The Setup

After the slow, continual sell-off of May and the implosion of GDP and the employment figure in early June, the long end in the US completely crapped-out on 7 June. The results were like a tsunami on our desk. Every day was like a funeral.

I spent virtually all of May fighting off an urge to close out my long futures position and go short. On multiple occasions, I stopped myself from doing so because of the wiser voices on the desk and my own greed. Approaching the data in the first week of June, I was incredibly nervous about the strength in the Aust economy showing through again. My inertia and inability to switch it around caused a blow-up of proportions that I could barely fathom. I spent the next couple of weeks wondering each day when and if the axe might fall on me. I found myself glad to be involved in peripheral activities for the desk as a whole because it at least felt as if I was adding something.

Then the end of June rolled up, some communication came out that confirmed there were some serious issues with our senior management and, most importantly, that Vincent wasn't trading until they were resolved. Suddenly, I realised that my issues and my performance, were in the grand scheme of things, insignificant. If it was just me that had blown-up, or if I was by far the biggest, then I'd have good reason to be worried; but it as it stood, the new year was going to wash my sins clean.

All this made for a strange situation with Vincent. He was, at his heart, a trader and a risk taker. Without this, I really wasn't sure what he was. We were like a pack of wolves, hunting together, sharing our kills and revelling in the communal excitement of it. Sometimes we killed, other times, the prey got away but regardless of the result, we lived and shared the life of the pack. Vincent was like the alpha dog of the pack. He was the big wolf, who we (especially me) would look to for guidance and inspiration. Now he was muzzled and we all regarded him curiously, because he was still alpha dog yet he wasn't, for now, one of us.

The new year rolled around and I went into the first week of July and the data season with a couple of key thoughts regarding our market:

1. The RBA was not likely to hike in 2007. The 'hurdle rate' for core inflation had been raised considerably by the low CPI figure in May. I figured (correctly, as it turned out) that the RBA would at least wait until the July CPI figure before acting (meaning a July hike was out of the question). Also, that core CPI figure would probably have to be 0.8 or above for the RBA to go in August. I didn't think that was likely and I figure that the market's reaction to the strong data in June was overdone. Stevens hosed some of that down in his speech in Brisbane in mid-June and the very low retail sales figure last week took some further wind out of those hawkish sails.

2. The dangers for large moves remain in the following areas:
a) Equity market correction/nervousness
b) Further credit market nervousness
c) Further correction in Bunds/Treasuries due to repositioning of forecasts.

a) has yet to be seen since late February 2007 and that move, caused by the 9% correction in Chinese equities and the sub-prime nervousness had mostly been erased within a month or so later. Many commentators (I'm looking at you, CitiFX) have been calling for the apocalypse in Equities for a while.

b) was really the story of the later part of June 2007. Complacency in pricing of risky assets had been called out by many observers for a long time. This move caused some pain for us despite futures trading a fairly narrow channel during this period. I still contend that this move has a fair way to go. A credit crisis could easily see a massive correction across the credit spectrum. Maybe not soon but I reckon when it happens, it'll happen in size and rebalance asset allocations across the asset risk spectrum.

c) is interesting because many people think that this move is basically done. I'm not so sure. With every investment bank in the world calling for multiple easings in the US this calendar year on the back of forecasts of rapid slowing in the US economy, the data was not co-operating. Unemployment, in particular was especially stubborn. In Europe, Bunds were bleeding a slow dance of death, seemingly drifting every night from 4.14 at the start of May to 4.44 by the end of May. When a bunch of houses, and especially Goldman so publicly gave up on these views in the first week of June, the market crapped out, with US 10s going from 4.86 on 31 May to 5.24 on 8 June. The easing bias had basically left the market and the US had gotten a defacto tightening-and a half.

I think that, in the shorter term and on an incremental basis, the US could drift any which way (leaving aside the factors discussed in a) and b)) but the independent bias for large moves in the long end could be found in an increase in non-tradeable inflation as the labour market arbitrage presently found between the developed economies and especially China and India dissipates. That move in non-tradeable inflation can only go in one direction and is completely inexorable. When this becomes expressed in longer term rates, to what extent and for how long, I'm not sure but there is a distinct possibility that the tightening cycle in the US, Europe and most of the world could have quite a way further to run. Even if the US takes a pause (which it currently has), the longer term trend could still be hawkish.

Putting this all together, I have kept a large long position in Bills and have been trading various different weightings in the 3s10s curve. I figure that being long out to 3 years will be helped if:

1. The RBA doesn't hike this year.
2. The equity market gets the jitters/craps itself.
3. Flight to quality occurs, probably being dragged along by the long end.

Being short the long end helps if:

1. The tail of the curve continues to even out.

This position could go wrong if:

1. The RBA hikes.
2. We get some extremely strong data (esp domestic).
3. The curve (from belly to tail) flattens in a bearish move (the strong domestic data, coupled with a big continued rally in the US would do that).