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Tuesday, 24 October 2017

A maze without an exit

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  • Peters 475px June 2014

Investors can’t afford the cost of getting returns to where they should be

IT’S BEEN A funny old week. Markets seem to have lost their way as they swing around, on a sixpence, from elation to despair.

In order to make a bit more sense of what is going on and why, I put in a call last week to Marcus Ashworth of BESI, a fellow scribbler. We compare notes from time to time as it has become all too easy in the current environment to think of everything to do with markets – especially bond markets – as being framed in black.

I’m not sure whether I came away more satisfied or more distressed, the former for reasons of not being the only person in the world to sense that it has all gone horribly wrong and that we haven’t seen the worst yet, or the latter because Marcus shares the sense that it has all gone horribly wrong and that we haven’t see the worst yet.

What we certainly were able to agree on was that there is a pervasive sentiment among our investing clients that asset prices have lost touch with reality, that they would love to be short up to the ying-yangs but that they don’t get paid to get it right but to make sure they don’t get it too much wronger (not a word, I know) than anyone else within their peer group.

WE ARE NOW beginning to see some of the Euribor-linked mortgages that were issued less than 10 years ago with very tight spreads go into negative interest rates, which have the lenders simply deducting the interest from the capital loan, thus creating along the way the self-amortising mortgage. In August last year the Federal Republic of Germany issued a 30-year bond, the coupon of which is higher than that of the Bayer junior subordinated hybrid 60-year bond issued earlier this month. A third – yes a third – of all outstanding Swiss franc bonds, guvvies, corporates, high-yield, the whole lot, are now in negative yield territory. I could go on.

Thus we find ourselves with an investor community owning stuff it fervently doesn’t want to own at prices it knows are wrong but with an inability to express that view by selling. I just wonder what the investment world would look like if investment management firms got paid to make money and not to track nebulous benchmarks. The language of overweight and underweight has become so ubiquitous now that I have even been told by a total return investor that they were underweight a credit in order to express the opinion that they no longer wanted to add to their exposure.

I suppose these are now pretty well trodden paths but the same investors who are terrified of what they own are equally fearful of what will happen should markets begin to slip. Jamie Dimon, CEO of JP Morgan, recently drew for the benefit of the authorities a large very large arrow, which he pointed at a dysfunctional marketplace while warning them that, in the immortal words of Al Jolson “you ain’t seen nothin’ yet!”

I do not like to repeat myself but I cannot escape the image created by the old joke of the man who fell off the top of the Empire State Building and who thought to himself, as he sailed past the second floor, “So far, so good”.

One would have thought that with Bund yields again and again making new lows – we traded below 10bp in the 10-year last week (which means €100 a year in interest for every €1m of paper bought or barely €1,100 over 10 years, including coupon reinvestment) – that all the world must be very confident. No such thing; nothing but fear and loathing.

Investors and central bankers alike now appear to feel that they are caught in a maze without an exit

JUMPING ACROSS THE Atlantic again, which member of the FOMC would you, if you were a CIO, prefer to live with? Top dove Narayana Kocherlakota or hawk-in-chief Charles Plosser? The answer has to be none of the above because you can neither live with returns where they are nor can you afford to suffer the cost of getting them back to where you’d like them to be.

The US Federal Reserve is aware that you can’t be a little bit pregnant and that when it makes its first move asset markets will expect it to keep going. It might not plan to do that and might truly want to tighten gently and only when the figures justify the next step being taken. The problem is that the market won’t believe the Fed, no matter how hard it tries to make itself clear.

It will take a long time for markets to forget Alan Greenspan’s famous line that “I know you think you understand what you thought I said but I’m not sure you realise that what you heard is not what I meant”. More to the point, the Fed cannot afford to tinker. It simply hasn’t got the room to manoeuvre.

Not only that, but it must also be aware of the risks that raising rates might bring if it does so in a liquidity-free environment that fills the space that was once a market. Central bankers can occasionally be more than just a little bit “ivory tower” but don’t believe that a single member of the FOMC, as those of most of the other rate setting committees, is not fully aware of the issues.

The bottom line is that central banks have painted themselves into a corner in their rush to counter the effects of their own failed policies of the early noughties that led to the near-limitless expansion of leverage and its eventual collapse. One problem was resolved by the creation of another problem, which will this time not trip up over implosive deleveraging but over its very antithesis – namely illiquidity.

Investors and central bankers alike now appear to feel that they are caught in a maze without an exit.

When the asset class bonds (let’s for the moment not call it a “market” on the back of the above) will blow its top is impossible to predict, but even a 50bp back up in 10-year Bunds will cost 5-1/2 points, which currently amounts to the equivalent of about one year of interest income but six years of yield. Any reader who manages money will know what it feels like and anyone who doesn’t might do well to stop and think about what it does. The air up here not only feels very thin; it is very thin.

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