December 09, 2015

Super Mario Draghi, bond market liquidity and 2016 outlook

Next to my old desk in London we had the original version of this Mario Draghi cartoon hung on the wall.

It felt fitting. I was covering the eurozone crisis at the time, and he really did deserve the "Super Mario" moniker after salvaging the mess left by Trichet et al. Unfortunately, many investors have grown to idolise the ECB head, and after serially not just meeting but exceeded expectations they had gotten into a frenzy of unjustified expectations ahead of last week's meeting. The best piece on just how excited people had become is this Socialist in the City blogpost (it's by a hedge fund salesperson in London):

"Everyone loves ECB day. The set up for this one was particularly good – I like to think of it as ‘Peak Draghi’..... The market had persuaded itself that Draghi was ‘Its kind of guy’. Everyone anticipated that the ECB would perceive what the market expected, and do more."

As he writes, "this simply isn't a stable equilibrium in terms of pricing an event". When these expectations were inevitably dashed (here is a good Reuters story on the ECB discord that probably curtailed Draghi's actions), markets threw a hissy fit. A really bad one.

Basically a lot of people were horribly positioned for this. It caused a carnage of euro short-covering and position reversals in other crowded trades, and a bloodbath for many hedge funds. “Everyone and their mother were short the euro,” one hedge fund manager told the WSJ. Doug Noland argued it is the "beginning of the end of the cult of Draghi".  Here is what another hedgie sent me soon late on Thursday (the last part is a little tongue in cheek).

"Discretionary macro getting utterly creamed in this EUR move. CTAs also. Long EUR trend with low vol means it was the consensus macro trade for both the humans and the trend models... I wonder what fresh bucket of shit Yellen can pour over me after the Draghi clusterfuck..."

Some perspective is needed of course. Some of the losses have since been reversed, and Claire Jones points out that while the ECB may have disappointed, what it unveiled was far from trivial. John Authers went to the Economic Club of New York to listen to Draghi "calibrate" his message. His takeaway was that traders would buy the euro "at their peril". Personally, I'm with Ray Dalio on this one. He sent out one of the most interesting notes last Friday, accusing investors of being "erratic" and arguing that "by now the world should know, don't fade Mario Draghi".

"Yet, the more the market discounts that Draghi will move inadequately (e.g the more the euro goes up and the stock market goes down) the more that it is likely the ECB will move at an accelerated pace and prove the market wrong.  That is because Draghi and the body of those in the ECB who shape policy with him understand how the economic machine works.  They understand that the degree of tightness of monetary policy is influenced by a) interest rate movements, b) QE movements (and related macro prudential policies) and c) currency movements.  With interest rates unable to move meaningfully, QE and currency movements matter most.  Clearly there needs to be more easing and clearly the more the currency rises, the more (and more forceful in completion) the QE needs to be."

Still, it's just healthy that people realise that Draghi is "just" a central bank governor, not a shroom-powered, flame-throwing super plumber. As one finance type tweeted this week: "Remember Wednesday, when Draghi was still omnipotent? Good times."

Bond market liquidity
Finally. At last someone big in the investment management industry has broken ranks to suggest that one of the best palliatives to concerns over bond market liquidity could in fact come from regulators. Here's Aberdeen Asset Management's Martin Gilbert talking to the Telegraph.
“It is all to do with us giving daily liquidity to our clients, when the underlying securities or bonds or government bonds that we own are maybe less liquid, and what this discussion is centred all around is, how systemically risky is that?”

He said it would be “great” if regulators stepped in to limit investors’ access to funds, a move which would limit the harm caused by a sudden run on the sector.

Mr Gilbert acknowledges the move would be highly unpopular if any individual asset manager tried to go it alone and impose such a change on its customers – hence wanting the Bank of England to take the lead.

I kinda agree. Daily liquidity has not been written into the UN's Universal Declaration of Human Rights, and there are compelling reasons to limit investors' ability to yank money out at a drop of a hat, both for their sake and for the sake of the safety of the financial system. Firstly, trading in and out of funds whenever panic or euphoria seizes an investor is bad for long-term returns. Secondly, the bond market is quite similar to the banking system, in that asset managers buy long-term assets with pooled short-term funding - a "liquidity transformation" in finance jargon. ‚ÄčThat makes bond funds susceptible to quasi bank runs if investors fear losses. Here's the Bank of England's latest Financial Stability Report, out last week, on the subject:

"The recent rapid growth in open-ended funds, and their continued investment in less liquid assets, has reinforced the risk that large-scale investor redemptions could result in sales of assets by funds that might test markets’ ability to absorb them. The risk is that this could impair market liquidity, which is already fragile, particularly in markets that are important for extending funding to the real economy."

Against this, the industry itself argues the fears of an asset managers blowing up are overblown, and point out to existing safeguards such as gates, redemption fees and payment-in-kind. But if you weigh up the potential costs of regulating away daily liquidity versus the potential gains, I think the answer is fairly easy. Banks can offer daily liquidity products (deposits) but given the systemic issues they typically enjoy a government guarantee. As a result, banks are heavily regulated. The idea of transposing a banking regulatory framework to asset managers was always idiotic, but that does not mean the industry as a whole should not face restrictions. The SEC's liquidity proposals look finicky and difficult to implement, so I think it would be better with simpler but sweeping rules severely curtailing same-day liquidity products. 

Seasonal special - 2016 outlooks

Everyone has been polishing off their crystal balls recently (and hoping that people have forgotten some of the sillier calls for 2015). The FT is no exception, and you can find all our 2016 outlook pieces gathered here. Some good stuff (here's me on inflation), but my favourite quote came from David Harding at Winton. Touché.
“People used to say oil couldn’t go above $30 a barrel because Saudi Arabia would open the spigots, and then it went to $100. Everyone ‘knew’ that long bond yields couldn’t go below 4 per cent, even [Fed chairman Alan] Greenspan called it a conundrum when it did. In the 1950s people said that stock yields always had to be higher than bond yields because equities were riskier. It’s amazing how surprised people are by surprises.”

Notable and quotable

"While it is too soon to panic, there are enough signs that bear very close watching in the coming months." David Schawel on some of the cracks in the corporate bond market. 

“People are going to be carried out on stretchers." Eric Platt and I on the same topic, highlighting how downgrades and defaults are on the rise, and triple-C bonds are getting hammered. 

Post Lehman there was too much to do and now there is again.” But Oaktree's Howard Marks is naturally rubbing his hands together. 

"Central clearing may give rise to other forms of systemic risk." The BIS's big report on central clearing, which is getting some people hot and bothered. 

"There are also powerful, fundamental factors that will restrain US Treasury yields, especially longer-term ones, which could even push them lower in the coming year." Me again, on how people are still too confident that US government bond yields will rise sharply in 2016.

“It was the next best thing to getting paid to be an athlete.” Former bond traders lament the emasculation of their profession in the WSJ. 

"Look who I've got on my podcast. It's Sean Connery! No, it's Carl Icahn." T. Boone Pickens has a chat with the granddaddy of activists. (And who knew Pickens has a podcast?)

"There might be good reason to amend the Trust Indenture Act, but not through a slapdash job intended to bail out some private equity firms from their own sharp dealings." Adam Levitin is unimpressed by Apollo's activities in Caesars.

Brazil is going to get much worse before it gets better." One of Brazil's leading hedge fund managers is not particularly optimistic about his country. 

"Brazil’s economy is still battered as it struggles with an ongoing recession, inflation and a political crisis." Invesco agrees. 

"Exchange-traded funds have suddenly become scary—at least to some in the investment community." The WSJ goes through five big things consider when it comes to ETFs. 

"Just because HFTs do more business on electronic market places does not make them good providers of a customer market-making service to real money or leveraged asset managers." A balanced Euromoney piece on algo traders and Treasuries. 

“No, we do not envision a significant surge in inflation. But we do think inflation expectations may be too sanguine." Me again, on how inflation could be the first unexpected surprise of 2016. 

"Some regulators say these products—known as “leveraged exchange-traded funds”—can be highly volatile, and expose investors to sudden, outsize losses." The WSJ on plans to crack down on a much-criticised product. 

“A lot of investors have gotten very complacent and comfortable with the idea that there’s global deflation and you can go long rates forever." Michael Hasenstab's US portfolio has negative duration ahead of the Fed move. 

'Will outflows increase, and how will this affect economic activity in emerging markets?" Olivier Blanchard et all on whether capital flows are expansionary or contractionary. 

"Are you an Alpha Hunter? A Team Trader?" Bloomberg's quiz to find out what kind of trader you are. Underwhelming quiz, to be honest.

"If a banker approaches the CEO of a Master Limited Partnership (MLP) with an offer to help, the CEO should run (not walk) in the other direction." Simon Lack on a struggling sector, ahead of Kinder Morgan cutting its dividend. 

"Anybody who has looked at the full Twitter feed or has searched for kitten videos will realise that it is remarkably difficult to find the big information lurking in the undifferentiated mess of data." Cantab Capital's Ewan Kirk on how "Big Information" is the next frontier for investment management industry. 

"Hedge fund investors are losing patience even with marquee firms as many of them struggle this year." Bloomberg on the expected wave of redemptions. 

"We also recognise that economies and markets rarely evolve in such predictable ways." Standard Life Investments on five forces that will shape 2016.

"That’s much weirder than negative swap spreads." Tracy Alloway on the latest market anomaly - the CME-LCH swap cost spread (this one has been around for a while, but it's getting worse)

"So while big market swings may not be comfortable for most investors, they can provide a convertible arbitrage strategy with lots of gamma trading opportunities." Calamos Investments on why volatility can be your friend. 

"The demographic problem of an aging population will not resolve itself by continued pursuit of traditional Keynesian demand stimulus." Research Affiliates on the demographic dilemmas.