10-Yr Swap Spreads hit their lowest level since 1988 on 3/9/10 hitting 3.25.  How many more days until they go negative? (Click on chart to enlarge)

10-Yr Swap Spread

Go short Treasuries, its the most obvious trade ever right?  While they might go up or down the MOVE Index continues to forecast less and less volatility, which at least to us indicates that the market is not expecting yields to change a whole lot anytime soon. (Click on chart to enlarge)

MOVE Index

Not sure if Chanos is right on China being in a huge bubble, but looking at the chart it appears as though at least a few investors are less than bullish. (Click on chart to enlarge)

FXI China ETF

We just crossed the one year anniversary of the current rally/bull market the other day.  Over that time on a weekly closing basis the SP500 is up over 66%.  This has been the largest one year rally in over 60 years.  We are starting to hedge our long exposure as we are currently cautiously bullish. (Click on chart to enlarge)

SP500 1-Yr Rolling Returns

Back in December we shorted the Euro on the basis of the EU being weak, overvalued, and sentiment becoming far too one sided.  In these pages we also looked at buying the USD on a technical basis. Looking at the USD and T-Bills however shows another reason for the USD rally. (Click on chart to enlarge)

US Dollar and T-Bill Yield

Happy Trading,

Dave@TheMacroTrader.com

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We run several different models that help us to determine what the market is favoring in regards to style-growth/value and size-market cap and right now they are pointing to a potential mean reversion trade going long Large Cap Value against Small Cap Growth.

Looking at the chart below you can see that over essentially the last decade the Russell 1000 Value and Russell 2000 Growth ratio has reached extremes around 1.00 and .82.  We are obviously nearing the lower end of the range where the Russell 1000 Value index typically takes over. (Click on chart to enlarge)

Russell 1000 Value/Russell 1000 Growth ETF Ratio

Since these types of mean reversion trades can last for a few years at a time it is important to look at as much data as possible.  Looking at monthly Russell data from 1979 to now you can see in the lower panel below that when normalized using a 36 month moving average that the ratio is more than one standard deviation away from the norm.  While it has been, and could definitely become more extended we are looking at this as a potential pairs trade using the ETF’s IWD for the Russell 1000 Value and IWO for the Russell 2000 Growth indexes. (Click on chart to enlarge)

R1KV/R2KG Ratio and Mean Reversion Charts

We also like the fundamentals of this trade.  If as we believe we are going to see what we are calling a slowth (slow growth) period for at least the next year or so and possibly for the next five plus years (what PIMCO calls the “new normal”) it would follow that the market would start to back out of small cap growth stocks and go to areas where there is more safety of principal as well as decent and reliable dividends.   This area typically is large cap value where most of the companies are diversified across the globe, across product lines, and have large cash positions.  In addition to the macro landscape, on a valuation/expected returns standpoint this area is also favored by some well known asset class return forecasts such as the GMO 7-Yr forecast seen in the chart below. (Click on chart to enlarge)

GMO 7-Yr Forecasts for US Stocks

Disclaimer-The Macro Trader currently does not hold any of these securities.

Happy Trading,

Dave@TheMacroTrader.com

After a 72% move higher in the SP500 a lot of bears are saying that the market has gone far enough and that we are due for a new crash that will take us back to and in some cases past the lows of 2008.  While a crash is possible and probably justified we are instead looking for something along the lines of a modest pullback to maybe a 10% correction.

One of our favorite sentiment indicators is that of put/call ratios.  We use the 5-day equity only put call ratio to warn of high risk areas and to point our low risk areas.  As you can see in the chart below we are currently at a reading of .51 which is not only below out “high risk” threshold but is also the lowest reading in over a year.  While the signal could be wrong it is hard to argue that options traders are not overly one sided right now.

5-Day Equity Put/Call Ratio and SP500

In case you want to see more bearish sentiment look no further than the 10-day total put/call ratio.  Anything below .75 is typically considered very bearish and right now we have a reading of .68 which is the lowest reading in two years.  Needless to say this indicator is also showing that option traders are too bullish.

10-Day Total Put/Call Ratio and SP500

One price based indicator that we use at The Macro Trader fairly extensively is what we call a reversion to the mean chart.  Basically it takes a long term reading of the market, normalizes it, and then gives an overbought/oversold reading.  We then plot one and two standard deviation lines above and below the mean.  As you an see in the chart below we are about 1.5 standard deviations above the mean which is significantly higher than we saw for most of the 2002-2007 bull market suggesting that things are a bit overdone.

SP500 RTM Chart

Add to all of this a TD Sequential sell signal a few day ago and how near we are to a 50% retracement of the crash and things look less like a buying opportunity and more like a selling/shorting opportunity.  Again we are not calling for a new low, just a pullback/correction.

Happy Trading,

Dave@TheMacroTrader.com

Disclaimer-The Macro Trader is short the SPY-Sp500 ETF

Since the start of our newsletter we have been using a relative strength table that looked at Fidelity Select Sector Funds to show what industry groups are leading and which groups are lagging.  The relative strength calculation is similar to the style used by Bill Oneil and IBD but is slightly shorter term in nature. We used the Fido Funds due the their price history and breadth of different groups.  Now that there are not only enough different industry group ETF’s, but also the needed price history we have revamped the model to use ETF’s instead.

We publish one list for United States industry groups and one that is focused on global ETF’s with several country and a few sector specific ETF’s.  These tables are valuable in a few ways.  One is that we have developed a trading model based upon them that uses the rankings along with buy, sell, and money management rules.  Over time this model has beaten the market with far less risk.  The other way that these tables are useful is that they show you what is strong and what is weak.

While this concept is not rocket science we are consistently surprised how little attention it is given by other traders.  By using relative strength we can see what is really working and where investors are going.  Many times the supposed “hot sector” is not really that hot.  By looking at the tables we can see what is really working and what is not.  For instance looking at the Global RS Ranking table below you can see the leaders and the laggards.  While it is no surprise that Brazil is at the top when was the last time you saw someone on CNBC telling you to buy Indonesia or Turkey?  Yeah we missed that segment as well. (click on table twice to enlarge)

Global RS Rankings

Right now this table is confirming to us that for the most part developed nations are weak and should be sold and that emerging markets are strong and should be bought.  No, this is not the first or the only tool that told us this same thing but it is one way in which we can systematically be long the best areas of the world and short the worst areas of the world.  It also gives us a road map of where investors are putting their money and where they are withdrawing it.

Another point worth noting is that while we are starting to run this as a “standalone system,” the system represents only a part of our portfolio.  In our trading and our newsletter model portfolio we use several different methods in order to build a less correlated portfolio trading across asset classes.

Happy Trading,

Dave@TheMacroTrader.com

Disclaimer-We are long EWZ-Brazil, EWT-Taiwan, and EWM-Malaysia

If you’re getting value out of our posts, you can do us a favor by linking to us and mentioning The Macro Trader to friends and co-workers. Here’s the link information for this article:
Title: Macro Trading Using Relative Stength
URL: http://www.themacrotrader.com/2009/11/10/macro-trading-relative-strength/

If over the past six months or so it has seemed as if you were partying like it was 1999 it might be time to reevaluate your stance.  One thing that we have been taking a closer look at lately is the pricing of risk.  Obviously when investors think that risks are low they will demonstrate risk seeking behavior.  We have seen this as the SP500 has climbed 56.6% from the March lows to the highs on 8/28/09.  With a rise like that you would think that 2008 never happened, of course if you believe that then you also believe  in a land of make believe with money trees, the fountain of youth, and SI models for all of us.

Of course some investors counter saying that while things could be better we are seeing the beginning of a recovery.  They then say that while the market will likely climb slower, that it will still climb higher.

While the above scenario is possible, anything is possible.  The more important question is to decide if the rewards outweigh the risk involved in being long equities right now.  Or even if at this point the better risk reward trade is to the downside.

Lets look at a few “risk gauges” or “fear indexes” as the press likes to call volatility indexes.  The first is of course the VIX.  After spiking to all time highs in October and November of 2008 we are already well on our way towards what was considered a “normal” level back in early 2008 before Bear Stearns.  The potential risks were obviously very mispriced at the beginning of 2008, are they mispriced again?  While likely not as off as they were at the beginning of 2008 we still think that there are a lot more real and potential risks then the market is currently pricing in. (Click on chart to enlarge)

SP500 VIX

What about foreign markets?  How do investors perceive the potential risks abroad?  Well if the VDAX is any gauge then investors see a rosy future in Europe as well.  Again maybe there are no big risks and maybe the EU is rock solid.  Then again maybe not.  With the complete lack of liquidity that businesses have had over the past several months in the EU it is really surprising that the VDAX is back to pre-crisis levels. (Click on chart to enlarge)

German DAX VIX

What about other asset classes?  What are investors saying about potential risks?  Using the MOVE Index which measures the range in which Treasury yields are expected to move over the next 12-months we can see that even here investors are becoming increasingly complacent.  What happened to the runaway inflation that we keep hearing is right around the corner?  Right now the market is saying that we will be in a 130 basis point range for the next 12-months. In The Macro Trader weekly newsletter we are long the TLT 20+ Year Treasury ETF and are expecting a bigger move then is currently implied via the MOVE index. (Click on chart to enlarge)

MOVE Index

Even in the currency markets we are seeing extreme complacency.  Apparently investors the world over are back to selling dollars in exchange for anything.  While the USD has its issues other currencies do to.  Right now the currency markets are not participating in the Keynes beauty pageant where you are trying to pick the girl that you think the judges will think is the beautiful.  No, with the current state of the global economy we are in the least ugly pig contest where we are only trying to find the least ugly.  That being said investors do not appear to see a lot of volatility any time soon. (Click on chart to enlarge)

JPM G-7 VIX

Even the emerging market currency volatility index is showing complacency. What happened to the banking issues in Eastern Europe? Apparently they vanished, or at least that is what it seems as though the market is telling us.  (Click on chart to enlarge)

JPM Emerging Market FX VIX

Even commodities markets are pricing in realtively low risk. While the price history of the Crude Oil and Gold volatility indexes does not go back as far as we would like, you can get a feel for what is happening as both indexes are dropping at a very steady rate.  Do investors really think that volatility will stay that low?  What happened to the oil spike if demand comes back?  And what happens if gold breaks $1000 on fears of hyper inflation?  (Click on charts to enlarge)

Crude Oil VIX

Gold VIX

Another excellent tool to evaluate the blind risk taking happening right now in the stock market is the JunkDEX invented by Bill Luby over at VIX and More.  By taking an equal weighting of junk stocks AIG, FNM, C, CIT, and BAC you can see how crazy or composed investors are acting. While we have seen, and actually use, an index of high momentum stocks we had never thought of making an index that tracks junk stocks to gauge investors risk appetite.

As you can see in the chart of the JunkDEX below the junk led the market off the bottom and then lagged until the last month when the index shot up +157.36% in a little over a month.  While it has pulled back over the last two days we are still in awe that investors are dumb enough to buy this junk at these prices. (Click on chart to enlarge)

VIX and More JunkDEX* vs SP500

After looking at all of this we need to ask ourselves if the rewards outweigh the risk to stay long?  Or if we should be flat or short.  In case you have not guessed we currently think that the risk reward is pointing to the downside.

Looking at the QQQQ we have a setup with a solid risk to reward situation. As you can see in the chart below the QQQQ has rallied back to its 50% retracement level, its 200-week moving average, and its downtrend line extending from October 2007.  While it could of course rally higher we like the risk reward enough to have put on a modest short position in our weekly Macro Trader newsletter. (Click on chart to enlarge)

QQQQ-NASDAQ 100 ETF

While not quite as nice of a setup as the NASDAQ 100, the SP500 also looks like a solid risk reward trade to the short side.  As you can see in the chart below of the SPY-SP500 ETF it has rallied up to the upper Bollinger Band and has already started to come back in.  We are looking for a move back to at least the $95-96 area. (Click on chart to enlarge)

SPY SP500 ETF

Obviously anything can happen.  The market could go up every day for the next year, or it could go down every day, but our job as traders is to look for the best risk to reward scenarios that we can find and place trades on probable scenarios and right now we think the most likely scenario is for the market to at least have a pullback if not a correction back towards its 200-day moving average.  Of course if this happens we will see the volatility indexes tick upwards to more realistic levels given our current economic environment.

*Our JunkDEX differs a bit from the one you can see at VIX and More.  After looking into it we found that  we built the index by simulating a $1000 investment in the index and in the SPY and Bill built it by normalizing the index starting value so we have slightly different values.  But don’t worry as the chart looks essentially the same and shows the same investor insanity.

Happy Trading,

Dave@TheMacroTrader.com

Disclaimer-In The Macro Trader newsletter as well as our accounts we are currently short some QQQQ-NASDAQ 100 ETF and long some TLT 20+ Year Treasury ETF.

If you’re getting value out of our posts, you can do us a favor by linking to us and mentioning The Macro Trader to friends and co-workers. Here’s the link information for this article:
Title: Volatility Indexes, Risk Appetite, Mispriced Risk, And Where We Think We Are Headed
URL: http://www.themacrotrader.com/2009/09/02/mispriced-risk-macro-trader

We decided that it was worth sharing our views of the inflation/deflation debate with all of our readers.  In our weekly newsletter we are already positioned to take advantage of some of the current as well as potential trends that will benefit from our scenario.

The following are our views on different parts of the puzzle that show that we are currently in, and will likely be experiencing deflation for longer then most people seem to think.

Savings-

Here are some interesting, and unfortunately not surprising, savings rate numbers.  The current savings rate is 5.7%, the all time high in 5/1/75 was 14.6%, the all time low was in 8/1/05 with a savings rate of -2.7%, the historical average is 6.8%, and the 10-Year average is 1.7%.  As you can see in the chart the past year has seen a huge uptick in the savings rate as consumers are trying to pay off debt and save some money.

Personal Saving Rate

Of course as savings go up spending goes down.  While this is good for the individual household it is a negative for the overall economy as it means less money is being spent on items from housing to cars to clothes.  While this could just be an abnormal blip in the scheme of things there are several reasons to think that this time the trend will hold for a while.

Baby boomers as a group don’t have anywhere near the funds to retire.  After 2008 wiped out 42% of the worlds wealth they should be scared and saving for their rapidly approaching retirements.  Once the economy starts to pick up they may very well start spending like it was 1999 again but we don’t think that they will because while most people are ok with the idea of working a bit past the age of 65, they do not plan on working into their 80’s and 90’s.

If the savings rate gets back up to the historical average of 6.8% or higher and then stays there for a while, it will be a huge drag on the economy. As consumers buy less and less, pricing will likely come down.  We are already seeing this in the form of huge sales in stores across the nation.  Many retailers have already had several markdown sales and it is safe to assume that this trend will continue for at least the next year or so.  If our projections are right and the savings rate gets back to “normal” we will likely see a re-pricing as most businesses just accept that fact that their profit margins will be smaller going forward.

Housing-

The monthly proclamations of a bottom by the NAR notwithstanding we have yet to see anything resembling a bottom in real estate. The Case Shiller 10-City index is down 33% from its peak and the 20-City index is down 32%.  Both charts look the same, which is to say each month is lower then the last month.  So far there has been no bottom.

Case Shiller 10-City Index

Not surprisingly housing sales numbers don’t look much better.  In spite of the monthly bottom calling we continue to see more new lows every few months.  As you can see in the chart below we are just off of new all time lows since the data series started in 1963.

SA Housing Sales

Zooming in a bit you can see that while we have had several blips over the last few years none of them have lasted for more then a few months and all have led to new lows. Our best guess is that we are headed lower in the next few months.

SA Housing Sales-A Closer Look

As if residential housing was not enough, the commercial real estate market is playing catch up.  Residential peaked in June 2006 and commercial held up until October of 2007.  Since October of last year however commercial has made a valiant effort to catch up and is now down -29.48% since then.  In fact from March to April alone it dropped -8.62%.  If real estate has found at bottom it is keeping its location secret because none of the data that we have seen points to it.

Moody’s REAL Commercial Property Price Index Composite(CPPI)

Of course you may be thinking that there has to be some commercial real estate that has found a bottom.  This may be the case on a geographic basis but it is definitely not the case when it comes to segments of the commercial market.  As you can see in the chart below industrial is the strongest part of the market and yet it is still down -14.26% from its highs.  Apartments are next being down -19.01%, followed by retail which is down -23.11%, and finally office space which is down a whopping -30.22%.  Judging by the massive drop this last quarter it is safe to assume that we have a ways to go before we really hit the bottom.

Moody’s REAL Commercial Property Price Indices

Employment-

In case you haven’t noticed employment has been horrible and getting worse.  One of the newest “in indicators” is the exhaustion rate.  While this indicator is not new it has luckily not garnered much attention over the years because it only gives a real signal once or twice a decade.  The exhaustion rate is the rate at which people come off, or exhaust, their unemployment benefits without having securing a job.  Why is this the “it indicator” right now?  Well if you look at the chart below you can see that we are not only at all time highs but are actually at 49.23%.  Yes, that means that almost half of the unemployed are done receiving unemployment money.  That of course leads to even less money to spend on anything.

Exhaustion Rate

After looking at the exhaustion rate chart it should come as now surprise that unemployment is high.  In fact it is at its second highest level ever at 9.4%.  As bad as unemployment is right now, it is going to get worse before it gets better.  We will likely hit at least 11% ,and we would not be surprised to see 12-14% unemployment before jobs data bottoms out.

Unemployment Rate

At this point it should not be much of a surprise but as you can see in the chart below, average weekly hours and non farm payrolls data are also both declining on a year over year basis.

Average Weekly Hours and Non Farm Payrolls

So how does all of this effect deflation?  If people are not working then they are not able to spend as much on consumer goods and services.  That includes clothing, food, entertainment, transportation, etc.  If they stay unemployed long enough and fall off of their unemployment benefits then they are able to spend even less.  Along with the lack of, or at least severely impaired, spending power there is a host of other side effects, which includes everything from defaulting on credit cards to defaulting on their mortgages.  As consumers spend less, businesses have to lay off more employees as sales drop off and margins are squeezed with exacerbates the situation.  One consistent relationship is that of the unemployment rate and capacity utilization.  As unemployment rises, capacity utilization drops as demand falls out.

Unemployment and Capacity Utilization (inverted)

If there is no demand then there is no spending.  If no one is spending then there can be no inflation.  If things are contracting then we are in deflation.  One more indicator that shows this is that of the output gap. The output gap is the difference between the amount that we can produce and the amount that we are currently producing.  In the chart below a positive number indicates under-utilization, and negative numbers reflect over-utilization.  If the line is rising things are getting worse and if it is declining things are improving.  As you can see the line has risen quite a bit and at least for now is showing no signs of turning around.  The output gap is a good indication of available demand.  As you can see. the output gap is bad and getting worse as demand continues to decline.

5-Year Output Gap

Banking-

While we could go on and on about banking we will try and keep it short.  Most people are pointing to the charts from the Fed on bank reserves and saying that they will cause hyper inflation.  Yes, the monetary base is at historic highs but guess what?  Until that money is actually in circulation it does not cause inflation.  You can print ten quadrillion dollars but if you bury it in a hole then it does not cause inflation.

Look at the chart below of the Adjusted Reserves.  As you can see it is at record high levels.  While it is extremely high it is not in circulation yet and likely will not make it to consumers for some time.

Adjusted Reserves

This number is extremely high due to all of the money that has been printed over the past year in response to the financial crisis.  But the inflationistas are missing one important point, namely that until banks have rebuilt their reserves they will not be lending.  As long as residential and commercial mortgage defaults continue banks will continue to rebuild their balance sheets.  Once they have a stable asset base they will start lending and we will likely see some really high inflation but until then we will be in a deflationary environment as the money is not being put into circulation.

Commodities-

Commodities are another reason that many use to justify their inflation arguments.  After having a good bull market from the end of 2002 until fall of 2007, they took off and got a bit parabolic for the first half of 2008 before crashing and coming back to levels not seen since 2002. Of course as anyone who has filled up their gas tank knows, commodities have started to climb once again moving from 200 up to 250 from the March lows.

Commodity Research Bureau Index

The rise has been widespread with energy, base metals, agriculturals, and even precious metals rising considerably.  Aside from precious metals it appears as though the primary reason that we had such a strong rebound was due to buying out of China.  In the first two quarters of the year the Chinese government decided to use some of their surplus to buy raw materials.  They bought a lot of copper, secured oil contracts, and stocked up on everything else.  Now it appears as though their buying is slowing to a trickle of what it was and with the run up in prices they are taking a break as they will likely get to buy more at lower levels.

While the buying out of China may help commodities put in a bottom, it does not appear as though it will drive them much higher.  With the possible exceptions of precious metals and energy we see most commodities turning in flat to slightly negative results for the rest of the year.  With the demand destruction that we have seen over the past year commodities have a tough road ahead of them before they will be able to climb higher.

Deflation-

So where does all this leave us?  Demand has been absolutely crushed on several fronts:  People are finally saving and paying down debt instead of spending.  Real estate is still falling, and with inventories as high as they are, will likely not fully recover for years.  Employment is as bad as at any time in the Post WW2 era.  Banks are still impaired and unable/scared to lend.  And with all this demand destruction commodities are unlikely to continue upwards for a while.

Finally there is the matter that while we can speculate on inflation we are currently in deflation as can be seen in the chart below of the CPI.  We have officially been in deflation for the last three months and while it might slowdown a bit we will likely stay in a deflationary environment for longer then most people think.

CPI-YoY % Change 1922-Now

What are we doing?

So if we believe that we are in deflation what do we do about it?  The best deflation trade that we have found is to be long bonds.  As we stated in our last blog post as well as the last few newsletter we are long TLT-20+ Year Treasury Bond ETF.  Not only are we in deflation but the trade was decent on its own merits.

Real yields on Treasury bonds at the end of May were at their highest levels since February 1995 and right now they are at 4.76% for the 10-Year and 5.58% for the 30-Year.  In an environment where we expect most assets to fall or go nowhere, we think that Treasury Bonds offer good value.

10-Year Treasury Bond Real Yield

Treasury bonds got almost as oversold recently as they were overbought back at the end of 2008.  By normalizing the trend using a 200-day moving average we build reversion to the mean charts that show how far above or below securities are from their mean.  In the case of the long bond our charts showed that it was extremely oversold and that it was a good time to start building a position.

TYX-30-Year Treasury Bond Yield Reversion to the Mean Chart

Looking at the chart of the TLT we could see it running up into the 100-105 range over the next month or two as investors take advantage of deflation, the oversold conditions, and the favorable real yield.

TLT 20+ Year Treasury ETF

While the long bond is definitely our favorite deflation trade, it also makes some sense to go long the US Dollar and/or the Japanese Yen as investors flock towards safety.  Other trades would be to short stocks and short commodities in anticipation of them falling as demand continues to decline and margins shrink.

And what about inflation?  We actually do believe that eventually all of this printed money will lead to some hefty inflation but right now we are in deflation.   Additionally the inflation trade is  the most overcrowded and one sided trade in the financial markets right now.  If we are right we will do well, and with the aid of risk management if we are wrong we will be stopped out for a small loss.

Happy Trading,

The Macro Trader

Dave@TheMacroTrader.com

Disclaimer-We currently hold positions in TLT

If you’re getting value out of our posts, you can do us a favor by linking to us and mentioning The Macro Trader to friends and co-workers. Here’s the link information for this article:
Title: Deflation And What We Are Doing About It
URL: http://www.themacrotrader.com/2009/06/27/deflation-and-what-we-are-doing-about-it/

In our ETF based newsletter, the carry trade is one of the strategies that we employ.  For those unfamiliar with the carry trade, you are essentially trading the interest rate differentials of different countries.  You short a low-yielding currency and go  long a higher-yielding currency.

You can make money in two ways.  You earn the “carry” if the currencies remain very stable, and neither move.  You can also make money in this trade by being correct in the direction.  For instance if you are short the Japanese Yen and long the Australian dollar, then you can also make money if the Australian dollar goes up, and the Yen goes down.

As an example of how to earn the carry, lets look at the Japanese Yen versus the Australian Dollar.  The Yen has been the carry trade vehicle of choice for much of the past decade because Japan has consistently had extremely low interest rates.  Australia, on the other hand, has had relatively high rates over the last decade.

To construct the differential for this trade, take one rate and subtract the other rate. In the chart below, we plot the difference between the AUD and the Yen since the beginning of 2007.  As you can see, at one point the carry was as high as 7.34, but it has since declined to 2.69.  If you had been long the AUD and short the Yen, you would have earned this interest rate differential the whole time.

AUD-JPY Interest Rate Differential

Of course as we already mentioned, in order to make money on the carry trade, your long must outperform or stay flat relative to your short position in order to make money since a big directional move against you will wipe away any gains that you would be making solely off the carry.

There have been several academic studies as well as real world trading results that show that volatility is the biggest risk that the carry trade faces.  Over the years, most studies were stuck using the SP500 VIX as a proxy for global financial market volatility.  While it correlates quite well, there are now some far better options to help track and manage risk in the currency markets.  We at The Macro Trader use the JP Morgan G-7 VIX index for our carry trading model as it correlates extremely well to the volatility in the DBV-Currency Harvest Trust ETF.

What we first found in the academic literature, later confirmed by our own testing and used successfully in our trading, was that when volatility in the currency markets is flat or declining, the carry trade works very well.  On the other hand, when currency volatility is high, the carry trade typically is a money loser because the directional aspect of the trade overwhelms the carry, giving you a loss.

We look at the JP Morgan G-7 VIX using two different charts.  The first one is a reversion to the mean chart where plot the VIX data, the historic mean, then one and two standard deviations above and below the mean.  When volatility is high and then falls below one standard deviation, we start looking to enter the carry trade and when it get above the one standard deviation line we would sell if not already stopped out.  On the downside, we look to sell when volatility declines too much since it represents excessive complacency and usually is a sign of higher volatility ahead.

JP Morgan G-7 VIX

The other way that we like to look at the currency VIX is to invert it on a chart alongside the DBV. As you can see in the below chart, not only was equity volatility declining, but DBV managed to base for a few months before climbing higher and then consolidating at its 200-day moving average.  Finally today it was able to break out to the upside.

DBV and JPM G-7 VIX

Finally we have the DBV itself.  As you can see in the chart below, not only was equity volatility declining, but DBV managed to base for a few months before climbing higher and then consolidating at its 200-day moving average.  Finally today it broke out to the upside.

DBV-Carry Trade ETF

Hopefully you see how volatility is bad for a lazy trade like the carry trade where you trying to get paid for sitting.  If volatility climbs above 1 standard deviation above its mean we will look to tighten our stops as the odds of a downside move increase significantly.

DBV-G-10 Currency Harvest Fund is an ETF that goes long the three highest yielding currencies of the G-10 and shorts the three lowest yielding currencies on a 2x levered basis.  While investors can go into the spot and futures FX markets and put on the same trade the DBV is a very simple way to gain exposure to positive carry in the currency markets.

Happy Trading,

Dave@TheMacroTrader.com

http://TheMacroTrader.com

Disclaimer-We currently hold positions in the DBV-G10 Currency Harvest Fund and FXA-Australian Dollar ETF.

If you’re getting value out of our posts, you can do us a favor by linking to us and mentioning The Macro Trader to friends and co-workers. Here’s the link information for this article:
Title: The Carry Trade And Volatility
URL: http://www.themacrotrader.com/2009/06/01/the-carry-trade-and-volatility/

For the first few months of the year West Texas Crude Oil was in an extreme contango situation.  In fact it got as high as 20% just four months out.  Looking at the 4-month contango/backwardization  in West Texas Crude Oil we can see that in just the past seven weeks it has dropped from over 15% to just 3.2%.

West Texas Crude 4-Month Contango/Backwardization

Most of the narrowing has happened in the near month futures, since over the past seven weeks the near month has rallied  27% and the 4th month only 14%.

Obviously the big question should be is demand really picking up? If so Oil should rise fairly quickly as we continue to see declining production as well as a decline in the ability to produce via the drop in rig counts over the last eight months.

Or is this a short term rise based on the notion that the economy is improving and this is just an extension of the risk trade?  If so then oil is to be shorted as are many other commodities as the reflation trade is put on hold.

We try not to fight the market and right now it is obviously in bull mode as it has moved up 75% from its lows.  That being said we tend to listen to the signals from economic indicators like capacity utilization, unemployment, and Fed minutes that show anything but an economic recovery.

West Texas Crude Oil

For now the trend is up and we are modestly bullish (that means we are flat) bulls.   However over the next few months we would not be surprised at all to be changing our view to the bear side and going short as the lack of demand likely overtakes these sorry excuses for green shoots and the economy, and therefore demand, roll over.

Happy Trading,

Dave@TheMacroTrader.com

Site Updates- Yesterday we installed Disqus to better  interact with our blog readers.  We welcome your views on energy, the economy, and any other financial topic.

One of our current positions is EWY the South Korean ETF. We went long a few weeks ago in our model portfolio based on the trend, valuation, and economic characteristics of South Korean stocks.

EWY-South Korea ETF

Another factor that got us into EWY was the increasing number of Asian countries that have been coming up in our global stock model.  Our global stock model looks at technical, economic, fundamental, and sentiment indicators to help find foreign stock indexes that meet our risk to reward criteria.

Apparently we are not the only ones to have found an opportunity in South Korea as the Oracle himself WarrenB apparently is getting long some South Korean stocks as well.

In order to catch our trades in foreign stocks as well as other asset classes like US stocks, bonds, currencies, and  commodities then sign up for a quarterly or annual subscription to The Macro Trader weekly newsletter with frequent intra-week updates.

Happy Trading,

Dave@TheMacroTrader.com

We track hundreds of different economic, fundamental, technical, sentiment, and cycle indicators.  Some are stand alone and only help us discern particular situations while others are full blown timing models that we use to get in and out of the market.  Some are very complex with ten and even twenty inputs ranging from jobless claims, to put call ratios, to nickel, to the advance decline line.  Essentially anything that we test that helps to give us an edge we use to some degree or other.  As global macro traders we of course have several models for every market that we trade, as well as models that only point us to markets showing abnormal movement.

As of a few days ago we had one of our longer term SP500 timing models trigger a buy signal.  This timing model is very simple and only uses the NYSE Advance Decline line and the SP500 closing price.  This models esge is not huge but it is solid and historically you are risking about 1:1 meaning that the historical return is almost the same as the worst historical drawdown.

In our macrotrader.com/subscribe/”title=”Macro Trader Newsletter” >newsletter and in our own trading we rarely use a model as an automatic buy or sell signal but we do use them to tell us which dorection to trade.  Right now this extremely simple model is showing that the advance delcine line has finally been able to have a sustained run and break above its long term trend, in this case the 150-day moving average.  Again we don’t, and don’t recommend, trading directly off of these signals as almost every model we track can be improved upon by selecting better entry and exit points but they do helo us tremendously in our trading.

SP500-NYSE Advance Decline Line

As you can guess we are becoming increasingly bullish after being bearish for the better part of two years.  Who knows if this rally will continue as there are a ton, and maybe a trillion tons, of harsh economic realities and hardships, but for now the trend is up and we are starting to lean to the long side.

Happy Trading,

Dave@TheMacroTrader.com

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