Global macro on one page - May 2017

The Fed and other central banks are not that important in the current thinking of investors. The focus is not on the policy musings of bankers but the real economic data. All that matters is whether growth has a strong chance to be above trend and whether global DM inflation has a chance of reaching and sustaining 2%. We are skeptics of both occurring.

A strong growth trend will allow the current risk-on environment to continue. Inflation moving higher will reinforce more conservative or hawkish central banker views. The euphoria toward the reflation trade is coming back to reality and is likely to move more closely to the real data.  Growth may be stronger than last year but break-out trends in growth are unlikely even with strong PMI's signals.  Bond investors have stayed cautious about this risk-on world and falling oil prices signal weaker demand. 

There is a disconnect between equity and bond market views of the world. We do not intend to fight the risk-on sentiment and side with the more conservative bond view, but any risk-on overweight is modest in the current environment.

LME Discussion paper on market structure - what do investors want?

There does not have to be a long discussion on what investors want from a metals exchange or futures contract. Liquidity, liquidity, and liquidity. We use the word three times for each of the liquidity forms that attract trading. It does not matter if you are a hedger or speculator, the demand is the same; deep liquidity so the cost of transacting is low. 

• Liquidity from tight bid-ask spreads.
• Liquidity from low transaction, hedging, and processing costs.
• Liquidity from deep markets that will not move when size is entered.  

Liquidity just does not appear. It is a function of the structure surrounding the market. The rules of the game matter if you want to create liquidity, so the new discussion paper from the LME is provocative approach to open a discussion on market structure (LME Discussion Paper on Market Structure - April 2017). 

The paper is a description and justification of the current LME environment, but also a call for help from investors to ask what they may need for a better market structure. This paper may be the best description of the current LME structure, but it also clearly shows how it is out of step with other futures markets. The recent sale of the exchange for over $2 billion suggests that the buyers are looking for a return on their investment. They want to provide an exchange service, but they also want to make a profit.

When we talk about liquidity in context of three types, we are discussing three levels of costs. The bid-ask spread is the immediate cost of transacting in the market. There are also a set of costs which effect any transaction. We call this the structural costs. Finally, there is the implicit cost associated with deviations from fair value. Of these three costs, the structural costs associated with market mechanics is what can be controlled by an exchange. If the cost of trading on an exchange is minimized, the result will be deeper markets with lower bid-ask spreads. 

So what impacts the trading structure? For an exchange, we can explicitly focus on a few areas.
1. The contracts that are offered, the terms and conditions. For most exchange markets there are a limited number of futures contract expirations. The LME is different from other exchanges with how they offer contracts. The focus is on the hedger/producer and their business needs not the speculator who would like a more focused set of market contracts. The disperse set of LME contract expirations may limit liquidity. A three-month contract offered every week creates less liquidity if you try and sell before expiration. 
2. The margin system. Again, given the focus on producers, the system of margin payments are different with present valuing back to cash price and not the daily market to market process found in most other futures contracts. This has an impact on the actual cash outlay and the cost of trading at the LME, making it more expensive to be a short-term trader.
3. The actual prices charged for using the exchange. The cost of trading the LME is higher than other futures contracts. 

The drivers of market structure have been the ease for commercial users who price against the LME and not speculative account who can increase volume, The current contracts specs reduce the potential basis risk and allows for more direct hedging at the expense of volume. A move to more "standard" futures may help with speculative activity, but may harm hedger opportunities. It is a balancing act for any exchange but the LME wants to touch this issue directly through the engagement of all traders. This is an interesting experiment. We wish them well.

Commodity investing - what is it all about?

What is commodity investing all about:

1. The curves and carry - backwardation/contango (inventory). Given the cash market for commodities is often not available for investing, the primary market for investors in commodities is the futures. Consequently, the shape and dynamics of the futures curve is a dominant factor for longer-term investing. Investors cannot think of commodity prices in isolation, no different than an investor can think about bonds without looking at the current yield or equities without dividends. Carry in commodities is as important as any other asset class. This is the cash return on the investment and the premium from the roll of the futures to expiration. We can describe part of this carry as convenience yield or a risk premium, but the result or impact is the same as other carry markets. The holding of the future as it moves to expiration will have a major impact on return for both long and short investors.

Simply put, if the markets are in backwardation, the roll will work in the favor of the investor like a tailwind. If the market is in contango, there is a roll or carry headwind. The backwardation story is closely associated with inventories. If there are low inventories, there is a high convenience yield. There is also a premium for compensating speculators, but the economics of inventory convenience yield seems to have a strong economic rationale. Show me whether markets are in backwardation, and I can tell you whether long-only commodity investing will be profitable.

2. The cycle - The long-term cycle in commodities is driven by technology, production, and investment. In the long-run, technology will place downward pressure on real prices. A cycle is caused when low prices result in less investment in production, extraction, or infrastructure. A combination of low investment and low inventory makes commodity markets sensitive to any supply or demand shock which will generate a longer term surge in prices. These cycles will be related but not solely dependent on the business or financial cycle. These unique cycles create the asset class diversification that is attractive to investors.

3. The trend - Given inelastic demand and supply, a shock to demand or supply may have longer-term impacts on commodity markets. There are likely to be trends. The lower level of transparency as well as the non-profit maximizing behavior of hedgers will often result in commodity prices trending.

4. The shock - Commodity shocks can be looked through the short and long-run. The short-run is dominated by demand shocks and production, weather, or logistic shocks. The longer-term price is affected by expectations on production. The front-end of the futures curve is not closely linked with these longer-term prices. Front-end volatility can be higher because of these short-term shocks.  

5. The diversification - The asset class is called commodities as if there is a close relationship between all of the markets in the asset class. This is not the case. A key characteristic is that there is often low correlation between commodities that are bundled together. For example, even natural gas is not closely correlated with crude oil. Of course, correlations will change based on market shocks, but for most investors, there is little relationship between different commodity groups.

6. The size - Commodity markets relative to other asset classes are small, so the dynamics of hedgers and speculators or market participants matters. These markets are small relative to the market capitalization of many companies. Volume and open interest may be high given the active trading, but the production of many commodities may be low relative to what many investors may expect. Hence, the activities of indexers or specific hedgers and speculators may have a greater impact than what would be expected in other asset classes. 

It is not about:

1. The cash price for commodities - Following the cash price as an indication of what may happen to futures can be a loser's game. The curve dynamics may dominate return and the cash price is often a elusive concept in commodities. There are cash prices for specific grades and delivery but that is a far cry from a general price for a market.

2. Inflation hedges - The link between inflation and commodity prices is not always strong. In the current sub-2% inflation world, the correlation between commodities and inflation may not exist.

3. Large amounts of passive capital - The pre-FC period was make by large increases in commodity index activity. A combination of backwardated markets and a super-cycle allowed for large amount of funds to flow into indices. Some called this the financialization of the commodity markets which may have cause an increase in correlation with other asset classes. Money has flowed out of passive index products and it is not likely commodity markets will be able to handle this activity. 

If you are going to make a long-only commodity investment do it because have the right tailwinds to ensure that you will be compensated for risk. If you are an active long/short investor, make sure you know where your returns will be coming from.

VIX and what to expect - the odds against the big jump

The VIX index, the most widely watched measure of market volatility, is at extended lows with a jump lower after the French presidential first round election results. The uncertainty and risk premium from this election has been taken out of the market. Economic uncertainty has also fallen since the US election although it is still elevated since the earlier last fall. 

Is volatility a thing of the past? Well, it seems that way. We looked at close to 7000 daily quotes on the VIX since 1990 and found that current volatility is at the 1.45 percentile. It is low. These low values do not last, but any strategy that needs a spread in the distribution will not do well during these periods. 

It should be noted from the QQ plot and the box plot that the distribution of volatility is far from normal. So even though volatility is low, the weight of the distribution is skewed to values below 20. This is not a normal distribution but one with significant positive skew.

The question in not whether the VIX will change, but rather how long will the low volatility persist. The policy uncertainty index has fallen since the Brexit and election highs over the last year, but it is not at significant lows. The latest GDP numbers for the first quarter are lower than expected. Lower end economic performance usually is associated with higher volatility.

Given the distribution of VIX prices, a comparison of toady's level versus the level in a month or two would not be helpful. Mean reversion will occur; nevertheless, the extent of the move may be limited given the clustering of low VIX values. There is a 32% chance of the VIX being below 15; a 50% chance below 18; and a 62% chance below 20.

The big move event is not likely if you are playing the odds. The numbers shows that upside jumps in the VIX are more likely than downside spikes. There is nothing usual with this behavior, but over any twenty day periods, there is only a 5% chance of jumping by more than 7 vol points and only a 4.75% chance of seeing a 40% or better up move over any 20-day period. Anyone expecting a big vol jump on mean reversion will be disappointed. This would still mean a vol that is less than 20 in the next month even if we had a significant spike.

We are not saying to accept low vol as a part of everyday life, but a return to anything like behavior during the Financial Crisis is unlikely.