Why Buy Bunds

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And we’re back. Panic time is here, investors (and the 1 percent a little bit) have been spooked with the Moodys’ Spanish bank downgrades, the Greeks election rigmarole, and JP Morgan’s innovative approach to hedging risk.

As expected investors are rushing into safe havens, Gilts, US Bonds, USD and………..bunds?? Wait a second – Why exactly are investors rushing into bunds when they are in effect putting their money right into the car crash they are trying to run away from?! It’s not because of the phenomenal 1.4% yield and it can’t be the preservation of capital.

The RED line (RHS) represents the bund in Dollar terms while the Blue is in Euro terms. From the beginning of this month, investment in bunds would give you 2% percent profit, but when it comes to repatriating this money, you will receive a 2% loss in $ terms! Investors have effectively tried to avoid losing capital by…..losing capital!

Looking into this panic trade in more detail, we turn to the bund option skew (NB: I have made the prices deliberately vague to protect my firm’s proprietary data)

The last time bund skew reach its current levels was the 21st October and the bund was trading 137.8. The positive call skew implies that investors believe the bund to rally in the future and on 21st October there was an upside to this strategy. Now, with the bund trading at 143.83 (all time highs) and the upside to buying a combo (buying a call option and selling a put option) being unknown and perhaps less profitable you would expect a cheaper combo but despite all of this, the combo is trading at the same price!

 

Combo payoff diagram if I were to buy the 19 calls and sell the 11 puts

 

 

 

There are plenty of trades that can take advantage in this misallocation of resources through panic (eg buying actual safe bonds and selling bunds while hedging out currency risk) but more than this, The 1 Percent ar astounded that the investment community hasn’t woken up and realised what the hell they are doing! Is it simply a habit that investors perceive the bund as a safe haven as it has been in the past? Are investors so stuck in their ways that they can’t see fundamental changes in the investment landscape? Hell, maybe I’m talking a lot of nonsense.

Time will tell :-)

Bank Run

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 What a way to start the day!!! Yesterday saw new all time lows for the SX7E bank index, coupled with all time highs on the bund – a Buffett phrase springs to mind…

“Be fearful when others are greedy, and

be greedy when others are fearful”

And on the Other Side of the Camp

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A very interesting take on the Greek re-elections in 6 weeks. According to an ITK source from Bruce Krasting’s blog, the Greeks voted the fringe parties in out of anger and confusion about what was going on.

80% of them want to remain in the security of the EU and on the realisation of what havoc their voting anger has done to Greek politics, you can expect the unexpected: IE voters coming together to vote the mainstream partys back in.

Will this solve the problem? no, but at least you can kick the can down the road.

Full article here!

The Secret Manipulation

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Imagine a world where you could keep your currency artificially low (in secret). Your exports stay competitive and you wouldn’t be subject to any political outbursts or protectionist policies. I suppose you could call this the Chinese Dream.

The thing is, the Chinese Dream exists right in front of you, sitting uncomfortably within the Eurozone. There’s no point in continuing this secretive narratic as the GDP figures yesterday have probably gave you a good idea as to who I refer to.

If the picture hasn’t helped, let me spell it out….. G E R M A N Y. To recap on yesterdays news, German GDP showed a jump to +0.5% compared to expectations of a +0.1%. Yes the papers said a beat 5x over, but from such a small base, this is just sensationalism. The main surprise was the German’s resilience in their export sector, whose strength was mirrored by Germany’s exporting companies such as Volkswagen.

The benefits do not end there. In fact Germany is actually the only country with a downward unemployment path. Indeed, with unemployment at 5.5%, they are the best in the Euro Class.What does this have to do with my title? Well let me answer your question with a little exercise:

Assume the Euro continues to trade and we bring back every national’s sovereign currency. French get their Francs and Germany get their Deutschmarks. Initially each currency is pegged to the Euro at parity. Suppose then we were to let all the currencies float freely, what would happen to the German Mark?

It would appreciate – significantly. In fact by sharing their currency with a bunch of inept and indebted countries, the Germans have received an unusual perk. As investors shun the Euro (while this is appropriate for the Eurozone), the depreciating currency does miracles for the German economy. I would go as far as to argue that they were aware of this possibility from the beginnings of the crisis and it brings me to consider whether the Germans have a huge incentive not to let failing countries leave the Euro.

If the loss of competitiveness from euro appreciation exceeds the loss from helping stricken countries remain in the Eurozone, the Germans will comfortably continue their current projects. However, despite this equation seeming relatively simple, the costs and benefits can’t simply be measured in monetary terms. For example, the low unemployment figure helps keep political stability and more important keeps the Germans from having to make any painful austerity cuts in the near term, while the exports help domestic companies grow creating more jobs and paying more tax!

Of course the flip side to competitive exports is uncompetitive imports which will hurt for a developed nation with an appetite for overseas technology but due to the German’s continual current account surplus, the undervalued currency clearly benefits exports.

Furthermore, we must remember that as a member of a currency union, it is only imports from members outside the currency union whose exports become more expensive for the Germans.

With a weakening Euro, we would expect to see some import substitution from non Euro countries to Euro Countries. According to the most recent trade figures this process has not been too clear, with import growth declining across the board (apart from the UK and OPEC countries).

What we can see is that the growth in imports has been higher in the Euro area(13.4% growth) than the US (6.7%) and China (2.5%) but lower than that of the UK and Russia.

UK is a true anomaly but I would assume Russian imports are due to the German’s increased need for energy..

 

 

 

 

 

 There are only two other countries who hold this incredible position. China and Switzerland. I will completely ignore the latter as the Swiss economy is such that currency manipulation does not seem to irk national leaders. China have (had) an altogether different experience.

The Yuan manipulation is as clear as the amounf of foreign currency they hold at their central bank. Most of us think it and most politicians have spoke about it. It is beyond reasonable doubt that China is a currency manipulator and if it weren’t for this global crisis (ie we are in dire need of China’s growth) I am sure that the US President would have said this publically. Under growing political pressure (but more importantly to land their economy softly) the Chinese have begun to appreciate their currency although this appreciation can be measured with baby steps.

I wonder how long it will take before Germany begins to be labelled in the same way, continually amending treaties, enlarging firewalls, and buying up more sovereign debt in order to keep the Euro depreciated.

Food for thought: What will happen with the Greek elections? If the Germans regard a cheap currency as a priority, they may well allow the Greeks to undertake a milder version of austerity, delaying them from the primary surplus goal while keeping the Greek people happy at the expense of the rest of the market.

The Pied Piper of Athens

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As yet another week of uncertainty begins we find ourselves asking the same questions again and again and again. What if Greece defaults? Will it default? Can it afford to default? Is it even in their interest to default?

With three attempts to form a coalition government down the toilet, it looks like the Greeks are going to pin their hopes on the second round of elections that will be held mid June. With the opinion polls as unstable as Joey Barton’s temper, it may be of no surprise that Syriza is currently leading them. Under Mr.Tsipras’ stewardship, he would like to see a Greek rejection of the current bailout terms, a nationalisation of banks and a reversal of many of the current austerity measures.

On the face of it, it seems like one big middle finger to the European countries that have pushed austerity onto the Greeks. An austerity that has caused huge unemployment (above 50% in youths) and massive reductions in state benefits. By reversing policies that are damaging the average Greek, surely Tsipras is the hero for his people…

Unfortunately for him, the solution isn’t as simple as spending bundles of money and if Europe doesn’t like it, they can ‘speak to the hand’. His policies may sound enticing for the voting population in the short term, but once their long term implications are considered, it seems like Mr.Tsipras has become the Pied Piper for the 21st century.

The Pied Piper of Hamelin is a German fable about a rat catcher that lured away the towns rat infestation by the sound of his magical flute. The flutes music was so hypnotising, so pleasant that the rats could not help but follow the Piper into the river, where all but one drowned. The people of Hamelin then realised their budget deficit was too great and had to implement austerity on the budget meaning the piper couldn’t be payed. He took this as a snub and played a song that enticed 130 children into a cave where none were seen again.

My point is simply that the children followed what they thought was pleasant and hypnotic music, but what they found at the end of the journey was a terrible demise. How does this mirror Greece???

Consider that Mr Tsipras has no domestic currency and therefore no printing press. In worst case scenarios you can default on debt leaving you debt free, but this won’t put you in a better situation when paying the bills. Tsipras can default on national debt but one thing he can’t do is default on the many people that rely on the state for their livelihoods (public spending amounts to 50% of GDP).

For arguments sake, lets say Syriza is elected and decide to carry out their plan. The first thing that will occur is the cessation of payments from the Troika to Greece. Once these payments have stopped, the Greek govt will have to cover the shortfall in the budget. It is highly unlikely, but assume they have access to the bond market, the bonds they could sell would be extremely short dated with penal rates of interest – why should good money be thrown into a bad economy?

Issuing in this circumstance will only delay the underlying problem for a short while (an underlying problem that will get worse once austerity is reversed) and ultimately the Greeks will default from their remaining debt obligations.

Mild panic will ensue (most banks have written down the value of their Greek debt to 20 – 25% and have probably accepted that these bonds will be worth 0 in the future) and Greece will now be debt free, HURRAAAAAY! The problem is that while they may not have debt, they still spend more than they earn (Greece earn EUR86bn in rev vs EUR102bn in spending) and with a black mark on their credit, they will be unable to tap the bond market for funds. For a country that is moving towards a budget deficit of 7.3% of GDP (8.4% should they refuse to implement the next round of reforms) balancing the books in an immediate time scale will be incredibly difficult. Initially, the Greek government could fire sale all of its EUR45bn of publicly owned assets (5bn sold so far)

Above is an outline of their intentions at the beginning of last year…. below is what has been accomplished.

After a supposed EUR11bn of money raising through privatisation, Greece has managed barely half of it and it. Under this extreme scenario, these businesses will not be able to recoup the full EUR50bn. If we assume they can recoup half of this money, they are slashing their future revenue streams for a one off payment of 25bn. Considering the primary deficit of 9.6bn EUR, this fire-sale will not occur quick enough to close the gap in the short term. So what else can Tsipras do to balance the budget?

Maybe the inherent culture of tax evasion can be tackled as data does show that an efficient Greek tax system could bring in an extra 5% of GDP or EUR6bn a year – maybe this could work after all!!!!! Unfortunately in the real world, it takes years to overhaul a tax system and the truth is there isn’t any real way that the Greeks can balance their books instantly.

From this point the Greeks will have two options:

  • Ultimate Austerity: Screw primary surplus by 2013, the Greeks will have to force through enough budget cuts for a primary surplus in year 1. This means a lot more cuts than even the overlords of the Troika would have wanted (now you get the pied piper analogy). After all of this talk of taking hold of their destiny, their destiny means a destitute economy.
  • Re-adoption of the Drachma.

In the 1 percent blog’s opinion, the re-adoption of the Drachma is the only credible alternative. A handicapped economy needs its own exchange rate mechanism in order to establish some kind of competitive advantage. It is likely that the Drachma will be worth a fraction of the Euro and once the Greece converts to Drachma, imports (which run at twice the EUR size of their exports) will become substantially more expensive, raising the cost of living. This state will remain domestic industries can pop up to provide these imports at more reasonable prices.

Furthermore, what of the Greek’s savings? For the few who haven’t moved their money overseas (according to the IMF, only 30% of deposits have moved overseas), the re-denomination of their savings into Drachma would lead to a sharp fall in real wealth.

Despite Tsipras offering the chance of a new beginning, it is this blog’s opinion that the Greeks will see a much deeper, faster and vicious austerity drive (as debt becomes unusable) coupled with a spike in the cost of living and drop in real wealth through the re-adoption of the Drachma.

Fair enough I haven’t given credence to the fact that once the Greeks have their own currency, they could monetize the debts through printing money but this can only be utilised in small measures because this kind of quantitative easing will surely lead to hyper-inflation (US and UK QE is different as the govt is swapping longer dated money for shorter dated money, keeping broad money supply constant.)

As much as the 1 percent believes that the current Greek austerity drive will only end in tears, it also thinks that Tsipras’ hasty approach will end in even bigger tears. In the long run, it is more likely that the Greeks will be more successful under the Drachma as the economy will be ignited through their tourism industry but these plans must be put on ice until the Greeks have achieved primary balance.

As a final thought, if and when the Greeks do achieve a primary balance, it will become almost certain that they will default on their remaining debt.

Efficient Market Hypothesis

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The Efficient Market Hypothesis is one of the most debated theories in modern economics. Penned by Eugene Fama, the EMH tells us that

Every market in the world is 100% efficient. Every piece of public data is correctly and instantly priced into the market, making it impossible to attribute stock market out performance to anything other than luck

My gripes with the theory lie in the fact that it assumes every individual as completely rational, armed with the same (and complete) analysis toolkit that everyone else in the world possesses. If this is true how is it so easy to find two analysts who will come to the complete opposite conclusion about exactly the same stock, using exactly the same Discounted Valuation techniques. However the biggest problem is that…

Not everyone is a rational invidual.

My evidence? Well how about two pieces….

 

Exhibit A: The Greek Election

What is quite amazing is how this election literally ‘crept up’ on a lot of people who work in the industry. Once the PSI swapped Greek debt out for other debt worth c.half the value, market participants seemed to consider the problem solved. Odd considering that even pre-election surveys showed that 60% of voters were not planning on voting for the mainstream parties.  With over 50% of youths unemployed, it wasn’t far fetched to consider the possibility that these individuals would not vote for austerity. In actual fact, not many did.

The EMH busting results? For the more astute investor, a 6% return on shorting the Athens index once the results were announced. Granted there was plenty of inductive logic to run through to achieve that investment basis but surely once the results were announced, the mkt would immediately become efficient?? As you can see by the above graph, it didn’t. As speculators digested the news and were told by various ‘trusted research houses’ that this may cause contagion, they index dropped a further 4.6%. Surely the above graph is the equivalent of a kick in the balls of the EMH?

Thanks for the example Didier!

Pro-EMHers may argue that more information came out on the subsequent days but I would argue flat out that it didn’t. Opinion pieces came out that swayed ther investment ethos of market professionals. This has nothing to do with previously unknown information and therefore the EMH-ers cant use this as an arguement. 

 

Exhibit B: The French Election

As the Flamby Rolex slanging match reached it’s pinnacle, it was safe to say that the fight was over before it started. I saw betting odds almost a week ago pinning Sarkozy at 14 to 1 for re-election. If the EMH can’t imply that the mkt has priced in an Hollande victory, maybe it needs a better pair of spectacles. Assuming it did, there should have been no opportunity to make any money.

I actually spoke to colleague around a week ago (and posted in a reply on this very blog) that the trade to be done was to buy bunds and sell French OATS. This was because a Hollande victory meant an increase in spending with no reasonable increases in tax revenue (increased budget deficit) would lead to increasing scrutiny on France by the ratings agency. This would in turn increase the risk of a sovereign downgrade, therefore applying pressure to the French bonds.

Furthermore, the socialist victory would lead to an investor realisation that no matter how much current governments stick to the austerity roadmaps; all it takes is a disgruntled populous to wipe them off the political map and replace them with someone, well, a little more self interested.

 This inductive logic could have been done on Monday or Tuesday and according to the EMH this was all priced in, but yet again it wasn’t.German bunds spiked to their highest ever value at 143, while French OATs floundered.

 

 

Just an Update

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While Europe stares into the abyss it should come to nobodys surprise that I haven’t had that much time to keep my readers updated on my thoughts and feelings.

So let me just talk up my own book.

1. As you all know I have been advocating a short of the AUDUSD (various posts). At pixel time today….

2. When looking at the French elections, I pitched a pairs trade going long the bund against the French bonds…..The trade is now up 30 points.

All for now – Onwards and upwards

 

 

Twitterithm – Update 2

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Happy bank holiday Monday’s all and to those (including me) who are sitting on their desks, better luck next time! For those more regular readers, you may remember that on April the 11th, I posted an inciteful blog regarding the use of Twitter in predicting share price movements.

I am happy to say that with just under one month of work, I have been able to bootstrap together a fantastic little php program that takes tweets in realtime and stores them on an external database for me! Hurdle one, has been safely cleared!

For about 2 hours I have been running the Alogrithm to search for ‘recipes’ and I have gathered 902 tweets, taking up 702kb (not even 1mb) of space…

If you want to play around with the recipe database, you can’t have it :)

What’s left?? An awful lot unfortunately. I have no real idea of the integrity of the database..will it turn off randomly (and render data useless) or give me corrupted nonsense, who knows…..

What I can tell you is that once I am happy the database is running smoothly, I shall begin writing new lines of VBA code that can pull the tweets into certain keyword groupings allowing us to turn this data into a metric for certain companies.

Stay tuned

 

Quick update for you, having run the keyword search Nokia and Lumia, I have managed to amass 44,704k tweets in 19 hours using up a whopping 274mb of data. As a result, I can’t actually pull the data off the server to analyse :( Maybe a more frequent download may be useful!

Collateralised Drug Obligations

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Mr. Gapper as printed an interesting article in today’s FT which gives us Professor Andrew Lo’s idea of a Collateralized Drug Obligation – Wow!

This CDO is modelled off what we all know and love as a collateralized debt obligation, essentially a big pot full of mortgages that pays you a fixed coupon as mortgagees pay interest – your own personal share in a mortgage book if you will.

I will accept that I am no medical expert but the article does pose some interesting thoughts and questions for us laymen. Primarily, why do we need to add some crypto finance element to the medical profession?

According to Lo, the medical profession has been struggling for a myriad of reasons. Firstly, many blockbuster drugs will soon go ex-patent, meaning they can be replicated and produced by other generic companies that will make treatment more affordable for the consumer (good news!). This so called ‘patent cliff’ means that large drug companies will not have the reliable earnings streams they used to. They are therefore less able to engage in R&D and as a result less likely to produce treatments and cures (bad news!). Since the blockbuster drug days of the 90′s, medical companies have moved from resembling Apple to British American Tobacco, low growth, low innovation and low valuation multiples…… How do we stop the rot and make these companies successful while encouraging them to cure more illnesses?….The C.D.O (the drug one)!

Lo suggests that because there is no significant returns to investing in the equity, the medical world should entice the debt owners, who are happy with lower and capped returns for a less risky investment. In theory you could package the research of 100 drugs into a total cost of R&D, with the few blockbuster drugs used to repay the capital and a little interest on top. Using a flow chart as an example…

Unfortunately there are a few differences between mortgages and R&D that may mean that a CDO would not be the cure for, well, finding cures.

First, a mortgage CDO is a fixed pot of mortgages which are an easily understandable and fixed asset class. A mortgage costs X and it will generate a return of Y over a period of Z, with an insolvency probability of P%. Each letter is a known and fixed entity. Because of this, you can package this into a debt instrument receiving a speicifc coupon on a certain date and this allows you to pay a coupon on the overall package. R&D is a completely different animal. The success rate is a complete unknown – about as unknown as the timescale of research, the cost of research and the take-up of the drug.

The company could, for instance, start research on one hundred projects and after 1.5 years be no closer to producing a drug. How is the firm going to pay the coupon???? Furthermore, what if these one hundred projects fail to yield a blockbuster?? How are they going to pay the coupon in the first place, let alone return the capital!

Looking at the problem with an investor hat on, who is going to buy a C.Drug.O when it has the return profile of a bond with the risk profile of an equity? Why would an investor take on such risk if there is no reward at the end???? No 10x capital growth, simply a coupon that pays x% a year.

We must tread carefully here as this type of investment is not a typical investment. Because this research is for the benefit of mankind, it is difficult to class an investment of this nature as a simple bond. The payoff is not simply profit, but a huge positive externality along with the feeling that you personally have made a difference in peoples lives. As the Beatles sang

“Money Can’t Buy Me Love”

With this in mind, a CDO is definitely NOT an investable asset class, it would have more success as a charitable mechanism. Instead of your donations going to other worthwhile causes, you can donate to the drug fund with the knowledge you may help create a cure for a disease and maybe receive dividends back from your original donation.

Mr Lo of course will look at all these problems in an upcoming paper, which has yet to be published – I look forward to seeing how he tackles the many problems associated with his idea