Tuesday, 17 July 2018

A taste of things to come?

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  • Peters 475px June 2014

The elimination of self-righting mechanisms led to the turmoil in the bond markets.

TO CALL LAST week “bruising” might be the understatement of the year so far. We saw unprecedented volatility, with global bonds in meltdown. And although the news wires were busily blaming it on all and sundry – was it what Janet Yellen said, or was it the Bill Gross comments; was it Greece, or was it something in Germany? – I’m afraid I am happy to stick with my view that we have nobody to look towards other than the authorities.

Do we lay the blame at the doors of the central banks that have been pumping cheap cash into the markets and have thus driven rates lower and markets higher than could ever have been fundamentally justified?

Or should we be looking to the politicians and the regulators, who have systematically destroyed all the organic self-levelling mechanisms that markets had developed over centuries in their frantic race to blame the banks – and the banks only – for the disasters that befell the financial system in 2007, 2008 and thereafter?

Forgetting for a moment the untold damage that has been done in the past month to the pension investments of tens of millions, much of what markets do, directionally, is driven by derivative markets.

These guys need to post margin that is calculated based on the implied volatility of the asset class. As volatility rises, they either post extra margin or they reduce risk. Thus, the sell-down looks from here more like the deleveraging of some of the hedge funds’ long positions than them establishing europhobic shorts, as some of the more cynical banker-bashers would have it.

SOME DREW PARALLELS between Thursday’s bungee jump, which saw the 10-year Bund trade in a three-point range, and the “Taper Tantrum” in the US in the late summer of 2013. But there is no real comparison. One took place when there was fear that QE was about to be withdrawn and the other while QE was supposedly in full swing, with at least another year before its withdrawal is even up for discussion.  

One desk head described to me the huge two-way move succinctly, saying: “Once the VAR managers had butchered their desks’ positions, the vacuum reversed.” He went on: “We had a 25 norm volatility grid move this morning, approx the same as Lehman in 2008.”

In other words, neither the sell-down nor the snap-back had anything to do with the ECB although there was certainly no sign of it sticking its neck out and trying to calm things down.

There was, however, one feature of the markets that could not go unnoticed and that was the invisibility of a cohesive market-making system. It’s absence has nothing to do with the central banking community as it was – nothing new here – sacrificed by the regulators on their very own altar of self-preservation.

I have in the past noted the feature of bond markets, which is that they tend to be all bid or all offer, and without the equalisation capacity of the Street, volatility rises fast. Isn’t this just what Jamie Dimon was warning of recently? Those who conned themselves into believing that pushing peer-to-peer trading platforms was going to make life easier have hopefully learnt a lesson

IT IS SAD that the authorities are always much faster at finding fault in others that they are in acknowledging their own failings. I recall back in the early 2000s when I met with a bunch of senior Bank of England operatives.

We were speaking about securitisation and they were all terribly excited that the repackaging and broad distribution of risk by way of ABS meant diminished risk concentration and hence substantially lower systemic risk from a negative turn of events. How they encouraged the growth of ABS!

When the brown stuff hit the propeller in 2007, it became clear that this risk dissipation also meant that nobody, the Bank of England included, knew where the bodies were buried and rather than exposing themselves to the risk of lending to the wrong peers, many banks took the prudent route and lent to nobody at all.

Those firms that didn’t make it, from Northern Rock to Lehman Brothers, were sunk not by their assets but by their inability to keep the liability side above water. Assets couldn’t be sold for the simple reason that nobody else could fund them either.  

The greater officialdom’s tinkering, the bigger the unknown outcome

THE MARKETS ARE weighed down with history of unintended consequences and it seems the greater officialdom’s tinkering, the bigger the unknown outcome. The world is full of risk but the authorities have done all they can to make it impossible for markets to efficiently deal with it.

Not only that, but the abundance of cheap money on one hand (and this is where the central banks come in) and the need for yield on the other have created the making of the perfect storm.

I am sure that although global bonds have once again shown their ability to scare, they are surely not quite ready yet to go into the grand reversal that many, if not most, players are expecting. There is no sign of imminent tightening anywhere. On the contrary, we are still seeing easing in the likes of China and Australia and although the Fed’s first move is on the horizon, few seem able to agree as to how far away that horizon is. Friday’s payroll numbers were certainly not strong enough to cause any particular upset in Treasuries.

What started out as nothing more than a run of the mill technical correction after a protracted rally turned into something approaching a full-blown crash, which probably told us more about the creaking structure of the bond market than it did about the value that is to be found in a 2%-yielding Treasury, a 1.5%-yielding Gilt or in a 0.25%-yielding Bund.

If markets can do what they have done in the past weeks when they have no particular reason to sell off, what awaits us when they do?

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