From Quantitative to Qualitative Guidance

“Participants agreed that, with the unemployment rate approaching 6.5 percent, it would soon be appropriate for the Committee to change its forward guidance in order to provide information about its decisions regarding the federal funds rate after that threshold was crossed.” - January FOMC minutes

During the last few months/years, the unemployment rate in the US has come down significantly, now nearing the 6.5% mark that the FED said would be a threshold (not a trigger) to revise its monetary policy stance. Additionally, they have argued that even if the unemployment rate is the best SINGLE measure of the "healthiness" of the job market, it only shows a partial picture of the whole market. 

In the coming months, the FED will be twisting its language to incorporate a wider range of indicators to assess the improvement in the labor market conditions. Stealing this chart from the Quarterly Inflation Report of the BoE (Bank of England), we replicated the next chart using indicators for the US, where, as shown below, the general condition of the labor market has substantially improved in the last year. The chart shows the z-score of each indicator compared to its mean from 2000 to 2007. As we can see, all of the indicators have shown a meaningful improvement, except for the unemployment and underemployment rate, for which there is some evidence that a structural change is going through.

One of the indicators that I would like to highlight, is the wage growth during the last months. Even if the pace at which salaries are growing is still below historical norms, we are just about to experience a sustained pick up in the income for american workers that, unlike others, is going to have an effect in the inflation figures during the next several months. Everything points to a normalization of the monetary policy as the FED expects, and points a risk to a faster tightening in the monetary conditions compared to market expectations. The curve in the US should flatten again and the USD should recover its gains vs G5 currencies. Equity market seems to be the one that will trade in a range, for the next few months.

Go Big or Go Home - Long DXY at 80.10, Target: 82, stop @ 79.46

The DXY is sitting just above a big trendline coming from mid 2011, and given how worried the market is about a potential slowdown in the US economy (more likely it is just about weather effects), the risk reward looks attractive. On the other hand, EUR is more than 50% of the Index, and being the case that the ECB is very behind the curve, especially because medium-term inflation expectations have been coming down (5 year inflation swaps are trading at multi-years low), the currency should find a hard time breaking the 1.3800-50 level. Finally, positioning in the currency looks relatively clean, specially vs low yielding currencies (most of which are in the DXY).

I am targeting 82 as a possible level in the near-medium term, with a stop around 79.46 level. (almost 4:1 risk reward)

Volatility is finally moving

During the last few weeks, we have had some developments that have pushed volatility higher (as shown in VIX in the chart below) including the mini crisis in EM, deceleration in China, and doubts about the strenght of the recovery in the US. Even if it would be difficult to see volatility much higher, everything points to a season of bigger moves in all of the asset classes.

I would stay long USD vs EUR and CAD.

5 year Inflation swaps in the EZ touching multi-year lows

Inflation expectations measured by the 5 year inflation swaps in the EZ are at levels not seen since the burst of the 2008 financial crisis. Draghi has mentioned that Inflation Expectations are well anchored, and this chart suggest just the opposite. Should Draghi be worried?

Mexican Oil and the 2014 budget

In the last months, we have experienced a collapse in the K factor (figure 1), something that has driven the price of the Mexican crude mix near to the lows we saw during the summer of 2012 (figure 2). 

The collapse in the K is a result of the fall in prices of crudes with similar grades that are trading in multi-year low levels and that compete with the MAYA crude in the gulf coast (for instance, Canadian Crudes, figure 3). 

The problem with this is that the 2014 budget assumes an average price of 85 dollars per barrel, when the Mexican mix is currently trading just below the $90 mark. What make it worse, is that the K factor has been revised to around -7 this week, (-1.5 compared to last month), being this K the one that will be in place from December first until the last day of the month. So, caeteris paribus, the Mexican mix at the beginning of December will be 1.5 dollars lower. Even if the K should be revised higher in the future, a sharp fall in the price of crudes globally could put pressure on Mexico's public finance. Moreover, if this scenario does not materialize, it is highly probable that the average price of the Mexican mix will be very close to the budget's assumption, leaving no extra revenues for the following fiscal year.

US Beveridge curve

The Beveridge Curve, known as the line that relates unemployment and the job vacancy rates, has shifted upwards since 2010. What this means (and as we can see in the chart below), is that for any level of unemployment rate we now should expect a vacancy rate 0.5% greater than it used to be before the crisis.

What can be read from this move, is that unemployment has a bigger structural component compared with the market that we used to know in the pre-crisis world; i.e. the inefficiency in labor market is now greater given the mismatch between the openings and the people who are out there ready to get hired. From a policy maker perspective, this could mean that monetary policy has done most of the job it could have done, and that tapering may not be as bad as some people might think.

What markets should be wondering

Since the second quarter of this year, markets haven been speculating whether tapering will happen in September, October or any other month, and all the surveys are based on this discussion. Even if that is an important question, what we know is that the FED will be very cautious about the speed of tapering, so maybe the relevant question is how fast the FED is going to slow the pace at which they buy treasuries and MBS in the market, and how much time it will take to normalize the monetary stance. When QE1 and QE2 were announced, we knew in advance the beginning and the end of them, this time around we do not. What matters as well are the tweaks that the FED could do to its language, specially in its forward guidance (change in thresholds).

Probably the FED will taper in September, and not because they are very happy with the evolution of the economy. They will taper because even if inflation is running below historical standards, inflation in financial assets seems to be excessive in some cases,  as reflected in the last few months in the sell-off of some financial assets, such as gold, high yield currencies, EM assets, etc. They want to have enough time so the markets can digest the withdrawal of stimulus that eventually will come, but at the same time, they can not afford any policy mistake and they will try to smooth the transition to tighter monetary standards. The recovery in the US seems to be robust enough to be sustained, but at the same time, the global economy has suffered some structural changes that will not allow this recovery to be as fast as we would wish.

In terms of trading, my favorite strategy would be to take advantage of this environment where volatility and correlations are low but at the same time valuations seems to be still stretched in a variety of assets. Differentiation and relative value should continue to pay in the next few years.