From Nic Lenoir of ICAP Markets and more generally the world are at a very interesting juncture. In physics, every system basically attempts to find a state of equilibrium. If a system that is in a state of equilibrium receives or loses energy from/to another system it can lead to a change in the state of equilibrium. Transitions at the micro level happen in steps even though looking at the world it seems like continuous evolution because what we witness is all the different systems that compose the universe in constant interaction. When a system is pulled with extreme force into two different directions it could appear like it is in a state of equilibrium, but the most minute change could lead to a drastic change in the system's state. An anecdotal example of this was offered to us a little over a decade ago when a group of illuminated brain surgeons decided to break the tug of war world record. For those like me who really don't understand what the world record of tug of war can be, it's just putting a record number of people pulling on each side. The experiment went wrong when after a few seconds of stand-still the tension in the rope exceeded capacity... the rope gave and sadly a few people lost their lives as each side of the rope backfired into the people pulling with extreme power. Why am I babbling about tug of war? Because the current state of the world economy is very similar to that world record attempt. The system is stretched in a lot of different directions: demand for resources, unemployment, conflicting stimulus policies chasing the same demand for goods, unsustainable amounts of debt... This is best exemplified with the latest currency intervention of the BOJ which was met with criticism by European officials and some observers in the US. Meanwhile their main objection is probably that Japan is going after the same thing they are: a cheap currency to try to grow via exports. People wonder if we are going to have a deflationary wave or hyperinflation: clearly there are arguments for both cases to be made, and those are the forces pulling the system in different directions. The markets are clearly highlighting this schizophrenia with bonds at or close to record highs, Corn, Gold, or Silver reaching for the sky, and equities in the middle gyrating with increasing velocity like a lion about to break out of its cage. My personal belief is that markets and people don't deal well with change, and for that reason I think it will end up in tears. Historical correlations are at risk of being shattered, and the most direct consequence is going to high volatility and brutal moves that will eventually take all paper assets down significantly, including commodity futures. Changes will not only be seen in the markets but affect the organization of our society as a whole. Clearly it won't happen overnight, but when things look like they are settling in an unsustainable state, chances are the longer they stay in it the more violent the exit will be. There is a lot of pent up energy in the world right that is looking for a new home, and a lot of money in the markets that has no clue where to go, and the answer lies in that this money is not worth as much as people think it is. That's why eventually there is going to be a destruction in value of paper assets. A trade that highlights this best is the 10Y UST-JGB yield spread versus USDJPY. You have the Fed on the bid for US Treasuries, and the BOJ on the bid for USDJPY. From 2009 to 2009 the R^2 between the yield spread and USDJPY was 87! Recently the currency has been following more closely the 2Y yield spread, but with the gap between the 10Y yield spread and USDJPY at its widest in 10 years back in March, and still far from fair value (see bottom chart on the picture, it is 65bps rich), with two central banks effectively compressing the spread from each end, I think this is a great way to capitalize on this tug of war game. On top of that the carry of owning 10Y US treasuries over JGBs is positive, the US curve is a lot steeper so the roll-down is in your favor as well, and with 10Y recently trading special in the repo market it adds gravy on an already very compelling trade. Maybe this will be one of the ways to benefit from a systemic reorganization. The trade gives you essentially a free option on a blow up in Japan since you are short yen and short JGBs while long USD and 10Y US Treasuries, on top of trying to capitalize on a central bank sponsored mean reversion while collecting positive carry... It seems so good that I am almost scared I missed something obvious. Some people point that the Swiss National Bank has been trying to weaken the Swiss Franc unsuccessfully and therefore the move by the BOJ is to be faded. I strongly disagree. Last time the BOJ intervened it marked a low in USDJPY that held for 3 years, so I don't think it is a fight people want to pick here.
