# Trading Fixed Income and FX in Emerging Markets * Author: [Dirk Willer, Ram Bala Chandran , and Kenneth Lam](https://www.amazon.com/Dirk-Willer/e/B08K3MWRYT/ref=dp_byline_cont_ebooks_1) * ASIN: B08HGNF4Z8 * ISBN: 978-1119598992 * Reference: [[https://www.amazon.com/dp/B08HGNF4Z8]] * [Kindle link](kindle://book?action=open&asin=B08HGNF4Z8) --- This book does the data analysis for our readers to generate a robust trading methodology for emerging markets. The result is a set of empirically validated rules of thumb that we find helpful to generate alpha. — location: [994](kindle://book?action=open&asin=B08HGNF4Z8&location=994) --- One reason for the resilience of our framework is that we care mostly about “deep” fundamentals of human psychology and behavioural patterns that are unlikely to change, rather than just economic fundamentals. — location: [1015](kindle://book?action=open&asin=B08HGNF4Z8&location=1015) --- EM is 65% global macro and 35% local, at least in EMFX and credit. EM rates have a higher local component. — location: [1034](kindle://book?action=open&asin=B08HGNF4Z8&location=1034) --- In our opinion, EM are currently in a sweet spot. They are large, liquid, and volatile enough to make meaningful investments possible even for large investors, but not so liquid that all the alpha has been arbitraged away. — location: [1228](kindle://book?action=open&asin=B08HGNF4Z8&location=1228) --- EMFX is mostly macro: 66% of the variation in EMFX returns is explained by global macro forces. This is followed by EM equities and external debt. At the other end of the spectrum are EM rates, where only 36% of the variation is explained by global macro factors. This makes intuitive sense, given how important local central banks are for local interest rates. Central bankers presumably place primary consideration on local fundamentals. — location: [1514](kindle://book?action=open&asin=B08HGNF4Z8&location=1514)explanatory power of global Variables in EM asset classes. Also check end of chapter summaries. --- This is about as idiosyncratic a story as any in EM during that time. However, in spite of that, the chart of USD‐BRL looks almost identical to the overall EMFX chart, as can be seen in Figure 2.1. There was not a single week where BRL sold off meaningfully at a time when EMFX did well. The BRL remained hostage to the global USD even during the most bearish parts of the Rousseff episode. — location: [1544](kindle://book?action=open&asin=B08HGNF4Z8&location=1544)BRL traded in line with F- MEX despite the idiosyncratic local story, Rousseff impeachment. --- EUR‐USD remains the most important macro driver for EMFX, SPX for EM equities, and EM high yield for EM sovereign spreads. Once more, EM rates are the exception, as US HY is a more important macro driver than UST. Furthermore, across asset classes, US HY ranks as the most important macro driver. Periods of rising US HY spreads are therefore the most important times to avoid long EM positions across asset classes. — location: [1654](kindle://book?action=open&asin=B08HGNF4Z8&location=1654) --- This means EM rates on average, and on an index level, tend to trade like a risk‐free UST asset. This is in spite of the fact that for individual countries, rates frequently move higher during times of risk aversion due to a weakening EMFX. But on an index level, periods of wider EM rates, in spite of lower US rates, are much too infrequent to distract from the meaningful positive impact of lower US yields on EM duration. When bullish on US rates, investors should add duration and not worry too much about the impact of rising risk aversion on EM rates. — location: [2023](kindle://book?action=open&asin=B08HGNF4Z8&location=2023)EM Sovereign on aggregate trades in line with UST yields even if there are local market risks. --- EM credit (in spread terms) has a consistently negative (and fairly large) beta to UST returns, largely because US yields typically rise during strong growth periods, which are usually credit positive and lead to tighter spreads. — location: [2028](kindle://book?action=open&asin=B08HGNF4Z8&location=2028)When UST yields increase it tends to be during growth and liquidity positive periods so EM credit spreads narrow, which is offset by higher yields by government bonds. For high yielders, the spread tightening tends to win out. --- Our second observation is that sell‐offs in real rates are more dangerous than sell‐offs in nominal rates. This is largely the case because break‐evens are mostly driven by oil. And, as we will see, stronger oil prices have been broadly EM positive – even for oil importers. Rising real rates in the US, on the other hand, make capital more expensive without offering the benefit derived from higher oil prices and therefore tend to be more pernicious. — location: [2071](kindle://book?action=open&asin=B08HGNF4Z8&location=2071)Real rate differential changes have a more important input on EMFX than nominal. Sell-offs in US real rates is dangerous for EMFX. Inflation breakenvens are positive across the EMFX spectrum, as growth is better. --- if the EUR strengthens against the USD, then PLN, CZK, and HUF strengthen by even more against the USD, and vice versa. — location: [2133](kindle://book?action=open&asin=B08HGNF4Z8&location=2133) --- In aggregate, and for local market purposes, the median emerging market is a large exporter of food, a small net exporter of minerals and metals, and a large net importer of energy. But the median tells only part of the story. There are important energy players (Russia, Colombia, Malaysia), meaningful exporters of minerals (copper in Chile, copper and gold in Peru, gold and platinum in South Africa, iron ore in Brazil), and foodstuffs (soy in Argentina, fish and wine in Chile, and rice in Thailand). — location: [2218](kindle://book?action=open&asin=B08HGNF4Z8&location=2218)which commodities are important for EM markets. --- Clearly, higher prices for the relevant commodities improve external balances for exporting countries and therefore support EMFX and EM credit in particular. — location: [2264](kindle://book?action=open&asin=B08HGNF4Z8&location=2264) --- Clearly, risk aversion impacts returns for EM credit the most significantly and returns for EM rates the least. EMFX is closer to EM credit than to EM rates but is more prone to decouple from risk aversion than EM credit. The beta of EM rates broadly fluctuates around zero, but with a slightly negative median. This is the case because EM rates have a larger UST component than EM credit does, and UST do well during times of risk aversion. However, it is interesting that typically, the beta for EM rates returns is negative, suggesting that the positive impact from the US rates channel is often not enough to create a positive performance for EM rates in this environment. — location: [2305](kindle://book?action=open&asin=B08HGNF4Z8&location=2305)EM rates are least effected by risk averse environments --- it is really only CNY that can decouple, largely because official intervention is keeping the beta low. But the beta of CNY to risk aversion will rise going forward, as Chinese authorities plan to move toward a more flexible exchange rate, one step at a time. — location: [2320](kindle://book?action=open&asin=B08HGNF4Z8&location=2320) --- Investors should cut EM rates risk only if they fear very major shifts in risk aversion. On average, aligning EM rates trading with US rates views generates alpha, irrespective of the fact that lower US rates are at times coincident with a rising VIX. Periods of an explosive VIX, where this rule of thumb does not hold, are too infrequent (and too hard to predict) to invalidate the overall result that investors should align the EM duration view with their US rates view. — location: [2407](kindle://book?action=open&asin=B08HGNF4Z8&location=2407)Mostly EM rates align with moves in us rates except for periods of extreme risk aversion. --- With respect to EMFX, higher US rates only tend to hurt during the most violent sell‐offs, when the sell‐off is driven by US real rates rather than nominal rates, — location: [2449](kindle://book?action=open&asin=B08HGNF4Z8&location=2449) --- When the USD depreciates during rising risk aversion, it usually is a warning sign of EMFX stress to come. — location: [2452](kindle://book?action=open&asin=B08HGNF4Z8&location=2452) --- During periods of EUR strength, CEEMEA FX overweights and Asia underweights are appropriate, and vice versa. — location: [2452](kindle://book?action=open&asin=B08HGNF4Z8&location=2452) --- During periods of expected commodity strength, Latam FX overweights and Asia underweights are profitable, and vice versa. — location: [2453](kindle://book?action=open&asin=B08HGNF4Z8&location=2453) --- Domac and Isiklar (2014) suggests that for the case of Turkey, for example, this may be because for every USD the current account in Turkey loses due to higher oil prices, Turkey's capital account improves by more than that USD of extra spending, as petrodollars start to flood in from the gulf region. — location: [2465](kindle://book?action=open&asin=B08HGNF4Z8&location=2465) --- Letting China into the WTO under quite favourable terms must count as one of the most underappreciated events in recent market and maybe world history. At the time, markets barely took any notice of this monumental event. — location: [2487](kindle://book?action=open&asin=B08HGNF4Z8&location=2487) --- While it is very hard to prove, many observers believe that there was a “Shanghai Accord” on the sidelines of the G20 meeting in February 2016, where then Fed Chair Yellen might have agreed to soften the Fed's hawkish stance in order to generate a weaker USD, which would in turn help engineer a weaker CNY on a trade‐weighted basis without having to deal with the negative tremors from a sharp move higher in USD‐CNY. — location: [2500](kindle://book?action=open&asin=B08HGNF4Z8&location=2500)Didn't realize before how speculative this was. --- We remember distinctly the first “China is bust” scare of our careers, in 2004! Fifteen years later, the numbers have become scarier, but the story remains the same. — location: [2636](kindle://book?action=open&asin=B08HGNF4Z8&location=2636)Interesting --- at the end of 2018, foreign ownership of domestic A shares sat at only 3.2%. Foreign ownership of local bonds stood at 2.8%, though the China Government Bond (CGB) market has a larger foreign ownership share, at around 7.9%. As a result, the correlation of A shares to the S&P 500 is among the least consistent ones across the various emerging equity markets, — location: [2674](kindle://book?action=open&asin=B08HGNF4Z8&location=2674) --- The Chinese authorities see foreign capital inflow as a solution to outflow pressures, rather than overly relying on the sale of accumulated FX reserves. — location: [2687](kindle://book?action=open&asin=B08HGNF4Z8&location=2687) --- In the past, index inclusion of other EM countries led to inflow well in excess of the estimates based strictly on fund assets managed against the relevant indexes. This is because countries often have to implement meaningful reforms to the micro‐structure of their bond markets as a condition for entry. Such reforms attract other investors who are not indexed, indexed, who buy the bonds due to the improved liquidity as a result of index inclusion. If this behaviour holds for China, foreign ownership could rise to 20% by 2023. — location: [2716](kindle://book?action=open&asin=B08HGNF4Z8&location=2716)Interesting point on reforms required for index inclusion, and subsequently attracting more interest. --- Currency trading also started out with an offshore version (CNH), but foreign investors now also actively trade the CNY, and they do so to a much greater extent than Chinese bonds or equities. — location: [2728](kindle://book?action=open&asin=B08HGNF4Z8&location=2728) --- For the longest time, the CNY was pegged, and trading it was therefore a sleepy affair. China was, as a matter of fact, almost the only significant emerging market that did not de‐peg during the Asian financial crisis in the late 1990s. — location: [2729](kindle://book?action=open&asin=B08HGNF4Z8&location=2729) --- To become a plausible competitor to the USD as both a transaction vehicle and a savings vehicle, the CNY will eventually have to be a floating currency. This objective has recently increased in importance, given that the US is arguably abusing the central role of the USD by cutting individuals or companies off the USD‐based financial system to increase the effectiveness of economic sanctions.4 — location: [2735](kindle://book?action=open&asin=B08HGNF4Z8&location=2735)De-dollarization --- it is not fully clear whether China was able to stem the tide due to intervention and increasing capital controls, or whether China just got lucky as the DXY turned, changing expectations for the CNY. Given this uncertainty, it is unlikely that Chinese authorities will move with undue haste again in the future. — location: [2774](kindle://book?action=open&asin=B08HGNF4Z8&location=2774)referring to the CNY devaluation. --- Going forward, the volatility of USD‐CNY is likely to increase, as the capital account will become more open. — location: [2796](kindle://book?action=open&asin=B08HGNF4Z8&location=2796) --- it is plausible that capital outflows only stopped because the DXY turned in early 2017. And the history of capital controls does suggest that if an expected depreciation of a currency becomes too large, local citizens find ways to circumvent even strict capital controls. — location: [2798](kindle://book?action=open&asin=B08HGNF4Z8&location=2798) --- a weaker CNY requires weaker currencies for the countries competing with China for exports into Europe and the US. Between commodity exporters and countries that compete with China in manufacturing, a large part of the EM universe is impacted by a higher USD‐CNY. — location: [2812](kindle://book?action=open&asin=B08HGNF4Z8&location=2812) --- it is a goal of the Chinese regulators to move away from quantitative tools and toward a clear price‐based framework, as per the 13th 5‐year plan (2016–2020). But for now, the market focus is firmly on the seven‐day repo rate. After all, the PBOC is mainly using seven‐day reverse repos for its daily open market operations. — location: [2862](kindle://book?action=open&asin=B08HGNF4Z8&location=2862) --- In the old days, global macro investors spent a significant amount of time on JGBs, given their importance for the global business cycle. CGBs are the JGBs for the new millennium, and it pays to watch the signals of Chinese rates to get the global macro cycle right. — location: [2885](kindle://book?action=open&asin=B08HGNF4Z8&location=2885)Interesting charts related to this section. CGBs provide information on the global business cycle. --- The comparison to the Cold War with the Soviet Union is not overly apt, largely because the Soviet Union cut most economic linkages to the West. In the 1980s, exports and imports each were only around 4% of Soviet GDP. — location: [2917](kindle://book?action=open&asin=B08HGNF4Z8&location=2917) --- We note, though, that the view that Chinese policy makers aim to move to a flexible CNY is not necessarily consensus. David Lubin, in his excellent book Dance of the Trillions, argues that China feels uncomfortable with market exchange rates and may therefore stick with a system of managed convertibility for a long time to come — location: [2944](kindle://book?action=open&asin=B08HGNF4Z8&location=2944) --- On the EM side, the one currency that comes closest to behaving like a risk‐free currency is EUR‐CZK, followed by CNY (given that it is highly managed). — location: [2973](kindle://book?action=open&asin=B08HGNF4Z8&location=2973)interesting! --- if we create a basket of the G10 commodity currencies (NOK, AUD, NZD, and CAD) and compare its correlation structure to an EM commodity basket (RUB, ZAR, CLP, COP, BRL, PEN, IDR, and MYR), the betas to those global macro market drivers are very similar and at times even lower for the EM commodity basket than for the G10 commodity basket. We conclude that when it comes to their trading behaviour with respect to global macro, G10 and EM commodity currencies — location: [2974](kindle://book?action=open&asin=B08HGNF4Z8&location=2974) --- the institutional framework is often weaker in poorer countries than in richer countries (and the classical delineating feature between EM versus G10 is, of course, GDP per head). — location: [3078](kindle://book?action=open&asin=B08HGNF4Z8&location=3078) --- A lot more damage can be caused if a market‐unfriendly candidate wins in the average emerging market than when this happens in the average G10 country, presumably because personalities often are able to dominate institutions in EM more easily than they can in DM, where checks and balances are more pronounced. EM currencies take such risks into account to a larger extent than G10 currencies do – but only when elections are close. Weaker institutions also make policies like capital controls more likely. — location: [3080](kindle://book?action=open&asin=B08HGNF4Z8&location=3080)It's interesting to consider what the differences are between EM & DM. Weaker institutions? Policy volatility? Market breadth & depth? --- for G10, more hawkish central banks typically lead to widening spreads of interest rates versus the US, which then results in a stronger currency. This is not true for EMFX, where local rates often move higher with weaker FX. — location: [3088](kindle://book?action=open&asin=B08HGNF4Z8&location=3088)Because of inflation differences? --- And This is What Makes EMFX Different from G10 FX. — location: [3102](kindle://book?action=open&asin=B08HGNF4Z8&location=3102)610&EMFXcanbedistinguishedbyhowcurrenciesreacttointerestratedifferentials,butpossiblyalsoinflationchanges --- If we had perfect foresight on rate differentials in G10 space, the P&L when going long the currency where rate spreads are rising, and vice versa, is consistently positive. The pattern for EMFX is different, though. Instead of pointing straight down, the P&L chart goes mostly sideways, neither making nor losing much money. This is an important finding. It suggests that even once we have controlled for episodes of rising risk aversion, it is still the case that more hawkish central banks are not necessarily bullish for EM currencies. One reason is that many EMs are attracting large capital inflows when local bonds are in a bull market, which is often the case when central banks are cutting rates. Such bond inflows can lead to currency strength in spite of lower rate differentials. — location: [3110](kindle://book?action=open&asin=B08HGNF4Z8&location=3110)Behaviour of EM currencies might be more related to capital flows, depth of capital markets and yield. --- Either rates differentials are important to trade FX, in which case the currency quacks like a G10 FX, or they are not, in which case we should treat that currency like an EM currency, even if the country is not categorized that way by more traditional definitions. — location: [3117](kindle://book?action=open&asin=B08HGNF4Z8&location=3117) --- while the cumulative returns for USD‐ and EUR‐funded carry trades are almost identical between 2003 to 2018, the EUR‐funded trade has a much higher Sharpe ratio. And the JPY‐funded cumulative returns are significantly higher than EMFX returns funded in either USD or EUR. The popularity of the carry trade in Japan is therefore not overly surprising. Still, with USD‐funded EMFX trades being prevalent in markets, we conclude that the carry trade in its simplest form has been eaten up by the USD bull market. — location: [3197](kindle://book?action=open&asin=B08HGNF4Z8&location=3197) --- we found that implied volatilities are clearly superior to realized volatilities for signalling danger. — location: [3311](kindle://book?action=open&asin=B08HGNF4Z8&location=3311) --- Large current account deficits are negative for currencies during episodes of rising risk aversion, as such deficits have to be financed, which is increasingly difficult when investors start to flee for the safety of their home markets. On the other hand, countries with a current account surplus benefit during crisis times as capital outflows stop (or even reverse), leading to appreciation pressures thanks to a strong current account. — location: [3323](kindle://book?action=open&asin=B08HGNF4Z8&location=3323)The current account deficit leading to depreciation during times af risk makes sense to me for countries where the assets owned by foreigners are risk sensitive and deficits / goods consumption is sticky. For example I am not sure it matters for the U.S. for surplus countries, it probably matters how sticky the surplus is and what assets they own. --- the best way to use current accounts is to look for improvements, rather than for levels, and that carry needs to be taken into account together with any current account model to generate alpha. — location: [3362](kindle://book?action=open&asin=B08HGNF4Z8&location=3362)Surplus countries tend to have low real rates. --- Other than carry and external position, the other major attraction of EM has been that growth tends to be higher than in DM, as EM are catching up with the living standards and know‐how of developed countries — location: [3404](kindle://book?action=open&asin=B08HGNF4Z8&location=3404) --- the “real” aspect of the REER concept corrects exchange rates for inflation differentials, which can be done using PPIs, CPIs, or unit labour costs (Harberger 2004). The “effective” aspect takes the composition of the export and import destinations into account. But all other fundamentals are assumed to stay constant, which clearly is an oversimplification that is rarely reflective of reality. The other problem with the REER concept is that the indexes were at some stage arbitrarily set to a predetermined initial value before they started to move in line with spot FX moves and inflation. — location: [3455](kindle://book?action=open&asin=B08HGNF4Z8&location=3455)PPP probably better than REER. --- The PPP valuation measure suggests that similar goods should cost similar amounts of money across countries. If they do not, free trade should go into overdrive, quickly correcting such arbitrage opportunities. — location: [3476](kindle://book?action=open&asin=B08HGNF4Z8&location=3476) --- We focus on an expression of breadth in EMFX where we count the number of up days over different time periods for all the EMFX currencies under consideration. It turns out that when breadth is improving, it pays to be on the long side of EMFX. — location: [3621](kindle://book?action=open&asin=B08HGNF4Z8&location=3621) --- Equity investors also typically do not FX hedge their shares, or at best do so partially; while in fixed income, the inflows from crossover investors are often FX hedged. Given that Asia is characterized by significant equity flows, while Latam and CEEMEA are more driven by significant fixed‐income flows, we focus here on Asia FX and how it relates to equity inflows into Asia. — location: [3648](kindle://book?action=open&asin=B08HGNF4Z8&location=3648)Remember, Catan fixed income market is large but equity market has a smaller share. --- CitiFX quants focus on events where momentum in flows from leveraged accounts is going in the opposite direction as the momentum of flows from real money accounts. The idea is that leveraged accounts are often moving first, and, in the end, real money will more often than not follow, creating some persistence to the overall flows. CitiFX Quants have had some success with such a trading strategy — location: [3681](kindle://book?action=open&asin=B08HGNF4Z8&location=3681) --- Extreme positioning, as proxied by flows, is relevant in determining whether investors should take the other side of consensus on the first sign that the consensus story may be changing. — location: [3687](kindle://book?action=open&asin=B08HGNF4Z8&location=3687)How I have thought about flows so far. --- To us, the most interesting finding is that consensus usually works. For 7 of the 10 percentiles, excess returns are positive; and the average excess return is positive and relatively large at 0.9%. Furthermore, it is not obvious that more extended positioning leads to worse returns. While the 0.0 to 0.1 percentile does not generate the very best excess returns for being long USD, it does generate excess returns that are positive and considerably higher than returns for some of the lower brackets. — location: [3771](kindle://book?action=open&asin=B08HGNF4Z8&location=3771) --- If volatility is low, investors are able to accrue the carry without heightened risk of capital losses. Furthermore, when investors conclude that they are in a low‐volatility regime, they tend to add to carry trades, which often leads to an appreciation of the high‐carry currencies in question — location: [3820](kindle://book?action=open&asin=B08HGNF4Z8&location=3820) --- In our experience, there is a clear pattern of how EM react to severe FX weakness. The first line of defense is FX intervention, at least if the country accumulated sufficient FX reserves during the bull days. If FX continues to deteriorate in spite of intervention, the next step often involves emergency interest rate hikes. If those also do not manage to stabilize the currency, the next step is either the introduction of severe capital controls or, finally, a major correction of the underlying economic policies, often with support from the IMF. — location: [3933](kindle://book?action=open&asin=B08HGNF4Z8&location=3933) --- FX intervention is the first line of defense because costs to policy makers are quite low. After all, carrying reserves is fiscally costly, as local rates are usually higher than USD rates. The direct costs of using FX reserves are therefore zero or even negative. FX reserves are also seen as insurance to be used in crisis situations. — location: [3943](kindle://book?action=open&asin=B08HGNF4Z8&location=3943)I hadn't considered the cost of holding reserves. --- large interventions (as percent of GDP), intervention toward fundamentals (proxied by three‐year moving averages or PPP), and backing up the physical intervention with oral intervention improve the likelihood of success on event day but do not help with the smoothing criterion. — location: [3974](kindle://book?action=open&asin=B08HGNF4Z8&location=3974) --- In Brazil, large interventions (above USD 2.5 billion/day) work. When done for the first time (or when firepower is meaningfully increased within an existing programme), the BRL outperforms the EMFX index, volatility adjusted, for around 10 days by 2.5%. Small first‐time interventions or programme extensions have no significant impact. — location: [3987](kindle://book?action=open&asin=B08HGNF4Z8&location=3987) --- While interventionist pressures have often brewed a long time before triggering a decision by policy makers, the chart for Brazil suggests that it takes a 1.5% underperformance over five days, obviously from an already very weak position, for the central bank to intervene. — location: [3998](kindle://book?action=open&asin=B08HGNF4Z8&location=3998) --- We also note that at times, emerging market policy makers intervene when their currency is strengthening too much. Here, the motivation is much less political (in that a stronger currency is seen as a sign of good economic housekeeping) and is mostly driven by the harm done by the appreciating currency to the exporting sector. — location: [4003](kindle://book?action=open&asin=B08HGNF4Z8&location=4003) --- Often, the inflows that drive the appreciation lead to a local boom, especially if there is intervention to keep the currency weaker than it arguably should be. Such inflows can then create inflation pressures – and a stronger FX is often an easy way to fight such pressures. — location: [4009](kindle://book?action=open&asin=B08HGNF4Z8&location=4009)Too much intervention in a strong currency could lead to inflation pressures. --- Whenever an emergency rate hike happens, the likelihood of another one occurring in short order is much higher than usual – the policy is often to hike until it “works” and the currency stabilizes. The second hike is usually significantly larger than the first one. But even in those clusters, the likelihood that a second hike is necessary is only around 25%. — location: [4046](kindle://book?action=open&asin=B08HGNF4Z8&location=4046) --- for cheap currencies, there is an initial positive follow‐through post emergency rate hike, and even in the bigger picture, the USD peak is in: the levels of the EM currency from just before the emergency rate hike are not seen again for a very long time. Given typically high carry, this is a success for investors and suggests a trading rule to go long cheap currencies post emergency rate hikes. — location: [4124](kindle://book?action=open&asin=B08HGNF4Z8&location=4124)Very interesting rule on how to trade FX around emergency hikes. Looks like [PPL --- The lesson for investors is to fade rallies induced by emergency hikes if the currency has not sufficiently cheapened into the hike. For policy makers, it suggests patience. The hikes will not work until the currency has sold off and has become at least somewhat cheap – or, even better, extremely cheap. — location: [4129](kindle://book?action=open&asin=B08HGNF4Z8&location=4129) --- Time is needed to allow the investors who are long the currency to cut their positions and for new short positions to be established. Only once that has happened can emergency rate hikes stabilize the currency, partly by increasing the costs for the shorts to remain short. In the context of emergency rate hikes, valuation is relevant. — location: [4149](kindle://book?action=open&asin=B08HGNF4Z8&location=4149)My thinking for why emergency rate hikes work better for larger devaluations was that funding becomes too expensive. --- the relevant EMFX on average sells off quite sharply against the USD going into the announcement of the IMF package. The median performance is similar but less extreme. Interestingly, at first, the announcement does not stabilize the average (or median) FX rate. Only in the top 10 percentile of programmes does the FX change direction with the IMF package and immediately stabilizes. But around 25 trading days later, the median performance also starts to turn around, and the relevant FX starts to strengthen. — location: [4297](kindle://book?action=open&asin=B08HGNF4Z8&location=4297) --- the average path of the currency (against the USD) in the run‐up to and aftermath of a contentious election. We find that election uncertainty, in the form of rising volatility and a weaker currency, generally begins six months prior to the event and accelerates at about the three‐month mark. But just a month before the election, the trend stalls out, and the currency turns around with two weeks to go. It often goes on to rally meaningfully after the election. — location: [4338](kindle://book?action=open&asin=B08HGNF4Z8&location=4338) --- “Political power is like playing a violin. You grab it with the left, but play it with the right.” — location: [4350](kindle://book?action=open&asin=B08HGNF4Z8&location=4350)Brilliant --- Investors often forget that even late Venezuelan President Hugo Chavez, who may have been the most market‐unfriendly EM leader in recent history, was not immediately a negative for the market. Figure 5.8 shows the relative performance of Venezuela USD bonds versus Brazil. As can be seen, most of the politically induced volatility happened prior to the election of 6 December 1998. In the election's aftermath, the big moves were for Venezuelan outperformance versus Brazil, not underperformance. — location: [4354](kindle://book?action=open&asin=B08HGNF4Z8&location=4354) --- AMLO also favoured a responsible budget and an independent central bank, though local observers were highly sceptical of how a responsible budget would be possible in light of expensive fiscal promises. — location: [4383](kindle://book?action=open&asin=B08HGNF4Z8&location=4383) --- Lower yields in DM would tend to be supportive for EM rates. But there are also factors that push EM rates in the opposite direction, making them behave more like credit. In particular, weaker currencies often lead to higher inflation expectations, which in turn undermine rates. — location: [4495](kindle://book?action=open&asin=B08HGNF4Z8&location=4495) --- rising risk aversion means that credit spreads widen. To the extent that EM rates have a credit component, even in local‐currency‐denominated‐bonds, this is another force that would push EM rates higher during episodes of risk aversion. — location: [4497](kindle://book?action=open&asin=B08HGNF4Z8&location=4497) --- Above that level of credit risk, local rates are highly correlated with CDS; below that level, the correlation drops very fast. Rates for a very similar group of countries as in the VIX study (Korea, China, Czech Republic, Thailand, Chile, and Philippines) can decouple from credit risk and behave more like a developed market rates product. — location: [4531](kindle://book?action=open&asin=B08HGNF4Z8&location=4531) --- Such thinking was highlighted by a famous 2015 incident when Jon Hilsenrath, back then the Wall Street Journal's Fed watcher, tweeted prior to a Fed decision that chair Yellen likes to arrive at an airport three hours before the plane leaves, suggesting that this evidence of high risk aversion would mean the Fed was unlikely to hike without preparing the market first. — location: [4669](kindle://book?action=open&asin=B08HGNF4Z8&location=4669)Couple of interesting continents on risk aversion by the Fed. --- on average, the right time to start receiving in past Fed cycles has been around the last hike. Until then, the right trade was to keep paying rates. Receivers remain the correct position until the last cut is close. While there are admittedly not very many observations, given how few Fed cycles there were, we will find a similar pattern for many EM, making us more confident that this rule is sensible to use in trading. Our findings demonstrate that the market is not overly forward looking, maybe due to the reasons alluded to in the previous section. — location: [4704](kindle://book?action=open&asin=B08HGNF4Z8&location=4704)Market does not fully price in interest rate cycles on the front-end allowing for trading rules. --- When QE programmes are unwound, the opposite behaviour is likely. Rates move higher into the announcements of stimulus removal, only to rally when, eventually, the removal of QE negatively impacts risky assets and/or the economy. — location: [4843](kindle://book?action=open&asin=B08HGNF4Z8&location=4843) --- EM central banks put a larger weight on inflation, because from a legal perspective they typically don't have a dual mandate. Furthermore, they often have less credibility and therefore are less able to look through transitory higher inflation outcomes. For this reason, most EM central banks have an inflation target, — location: [4867](kindle://book?action=open&asin=B08HGNF4Z8&location=4867) --- the sensitivity of inflation to FX, i.e. the pass‐through, is the single biggest difference between EM and G10 fundamentals when it comes to rates trading. — location: [4878](kindle://book?action=open&asin=B08HGNF4Z8&location=4878) --- EM are often small and relatively open economies where import shares are higher than in the often more closed DM. Therefore, the weights of imported goods in the CPIs are higher in EM than in the G3. Furthermore, lower GDP per head implies a higher weight of food (and, for some regions, energy) in the CPI basket. Food and energy are often at least partially priced in USD. — location: [4880](kindle://book?action=open&asin=B08HGNF4Z8&location=4880) --- The countries where rates move meaningfully higher when risk aversion rises are also the ones that are sensitive to their own FX depreciating, as illustrated in Figure 6.19. For those countries, it is important to keep in mind that it is not consistent to be bullish on the interest rate of a country and bearish on the FX. — location: [4899](kindle://book?action=open&asin=B08HGNF4Z8&location=4899) --- (PCA) comparing inflation across the globe, we find that 83% of inflation in emerging Asia, 61% of inflation in CEEMEA, and 55% of inflation in Latin America is driven by the first principal component, i.e. by a global factor. This global factor is highly correlated with global commodity prices. — location: [4948](kindle://book?action=open&asin=B08HGNF4Z8&location=4948) --- there is a subset of EM where higher commodity prices lead on average to lower inflation. This is true for most commodity producers among EM. To be precise, factor loadings for a PCA of the first factor for inflation are negative for Brazil, Chile, Colombia, Peru, Russia, South Africa, Indonesia, and Malaysia, i.e. precisely the subset of countries that export commodities. — location: [4952](kindle://book?action=open&asin=B08HGNF4Z8&location=4952) --- when commodities move higher, EMFX of commodity producers outperform. Large moves by the FX of commodity producers then pushes inflation of tradable goods (and often of commodities, in local currency terms) lower, more than offsetting the move up in USD prices of commodities. — location: [4966](kindle://book?action=open&asin=B08HGNF4Z8&location=4966)Commodity produces FX and bonds do well when the world is worried about commodity inflation. --- The fact that more and more central banks are able to cut even with the Fed hiking can be read as a sign that more EM are closer to graduating to developed market status, at least when it comes to monetary policy and rates. — location: [5006](kindle://book?action=open&asin=B08HGNF4Z8&location=5006) --- If, for example, commodities have clearly turned down, also in local currency terms, the best receivers are in (non‐commodity producing) countries that still show some inflation above the central bank's inflation target, maybe just because of longer lags or domestic inflation pressures that will in the end be overcome by global and commodity pressures. — location: [5050](kindle://book?action=open&asin=B08HGNF4Z8&location=5050)Anticipating domestic inflation in non-commodity producers I can give signals for rates trades. --- One rule of thumb that we have found useful is that it is very rare for EM central banks to continue raising interest rates once annual inflation has turned lower. While this may sound obvious, it is not. After all, inflation can be, and often is, still substantially above target when yoy peaks are materializing. — location: [5082](kindle://book?action=open&asin=B08HGNF4Z8&location=5082) --- On average, rate cuts start when the median CPI is 35 bp lower than where it was when the last hike happened. But by the time of the first cut, median inflation is still 1.3% above the upper end of the respective inflation target. It is good enough for central banks that yoy inflation is going in the right direction, especially as inflation expectations tend to extrapolate the last set of inflation prints. — location: [5092](kindle://book?action=open&asin=B08HGNF4Z8&location=5092)Very interesting. CBs start cutting even with inflation above target, as long as the Yo Y trend has changed. --- Often, central banks are very happy to keep cutting rates even with inflation bottoming, if growth happens to be weak. Even though EM central banks usually are inflation targeters, growth does enter the equation whenever inflation is firmly under control. — location: [5102](kindle://book?action=open&asin=B08HGNF4Z8&location=5102)whereas they are quick to stop hiking. --- The early timing of the cut surprised the market. The cut was widely seen as premature by analysts, because inflation was still rising and because prior to the cut, President Roussef had asked for monetary easing. For the President to publically call for easier monetary policy to be implemented by an institution that was de facto seen as independent (if not dejure), raised many eyebrows. — location: [5177](kindle://book?action=open&asin=B08HGNF4Z8&location=5177)Re-read this whole section on Brazil. It's very informative. --- violent repricings in US rates are relatively rare. Furthermore, it is somewhat reassuring that these highly volatile episodes usually happen at only two points in the US rates cycle: around the last cut and leading up to the first hike. Once a smooth hiking cycle is in place, US rates reprice in an overly volatile manner much less frequently. — location: [5206](kindle://book?action=open&asin=B08HGNF4Z8&location=5206)The behaviour around last hikes, first cuts , last cuts, first hikes is very interesting and gives practical rules for investing. --- starting with NFP day in May 2013, US 10‐year swaps moved from 1.80% to a high of 3.18% on 5 September 2013, mostly driven by Fed governor Bernanke's suggestion to taper the existing QE programme. The sell‐off only ended when the Fed became more dovish and suggested that the start of the tapering of QE would be pushed out somewhat. — location: [5227](kindle://book?action=open&asin=B08HGNF4Z8&location=5227)Is this the taper tantrum? --- finally, another lesson is that when local and external forces happen to align, investors should go all in. As it turns out, 5 September was not only the peak in US rates, but also the start of more cuts from Banxico. Banxico had rung the bell. — location: [5246](kindle://book?action=open&asin=B08HGNF4Z8&location=5246)Revisit this section on Mexico. --- Even in EM, where central banks can turn from hikes to cuts much faster than G3 central banks can, one year is just too short to benefit much from the change of stance by the respective central bank. 1s/2s therefore tend to flatten after the last hike is in, as shown in Figure 6.34. — location: [5263](kindle://book?action=open&asin=B08HGNF4Z8&location=5263) --- Flatteners work best when, in addition to the local central bank cycle, US rates are also trading well. And the best steepeners are a combination of a local rate‐cutting cycle and US Treasuries trading poorly. — location: [5299](kindle://book?action=open&asin=B08HGNF4Z8&location=5299) --- For EM, there is an added benefit to replacing a receiver with a steepener, which has been illustrated by the case of Mexican rates during tapering. For most EM, risk aversion steepens the yield curve. — location: [5309](kindle://book?action=open&asin=B08HGNF4Z8&location=5309)Sleepiness in EM might be better than long yield streamers sometimes, when the long yield lakes on extra risk premium. For example during Em risk off, liquidity events, or when USTs are trading poorly. --- favouring front ends during easing cycles does little for cash‐constrained investors, who would have to give up meaningful DV01 in order to position at the short end. We think that, just as for the US, cash‐constrained investors are better off positioning in the belly to back end, — location: [5314](kindle://book?action=open&asin=B08HGNF4Z8&location=5314)not enough duration. --- P&L of receiving five‐year swaps of the three highest real yielders against paying the rates of three lowest real yielders. Average inflation for the past five years is used to deflate nominal rates. — location: [5357](kindle://book?action=open&asin=B08HGNF4Z8&location=5357)You should byq buy bonds with high real yields deflated by a long-running inflation average. --- Whether such term premium models work in EM is an empirical question. One hesitation is that often, countries that show a low term premium, which could justify the initiations of payers, are countries where cuts are expected. And countries that show a large term premium, justifying receivers, often are countries where hikes are expected. This has been demonstrated by Kiguel and Willer (2018). At times, upcoming easing cycles require receivers even if term premia optically appear low. — location: [5374](kindle://book?action=open&asin=B08HGNF4Z8&location=5374) --- receiving five‐year rates whenever the term premium is more than one standard deviation elevated, when using a three‐month rolling window, leads to the best results. — location: [5380](kindle://book?action=open&asin=B08HGNF4Z8&location=5380) --- payers for curves with low risk premia do not work as well as receivers, though Kiguel and Willer provide some evidence that term premia below zero should be paid. Furthermore, using term premia to rank countries does not appear to lead to superior returns. Finally, aggregating term premia for EM overall and versus the US term premium also does not generate alpha. Therefore, we do not advocate relying on term premia either for an assessment of the EM rates asset class or for country rankings as a relative valuation tool. — location: [5384](kindle://book?action=open&asin=B08HGNF4Z8&location=5384)Term preen, a work when it is high, relative to recent history, and on a short term basis. It doesn't work well for rising rates, or for choosing between countries. Except maybe when it is below Zero. --- Another way some investors think about valuation is to look at the slope of the curve. The theory is that a steeper curve offers better value, partially because the carry is more attractive. We already outlined that we are not great fans of carry in the context of curves, because we feel that often the time to be long is exactly when curves first invert. We also note that the appropriate slope of the curve must strongly depend on the current stance of monetary policy. — location: [5396](kindle://book?action=open&asin=B08HGNF4Z8&location=5396)The slope of the curve can be a source of return through roll-down yield. However roll-down yield can often move contrary to the Level of the curve. The shape ca depend on charges in monetary policy. --- Overall, we conclude that there is a small credit component to real rates that only becomes more sizeable for weak credits, which trade above 200 bp for the five‐year CDS. — location: [5432](kindle://book?action=open&asin=B08HGNF4Z8&location=5432) --- A small credit component for real rates is in line with the empirical observation that changes in CDS and changes in local rates are highly correlated, especially for weaker credits. If the CDS moves, real rates move, too, given that some fraction of the real rate is indeed compensating for credit risk, and this part grows whenever the CDS spreads move wider. — location: [5443](kindle://book?action=open&asin=B08HGNF4Z8&location=5443) --- Generally, the receiving cycle starts when there is one hike left in the hiking cycle and broadly continues until there is only one cut left in the easing cycle. The opposite holds true for paying cycles. During easing cycles, steepeners tend to work; while during hiking cycles, curves tend to flatten. For EM, the cycles can get more complicated due to the impact of the global cycle on the local rates cycle. — location: [5459](kindle://book?action=open&asin=B08HGNF4Z8&location=5459) --- Valuation also works to some extent, as countries with high real rates tend to outperform countries with low real rates over time. Using term premia relative to their own history also generates alpha. Finally, steeper curves, adjusted for the monetary policy cycle, tend to outperform curves that are too flat. Credit risk becomes a large part of valuing bonds only for very weak credits. — location: [5463](kindle://book?action=open&asin=B08HGNF4Z8&location=5463) --- linkers are popular instruments in certain EM, especially in the (mostly Latin American) countries with a history of high and variable inflation. Those inflation‐linked markets are well developed in several such countries. — location: [5495](kindle://book?action=open&asin=B08HGNF4Z8&location=5495) --- In aggregate, the market capitalization of linkers is around one‐fifth of the market capitalization of nominal bonds when comparing values for both asset classes at the end of 2018. — location: [5499](kindle://book?action=open&asin=B08HGNF4Z8&location=5499) --- The bulk of linkers are issued by Brazil (more than 52% of the index), followed by Mexico. For Brazil and Chile, the market capitalization of the linker market is actually higher than the market cap for nominals – in the case of Brazil, very meaningfully so. — location: [5501](kindle://book?action=open&asin=B08HGNF4Z8&location=5501) --- Going further out on the curve also means that we don't have to be as sensitive to the inflation seasonals, which play a very important role at the front end of the curve where the inflation carry is much more relevant given the short duration. — location: [5590](kindle://book?action=open&asin=B08HGNF4Z8&location=5590) --- during easing cycles, nominal rates usually outperform significantly. — location: [5593](kindle://book?action=open&asin=B08HGNF4Z8&location=5593) --- The best environment for linkers is one where commodity prices rise but the local currency does not appreciate, or when EMFX weakens without commodities selling off too significantly. — location: [5640](kindle://book?action=open&asin=B08HGNF4Z8&location=5640) --- Given that inflation targets are more often missed to the upside, it is not surprising that breakevens usually trade above the inflation target and are often closer to actual inflation. When breakevens trade below the midpoint of the target, it has historically been a signal to go long inflation in Brazil, Colombia, and Mexico, as such episodes have been rare and fleeting, occurring only 5% of the time in Brazil, 7% of the time in Colombia, and 8% of the time in Mexico. — location: [5751](kindle://book?action=open&asin=B08HGNF4Z8&location=5751) --- It is an interesting question whether the existence of the long‐duration linker market held back the development of a long‐duration nominal bond market. Clearly, having a long‐duration linker market in place made it less urgent for both the government as the issuer as well as pension funds and other long‐term holders to venture out on the nominal bond curve. — location: [5839](kindle://book?action=open&asin=B08HGNF4Z8&location=5839) --- With respect to Brazil, it is important to know that the country is in the process of lowering its inflation target. So far, it has been agreed that the target will be moved from 4.5% in 2018 to 3.75% in 2021, presumably with a goal of eventually arriving at a 3% target. — location: [5844](kindle://book?action=open&asin=B08HGNF4Z8&location=5844) --- The median policy rate peaks at around 50 trading days after an emergency hike. Rate cuts start on average at around 75 trading days (or more than 3 months) after an emergency rate hike. As we laid out earlier, on average, emergency rate hikes stabilize the currency, though not on day 1, and only for cheap currencies. — location: [5913](kindle://book?action=open&asin=B08HGNF4Z8&location=5913) --- Just prior to the second leg up in the (median) policy rate, a month or so after the initial hike, the P&L of the two‐year and five‐year receivers bottom. This is when investors should begin receiving rates. — location: [5933](kindle://book?action=open&asin=B08HGNF4Z8&location=5933)Emergency rate hikes create underperformance in receivers lasting for a month after the hike. Great chart. --- default probabilities for EM sovereigns have been generally lower than default probabilities for US corporates, while recovery values have been higher. The default probability for sovereign credits below investment grade was 2.5% for the period from 1983 to 2016. During the same time, the default probability for US HY was 4.2%. Over the same period, the recovery value was on average 65% for sovereigns (and 45% if weighted by value), but only 37% for US HY. — location: [6097](kindle://book?action=open&asin=B08HGNF4Z8&location=6097) --- the sweet spot on an IR basis in terms of ratings has been BBs. As and Bs also still generate respectable IRs, while for BBB, performance has been much worse. For duration, the sweet spot has been the front end, and in particular anything below five years. The worst performance occurred in the sector with the longest duration (>10 years), partly because the roll‐down is typically worse. — location: [6212](kindle://book?action=open&asin=B08HGNF4Z8&location=6212) --- One reason for the poor performance of BBB is that there has been a downgrade cycle during the period under study, and the worst market impact of a downgrade is when IG is lost: i.e. when ratings move from BBB to BB. These downgrades dragged down BBB performance and have helped BBs. BBBs should especially be avoided during weak growth cycles. — location: [6263](kindle://book?action=open&asin=B08HGNF4Z8&location=6263) --- As such, we would conclude that when the ISM peaks, real money investors should not only move out of HY and into IG but also reduce duration even for the safest curves — location: [6300](kindle://book?action=open&asin=B08HGNF4Z8&location=6300) --- The classic indicators that credit investors as well as the rating agencies follow are based on the external position of a country and government finances (both flows), as well as debt levels (the stock). In particular, popular indicators are the current account balances, fiscal balances, debt levels, and inflation. Typical warning signals are current account deficits in excess of 3–4%, fiscal deficit in excess of 7–8%, external debt of more than 45%, and inflation above 20%. — location: [6312](kindle://book?action=open&asin=B08HGNF4Z8&location=6312) --- A second way to forecast credit fundamentals is for investors to be on the lookout for signs of major exuberance with respect to asset markets as well as flows, which often go hand in hand with imbalances in current accounts and fiscal accounts. We propose to use the analysis of Ray Dalio from his excellent book on credit cycles as a guide (Dalio 2018), which we implemented for EM (Willer et al. 2019a). — location: [6332](kindle://book?action=open&asin=B08HGNF4Z8&location=6332) --- Under Kirchner, the country had largely insulated itself from the world economy by implementing severe capital controls, massaging economic statistics, and breaking off relationships with the IMF and international creditors. It had also resorted to large central bank financing of government deficits, and subsequently artificially suppressed inflation with price controls. — location: [6360](kindle://book?action=open&asin=B08HGNF4Z8&location=6360)Argentina under Kirchner. --- This combination of weak fundamental indicators and bubbly financial markets meant that the table was set for a major crisis. By late 2017, both the economic and market indicators were therefore in line with levels that typically precede a severe debt crisis, as illustrated in Figure 9.16. — location: [6378](kindle://book?action=open&asin=B08HGNF4Z8&location=6378)Argentina followed the classic credit cycle. --- the revision of the inflation target was a shock to investor confidence that led to outflows and to a sharp correction in Argentine asset prices. The narrative had changed, and investor focus shifted decisively from a positive political narrative to macro fundamentals, making Argentina susceptible to a sudden stop of capital flows. — location: [6390](kindle://book?action=open&asin=B08HGNF4Z8&location=6390)The inflation target revision happened in Dec 17, and the market peaked before volmageddon. It was likely more related to the business cycle and liquidity. --- Argentina tried to stem the tide with emergency rate hikes, but they came too early and before the peso cheapened sufficiently. — location: [6392](kindle://book?action=open&asin=B08HGNF4Z8&location=6392)Emergency rate hikes only work if the currency is sufficiently cheap. --- some countries still use pegged exchange rates, especially in the Gulf. For commodity producers, a pegged exchange rate is especially ill‐designed to cope with the manifold external shocks that being a commodity producer entails. This is illustrated in Figure 9.17, which shows the three pegged oil credits (Bolivia, Iraq, and Oman) underperforming the EM commodity credit basket during the last three major episodes of falling oil prices. — location: [6403](kindle://book?action=open&asin=B08HGNF4Z8&location=6403)Could the Gulf county pegs be at risk after the next commodity cycle bust. --- EM tend to have inflationary busts, rather than deflationary busts, largely because FX tends to adjust very significantly, leading to high inflation. — location: [6417](kindle://book?action=open&asin=B08HGNF4Z8&location=6417) --- The IMF packages therefore end up providing both the benefit of access to credit as well as the benefit of a having a scapegoat for the required adjustment. — location: [6427](kindle://book?action=open&asin=B08HGNF4Z8&location=6427) --- spreads widen significantly two months prior to the IMF announcement, by an average of 130 bp and with a median of 45 bp. Spreads stabilize around 15 days before the announcement. This is likely the case because there are typically rumours of an IMF deal ahead of the announcement. — location: [6436](kindle://book?action=open&asin=B08HGNF4Z8&location=6436) --- Median spreads subsequently move sharply lower: 150 trading days after the announcement, the median spread is more than 100 bp tighter than just before the IMF announcement. Furthermore, as also noted in the Citi report, there is no strong relationship between the size of the programme, — location: [6444](kindle://book?action=open&asin=B08HGNF4Z8&location=6444)IMF probably accurately estimates the size of the bail-out needed. --- Once the restructuring is concluded, sovereigns can generally borrow again quite quickly.3 Two years without external borrowing is usually easy for a sovereign to survive, given that as a result of the crisis, current accounts are often in surpluses and USD needs for debt repayments obviously fall to zero. — location: [6467](kindle://book?action=open&asin=B08HGNF4Z8&location=6467) --- spreads will initially be higher upon a return to capital markets. But even that impact is short‐lived. Borensztein and Panizza (2008) show that spreads are about 400 bp higher than they should be in year one, falling to a 250 bp premium in year two, and then falling quickly to zero. — location: [6470](kindle://book?action=open&asin=B08HGNF4Z8&location=6470) --- Fundamentals will also likely have improved, as defaults are often coincident with recessions, which tend to compress import demand and lead to fast adjustments of the balance of payments. The currency has often become very cheap. This creates inflation, which usually erodes real wages and makes countries more competitive. Often, old governments fall, generating hope that economic management will improve. But investors, still shocked by the recent default, require very high risk premia to be tempted back into the market. As such, a default creates the very best circumstances for investors to invest in bonds of the relevant country. — location: [6476](kindle://book?action=open&asin=B08HGNF4Z8&location=6476)Conditions after default create stronger fundamentals and a high risk premium. --- defaults in the absence of an inversion are even rarer. As such, Brazil credit was an easier buy than Turkey back in 2008, as it never inverted. The Brazil one‐year CDS trading above 500 bp likely reflected risk aversion rather than rising default risks. While it is impossible to compare the “true” default probabilities for Turkey and Brazil in 2008, we would be biased to sell CDS protection after spikes for countries that do not have an inverted curve. — location: [6630](kindle://book?action=open&asin=B08HGNF4Z8&location=6630) --- In particular, a cash‐neutral portfolio that is long the five cheapest countries relative to the ratings curve and short the five most expensive countries relative to the ratings curve generates a Sharpe ratio of 0.9 under the assumption of semiannual rebalancing, compared to the Sharpe ratio of the long‐only strategy of 0.64. While the strategy has a positive beta (on average 0.7), as the longs have a higher beta than the shorts, the portfolio does not systematically underperform in periods of negative index returns. — location: [6679](kindle://book?action=open&asin=B08HGNF4Z8&location=6679)Buy credit with yield spreads too high relative to rating agencies scores and short low yield relative to ratings. --- rating agencies will only downgrade when the situation is already relatively dire, which is at a time when markets have already priced in a fair amount of the worsening fundamentals. In spite of this institutional latency, rating agencies can be market moving. The reason is that many investors are highly ratings conscious and may, for example, have mandates that are purely investment grade. This is not as arbitrary a threshold as it seems. Since 1975, there has not been a single default by a sovereign that was ranked IG one year prior to the default by S&P.7 — location: [6699](kindle://book?action=open&asin=B08HGNF4Z8&location=6699)Agency ratings have meaning, such as lack of default in IG, and are important for some institutional mandates.Changes in ratings cause changes in flows,but the market moves befor eagencies! Ratings changes are not tradeable! --- Figure 9.23 shows the median z‐score of the spread change going into an upgrade/downgrade on day 0. In the 60 days before day 0, spreads tighten into upgrades and widen into downgrades. Spreads then stabilize after the event. Downgrades have larger moves into the event than upgrades. — location: [6707](kindle://book?action=open&asin=B08HGNF4Z8&location=6707) --- It is, of course, not clear whether the spreads move in anticipation of ratings action, or whether both ratings action and spread tightening are driven by the same (improving) underlying fundamentals, or whether rating agencies (subconsciously) become bullish due to euphoric price action. — location: [6709](kindle://book?action=open&asin=B08HGNF4Z8&location=6709) --- by the time the rating action occurs, the party is over, especially for downgrades. — location: [6711](kindle://book?action=open&asin=B08HGNF4Z8&location=6711)This is important! The rating change marks the end of the move. --- In summary, we think traders should not react to most upgrades or downgrades. By the time they (upgrades or downgrades) happen, the market has already fully priced it. — location: [6769](kindle://book?action=open&asin=B08HGNF4Z8&location=6769) --- the key is to avoid credit longs going into US recessions, the time to get out of credit longs in general and the carry trade in particular is when the US curve first inverts and subsequently disinverts. — location: [6813](kindle://book?action=open&asin=B08HGNF4Z8&location=6813) --- Moving to FX, given more binding liquidity constraints in bonds, we apply HRP as well, and compare it to simple risk parity, equal weights, and the existing benchmark. Here, risk parity outperforms in IR terms, followed by HRP. But all three approaches outperform the benchmark, suggesting that portfolio construction can be instrumental in generating alpha. — location: [7341](kindle://book?action=open&asin=B08HGNF4Z8&location=7341) --- With rising wealth and increasing formalization of the economy, the service sector usually expands, both as a percentage of a country's GDP and as a fraction of the consumption basket for which inflation is calculated. This leads to lower FX inflation pass‐through over time, which eventually should also impact the psychology of linking inflation to the exchange rate. — location: [7534](kindle://book?action=open&asin=B08HGNF4Z8&location=7534) --- The reduction of debt denominated in foreign currencies is also a typical development as EM increase the size of their local financial systems over time, creating a natural demand for local currency‐denominated assets. — location: [7536](kindle://book?action=open&asin=B08HGNF4Z8&location=7536) --- one major difference between the 1997–1998 crisis and the 2008–2009 crisis: in the more recent crisis, commodity prices fell much more significantly than a decade earlier, as per Table 11.3. Commodity prices fell so drastically in 2008–2009 that they were lower for EM even after taking currency depreciation into account. This might have led to an exaggerated impression of a weaker pass‐through effect of FX to emerging market inflation, as the impacts of FX and commodities on inflation are hard to distinguish from one an other, — location: [7556](kindle://book?action=open&asin=B08HGNF4Z8&location=7556)