We all know the story by the now.
Years of central bank accommodation has driven investors down the quality ladder in search of yield, leaving everything priced to perfection and the hope is that the eventual unwind of stimulus will be benign as policymakers stick the proverbial dismount with predictable forward guidance, gradual tapering/balance sheet rundown and rate hikes that only proceed with the market’s implicit consent.
Forward guidance is set to take the baton from asset purchases as the go-to mechanism for implicit central bank vol. selling and to the extent policymakers remain adept at calibrating expectations to align with the evolution of the normalization effort, the ubiquitous short vol. trade in all its various manifestations will remain viable or at least not implode in dramatic fashion.
Exogenous shocks have the potential to derail that effort – to upset the tedious balance. Trade wars could stoke inflation, ill-timed fiscal stimulus could complicate the reaction function, etc.
Meanwhile, the distortions wrought by QE and accommodation more generally have made markets fragile. The JGB market, for instance, effectively no longer functions. Relentless spread compression in, for example, € HY, creates potentially dangerous anomalies (e.g., Italian junk trading inside of U.S. Treasurys).
In the background, the proliferation of HFTs and the unintended consequences of the epochal active-to-passive shift have created an entirely new underlying market structure that has never been stress tested in any meaningful way. Evidence from August 2015 and, more recently, February of this year, suggests the inherent fragility will be exposed quickly.
Well, speaking of fragility and the state of markets in 2018, Algebris’s Alberto Gallo is out with a new note called “The Age Of Fragility” and it’s pretty interesting to the extent it underscores everything said above.
He begins by noting that while everyone assumed the “synchronous global growth” narrative that, along with “still subdued inflation”, underpinned the low vol. regime in 2017 would shift in favor of a U.S. centric story, no one was prepared for global growth ex-U.S. to flatline. He also notes that as the policy divergence theme reasserts itself (in the process moving rate differentials in favor of the dollar), the first dominos are starting to tip.
“At the beginning of the year, we prepared for an environment of benign divergence, where the distribution of global growth would become increasingly skewed in favour of the US, yet still remain positive elsewhere,” Gallo writes, before cautioning that “today, this is worth reconsidering.”
He moves on to note what myriad folks have recently pointed out, namely that historically speaking, Fed tightenings have “coincided with unwind of carry trades and bursting of financial asset bubbles”:
But this time may indeed be different (i.e., worse) for a number reasons. Here’s Gallo:
That said, there are peculiar characteristics which make this tightening cycle different from others: asset overvaluation, rising wealth inequality and misallocation of resources resulting from persistent low/negative interest rates.
When he moves to discuss why markets are more fragile, the usual suspects are lined up.
Simply put: modern market structure is risky and the fact that the post-crisis regulatory regime has made banks more reluctant to lend their balance sheets only makes the situation more dicey:
With asset prices influenced by central bank demand and investors accustomed to ten years of extraordinary stimulus, we have evidence of increased fragility. One area of fragility is trading liquidity in equity and bond markets, which has become scarcer as asset managers have taken higher risks and banks have re-trenched due to tighter regulation. Since 2007, equity and bond markets have experienced at least eight flash crashes. While the median level of volatility is lower than the pre-QE period, the magnitude of volatility shocks is larger. Put differently, markets are alternating between longer periods of calm and sharper, more sudden shocks. Adding to the lack of trading liquidity and polarisation of volatility shocks are passive and quantitative-driven trading flows, which now account for over half of all equity trading flows, and which can also exacerbate downward moves. Scarce liquidity and herding both act as feedback loops, amplifying shocks in what H. Minsky first described as financial fragility.
As a reminder, here’s how the market share for algos has grown (this underscores the bolded points above):
There’s a ton more in Gallo’s full note, but as far as what Algebris is doing to mitigate risk, here are the four ways in which they have “gradually shifted their portfolio construction”:
- Better liquidity. We have reduced the amount invested in cash bonds and substituted derivatives, including credit default swaps, as a tactical long (or short) instrument.
- Barbell strategies and dry powder. We have increased the amount of liquid ‘dry powder’ instruments, creating a barbell between risky and risk-free assets.
- Shorts. We have increased our directional shorts vs. what we think are some of the weakest firms and economies. We think Emerging Market debt remains vulnerable to a repricing, particularly in Brazil and Mexico, both of which face elections this year. Triple-B rated corporate bonds which have benefited from ECB purchases may also widen.
- Tail hedges. We have increased the amount of hedges for bigger tail events, using convex instruments like mezzanine tranches or options contingent on a change in correlation regime, for example between currency and equities, or between equities and interest rates.
Take all of that for what it’s worth, but the overarching point is that things are changing and the benign narrative around central bank normalization seems to be giving way to something less, well, less benign.
Market structure risks aren’t doing anything to assuage the concerns of those who are worried.
Of course if you aren’t worried, then by all means…
