dollar vs. yen and, later, vs’ euro. But my strongest conviction was in the long end of the US Treasuries curve, where I had a disproportionate risk concentration by the beginning of 2014.

According to my strategic language (which I explain in detail in my book) being long USDCNY  (betting on RMB devaluation) was, while attractive on its own, a strictly inferior trade with respect to other positions in my portfolio.

For the currency devaluation to occur, at least one, if not both of the following conditions had to be concurrently satisfied:

Broad dollar strength

Dramatic weakening of Chinese economy

My portfolio was already directly aligned with the first condition; and a massive Chinese slowdown was likely to affect the global risk appetite and cause a flight to the US bonds. Thus, in 2014, the currency bet was redundant to my portfolio and I stayed out.

In 2015, the game had changed: the dollar had already rallied and so had the bonds, making those bets no longer as superior. I was increasingly convinced by the arguments for the necessity of the Chinese credit cycle unwind. (I will omit the discussion of idiosyncratic pros and cons  - I have written on the subject enough and for further information read “A Great Leap Forward?” by John Mauldin and Worth Wray.)

Yet I was waiting for another shoe to drop: the stock market. I thought Chinese stocks screaming up would give the government a good excuse not to devalue. Yet without devaluation the equity bonanza was likely to end in tears.

So I got involved in two very uncharacteristic trades: long USDCNH (offshore bet against RMB; at this point it appears I might have done better with USDCNY) and short FXI (Hong Kong listed Chinese large cap). I chose to bet against the dollar expressed ETF, because I was hoping for an additional benefit in the event of currency devaluation.

But Chinese stocks were rallying and I had no intention to be wiped out by shorting into the bubble (I’ve written about this too). So my only “option” was to buy puts, illiquid and expensive as they were. And as the market continued to rally another 25% since I started, I kept adding more puts, but I was beginning experience pain.

Why would I get involved in buying options and in betting against a currency with positive carry? I have cautioned against both of those things in my book. There are times though when the risk-reward appears so skewed, that it is beginning to have the flavor of a “free lunch”. I decided that the opportunity was too great, and in the absence of the ability to structure a “no-lose” trade, I had to risk some fixed amount of capital.

Initiate the positions and run them to the bitter end. No hedging, no whining.

Not only my long dollar/long bonds came under pressure in Q2 of 2015, but the capital committed to bets against China was grinding away. Fortunately, I had been positioned with enough caution to keep all the trades.

Needless to say in Q3 things got much better.

But I want to emphasize that my entry points were not perfect and the trades are far from complete with my portfolio still leaking carry and decay. In fact, the extreme scenarios, I have been hoping for, HAVE NOT yet materialized.

The equity trade I think will be over soon one way or another. But I still see no way out of further currency devaluation, and I will continue to pay carry to stay in the trade. With the full understanding that the whole strategy may yet end up being a loser.

Chart Source: Yahoo! Finance

Image: Terracotta Army by Tom Wachtel

[alexgurevich]

Superior Trades Aim for Wider Targets.

This has been a busy month, already! 

In my book the “The Next Perfect Trade - the Magic Sword of Necessity”, which is now available on ebookit and amazon, I take the reader step-by-step through the process of selecting trades that are aided by market tailwinds. Broadening your range of success is the focus of my portfolio approach.

Also, I recorded my newest interview with Raoul Pal on  RealVisionTV (my first interview is available for free on its site using this link; for the latest one you’ll need to subscribe but I find its content invaluable so please take the step to sign up using promotion code “Alex”). It was an excellent chance to review the concepts I was pondering as I was writing the book over the last year, and apply them to the current turbulent markets.

There is no longer an easy equivalent of the logically irrefutable long dollar/long bond trade of 2014; however, chaos breeds opportunities. What does my current investing strategy dictate?

The approaching Federal Reserve meeting is the most contested one in years. In the past, I worked hard to predict the exact path of the Fed Funds, and I was not bad at it. But nowadays I often feel that there are bigger fish to fry.

Some people think they will tighten several times in a row and some people think they are not tightening in our market lifetime. Let’s accept this uncertainty and try to come with a portfolio which will work regardless.

Long-dated bonds were my beacon through this cycle. Again and again, I have been repeating the mantra:

No hike means bonds earn carry

Hike means stronger dollar, curve flattening and long bond rally

Another beacon of value in the times of stock market correction, may be cheap, established technology companies that are unburdened with excessive debt and have proven to be able to adjust to the change.

On the other hand, the world of currency trades has shifted from “slam dunks” to merely “good risk-reward propositions”. My significant bets on weaker euro, yen, Swiss Franc, and yuan, after the original surge, have meaningful downside.

Chinese currency devaluation is coming into focus. I am inclined to stay with the trade as I can’t imagine any other way to stem the tide of capital outflows.

I have to face that sitting here today having little conviction about the direction of the stock market or economic growth (both domestic and global). This doesn’t mean I can’t have a position.

In my book and in my recent interview, I explain how I rely on my understanding of causality chains between various asset classes, rather on predicting the market direction.

So don’t get flustered by volatility. Take a deep breath, and instead of aiming for the narrow target of precisely anticipating the price action, look for trades that will succeed even when your views are wrong.

Image: Target »» 0o.o0 «« by Erika

[alexgurevich]

Currency regime changes: not the “How”, but the “What”.

Like the old Soviet Regime, certain market regimes seem to be entrenched so thoroughly, that it is impossible to visualize any mechanism, by which they can be dislodged. But the Soviet Union fell and did so in a fashion few could have foreseen.

Until only a few years ago, Japan appeared to be caught in the never-ending purgatory of deflation, sagging growth and capital markets, and meaningless reform promises. In 2012, the current account surplus was not scheduled to elapse for a few more years, and the market flows, according to strategists, continued to support the yen. And then the sudden collapse of DPJ and Abenomics. You know the story.

And you also know the story of the Swiss Franc. First it was immovably pegged at a too weak 1.20 exchange rate to the euro. Then the immovable and indestructible peg suddenly evanesced. The franc briefly rallied above parity, which was way too strong. It appeared that the SNB had no means to control the currency appreciation. Until they did. And guess what? EURCHF drifted to somewhere in between 1.00 and 1.20. Probably where it should have been to begin with.

You probably can see where I am going with that. If general economic principles and historical patterns dictate that something has to happen, it probably will. Even if you see no possible mechanism to drive the transition.

Which, of course, brings us to China. In my post

http://alexgurevich.tumblr.com/post/121445061347/china-you-have-to-know-the-rules-to-play-the 

from June 13, 2015, 

I reviewed a book by John Mauldin and Worth Wray A Great Leap Forward?

 I conceded that both China bulls and bears were making strong points. And with regards to currency I was giving heed to both those who said that a massive devaluation was inevitable and those who pointed out the imminent deval was neither necessary nor in the interest of the government.

There were few precedents to establish how price and credit overextensions unwind in tightly controlled communist/capitalist markets.

Personally though, I leaned to the bearish case for both equities and currency, based on the historical pattern for countries with credit growth excesses. Until proven wrong, I had to assume that the “what” of the equities correction and currency deval, even if I didn't know the “how”.

And given that I ALWAYS put my money where my mouth is, my strategy did not permit me not to trade accordingly. 

It was not cheap and my timing was not perfect. And today it is too early to celebrate victory: all my gains are reversible.

Now what? Do I stick to my guns and expect more of the same?

If you were wondering why I haven't posted any anything extensive on the RMB devaluation thus far (I suspect you have better things to do than to wonder why I don’t post): I had relatively little to contribute to the discussion. I don't have a clear idea why they did what they did and what their long-term plan is.

So in the absence of such insights, I have to stick the fundamental principle which drove the China trade, as well as other examples above:

Unsustainable will not be sustained.

If you see a major dislocation what have to bet on it eventually being rectified, even if you fail to understand the mechanism of the shift.

One of the reasons I prefer simple directional trades is because the “what” of the market is often easier to discern than the “how”.

And with the respect to China, if (and that’s a big if) you believe that the major dislocations are still there, it is reasonable to assume that they won’t be fixed by a 5% currency move. And so, regardless of what the authorities may have in mind, the odds are skewed towards further devaluation.

Chart source: Yahoo! Finance

Image: The Unstoppable Wave by Theophilos Papadopoulos