Wednesday, May 26, 2010

Buy on Dip or Wait for Double Dip?

Major causes of recent dip

1) Greek crisis morphing into a European crisis
2) Fears of China over tightening
3) Investors think that new financial regulations are not well thought out and too harsh
4) European liquidity and counter party risks re-emerging

What we think, and would do
1) We think that while we should be ready for a double dip by buying some put options on existing important long positions,
2) And that the end of this period of risk aversion should be quick
3) Keep a close eye on the spread between the Overnight Indexed Swap rate and the 3-mth LIBOR which is an important measure of risk and liquidity levels in the market. A high spread indicates a decreased willingness to lend by major banks. Normal spread is approx 0.10% and has spiked up to 0.28% recently. During the 2007-2009 crisis, this indicator had spiked to a high of 3.64%. If you can read this email, you can keep a good track of it here:

Macro Strategy
Do you remember when it seemed so obvious to be long risk? Fed was on hold, inflation was low, and the economic data continued to improve. Goldilocks was back and 2010 was supposed to be a good year for risk and selling volatility.

Friends - fun has turned to tragedy. The Greek crisis morphed into a European one. China tightening fears are taking a toll on equity and property markets. Financial regulation is frightening investors to take cover in fox holes. One of worst memories of 2008 was the funding crisis reflected in the OIS-Libor spread. This is turning ugly once again. It is not so much about liquidity this time as it is about counterparty risk.

For investors the choice after the recent correction in risk is rather digital. Do you buy the dip or position for the double dip? The answer to that is rather simple. Do you believe ISM sinks to 45 and claims go back above 550k and the US in on the verge of a second recession in 2011? If not then this week is likely to be an inflection point for risk.

If risk bottoms out, safe haven bond markets are vulnerable. Maybe it is a tail risk or maybe it is not, but a meaningful bear market in bonds seems possible if the buy the dip thesis proves correct. The weakness of the buy the dip thesis is that it minimizes the downward negative spiral dynamic. Weak growth, declining sentiment, deflation, and deleveraging are all self-feeding leading to a possible second leg of the banking crisis. Markets are giving this some delta now, but the real concern is that when policymakers check their tool box, they will find it bare. Fiscal policy spent, rates near 0, QE does not work.
Mr. Macro is taking a straddle position here. The advice is to reduce but not totally eliminate double-dip hedges. Buy puts on the Reds as a way of having an option on potential normalization and a reduction of safe haven premium. If forced to decide what happens and forced to get off the fence, the most logical outcome is that the risk off phase ends rather sooner tha later. History tells us risk aversion events are quick, not prolonged. So if risk off ends, then normalization could begin as a theme for the summer. That does not mean that the double-dip is ruled out, but markets may want to wait for some evidence about the downside of ISM and Ifo and the outcome for US unemployment claims before fully embracing that thesis.

Whether the normalization trade proves correct could be as simple as understanding the dynamics of OIS-Libor. That is the most important barometer because of the implications for the cost and availability of credit more broadly to the economy.

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