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Friday, 15 December 2017

Living in an age of parallel realities

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I am away from the markets for just one day and every certainty has of a sudden turned into an uncertainty. 

From the DUP scuppering the settlement between the UK and the EU with respect to the inter-Irish border, and with it the entire divorce process, to wobbles on the US tax reform proposals to the Mueller probe persistently chipping away at the Trump pedestal. All the while bitcoin’s seemingly unstoppable rally continues with it now knocking on the door of US$12,500. 

The easiest conclusion to reach is that we are living in an age of parallel realities. On one hand there is the reality of the body politic that wafts around in its own lofty heights. Then there is the reality of everybody else out there simply trying to make a crust. Finally, there are financial markets which, although paying lip service to the former two, are off on a mission to somewhere although few, if any, can quite work out where that somewhere is.

 

Forever blowing bubbles 

After months of the same old arguments being bandied around, we haven’t really got any closer to understanding what is driving markets other than classic bubble thinking, which is that although we can’t find reasons for asset prices to go any higher, we are even more scared of missing out by not being on board for the ride. 

Irrational exuberance? To be sure, there’s plenty of that around. But let’s face it, if markets were rational then few of us would have a job; in some way we make our living by trying to convince ourselves and then others that we have an edge in sorting out the irrationality. I might be one of the few who can still remember The Wall Street Journal’s attempt to test the theory that a blindfolded monkey throwing darts at a board full of the names of stocks could pick a portfolio that would perform just as well as one picked by experts. I trust I don’t have to go into the details of the outcome. 

Within credit markets the most important number to figure out is the spread. It’s no secret that yield to maturity, the measure of all measures in the bond market, is just as fictitious as a game of Quidditch. YTM assumes that every coupon, conventionally paid twice a year, can be reinvested at the same rate of interest at which the bond was originally priced. So if a 10-year bond was sold when the 10-year rate was, say, 4.00%, then for a 4.00% yield to maturity the 9.5-year rate would have to be at 4.00% at the time the first coupon was reinvested, then the nine-year rate six months later and so on. Thus, nine-and-a-half years later, when the last coupon is paid, the six-month rate would still need to be 4.00%. I don’t know how many standard deviations would be required to bring about this outcome but I’m sure it’s more than the 23, which were theoretically needed to bring down John Merriweather and his Long Term Credit Management construct but which in practice collapsed in a pile of dust in 1998. So we take the fiction of the yield on one bond, spread it against the fiction of the yield on another bond and then get highly excited about the result and talk about it as though we held the answer to life, the universe and everything. 

Is contemplating the merits or demerits of Italian high-yield bonds trading at returns below those of 10-year Treasuries any more pertinent or rational than believing that bitcoin is still a buy at US$12,500? One reader kindly pointed out how the UK and EU governments are planning to regulate bitcoin and to bring it into the regulatory framework. Really? My reply was that the authorities would do better to find ways of living with the reality of cryptocurrencies rather than trying to fight them. If they think that they have succeeded in regulating bitcoin today, then by tomorrow morning there will be a new cryptocurrency taking over.

In the greater scheme, most markets currently seem to be only marginally affected by reality and are trading to their own tune which is one long rally, intersected by corrections. And the higher markets go, the more difficult the position of central banks becomes as they consider their options for normalising monetary policy. The Fed is well ahead. Not maybe of the curve but certainly of its Frankfurt-based peer. Eurozone GDP might “only” be growing at 1.8% as opposed to the US, which is sporting a quite lively 2.3%, but the underlying rate structure in the eurozone with the ECB’s key refinancing rate still at zero and 10-year Bunds at 29bp looks horribly wrong compared to where the US is, or even where the UK is. The problem isn’t only where Italian high-yield is pricing but where the eurozone’s risk-free curve is lodged.

 

Reality bites  

So here’s the question: do you want to get killed now by jumping off a fast moving train or do you want to wait to get killed when it either derails or hits the buffers? The investor community in general seems happier to hang on in the hope that there might possibly be a soft landing out there somewhere in the future. If the world can convince itself that something as fictitious as yield to maturity is a useful tool with which to price trillions of dollars’ worth of debt and, in the same vein, price/earnings ratios to value equities, then believing that the central banks are in control and that all will ultimately be well in the garden isn’t such a huge leap of faith. I hate the valuation of markets but until I can see enough other people feeling the same way and also preparing to act upon that sentiment I can see no reason not to remain long. 

Keynes was right when he wrote than markets can remain irrational for longer than you can remain solvent.

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