So what do you want to do now?

Let's put together some thoughts:

1. If China revalues its currency, there will be less Treasury bond purchases, more of a deficit issue and hence USD being worse off. China will not revalue if hard landing occurs before any further change in capital control or foreign exchange policies.
2. Fed is unlikely to hike aggressively even though US growth is building strength and inflation may be creeping through. However inflation is mainly due to demand driven commodity price rally. This consumer demand in US has been largely been supported by the mighty housing market. Hence Fed would not want to derail this consumer welfare. If they hike too fast, a possible shock to the system can lead to housing bubble burst and subsequent recession and deflation.
3. The housing bubble has two exit plans: bubble can burst or leak. While an aggressive Fed can lead to the prior case, a more "measured" Fed lead to the latter case. Just look at UK, the booming housing market reacted a series of measure rate hike. Gradually, the marginal buyers and first time buyers are priced out of the market. Rental lodgers are in vogue and investors began to hit bids. It all happened in a normal, non-chaotic fashion. So all I am saying is that US can too experience a normalization of the housing market without undergoing a bubble bursting experience.

Trades:

We believe that USD remains in its long term bear trend. Carry unwind will simply allow entry of short USD at a better level since the effect of Chinese revaluation will push DXY to new lows. Furthermore, Asian currency will benefit most while EUR remains the de-facto benefactor of this currency movement. A basket of currencies will be a good way to set up this trade. In addition to buying EUR and JPY, we also like 1. Gold for its flight to quality and inflation hedge qualities, 2. AUD for the country's rich resource, relatively politically independent and commodity linked economy.

For now, we like to trade range for US 10y note: 4.30- 4.70%. With this economic backdrop, S&P looks overvalued versus dollar, bonds and oil price.

Oil, Gold, Risk Premium and China

OIL
Goldman economics team wrote a piece on the implication of high oil price yesterday. The summary is that if higher oil price is due to demand-driven, we would see inflation, aggressive fed hike and slower growth. However if higher oil price is due to supply-shock, we may see recession, fed ease and transitory inflation rise.

Our view is that while there is a good probability that China and US consumer growth can continue to drive this demand, there is also a finite probability that political uncertainty or terrorism can lead to supply shock in the system. Both factors point to higher oil price. While looking at fundamental, JP Morgan's Commodity Outlook and Strategy (April) wrote that Oil supply is definitely on the high side versus 10 year average. The supply situation does not justify the present oil price.

So the question is, why oil is trading 50s. My view is that 50s is not a stable equilibrium but reflecting a balance of the extreme view of 60+ oil price to 30-40 reversal. If vol is cheap, I would be long the wings.

GOLD
Looking that the high oil case, I propose that in both demand-driven and supply-shock, we should hold gold. In the case of inflation or fear, Gold price will rise. Especially if unfortunately we see political uncertainty due to terrorism, the flight to quality may not be US Treasury this time round (due to US political and economic risk - deficits).

RISK PREMIUM
We have been a keen follower of risk premium in the market. While there are certain amount of unwinds in carry trades (such as usd/asian, yield curve, spread products… etc), the risk premium is at a more neutral level rather than towards risk adverse or fear. We determine that by looking at USD/CHF which has moved to its 200day moving average. It certainly still reflects the complacency in the market. In addition, the implied volatility in all asset class is still low. We worry that the market is at an unstable equilibrium at the moment.

CHINA
There is a finite chance that China will revalue its currency. Unless we have a hard landing in China (also a possibility), Chinese government is looking for their window of opportunity to revalue the reminbi. Since the implication that China will not buy as much treasury in the future and possibility that other Asian countries will follow with actions rather with words so far, we see short USD/Asian still being the cheapest way to play this trade.