Monday, February 13, 2017

Leaning on Currency Trades

In a bull market everyone is a genius. In the month or so I enjoyed profits in all directions – equities, currencies and commodities. The problem is that idiosyncratic contributions are wearing thin and the gains are more and more dependent on market wide movements. So I decided to do another macroeconomic review, starting with currencies.

A quick disclaimer: anytime someone tells you about a “macro trade”, it’s got a lifespan of about 3 months or less. The reason is market moves feedback to real world fundamentals and no one knows how that will play out with any certainty. The trick is to anticipate a sort of decision tree, and ride the trend when real life plays out as you expected, and be ready to do an 180 when events go down a different path. This is why macro guys like Druckenmiller can flip flop all day yet still make money.

With that out of the way, I’m long Russian ruble, Danish krone and USD, short euro, and anxiously watching the USD.JPY pair. I will explain each below.

The Ruble

I've been riding this trend since late November/early December. I actually have no great conviction on the ruble, but I love Russia’s situation –their geopolitical and economic outlooks are clearly improving.

In the 1970’s and 80’s, the U.S. and its allies opened up to China to counter the Russian threat. Now in the 2010’s it’s the reverse. The U.S. will warm up to Russia to balance against China. Trump clearly wants to work with Russia and France could elect Le Pen, who views Russia more favorably. Shinzo Abe in Japan is getting closer to Russia as well.

This all improves the probability that the current sanctions against Russia will be removed. On top of that, Russia is coming out of a recession and oil prices have stabilized. Inflation will likely subside, which can lead to the central bank cutting rates. Russia is also looking to lower its budget deficit.

The combination of lower expected rates, budget consolidation and improving sovereign credit is the best possible set up for bonds and has mixed outlook for the ruble. Unfortunately I have no access to Russian bonds, but I will settle for going long the ruble and Russian equities (which I also have positions in).

Even if the Central Bank of Russia starts cutting rates, the ruble should still be supported by a relatively high rates and portfolio inflows into the country. Once ruble strength start fading, Russian equities could be the next bull market.

Euro: short EUR/USD and EUR/DKK. Get ready to buy French companies

The dissolution of EU is on everyone’s mind but what happens to the euro is anyone’s guess. The euro could strengthen because weak countries like France and Spain would exit, leaving euro as the currency of a very strong Germany. The euro could also weaken because any dissolution requires a long transition period and the ECB will go on a quantitative easing binge while they’re at it.

At least in the next few months, I think the latter is more likely. So I’m shorting the EUR against the U.S. dollar and the Russian ruble.

I’m also shorting the euro to go long the Danish Krone. The downside is low here as I’m shorting a currency that is pegged, yet undervalued.

Denmark has one of the highest current account surpluses as percent of GDP in the world. If you think Germany has undervalued currency because it uses the euro, then the Danish krone is just as undervalued because of the peg to euro. Denmark also has zero interest rates and an overheating housing market. Does that sounds like an economy that needs more QE? If the ECB unleashes another round of QE, I doubt Denmark will want to follow suit, so they have to unpeg and let the DKK float upward.

Finally, a full dissolution of EU would be great for France. Upon completion, I expect French companies to be big beneficiaries as France would have much needed flexibility on fiscal and monetary policies. French companies will also enjoy great operating leverage with that 10% unemployment rate.

Yen: USD/JPY short in the next month could be the next pain trade

We are heading into European elections and there’s a high probability that populism will win out in Netherland and France. This could trigger a global risk-off with international funds pouring into JPY.

On the USD side, Trump's tax/trade/infrastructure plans (it’s all tied together now as you can’t have one without others and not blow up the budget) would certainly not be passed the next few months. So we can see deterioration in USD as expectations are pushed toward later dates.

Any JPY strength would catch the market by surprise. The market is still very long USD. As for yen positioning, “large specs” went from very long JPY to net short to less short (but still net short) in the past few months. This suggests more room for JPY to the upside.

I'm not going to short USD/JPY however. At the time of this writing, USD/JPY is at ~114. More likely I will wait for the pair to drop to 109.5 or even 106 and resume a long USD.JPY position.