It's All Relative

One of the aspects of trading a hedge fund that I enjoy most is the ability to express a trading perspective in unique ways, rather than simply getting long or short a particular market or financial instrument.

One technique I frequently utilize is a relative value trade. At its essence, a relative value trade allows me to trade one market long and another market short in order to capture the difference in relative returns of the two markets. The beauty of this type of trade is that in addition to only having to be correct about the relative returns of two markets rather than the absolute direction, it also allows me to dramatically reduce the risk profile of a stand-alone long or short position. This gives an additional margin of safety.

In trading, a margin of safety is the adult equivalent of your childhood blanket, “Bobbi,” that started out whole when you were two but a few years later was in shreds, barely clinging to life but still providing you with a sense of security.

What’s not to love about being able to express a trading perspective in a way that allows you to be profitable even if your thesis isn’t perfect?

I’ve been watching the British pound for the better part of four months, waiting for an opportunity to take a stab at this market from the long side. The pound has had a very difficult year, but when a beaten-down market begins to stack up bullish catalysts that go largely unnoticed by most investors, I become very interested.

When trading currency pairs, the relative value trade is built in naturally. For example, if you are long the euro-U.S. dollar currency pair then you’re speculating that the euro will outperform the U.S. dollar on a relative basis. Even if the euro loses value over your holding period, you’re still a winner as long as the USD declines more.

For the sake of my “Pound of Flesh” trade, I have keyed-in on the pound-Aussie dollar currency pair as the instrument that will give me the best risk-adjusted potential for profit should my optimism for the British pound prove correct.

Divorce is Tough

The pound has been the kid stuck in the middle of divorcing parents for the last twelve months. On June 23, 2016, the UK voted to leave the European Union, in an epic win for the populist movement. That Friday, markets went wild, with gold and Treasuries ripping higher while equity markets got taken out back.

But the real loser in this divorce between the UK and EU was the British pound.

Prior to the referendum vote, the pound hit a three-year high. But in the last nine months it’s lost over 20% of its value, has officially crashed and is trading at the same price as when Wall Street hit theaters. Greed is good, anyone?

The pound has been range-bound for the last six months, largely due to uncertainty about how Brexit would officially move forward. Well, the uncertainty ended last Thursday when Prime Minister Theresa May formally notified EU Council President Donald Tusk that Britain really is quitting the bloc it joined in 1973. There is nothing the market hates more than uncertainty, and from a political perspective a major hurdle has just been crossed. But politics isn’t the only reason to like this trade market from the long side.

It’s Fun-Damental

For me, everything starts with a market’s Fundamental Gravity, which consists primarily of the trajectory of the economy and central bank policy.

Since Brexit, the doom-and-gloom crowd has been calling for the end of UK civilization. At some point, these folks need to put away their pitchforks and become data dependent, because the economic data continues to massively outperform expectations and, more importantly, continues to improve.

UK annual GDP growth has accelerated for three consecutive quarters and is now sitting at 2%. Both manufacturing and service sector data are sitting well above their pre-Brexit levels.

It’s not just hard data improving, because so-called “soft” data has improved markedly since last June’s referendum. The UK ZEW Economic Sentiment Survey has improved in six of the last eight months and the Small Business Sentiment Index is at three-year highs after accelerating for three straight quarters.

But improving growth is only one side of the economic equation; the other side is inflation.

All three key measures of inflation — core, consumer and producer prices — have been following the rest of the world’s lead and ripping higher. All three measures are now sitting at the fastest pace in over three years.

Improving growth and heating inflation have led to a hawkish shift in the Bank of England (BoE), where most members are coming to terms with the need for a rate hike sooner rather than later.

Shorter than a Pair of Daisy Dukes

The reason the pound looks even more compelling from the long side is that most people are either blind to or willfully ignoring the economic data and what it portends for BoE policy.

The amount of speculative short positioning in the pound is currently at an all-time high. In fact, the amount of money that is short the pound has exceeded $8B for the first time since data collection began in 1999!

This positioning has been massively tilted to the short side for months, and it’s only a matter of time before those historic positions unwind. For my money, the time for that unwinding is now.

After last week’s official trigger to Brexit, there are no other concrete future dates for bad news. This should cause many bears to capitulate and buy the pound to close their shorts.

As a result, the dominant fund flow in the coming weeks will be investors buying the pound, and there is a whole lot of buying to be done. Can you say “short squeeze,” anyone?

From a gravitational perspective, it doesn’t get much more bullish than what I’m seeing right now for the pound.

Put Another Shrimp on the Barbie

My rationale for picking the Aussie as the short side of this relative value trade is, as always, gravitationally driven.

When I evaluate the Fundamental Gravity of the United Kingdom, compared with Australia’s gravity, I find the stage is set for the pound to outperform the Aussie.

Historically, when these two economies are positioned the way they are currently, the pound-Aussie currency pair typically gains between 2% and 7% over a three-month period. The average loss for this pair during similar economic environments is approximately 90 basis points. So, from just a fundamental perspective, there is $2 of profit potential for every $1 of risk. That is definitely a bullish check mark.

Quantitatively, the Aussie looks poised for a pullback after gaining 6.4% during Q1. If you are new to currency trading, a 6% gain in a currency is a monster move. To put the Aussie’s year-to-date rally in perspective, it has even outperformed the S&P 500 by 22 basis points!

For the last year, the Aussie has been trading in a range between $0.715AUD and $0.775AUD, closing last week near the top end of the range at $0.763AUD. If this twelve-month trading range holds, my quantitative model indicates the Aussie will likely fall to around $0.734AUD, which means there is twice as much downside as potential upside.

Behaviorally, the positioning in the Aussie is the complete antithesis of what we are seeing in the pound. Everyone and their mother is long, strong and ready to get down. Investors are still sitting with the longest Aussie positioning in the last three years, and this is even after the epic rally to start 2017. That Aussie chamois is damn near dry, folks; remember that greed kills profits.

The Bottom Line

On the long side, the pound has had so much bad news priced in that for the last few months it hasn’t been able to weaken further when faced with more negative news. Add to this a hawkish shift in BoE policy, political clarity and everyone leaning to the wrong side of the boat, and the scene is set for one hell of a rally.

On the short side, all three gravities for the Aussie are decidedly bearish, and when I couple this with a long pound, I get a relative value trade with a very favorable risk profile because both sides are skewed in my favor.

Remember, in addition to a more attractive risk profile, the beauty of this trade is that if I’m wrong about the direction of the pound or the Aussie, there is an extra margin of safety. As long as the pound outperforms the Aussie on a relative basis, then the trade will still be profitable.

Having a margin of safety allows a hedge fund manager to sleep well at night, and I’m betting it can do the same for you. Stay data dependent, process driven and risk conscious, my friends.