In what, for the past seven years, has been an upside-down investing world where the opposite of what financial and economic theory – and certainly consensus – suggests should happens with centrally-planned regularity, what better trading recommendation list than one focusing on the “Costanza Trades” for the year ahead.
Conveniently, that’s what RBC’s Mark Orsley has put together, so for those who know what the right trade is, and need just that little bit of confidence push to do the opposite, here it is…
2017 Costanza Trades
It’s that time of year. Candy canes, holiday lights, and your inbox’s are surely cluttered with 2017 “Year Ahead” pieces. I find it hard enough to accurately prognosticate just a week or two out in these markets so I find it amazing bank research teams can predict what’s going to happen over the next 12 months. However, these pieces are useful in some regards as they are very good at nailing the consensus themes and are excellent counter indicators. For example, a well-known, large investment bank across the street from us had 5 of their 6 “Top Trades of 2016” stopped out in the first month of the year. Yikes.
Long time readers will know The Macro Scan takes another twist at year end to present next year’s top “Costanza Trades.” For those of you not familiar with George Costanza, his character on the sitcom Seinfeld could do no right when it came to employment, dating, and life in general. In one episode, George realizes over lunch at the diner with Jerry that if every instinct he has is wrong; then doing the opposite must be right. George then resolves to start doing the complete opposite of what he would do normally. He orders the opposite of his normal lunch, and he introduces himself to a beautiful woman that he normally would never have the nerve to talk to and says, “My name is George. I’m unemployed, and I live with my parents.” To his surprise, she is impressed with his honesty and agrees to date him!
I find employing the Costanza method to trading an interesting exercise. Ask yourself; what are the trades that make complete sense and all your instincts say are right, and then do the opposite. Basically what you end up constructing is an out of consensus portfolio and we all know how consensus trades work out in this market.
Employing the Costanza method can identify interesting, non-consensus trade ideas that could kick in alpha.
Last year’s list of the top 10 Costanza trades produced 7 winners:
Last year’s Costanza trades:
- 1) Short Euro Stoxx: small winner (-30bps, was down as much as 18% this year)
- 2) Long S&P’s: winner (+12%)
- 3) Short Dol/Yen: winner (-2.5%, was down as much as 17%)
- 4) Long Euro: X loser (-4%)
- 5) Short Euribors: X loser (+11bps)
- 6) Long Eurodollars: X loser (-17bps)
- 7) Long Oil: big winner (+41%)
- 8) Long Copper winner (+18%)
- 9) Long High Yield winner (+7%)
- 10) Long EEM winner (+9%)
I can’t tell you how bad those ideas looked at the end of last year but it came through with an amazing 70% hit ratio! Costanza was on to something so without further ado, here are the 2017 Costanza trades in no particular order, or the trades that all your instincts are probably saying are wrong:
2017 Costanza Trades:
- Short S&P’s
- Long UST’s/front end flatteners/short Breakevens (all really the same idea)
- Long EURUSD
- Short USDJPY
- Short USDCNY
- Long Gold
- Short Oil
Let’s go through each and assess the probabilities of the trade working (probabilities are purely off the cuff estimates for arguments sake)…
1. Short S&P’s
This is about as consensus as you can get. I saw a list of 17 sell side firms’ 2017 year-end targets and all 17 of them had bullish objectives. The average target was 2366 with a 2350 median which would be roughly 4% higher than here (they really went out on a limb there). Even some of the most well-known perma bears have capitulated bullish recently.
Instinct: Trump will reflate the economy via tax cuts and fiscal stimulus; repatriated Dollars will go to share buybacks; there is still a high amount of cash on the sidelines and real money still is underinvested in equities.
Costanza: there is no guarantee Trump will follow through and/or be able to institute any of his campaign plans; bonds are getting more attractive especially to pension funds that are closing their funding gap; geopolitical risks are rising.
Estimated probability of Costanza being right: 20% in 1H, 40% by year end. This is so consensus that I am worried about being long. That said; it is true that large asset managers who rotate their book about as quickly as the Titanic could turn have still not fully bought into this rally. Therefore, if Costanza does prove right, it will probably be later in year once the rotation is complete. We expect dips to be get bought very quickly in the beginning of the year.
It is hard to argue with this bull trend in SPX…
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2. Long UST’s/front end flatteners/short breakevens
All three are essentially the same idea so let’s just combine it. The fixed income market slowly started to sell off in the summer as Brexit risks faded and global growth improved. Trump was the big kicker that got the reflation theme running on his pro-growth policies that will also lead to more supply. That got rates, curves (2s10s), and breakevens all moving higher in tandem.
The market is now very positive on forward growth and inflation prospects, and remains positioned for a more aggressive Fed as specs are still at or near record shorts in Eurodollars, Fed Funds, and 5yrs.
Instinct: Trump will reflate the economy via tax cuts and fiscal stimulus; Fed to be more aggressive in 2017; foreign central bank selling; increasing long end issuance; potential for ECB and BOJ to taper
Costanza: there is no guarantee Trump will follow through and/or be able to institute any of his campaign plans; bonds are getting more attractive especially to pension funds that are closing their funding gap; geopolitical risks are rising; composition of the Fed shifting to more dovish; still yield seekers around; long-term demographics
Estimated probability of Costanza being right: 50%. I could actually see this potentially working out later next year. If you look at the long-term chart of US 10yrs, there is the potential for a move up to 2.90% and still be in its long-term down trend that is probably largely due to the aging demographics of the US. I have been arguing that we have witnessed a regime shift and all the reasons for the short trade instinctively make sense; improving growth/inflation even before the election, Trump stimulus plans, etc., but the sheer crowdedness of the trade should concern us all. However, much like equities, there are still many large Real Money types that have long standing UST positions that need to be sold. This makes it a coin flip but I could see a move higher in rates first and then back into the long-term trend lower.
US 10yr yields – 1986 to present – 10yrs have more room to run higher before finding its long-term down trend resistance…
Trade Idea -> One of my favorite Costanza trades entering the New Year is selling the EDH7/EDM7 spread around 19bps. The market has priced in more than 2 hikes for next year which is approaching the Fed’s forecast of 3 hikes. First of all, when has trading off the dot plot ever proved successful? Secondly, I think pricing in 2.3 hikes in 2017 is about the most the market can do at this point considering we haven’t seen Trump implement any of his plans yet and there is a brewing trade war with China. Not exactly positive for growth. This plays for a less aggressive than expected Fed during a year the Fed becomes more dovish as three hawks gets replaced by three doves (note Trump can insert two additional member upon taking office).
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3. Long EURUSD
The Euro/USD cross has mainly been driven by the Dollar side of the equation as interest rate differentials has moved in favor of the USD. You could sprinkle in Italian Banking issues and general European political risk but it has really been about the Dollar this year.
Instinct: interest rates in the US will keep moving higher widening the differential between Europe and the US taking the Euro lower.
Costanza: growth has been pretty good in Europe; the slow ECB taper could start to move differentials back towards the Euro.
Markit Eurozone Manufacturing PMI…
Estimated probability of Costanza being right: 30%. The central bank divergence theme is alive and well as the US remains in a tightening bias while Europe will be stuck keeping rates unchanged for 2017. However, Costanza could win if Trump fails to boost growth and the Fed once again does not realize their dot plot. So it is not impossible for the Euro to rally but the divergence theme should keep it under pressure once again next year. Add in the political risks as there are elections in France where the Euro critic Le Pen has a somewhat legit chance of winning. There is also elections in Germany were Merkel and her party will be in big trouble given the recent attacks in Munich allegedly by a migrant. The political undertones in Eurozone are certainly not working in the Euro’s favor. Lastly, the Euro just broke a major long-term trend support line. I think we should stop talking about parity and start talking about 0.9000.
EUR/USD – 2000 to present…
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4. Short USDJPY
This is a very similar idea to the Euro as interest rate differentials have pushed the Yen weaker versus the Dollar. Clearly the Fed remains in its hike cycle while the BOJ is nowhere close to hiking so the only thing that can unearth this trade is if US monetary policy falls short of expectations. Additionally, there is loose talk going around that Trump and Abe have struck a deal where Japan will fund Trump’s deficit spending and in exchange the US will allow Japan to depreciate their currency further. It is a bit conspiracy theorist but also not a crazy idea. The only push back is at some point (>125?), the Yen weakness hurts small businesses and importers, so would a 150 USDJPY really be that beneficial? Up for debate but that idea has been thrown out there.
Instinct: interest rates in the US will keep moving higher widening the differential between Japan and the US taking Dollar/Yen higher.
Costanza: the market has priced in a more aggressive Fed so there is a lot of downside if the Fed proves to be more dovish than expected; the BOJ will taper; a chance the BOJ move away from NIRP
Estimated probability of Costanza being right: 30%. It really comes down to will the Fed live up to the hike hype. The other Costanza arguments of abandoning NIRP and tapering seem like a stretch to me, but this is generally considered the most crowded Dollar long so on that alone Costanza could be proven correct. Dollar/Yen is not quite yet realizing the same technical breakout as the Euro.
USDJPY – 1980 to present…
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5. Short USDCNY
Unlike the Euro or Dollar/Yen, this cross has been driven by both sides. China has acted to devalue their currency to slow their economic decline and the US side has been driven by the reflation trade and more aggressive Fed expectations.
Instinct: China will continue to keep their currency weak to stimulate growth; US reflation trade will keep US rates moving higher which keeps the rally in USDCNY going
Costanza: China growth picking up reducing the need for a weak currency; China has recently tightened liquidity (thru HIBOR/SHIBOR) to stem the depreciation; the market has priced in a more aggressive Fed so there is a lot of downside if the Fed proves to be more dovish than expected
China Manufacturing PMI…
Estimated probability of Costanza being right: 40%. I am going to give this one a little more of a chance. I think most people are incorrectly assuming that growth in China is weak. I am not saying there aren’t credit issues in the shadow banking system, but as you can see above, PMI’s are actually robust indicating an improved forward growth outlook. Anecdotally, I don’t know one person or firm that has talk about putting on USDCNY downside. This could actually be more of a consensus trade than S&P’s and thus warrants a higher probability of Costanza being right.
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6. Long Gold
Gold has been declining since Brexit risks faded over the summer and the depreciation really gained momentum once Trump won the election. It is moving because real yields and the US Dollar have been rising which makes its 0% yield useless in this environment.
Instinct: US Dollar and real yields will continue to appreciate taking Gold lower.
Costanza: Geopolitical risks are rising with US/China; inflation is picking up; the market has priced in a more aggressive Fed so there is a lot of downside if the Fed proves to be more dovish than expected
Estimated probability of Costanza being right: 30%. I find the Costanza reasons to be weak. Yes there are geopolitical concerns but they will get sorted out via trade wars not military wars. Gold has not been a good inflation hedge, so that leaves only a disappointing Fed as the reason why it could go higher much like the Euro and thus the same probability. Note that Gold is coming up on a very important long-term trend line.
Gold – 2004 to present…
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7. Short Oil
The OPEC and non- OPEC production cuts really changed sentiment. It went from a global supply glut story to one of more balance if not slightly imbalanced if demand picks up as expected. Specs have gotten very long, and now it is a matter of will OPEC member stick to the deal and will US Shale increase production at these more attractive levels?
CFTC NYME Crude Oil Net Non-Commercial Futures Positions…
Instinct: OPEC and non-OPEC members will cut production as agreed to keep the market balanced; demand picking up
Costanza: OPEC deal will not live up to the agreed upon production cuts; US Shale production increasing; producers happy to hedge above $50; Dollar strength will put pressure on oil
Estimated probability of Costanza being right: 60%. I can see Costanza getting this one right. While I think OPEC will more than likely keep the cuts as they said they would, this trade could work simply because US supply comes back online. In fact, it is already happening. The switch has been flipped on. Additionally, this could be a very good sneaky Dollar long proxy. How can oil keep rising if the Dollar is going to appreciate?
Permian Basin Rig Count is rising briskly…
WTI crude (black) vs. USD Index (inverted in blue) – note the divergence recently. How can this persist?
After writing this list, it amazes me how connected every single one of these ideas are and basically why the “probabilities” of each Costanza trade working are so similar. There are always correlations but more so than any year I can remember, the macro themes are as interrelated as ever. Basically whether you are long stocks, long Dollar, short fixed income, or short Gold, you are betting that Trump’s policies will be introduced and implemented as stated. I doubt that these plans will go through smoothly as we have already seen Trump fade on campaign pledges and some modest push back from the Republican leadership. However, I think you will get bailed out on the simple fact that the reflation rotation has still not been completed by the large real money types. It may not last all year, but it should continue in Q1 and we continue to think that any January correction in risk assets will get met with brisk buying. There are also some very good anti-risk trades which will offset your reflation trades that also won’t hurt much if the current trend continues like the EDH7/EDM7 flattener.
I want to thank everyone for their support this year and I wish you much success in 2017!
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