Hedge funds drive Treasury market - Their behavior may create market dislocations

Solve one supposed problem and you may create another, the law of unintended consequences. Banks used to be the key driver of trading in Treasury, but that has changed with Dodd-Frank and other bank regulation. In its place, hedge funds have become the dominate player in active trading. A change in players with different capital commitments and trading objectives will spill-over to issues of pricing and liquidity. This switch to hedge funds has not been an overnight change, but hedge fund gross Treasury exposures have risen to $2.4 trillion in 2020 with a large focus on relative value arbitrage between cash and futures supported through repo funding. Treasury trades by hedge funds were crowded before the March pandemic. 

New analysis has found that hedge fund Treasury exposures declined significantly in March 2020 as returns from basis trading and RV trading declined. See "Hedge fund Treasury trading and funding fragility: Evidence from the COVID-19 Crisis". The threat to market liquidity from changes in hedge fund exposures is significant. Highly levered hedge fund trading will be sensitive to performance and will impact the trading of other Treasury market players when there are large position adjustments. The Treasury market may be more sensitive to macro surprises that impact the yield curve and financing. This places greater pressure Treasury dealers and increase risk premia especially for off-the-run Treasury issues. 

Market structure is a critical component for understanding the changing sensitivities of prices to market information.

Stock-bond positive return correlation a reality

The stock/bond return correlation has turned positive which is the largest threat to any diversified manager. Whether this relationship lasts is now the important question since a large correlation flip does not happen that often. We have been in a 20-year period of negative correlation after a 35-year period of positive correlation. Nevertheless, we have signs to help us answer the diversification question.

A breakdown of the drivers of the covariance between stock and bond can be seen in three major components: the variance of the discount rate, the covariance between cash flows and rates, and the covariance between equity and bond risk premia. The impact of rising rates is positive on covariance. A rise in rates will reduces the discounted value of cash flows for any investment. The relationship between cash flows and rates is ambiguous because it depends on the relationship between economic growth and interest rates. The growth and rate relationship is tied to economic policy reactions and growth. The final key driver of covariance is the relationship of risk premia between stocks and bonds which changes with volatility and risk aversion. A shock and flight to safety will force the relationship to turn negative, but that may not be a permanent relationship.

These covariance factors will be affected by the interaction between monetary and fiscal policy and economic activity, so this should be where we focus our time. If monetary policy is used to combat inflation in a rules-based approach as described by the Taylor Rule, then rates will rise with economic activity to stop inflation which will lead to a negative correlation between equity and bond returns. On the other hand, if monetary and fiscal policy are coordinated and used to enhance growth over inflation there will be a positive stock/bond correlation.  

The macro policy regime will define the stock/bond correlation and this is forward-looking and not just a function of past history. 

 

Commodity traders in "The World for Sale" are still a mystery

 

The World for Sale: Money, Power, and the Traders who barter the Earth's Resources by Javier Blas and Jack Farchey dishes the details on the success of the top commodity trading firms over the last few decades. They will go where other will not and take huge risks that other will pass over to find deals and match buyers and sellers for large profits. 

The book is filled with interesting characters, but overall, I am left without many details of how these traders were able to assess risks and gain a trading advantage. There is also too little on how these firms were able to exploit information dislocations in a competitive marketplace. Is it just greater risk appetite? Clearly, global upheaval and geopolitical restrictions allow for traders to profit from uncertainty, but there seems to be more to the story. 

As an economist and investor, I want to learn about how profitable traders assess risk, deal with uncertainty, structure trades, and form repeatable success. Near the book's end there is an afterthought about information advantage, but the authors do not tie all the pieces together on how these commodity trading firms are successful. I enjoyed the stories, but I don't really know or care about these wildly successful traders. 

Dispersion in central bank behavior - No one size fits all

Everyone focuses on Fed activity, but there are growing policy differences and opportunities in other countries. Looking at June monetary policy changes and focusing on larger market, there are clear differences in central bank responses to inflation. We are not counting central banks that have announced no changes. Differences in policy mandates are now leading to increased rate differentials. 

Central banks in countries where foreign capital flows are more sensitive to real rates are showing a strong and quicker response to inflation surges regardless as to whether they are transitory than G7 countries. While this may not put any pressure on the Fed, it does offer investors with a focus on EM a chance to find potential carry and flow trades. The interaction between real rates, exchange rates, inflation, and capital flows can be complex; however, these central banks all desire to stabilize and manage current inflation.