Our Favourite Trades to Start 2023

Gaining Conviction at the Outset

We like to wait until the second week of January to publish our favourite trades to start the year. Banks tend to publish before Christmas and are forced to update in the new year, while others put trades on the first business day only to hit by random market flows. 

The good news is that several macro themes have started to emerge in the second week of January. One is that the China reopening theme has more legs, another is that Euro core inflation is still trending up. As for the US, the dataflow appears to be validating calls for a moderation to inflation or even the Fed hiking cycle. 

As for our trades, we like narrow our timeframe to the next three to four months. This allows us to give higher-conviction views. It also forces us to think about trades that we think will work well in the coming months. We’ve come up with seven themes – each associated with a set of trades. They span FX to rates to equities.

Our Themes and Trades

• Rest of the world catch-up: sell USD vs EUR, JPY

• China dash for growth: short USD/CNH, long HSI

• UK rolls over: UK Steepeners

• Euro (bond) supply issues: sell BTP vs bund

• Aussie rebound: sell GBP/AUD

• Too much Swedish love: receive Swedish rates vs euro

• No time for tech: long SPX vs Nasdaq      

Global: Goodbye Greenback, Rise and Shine Rest of World

(Bilal Hafeez, [email protected])

The Trade: sell USD vs EUR, JPY

We are at the dollar endgame. USD remains near its highest levels since the mid-1980s. And now, foreign investors are selling US equities while the markets believe the Fed is close to ending its hiking cycle.

However, you could have constructed the same bearish dollar view at various points last year, despite it not playing out until Q4. Moreover, previous multi-year dollar turning points proved choppy before turning down. Therefore, we err on the side of caution, tactically trading the dollar for now, before deciding whether the dollar downtrend has properly emerged.

Our framework suggests selling the dollar right now for three reasons:

1. US recession fears. The US yield curve has inverted and suggests a recession is likely in 2023. Moreover, recent weak PMI and falling working hours data support this narrative. The exact timing of a recession is hard to discern especially with a still-strong labour market. But until broader activity data turns up, the recession narrative will likely persist. The dollar has previously tended to trade sideways or weaken into recessions (Chart 1). Stabilising Euro-area growth and the China re-opening could further help this weak dollar trend, too. This shifts the dynamics towards rest-of-the-world growth outpacing US growth.
   
2. More hawkish ECB, BoJ and others versus Fed. Aside from growth, inflation trends are diverging. US core CPI appears to have peaked, while core inflation in the Euro-area, Japan and most of G10 continues to increase. This could be the typical lag seen where the US leads to the Euro inflation cycle such as in the 2000s. This suggests the ECB is nearer the middle of its hiking cycle than the end. As for the BoJ, with 10-year JGB yields trading at the 0.5% upper bound of the Yield Curve Control (YCC) target, we could see another YCC widening. That in turn could support the yen. Meanwhile, the Fed is the process of reducing the size of its hikes. Admittedly, we think there will be a point in the year when the Fed spooks the market as it fails to ease, but that could be a Q2 story.
   
3. Technicals support selling dollar. Our momentum models are signalling sell USD against both the EUR and JPY. Hedge funds are scaling back EUR and JPY shorts, while real money are holding on to EUR longs and reducing JPY shorts. These trends could continue, supporting a weak dollar phase. However, our correlation monitors indicate that the dollar is weaker than expected given the levels of rates and equities, though the dollar undervaluation is less acute relative to changes in rates and equities.

Overall, we like to be short the dollar against both the euro and the yen. We would look for a move towards 1.12 and 125, respectively. This would take these pairs back to their levels in 2022H1.

China: Long Risk on the Dash for Growth

(Bert Gochet, [email protected])  

The Trade: short USD/CNH, long HSI

We went long China risk in November when signs suggested the zero-Covid (ZC) policy and property restrictions were about to be relaxed. Initially, we did not expect a significant reversal of the policies, but we thought that tinkering with it was enough to lift the cheap valuations of, in particular, China equities and the currency.

In the weeks and months that followed, we (together with the market) have been surprised by how fast policymakers have moved. By now, all ZC rules are dismantled, and many of the property restrictions are relaxed. As a result, Hang Seng is up 45% from its October nadir, and likewise CNH rallied 7.5% from its 7.34 low.

The key question for investors considering entering these trades now is this: is there still space for these trades to run? Our answer is yes, for the following reasons.

1. Post-pandemic activity is increasing faster than expected: One of the concerns about the rapid dismantling of the ZC policy was that it would lead to popular unrest or stoppages in supply chains. However, none of this has happened. In the Tier 1 cities, more than 50% have already been infected, and mobility indicators are now rising sharply. 
   
2. The new government wants growth, but market remains skeptical: Since November, not a week has gone by without a new stimulus announcement from policymakers. The new government, chosen at the Party Congress last year, will start its official term only from March, but policies to boost growth this year are already being established. The property sector has seen various measures – the most relevant so far is the cancellation (or at least the delay) of the so-called ‘three red lines’ policy. That said, the market remains skeptical of all these measures’ impact, and therefore consensus is currently still for YoY housing sales growth to remain flat. But we think the government will not be satisfied with flat growth, and more measures will follow to increase it. 
   
3. The days of unlimited fiscal spending are gone, but household savings have grown: Still, even when the focus is on boosting growth, the government clearly recognizes the limits of fiscal spending. During the pandemic, there were no stimulus checks in China, as in the US and elsewhere. However, Chinese households decided to save for themselves during the period, and savings balances have risen over the past two years. This will boost consumption now the country has reopened. Economic growth in China will be around 5% this year, with a peak in growth probably by the end of 1Q and during 2Q.  
   
4. CNH and equity and equity valuations are still attractive: The start of the year has brought increasing conviction in the spec community for holding long CNH. Yet ultimately it will be onshore market participants that determine whether CNH can rally further. In that sense, it is helpful that corporate exporters are still underhedged and that they have a seasonal tendency to sell USD/CNH at the start of the year (Chart 1). It is therefore still likely that CNH rallies further. We recently extended our target to 7.70, but we do not rule out moving it further still. As for equities, the Hang Seng P/E reached a low of 5.5 in October and has since risen to 7.5. But a further normalization towards the 10-year average of 9 is likely now that both Hong Kong and China are open again (Chart 2). 

The UK: BoE Rolls Over – Gilt Steepening

(Henry Occleston, [email protected])

The Trade: UK Steepeners.

I have been calling the BoE dovish pivot for a while. Initially, I looked for such a move at the November MPR, but then shifted it to this February. The disastrous mini-budget and the surprise loosening of HMT purse strings helped push back my initial estimate.

Now, however, the underlying case for dovishness can build. The hawks have largely dropped the need for further front-loading, the doves are already calling for a pause, and the important neutral voices are focusing more on the turning labour market and declining business expectations for price growth (Charts 4 and 5). Near-term data will be very important (CPI and labour market data in particular). But for now, the trajectory towards a February pivot remains solid.

From the rates side, a pivot would mean a tempering of future market pricing (currently peaking at 4.5%) towards 4-4.25%. This, alongside the heavy slate for gilt duration supply (exacerbated by active gilt sales) should allow for curve steepening (our PCA model is looking for this also).If everything pans out as I expect, there should be room for UK 2s10s steepening out to 70bp. The risk to this is that data causes the BoE to delay its pivot. On this, next week’s releases will be crucial.

Europe: Euro (bond) Supply Issues

(Henry Occleston, [email protected])

The Trade: sell BTP vs bund.

Unlike the BoE, the ECB looks well positioned to continue hiking. I expect terminal above 3.5%. Unless there is serious market dislocation, they will also likely begin the well telegraphed passive QT in Q2. This, alongside the heavy EGB issuance slate (which will probably need to be further increased given how optimistic European treasuries are on growth, Chart 6) and the possibility of another energy price spike, should keep EGB yields well supported.

I have been bearish core EGBs – we took profit with 10Y Bund at 2.5% over the holiday. Yet the weight of supply looks more set to hit the periphery (Chart 7). This, and the risk that new political tensions between Italy and the EU establishment develop on the back of high deficits and gas-restocking efforts, should keep periphery debt under pressure.

I expect to see 10Y BTP/Bund spread finding a new bottom soon before re-widening out towards 250bp. Outright, 10Y BTP has room to sell off towards 5%. The biggest risk on this side is probably of a generic rates bid coming from a Fed dovish pivot story. This was the case through H2 of last year. Now, yields are under pressure once again.

Key Stories for Europe in Q1

1. Clash of the ‘Tighteners’ – the ECB is getting worried about loose fiscal policy. European governments want to support households and businesses through the energy crisis and likely increased economic hardship. State elections in Germany, a general election in Spain and the need for Italian PM Meloni to fight her country’s corner could drive new tensions in policy.
   
2. April Fuels – the mild winter has been a positive story for EU gas storage. Supplies for next year without Russian gas remain a worry. That risk has declined in recent weeks, but this is not a one-player game, and the risk of new supply disruptions emanating from either Russian activity or simple misfortune (recall 2021’s Suez blocking) remains high. Supply diverted to fuel China’s reopening will also be a factor. What the situation is in spring, when EU countries typically start refilling stockpiles, will be critical.
   
3. Sharing the Losses – with the ECB now set to begin QT, and the BoE actively selling its bond holdings, greater scrutiny will be put on who bears the financial cost. For the UK, it is relatively simple – HMT does – that has been well set out and well scenario’d. For the ECB, it may be more complex. As the hawks push for more tightening, ultimately there will probably be calls for active sales. Then, the conversation on losses may take on a more beggar-thy-neighbour tone. It is not a problem for the immediate term, but it is one to watch.
   
4. Turkish Elections – while until June, the run-up to the election will be important. Current polling suggest incumbent President Erdogan will lose, but he has previously shown an inclination towards playing unfairly. It is hard to say whether that could extend to provoking external distractions (to the East, or the West). Turkey holds a key geopolitical position as a counterweight to Russia in the Black Sea, and as a transit point for Azeri gas flows. Therefore, its foreign policy being dictated by the election would be a serious tail-risk.

$-Bloc: Back Up From Down Under – The Aussie Rebound

(Ben Ford, [email protected])

The Trade: sell GBP/AUD

China is reopening. At the same time, the government is providing a non-stop stream of support, with housing targeted in particular. Even without the exceptional support, the reopening would be bullish for AUD (Chart 8). This time is no different. And now, Australian coal exports are returning to China. That means a cashflow that used to be exchanged for a third of Australian exports (pre-ban) and roughly a quarter of Australian coal is set to return.

But what if you think the China reopening is already priced in? Then you would need another bullish AUD factor. Thankfully, Dominique believes markets are too pessimistic about US Q4 GDP. A potentially positive growth surprise against a backdrop of a perceived inflation slowdown could be positive for risk in general and therefore AUD, too.

We prefer to trade this upside versus GBP for three reasons:

• UK data likely remains weak while Australia data likely holds up better until March (most mortgages will roll to floating then).
• The BoE may still be overpriced – Henry thinks BoE terminal could be as low as 4% if they pause in February – while the RBA is underpriced for the February meeting.
• GBP/AUD has fallen 3.5% and the next technical resistance remains at least 3% away (1.70) and could even fall another 6% (1.65; Chart 9).

We see value in turning short GBP/AUD with an initial target of 1.70 but see 1.65 as achievable.

Scandies: Too Much Swedish Love

(Ben Ford, [email protected])

The Trade: short Euro vs Sweden 2Y swaps

The Swedish economy is proving stronger than forecasted. Latest data shows GDP moderated -0.5% MoM in November following a strong October (+0.7% MoM), implying a better-than-expected outcome for Q4 than the Riksbank had forecasted (-0.8% QoQ). However, weakness will prevail (Chart 10). Swedish households remain highly levered – a 1pp increase in the policy rate today means consumption will slow around twice as much as 15 years ago.

At the same time, we expect core data (CPIF and wages) over the next quarter to prove beneficial for Riksbank doves. Our model for Swedish inflation is yet to bake in a second peak, reflecting easing energy prices (Chart 11).

Meanwhile, core inflation (CPIF excluding energy) has printed (marginally) below forecasts. And while the proposed salary increases (+4.4%) across the trade unions are the highest since the Industrial Agreement was introduced 26 years ago, the employer organisations rejected the demands. Instead, they suggested a one-year wage increase at 2.0% and a one-time payment of SEK3,000. Even if they do go through at +4.4%, they represent less than a quarter of the workforce. The average employee has seen just an average 2.74% YoY increase in their average monthly salary.

We think it confirms the Riksbank is approaching the end of its hiking cycle while the terminal rate may well be overpriced. And, to trade this view, we look to the European Central Bank (ECB), which has significant work left to do. How far they go is a hard question to answer. How much longer for, however, is probably easier to gauge. ECB Villeroy, for example, expects rates to peak ‘towards the summer’. In short, we are approaching the end of the Riksbank hiking cycle, but not the ECB hiking cycle.

Comparing swap yields in similar scenarios, we find that the two-year spread has spiked on each occasion (Chart 12). In two of the three, the spread peaked around 50bp on both occasions (early 00s: +47bps; ’06 to ’08: +72bps). Currently, the pair trades at -8bps and, over the next quarter, we think it will return to 50bp.

There is value in being short Euro two-year swaps vs Sweden two-year swaps with a target of 50bp.

The US: No Time for Tech ­– Pick Your Equity Spots!

(John Tierney, [email protected])

The Trade: long S&P 500 vs NASDAQ 100

From a macro standpoint, we are underweight US equities in our overall asset allocation framework. We see risks tilted to the downside in 2023, due to persistent inflation, a hawkish Fed, and soft earnings growth. But that scenario plays out later this year.

For now, we think equities will trade in the range of the past six months in coming weeks and perhaps months pending new developments that will push markets higher or lower. That would be 3800-4100 for the S&P 500 (SPX) and 11,000-12,500 for the NASDAQ 100 (NDX). A combination of robust labour market, ongoing economic growth and expectations that the Fed will hold its policy rate near 5% have lifted hopes of a soft landing.

To push above that range, inflation must subside, the economy must survive a soft landing scenario, and there must be strong expectations the Fed will cut rates in the near future.

To break to the downside, inflation must prove persistent, the Fed keep raising rates (or threaten to), and earnings growth be stagnant.

A trading range market creates opportunities for trading-oriented investors. We think equities will benefit from a modest tailwind in the short run. The Atlanta Fed GDPNow model is projecting Q4 GDP of 3.8%, and Q4 earnings season will likely deliver mostly constructive earnings reports. The risks, of course, will come from ongoing inflation reports and potentially hawkish Fedspeak, as well as ongoing (and well-known) geopolitical tensions.

Here are some of our favourite equity trades (relevant ETFs are in parentheses):

Major Indices – Within equities, we are overweight SPX (SPY) and underweight the NDX (QQQ) and Russell 2000 (IWM). If the economy performs as we expect, both the NDX and Russell 2000 will underperform the large cap SPX.

Overweight Energy (XLE) – Within sectors, our favourite trade is to overweight the energy sector. The primary reason to favour energy is that fossil fuel companies are now prioritizing returning cash to investors via dividends and share buybacks rather than investing in new projects. The free cash flow yield for the SPX energy sector is now about 11%, versus a historical norm of 2-4%. The market has not yet priced in the change in energy company policy. The decline in oil prices from near $90/barrel in November to $75 recently has created some headline risk, but we see this as an opportunity to add to energy positions. Indeed, a silver lining of lower oil prices is that energy companies will not be tempted to return to investing in exploration and production.

Overweight Value (RPV)/Underweight Growth (RPG) – Given that the economy remains at risk of tipping into recession later this year, we favour value over growth. Growth will struggle as long until interest rates decline and a until soft landing does indeed emerge. Investors can get exposure to value via the ETF RPV and to growth via RPG.

Overweight Healthcare (XLV) – Even in recession scenario, the healthcare sector will continue to be steady. Investors can hold it via the XLV ETF.

Overweight Airlines (JETS) – As long as the economy avoids a severe recession, consumers are anxious to travel. Between lower fuel prices and still not at full capacity due to labour shortages, airlines are enjoying an unusual period of profitability.

Underweight Consumer Discretionary (XLY)and Technology (XLK) – Consumer demand for many consumer discretionary products and technology evaporated as the Covid-related restrictions were lifted about a year ago. They show little sign of recovering. As noted, people are more interested in spending on services and travel.

Corporate Bonds Are a Hold

Corporate bond spreads will widen in a scenario of economic weakness on expectations of rising default rates. The issue is how much corporate defaults rise.

In our view, corporate bond markets are in good shape. Many companies took advantage of the extended period of very low rates to refinance existing corporate bonds and extend maturities. Hence most companies will not need to roll over maturing debt at the worst time. Companies have also generally been conservative about adding leverage in recent years. In the high yield market in particular, companies have kept debt/EBITDA ratios in line. In addition, interest coverage ratios are considerably higher than historical norms because of low interest costs.

In a recession scenario, we expect corporate bond spreads will quickly recover as investors realize that default rates will likely be much lower than the credit cycles of the early 2000s and in 2009.

We suggest holding the investment grade sector via the LQD ETF and high yield via HYG or JNK ETFs and riding out possible spread volatility later this year.

We note that the corporate bonds in the ETFs are exposed to both credit and rate risk. Investors who want to avoid rate risk can short Treasury ETFs. A good alternative for the longer duration LQD is IEEF (7-10-year Treasuries). For the intermediate duration high yield sector, we suggest VGIT (intermediate maturity Treasuries).

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

Bert Gochet is a strategist at Macro Hive, specialising in Emerging Markets strategy. Between 2009 and 2017, he was co-head of global EM strategy with a focus on fixed income and currencies at JP Morgan.

Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.

Ben Ford is a Researcher at Macro Hive. Benjamin studied BSc Financial Mathematics at Cardiff University and MSc Finance at Cass Business School, his dissertations were on the tails of GARCH volatility models, and foreign exchange investment strategies during crises, respectively.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)