Tuesday, September 13, 2011

A Rorschbach test for traders

The Rorschbach inkblot test was supposedly an interesting psychological test. You looked at an inkblot and what you saw said more about the you than the inkblot.

Here is an interesting test for both bulls and bears. On Monday, US equities rallied in the last hour on reports from various media outlets that the Italians were in serious discussions with the Chinese about buying Italian debt. Here is the original report from the FT and another from the WSJ.

For the bulls who are ready to jump in on the long side on this news, consider the following trade as a test of your resolve.

The SNB has indicated its willingness to defend the CHFEUR exchange rate to prevent the Swiss Franc from rising any further against the euro. In effect, the SNB has become the liquidity provider of last resort to the eurozone. Given the combination of Swiss resolve and the news of a possible Chinese rescue of Italy, why not put on the long Italy/short Switzerland carry trade? Two-year Italian paper is yielding roughly 4.5%:

Italian Bonds - 2 year gross yield

...while Swiss two-year paper is yielding a measly 6 basis points - effectively zero:

Swiss Government Bond generic 2-year Note bid yield

Imagine you're a hedge fund. Buy Italy and short Switzerland. Lever the trade up 10x or 20x. Think of your return!

If you're truly bullish and believe that this represents the turning point, then would you put on that trade? Underlying that assumption is that, even if Greece defaults, any contagion would be contained before it reaches Italy.

Of course, there is the contention from ZeroHedge (which has always a bearish bias) that Asians are reluctant to buy Italian bonds because if the ECB won't buy it, why should they?
On one hand we have FT "reporting" about Chinese Italian bond purchasing ambitions citing "unidentified Italian officials" one day ahead of a major Italian bond auction (wink wink nudge nudge). On the other hand, we have Reuters, citing a real live Italian Finance Minister (though not for long) Giulio Tremonti, who tells us a slightly different story, which, gasp, cites real live people: "Italian Economy Minister Giulio Tremonti said on Thursday that Asian investors are reluctant to buy Italian bonds because it sees they are not being bought by the European Central Bank."
For the bulls, the answer is, "It doesn't matter what the ECB does. The SNB stands ready to provide oodles of euro liquidity to the market."

For the bears, there is that minor item in the WSJ article stating that CIC has $200 billion in reserves. Assuming that only a small fraction of the $200 billion goes into Italian bonds, will it be enough?

Where do you stand?

Disclaimer: I am not advocating that you take any position in the long Italy/short Swiss trade. It's just a way of getting you to think through the implications of these latest developments.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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