Trade into the debt ceiling deadline weekend

My trade going into the weekend will be short bonds (TLT), long silver (SLV).  Judging by today's price action, these are hedged, since after news of still no-deal going into today, both gold/silver and bonds ripped.  The price action appears to be treating gold/silver as "safe havens" in this case.  However, gold/silver typically tracks equities somewhat, and any raise on the debt ceiling will be even more dilutive to the USD.  So if the market thinks of this aspect to gold/silver instead, it could rip, which is contrary to public opinion of what would happen.  Likewise, the price action in bonds today is treating USTs as a "flight to safety."  However, if no deal is done, the market could treat this as an additional credit risk, and USTs could actually tank, especially if they officially get their ratings cut.

So this is the scenario as I see it:
1) No deal: then I lose on bonds (with the potential that the market will actually treat bonds differently on monday than it did today by focusing on credit risk rather than flight to safety factors), win on silver
2) Deal: I win on bonds, lose on silver (with the possibility that I don't actually lose on silver, but that it instead almost tracks equities, which should rip)

Debt ceiling; UST bond ratings

Moody's follows S&P in putting US bonds on watch negative.  However, they state that this is specifically related to any possible inability to raise the debt ceiling.

I have complete confidence that our gov't will figure out a last second solution for raising the ceiling.  That's simply how negotiations go... the vast majority of standoffs get done at the last second.  Also, there are so many possible workarounds to avoid default, it's not even funny.  So in that sense, I will be looking to make a bet on no-default as we increasingly approach a deadline.

However, in the longer-term sense, it's interesting to see the market finally start to see the big macro events unfolding... one day, US debt could easily be in the same situation as Greece is now.

It was very funny listening to Bernanke respond to Ron Paul's question about whether Bernanke considers gold to be money.  Bernanke's job is to keep foreigners buying USTs and USDs for as long as possible rather than gold/silver, so obviously he has to deny that gold is money while no doubt knowing the opposite to be true.  Bernanke's not an idiot... his position is political.

Gold/silver

Today Bernanke got the ball rolling on rumors of QE3, as he knows our economy still doesn't look that hot (driven by continued low housing prices and high home inventory overhang, which will likely keep prices low for awhile).  This may spark the next upleg in gold and silver.  GDX, a gold miner stock ETF, after diverging below gold, has now been catching back up.  This is what Soros had recently replaced his gold holdings with.

Fed announcement tomorrow

With the end of QE2 arriving and Bernanke due to talk tomorrow, I will be going into the meeting w/ positions somewhat at the inverse of several months ago, when the Fed announced what exactly it would be buying for QE2.  Instead of being short T-bonds, this time I will be long, as this is exactly the sort of "sell the news" play that tends to screw over every one trying to be logical.  The event tomorrow is the perfect opportunity for the big players who want to buy bonds to do so, as all the logical traders will be thinking that this is a sell w/ QE2 coming to a close.  I will also be long gold/silver in case any other methods of easing are discussed, and the bonds and gold/silver positions will be hedged w/ a short in the equity market.  This is a play on the meeting only--I have not and will continue not to take a position on bonds long term, as the macro drivers are competing; deflationary/deleveraging pressures are offset by worsening credit risk.  I remain bullish on gold/silver long-term, as the macro drivers for those haven't changed, and many of the weak hands have been driven out of silver in the recent downmove.

Refining margins

With what appears to be a bottleneck at Cushing, WTI crude continues diverging bearishly against Brent while the term structure for gasoline remains bullish.  Refiners must be making a fortune.  Going long refiners against a short XLE or ERX is probably not a bad idea

The best risk/reward market short remains eurodollars

With the TED spread at only ~24bps and short-term rate expectations sitting on lows, there isn't much lower LIBOR rates can go.  http://www.bloomberg.com/apps/quote?ticker=.TEDSP:IND#chart.  In the event of any kind of market panic, eurodollar futures will tank.  In the event the equities and/or other markets continue trickling higher, your losses on short eurodollars will be minimal.  Of course, this is only an intermediate-term hedge for equities, and cannot be relied upon for tight day-to-day correlation.

Still long VLO

Gasoline futures are in a nice backwardation, which is bullish, and WTI crude is at this point still in a slight contango, which is overall somewhat neutral.  Given this, there's no reason to fade the new highs in refining margins.  Not bullish on the overall market, but I'm still long VLO w/ market shorts to hedge.  It's at 28 as I write this.  I originally bought the breakout at 20, as you can go back in my blog to confirm.

TED spread interesting

If inflation is actually picking up at all, as may be finally be the case as indicated in my post http://uptrendingequity.blogspot.com/2011/01/important-trend-change-in-economy.html, then a yield-curve flattener trade may present a pretty good risk/reward setup at this point.  Rather than bet directly on short-term rates to increase, a bet on rising 3-month LIBOR rates against decreasing 10 or 30-year rates may be more appropriate, given the ludicrously low rates that banks are able to receive right now.  http://en.wikipedia.org/wiki/File:Ted-Spread.png.  Technically, if you duration-weight each side of the trade equally, you are indifferent to inflation.  A flattening yield curve should occur before a major bear market occurs, however.  I believe this trade presents a much better risk/reward than attempting to short equities in general, and the timing is more appropriate at this time, as the Fed thus far has denied any near-term possibility of raising rates for awhile now.  So the timing is ripe to catch people by surprise on the short-end.  By betting on increasing LIBOR instead of fed funds rates, as well, then you are hedging a net long equities portfolio even better against crisis scenarios.  To the extent rates on the long-end may rise more than the short-end rises, this would indicate runaway inflation beyond what the Fed is lifting rates to match, which I believe is possible only once housing comes out of its bottom, which can happen only once housing inventories dry up.  In that scenario, equities should rise even more than inflation.  So if you're long equities with a yield curve flattening trade to hedge downside, you should be in good shape.  Of course, I like to get in trades when the trade is trending my way, and this one isn't quite yet.  So I'd be light in the trade at this point.

Short GE futures (betting on short-end LIBOR rates to rise)
Long ZN (10-year) or ZB (30-year) futures (betting on rates on the long-end to drop).  Better yet, short TBT to pick up extra decay from the leveraged ETF.
Make sure you size appropriately to duration weight it.

Because gold/silver perform better when carry charges (interest rates) are low, increased interest rates may dampen their rise.  Therefore, this yield curve flattener may be a good hedge for a long gold/silver trendfollowing long hold.

Perfect strategy to hedge the trendfollowing approach

For those who haven't heard about "trendfollowing," please look it up.  For example, check out http://www.automated-trading-system.com/ and http://www.automated-trading-system.com/resources/trend-following-wizards-fund-performance/.  I believe in trendfollowing in general, and the results speak for themselves.  There's a human psychological explanation for why it works, and the purpose of this post is not to address all the nuances of trendfollowing.  In contrast, I intend to introduce an idea I've never read about before, that marries two strategies that perform well over time, but at completely different time periods.

It's been well-documented how the various leveraged funds decay over time.  Without getting too much into detail, this is due to daily rebalancing.  For example, FAS and FAZ, two triple-levered financial ETFs, are both down over the course of the last year, even though one is long and one is short.  The natural strategy is to short both of them.  The problem with that is when there are extended intermediate term trends, you can get hurt badly, as you are getting heavier in the position that has been losing, and lighter in the position that has been winning (see ERX vs ERY since the latter half of 2010, for example).  Sounds to me like the opposite approach of trendfollowing.  So why not marry the two?  Combine the short-term mean reversion benefits of shorting levered funds with the intermediate term benefits of trend-following, and you have combined 2 inversely correlated strategies that win long-term, but which win at different times.

In picking a diversified list of assets, I would come up with with the following levered funds:
Bonds
short TMO and TMF
EM Equities
short EDZ and EDC
Domestic sector-based equities
short FAS and FAZ
short ERX and ERY
short DRV and DRN
short TYP and TYH
Commodities
short DAG and AGA
short DTO and UCO
short DGP and DZO

I would be very interested in hearing how a simple strategy of shorting all these, and occasionally rebalancing, combined with a trendfollowing approach, may enhance return vs drawdown characteristics.  I would also be interested in trading with you!

Brent/WTI

With the Mar WTI now rolled into Apr, which is much pricier, I'm contending against some strong negative roll yield on the Apr if I remain long the front month.  When there's such a steep contango, the newly-rolled front month tends to slide down to prices near where the previous front month had traded.  This had happened when Feb WTI rolled into Mar, when Mar promptly sold off.  As such, I'm taking off all 4 legs of my oil trade to take a break from this craziness.  I will still make select daytrades based on technicals.

With oil skyrocketing, the distillates can't keep up, and refining margins are falling a bit.  Not sure if refiners will continue ripping or not.  Stagnating oil hasn't kept the oil majors from mini-ripping for the last few months.

WTI vs. Brent blowing out

I've been getting killed on the front-month arb, along w/ everyone else, and I suspect there may be a fund or two in the same trade as me that are going down in flames and may have already liquidated or may need to do so soon.  However, the other legs of my trade as described in my earlier post http://uptrendingequity.blogspot.com/2011/01/vlo-and-refining-margins.html have been keeping me in the game. Arbs can be a pain in the butt, and anything can happen in commodities, so I'll daytrade oil in special circumstances and look for signs that reversion on the front-months is likely, like soon after any news of a fund blowing out on this trade, or other outstanding technical setups

WTI vs. Brent arb seems to be reverting starting today

Today I started leaning heavily on the reversion trade.  Long Mar CL, short Mar COIL.  Also short Dec CL, short Dec COIL as a way to hedge against the chance that WTI SHOULD be cheaper than Brent long-term (which I doubt, but it reduces my risk greatly).  In addition, I'm no longer short long-dated WTIs against short VIX futures.

Also, the VIX index is now between the price of Feb and Mar VIX futures as I write this, so I'm long Feb VIX and short Mar VIX futures.

Important trend change in the economy

After declining throughout the aftermath of 2008 and basing in the latter half of 2010, bank lending has started to come up out of its base.

If base lending were a stock, I'd buy it right now.

This is important because many people falsely equate printing more money as necessarily causing inflation, while completely neglecting the fact that inflation=money supply (printed money) * money velocity (bank lending in the fractional reserve system).  Now, it finally seems that we may avoid the plight of Japan of the last 2 decades and the US Great Depression experience because the Fed has so forced so much liquidity into the system that money velocity is on the upswing.  It might be no coincidence that the uptrend on the gold/silver charts appear broken, perhaps portending increased interest rates caused by increasing inflation (contrary to popular belief, gold/silver are not "inflation hedges"; empirically, gold/silver in USD terms outperforms during times of low US interest rates).

That's not to say that the housing and muni markets aren't still sickly, US debt credit risks atrocious, and USD fundamentals abysmal.  Of course they still are.  Housing will remain a drag on aggregate US inflation until housing inventories dry up.  But I'm no longer as deflationist as I was before I saw this chart.

VLO and refining margins

As an additional hedge to the 3-way arb described in my earlier post Brent/WTI spread very wide, because the short long-dated WTI futures is overweighted in that arb, while RBOB (gasoline) futures are in backwardation, which would indicate further strength in gasoline, all other things being equal, you might want to buy VLO, the cheapest refiner fundamentally, with a great chart to boot, as an additional hedge to the previous trade.

Essentially, the trade as it stands now is a 4-way arb where every part of the trade has positive expectation of profit on its own, but hedges other parts of the trade nearly perfectly.  The legs of the trade are:

Long 1 unit Mar WTI
Short 1 unit Mar Brent
Short 1 unit Dec WTI
Long 1 unit Dec Brent
Short 1 unit either Dec or Jun WTI
Short 1 unit Feb VIX
Short 1 unit Mar VIX
Long some VLO, offsetting the short Dec/Jun WTI

This should essentially make you net flat risk aversion.  I'm currently in every leg of this trade.

Brent/WTI spread very wide

Feb WTI crude contracts are now trading at a discount to Brent crude of between $6-7/barrel.  This is unsustainable longer term.  See http://www.bloomberg.com/apps/quote?ticker=CLCO1:IND for some charts of this.

At the same time, contango is widening on the WTI contract.  This is typically bearish for the whole term structure.

So while the Brent-WTI arb would dictate long Feb WTI, short Feb Brent, the contango situation would dictate short further out WTI (like the liquid Dec '11 contract).  So I may do a four-leg trade to reduce risk, reduce margin requirements, while increasing expected return even further: Long Feb WTI, short Dec WTI, short Feb Brent, long Dec Brent.

If you would like to incorporate a third trade idea into this trade, since the long Dec Brent future leg has no edge in and of itself, but was taken as a hedge to everything else, that leg can be replaced with other positions having an edge.  Specifically, as described in  Uptrending Equity: Volatility arb, the steep contango in VIX futures provides an edge.  Because short VIX futures is essentially a long equities market position, and because oil is strongly correlated with the equities market (due likely to the "borrowed currency" status of the USD in the currency carry trade, meaning the correlation is likely to remain high for as long as the interest rate on the USD remains low relative to other worldwide currencies; graphs of oil/SPY correlation and interest rates here: http://www.riskwatchdog.com/2010/08/12/oil-correlated-to-equities-risk-appetite/ and http://www.tradingeconomics.com/Economics/Interest-Rate.aspx?Symbol=USD), the long Dec Brent position could be replaced with short VIX futures.  You will have to figure out for yourself what the appropriate size for the substitute should be.  Naturally, this would use more margin and incur more risk, but would simply combine yet another successful strategy into the trade to eliminate the hedges from each corresponding trade that don't provide any natural hedge.  In other words, by combining the VIX strategy with the oil trade, I can eliminate the long Brent Dec crude position from the oil trade, and eliminate the short SPY or long SPY puts position from the VIX paired trade.

Will look for the Brent-WTI spread to begin converging to get in.