End of Year Review 2014 - It's been a tough Year

This year has been a challenge to say the least. Many strategies were tested to extremes, volumes have petered out in many markets, and volatility has produced wild swings in other markets.

On the Bond front, we have seen Yield Curves Flatten across European and UK markets with the Euribor Yield curve almost totally flat. Negative interest rates coupled with low inflation has put to bed any rate increase in the near future, leaving QE as the next catalyst to try lift the economy
.

Trading has been very difficult in Euribors as volumes have dropped off a cliff. My strategy required Yield curve movement, but with the current policies and an 80% volume drop from a few years back, has pretty much ended any trading involvement for the time being in the Euribor Space. Many Market Makers have been hung out to dry as well and Euribor Options as you would expect has also seen dramatically reduced interest. I like many others are waiting to re-enter this market but as the Euro Economy falters, the likelihood for any kind of rate action seems very limited in the near future.

Short Sterling has seen more action as inflation in the UK was above the 2% CPI target in the early part of the year, and the economy was generally on a much stronger footing. Rate rise expectations were brought forward to Q4 2014 by some banks and this in turn lifted the front end spreads. However this expectation had waned coming to year end as inflation dropped, on the back of weaker commodity prices, and now is sitting just above 1% which is below the 2% target set. This has set back expectations to late 2015. Trading Short Sterling has been mixed this year, with some good opportunities selling the Spreads at the top of the range, which was around 17-20 in Sep15Dec15 and Dec15Mar16. However as the year went on, the volume continued to drop and there were times I was stuck in Spreads for over a month, which made it very difficult to consistently make money in the back end of the year.

Bonds in general have had a stellar year, with Bunds trading over 155, 10 Year T-Note traded over 127s and Long Gilts touching 120. This was against what most commentators were thinking early on, with the most surprising play being the up move US bonds. Despite the conclusion of QE and a very Strong Q3 GDP number Bonds still remain relentless to the upside along with Equities. The market has seemed to price in very low rates for a while to come and in my opinion it seems like this will hold true as the FED seem very reluctant  to start tightening policy. Firstly the recovery is fragile, second with the Stock Market as extended as it is, the potential for a sharp correction is very likely and we know central banks don’t like that. It seems to me the market has the central banks in their control, and I feel the first rate hike will be a coordinated hike with the UK possibly.

In my opinion raising rates from rock bottom to say 0.75% in the US or 1% in the UK shouldn’t be enough to derail any positive momentum that has built up. It gives savers a bit of yield also, plus stop the notion that we have to yield chase since you can’t get yield anywhere else. These rates would still be historically very low but not extra ordinarily low which in turn provides some sense of normality.

Equities have been in a world of their own in the past 2 years, with new record highs being hit on something like 20% of the days in 2014 in the US. Whilst the US is benefiting from improved fundamentals Europe is still very sluggish. Although judging by the gains in the DAX, CAC and EuroStoxx you wouldn't have thought this. The decoupling with the market and reality is alarming to say the least, but cheap money has been the number one catalyst for the market, and whilst stimulus is thrown around from Europe, Japan, China to name a few, the market will continue to rally because “There is nowhere else to get Yield” so they keep saying.

Many smart fund managers have been on the side lines looking for that elusive pullback, but we have seen time and time again that any pullback that does occur is followed by a very sharp reversal back to the upside. The action of the week on December 12^th was remarkable, we had a 4% correction in the SPX in 3 days followed by a gain of 38 points and 48 points for a two day rally of almost 90 points! The DOW in this same two day period moved up over 700 points, the DAX moved over 600. These type of gains is what you mite expect after a longer term correction, but not around all time highs. These sharp moves have made position trading very difficult, as you are almost certain to be stopped out.  With many fund managers under invested, any dip is swallowed by the large influx of cash on the side lines. Coupled with the reduced liquidity on the books, and increased volume at that time this created more exaggerated moves making it a casino like environment to trade.

Coming to 2015 I can imagine more of the same type of action, as multiples continue to increase with minimal earnings growth all on the back of low rates, QE and “Patience” from the FED.

What is clear though is that this epic bull market rally has been on the back drop of sluggish worldwide growth, super low rates, QE from many central banks, and falling commodity prices underpinning low inflation. However the longer this continues the more out of sync with reality this market will become, and history has taught us that this doesn't end nicely.

Personally this year I have had to change my strategies a lot and going forward I will be using a lot more options to create synthetic longs and shorts, as it will give me time to be right rather getting whipsawed out. The key to being profitable right now is to survive the sharp swings when they come, and being patient. While markets continue to be at highs, the risk to reward for going long in both Equities and bonds is a high risk trade in my opinion, so my bias will be to the downside. Although the bears have been killed the last two years, the key is too stay small, and play many occurrences.

I can see 2015 being similar to 2014 in the early part of the year, with buy the dippers pushing Equities up on any pullbacks, and Bonds pushing up on any sell offs, coupled with more declining volume. Although I think if this pattern continues and macro data continues in its current trajectory then we could get potential rate announcements from the fed which could put the brakes on the rally and provide some big volatility. What happens in the commodity space will also have an impact, as the continued decline in Oil will bring down the energy sector as well as many Oil producing countries which rely on Oil as their main source of income.

As far as trading Is concerned it is likely we going to see the market continue to be increasingly dominated by Algos with human activity in the day trading space becoming less and less. Either way the next few days is a time to reflect and adjust those strategies to deal with the new normal that is among us.