Alternative investments - Return dispersion is costly

Dispersion can be function of misclassification. When things are wrongly bundled, there will be a greater dispersion. However, dispersion can also be related to differentiation in skill. If there is a wide dispersion in ability, there will be a wide dispersion in results. Of course, in a market economy, those with poor skill should be dropped from the performance set through failure. In the long-run that will be true, but in the shorter-run there may be inertia with firms leading to failure. 

What the CAIA chart for a given year shows is that some \investment sectors will have more return dispersion than others. You get paid for finding winners in alternatives. You don't get paid much for searching for winners in public fixed income. 

Using a benchmark or median firm is not that costly in terms of leaving money on the table by not finding the top quartile firm or by picking the wrong firm who falls in the bottom quartile. The penalty for being wrong or suffering from regret is higher for private equity or venture capital. More due diligence time and effort have to be placed in the alternative investment sectors. Choosing the average firm does not buy you much for performance. Investors have to go big on due diligence or go home.   

Forecasts, Regime Changes, and Rational Expectations

The economy has now changed forever. It is an often-overused phrase, but in this case, it is true. Look at any macro time series and there is a multi-standard deviation shift down. Call it the COVID-19 recession or the Great Lockdown, it does not matter, the shift changes all forecasting given the size and speed. There was no trend lower. It has been a falling off of a cliff event. This shock is not just a low probability event conjured in our minds. It has happened and now forecasts, and the use of data have to be recalibrated. 

Any forecast of the future that employs past data to extrapolate into the future is wrong and not rational. Moving averages on fundamentals are problematic.  If you are doing that, stop now. Any data based on pre-March information, is irrelevant for near-term analysis. While assets prices declined with the fundamentals, the post shock links will be harder to calibrate.

There was a structural break that cut the link with past data and forecasts. The work on forecasting time series with structural breaks does not provide easy solutions. The focus of most research has been on finding breaks and regime changes and not dealing with how to forecast after the break occurs.

Look at the Jim Stock's weekly economic indicator index (WEI) that is a good example of nowcasting. It is forecasting a double-digit real decline in GDP. This forecast is useful, but the question is how to calibrate new information that can be mapped to asset returns. How do you effectively use the pre-March data?

Initial jobless claims have exploded, but what will be the meaning of a slight decline over the next few weeks. It will be good economic news, but can it be translated into a stock or rate sensitivity that has meaning versus sensitivities in a pre-COVID19 world. There is a significant shadow effect if one looks at say a 12-week moving average. After the last twelfth week rolls off, the new series has disconnected behavior with the past. We are dealing with a high degree of model uncertainty.   

Expectations have to be forward looking and use all current information. Adaptive expectations will not cut it, but rational expectations seem somewhat vacuous. In rational expectations, economic agents know how the economy works and these expectations impact the future economic results. There will be mistakes but expectations, on average, will be correct. This sounds good, but what does it mean in a new economic reality. Expectations will impact markets, but it will not be based on knowing the economy. It will be related to rational beliefs based on competing models that may seem rational but cannot all be correct.

Some simple rules: 

• Models are now highly uncertain, so an ensemble of models which evolve will be useful. Those models that fail or reveal to be useless should be dropped.
• Work with survey data or data that has short look-back and not subject to revisions. 
• Focus on nowcast across a number of variables and limit look-back on times series.
• Highlight structural regime changes from policy to maintain forward-looking forecasts. Use theory to extrapolate the policy impact.
• Conduct and place more weight on scenario analysis. Think of alternative policy and economic outcomes and then handicap.

Alternative risk premia match well versus hedge funds

What is a hedge fund? From an investment and risk perspective, a hedge fund is a combination of factor styles and risk premia formed within an investment fund. There may be skill through the generation of unique returns or alpha, but as investors become better at decomposing risk factors, it becomes more apparent that hedge funds are often just a combination or bundle of these risk factors including carry, trend, momentum, value, and volatility across the set of asset classes of equity, rates, currency, credit, and commodities. 

Some hedge funds specialize in a style or asset class. Some hedge fund managers are discretionary and others are systematic. Most can be described through alternative risk premia (ARP) bank swaps which are total return swaps linked to an index that is associated with a well-defined risk factor. It is an alternative way of accessing risk factors. It does not mean that the bank ARPs are better or have special skills, and it does not mean that good hedge funds are not available. It is just another way of investing in risk factors. 

The folks at Premia Labs, the bank swap data provider, have compared a bundle ARP swaps against the SPX and HFR equity hedge fund index and find that a global cross-sectional, equity multi-factor, and global trend ARPs performed well during the first quarter. Additionally, when focused style risk factors are compared with  hedge funds indices, they have provided better returns for the first quarter of 2020.

The cross-asset trend and merger arbitrage ARP indices did better than comparable HFR indices. The outperformance may be caused by the index construction. It can also be caused by what may be a fee advantage with doing the total return swap which does not charge a management and incentive fee. At the least, ARPs returns should be compared with similar styled hedge funds. For example, the choice set for trend-followers should include not just a representative sample of hedge funds but a set of available ARP trend swaps. 

The search for diversification and return generation should be broadened during these crisis times to include liquid bank swap products. Bank risk has increased but so has the risk of hedge fund illiquidity and failure. The delivery choice set for any risk exposure should be maximized and then assessed to find the best ways to access risks. 

Getting a handle on the COVID19 shock - Forecasts are sobering

We know the current pandemic/lockdown is bad, but using that words gives us little information. The question that needs to answered is how bad the shock will be and how long will this last. We know there is a lot of research from Wall Street firms, but we also want to highlight some of the work by academics to show how they approach this forecasting problem. While I may not completely agree with their methodology, their viewpoints provide a useful framework for consideration. 

In the new paper, "COVID19 and the Macroeconomic Effects of Costly Disasters" NBER working paper #26987, the authors use the times series from costly and deadly disaster to create a VAR model that can measure the impact of a shock on industrial production, services, and other economic variables. The data were collected from NOAA and the Insurance Information Institute. The assumption is that the economic response with all these shocks have some commonality.

Sizing the size of the shock as a number of standard deviations from normal can then be translated into macro variables. The authors make a reasonable assumption that the Great Lockdown will be a 3-month 60 standard deviation shock which translates into cumulative 10-month loss of 12.75% in industrial production and an employment loss of 17% or 24 million jobs before the recovery starts. The situation is even worse if a non-linear model is used.

This is the first shock where there is a shutdown of national production not associated with a shock to capital stock like a hurricane or terrorist attack. The global impact is not included in this model.

These are scary numbers that are not consistent with the behavior of financial markets. It is unclear whether the policy responses will be able to arrest this decline. While this is all in the realm of speculation, our attention should be focused on these possible scenarios.

See also Uncertainty and the COVID-19 recession - It is all about the uncertainty

Not theory, reality - The world of negative oil prices

Studying advanced microeconomics often requires learning to work through special cases of extreme behavior like negative prices. Counter-intuitive thinking is often required, but the process provides a deeper understanding of price dynamics and thinking out of the box. Now, we are living in world where negative prices are a reality. This is not just manipulation of rates by central banks but private market dynamics. Think of all the grey hairs given to risk managers. Yet, the price dynamic we are seeing are not irrational. 

The negative prices for May front-month futures at contract expiration, while surprising and not normal, make sense in an oil world of extremes. This can be explained through number of economic channels, production and producer behavior, inventory, and future contract construction. When all of these effects move in tandem to drop prices, there is no floor at zero.

One of the most interesting research papers on exhaustible resource over the last few decades has been "Hotelling Under Pressure" published in one of the leading economic journals (Journal of Political Economy). It refutes the Hotelling theory of exhaustible resources which describes the behavior of miners in the face of changing prices. "Hotelling under Pressure" shows that oil is different than other exhaustible resource because it is not lifted from a mine like gold but propelled to the surface by pressure. The long and short of their work is that oil production is not sensitive to price. Prices may fall and there will be cuts in drilling, future production, but not current production. Oil coming out of the ground will not be turned-off.  The supply will keep coming. We are living in a world where oil production will not be shutdown.

For storable commodities, there is a safety valve from holding inventory. When there are low prices today, commodities can be held in inventory until tomorrow. If prices are high, they can be smoothed through taking the commodity from inventory for sale today. Price extremes can be avoided at least until there is a no inventory available, then all of the supply or demand shock has to be displayed in spot or the nearby futures prices. No storage with continued production, there is no place to put the oil. At the extreme, a producer will have to pay someone to take the oil. It is not a choice but a requirement.  

These price dynamics see further extremes when demand and supply are inelastic. With simple microeconomics, the volatility of any commodities is directly tied to the price inelasticity. Oil production does not change with price in the short-run, and if normal demand for refined products falls, there is no place else to go with the production. No driving, no demand for gasoline, and no demand for crude by refiners. It cannot be used for some alternative purpose. 

We then come to the place where all of these issues must be resolved, the expiration for a futures contract with delivery at specific location, Cushing Oklahoma. Long positions have been closed or rolled to future contracts before expiration or receive delivery of oil. There is no cash settlement. You can call it a squeeze or corner, but if you are short futures, you may want to deliver oil, but longs have no place to hold oil. Longs will sell at any price to get out before expiration, even at negative values. The cost of taking delivery is prohibitive, so the market clears at levels where buyers are paid to take oil. The price is based on ability or inability to store and expectations of whether there will be market participants to take the other side of the futures trade. The day of reckoning is at expiration. Hopes, fears, and reality meet contract terms. 

Can it happen again? Yes, but since we have a new reality, any extreme price crunch will be realized sooner yet may be muted because all traders will know it is possible. Unfortunately, these extreme events compromise the use of the oil futures market.

“The Great Liquidity Crisis”, "The Great Lockdown", or "The Pandemic Crisis" - What's in a name?

Every crisis needs a name, but what is in a name? A lot. It frames future discussion about the crisis and defines the type of crisis. The naming meme frames expectations of what happened and what should be the response. This crisis needs a name and a single leading candidate has not arisen. 

JP Morgan strategist Marko Kolanovic is calling the current environment “The Great Liquidity Crisis” for financial markets.  Other have called this shock "The Great Lockdown" as if the lockdown is the primal cause. The less imaginative investor will just say it is the COVID-19 or corona virus recession. 

We think it is important to separate the financial and economic shocks that we have seen from the COVID-19 pandemic. Of course, financial and economic problems are closely linked, but to truly understand this crisis the two have to be disentangled. This crisis may have initially been the COVID-19 recession. It was reformulated to the "Great Liquidity Crisis" and is now the "Great Lockdown". As we solve one crisis or component of the crisis, another one raises or takes precedent. There is not one problem or one solution, or one name. It is not a policy failure at this point, albeit ex post it may seem as though the signs of failure were obvious. Given uncertainty, failure may rest with not acting fast enough early and too slow later.  

We need a name for this.

Easier to break than to build - Hysteresis with COVID-19

This collapse is not the result of a financial crisis. It is not even the direct result of the pandemic. The collapse is the result of a deliberate policy choice, which is itself a radical novelty. It is easier, it turns out, to stop an economy than it is to stimulate it. 
- Adam Tooze, Foreign Policy Voice

The one thing you learn as a child, it is much harder to build, then to destroy.  Blocks, Legos, Lincoln logs, it is all the same. You can work on something for hours, but taking it apart or giving it a whack will reverse all of the work quickly. 

Why would we think that it will be different for a complex system like an economy, yet here we are with a pandemic and an imposed destruction (lockdown) of an economy. There are policies to offset or lessen the impact of this imposed or controlled slowdown especially with monetary policy, but we have no idea whether we can put it back to together or what new shape we will see in six months. 

There are different types of recession which will have different response to a shock. The Great Financial Crisis was a banking liquidity recession. Most recessions are inventory adjustments. Many recessions are associated with balance sheet adjustments. Some are associated with tight money or poor policy choices. This is the first one where we lockdown an economy and then try and offset the effects with liquidity. 

What we do know is that there is a particular problem with macroeconomies that go into steep and long recessions, hysteresis, the fact that temporary setbacks can have permanent effects and non-reversible adjustment paths. Economies are path dependent and a lockdown shock will change the growth path around the globe.

Keynes believed that in aggregate economic systems are not self-adjusting, and Marshall argued the same thing for a market, "if the normal production of a commodity increases and afterwards diminishes to its old amount, the demand price and the supply price are not likely to return, as the pure theory assumes that they will, to their old positions for that amount." 

Systems will not go back to the old days. There will be industries that will be harmed to such a level that they will not be able to return to the past. The energy market, airlines, leisure and retail will be all change to name a few. Regardless of current market gains, the process of sorting between winners and losers should be ongoing. There is no self-adjustment and no quick fixes.

All about just trying to answer, "What is going on here?"

"A great deal of strategy work is trying to figure out what is going on. Not just deciding what to do, but the more fundamental problem of comprehending the situation.", according to Richard Rumelt, author of Good Strategy/ Bad Strategy.

We are seeing forecast and opinions about what will happen next come fast furious when what investors first need to step back and ask the simple, yet critical question, "What is going on?" 

"What is going on?" is not an issue of just stating more facts. Facts are not analysis. Analysis is the weaving of facts to tell a story. The answer to what is going on is not more data but more thinking about what are the causes for the situation. 

An economy is a complex system so when the system is perturbed there will be unintended consequences, secondary shocks and market adjustments. When there is a new shock not previously experienced and large policy responses, the feedback will cause further distortions. The focus requires analysts and step-back and assess deeply before making predictions. This is not easy in real time, but a framework of what is broken, what can be fixed and what is working is necessary.  

The COVID-19 crisis - A comparison with the Great Financial Crisis

Is the COVID-19 crisis different than the Great Financial Crisis? Of course, it is although there are some common characteristics. With a large common shock, there will be a one-way flow that creates a liquidity crisis. This liquidity shock is a common component across both crises, but it is important to contrast the two events to understand the transmission through the economy. This is not a regular inventory adjustment recession nor is it a financial recession. It is an economic shock that has spilled over to financial markets. Hence, the response and the adjustment process will be different.

What is a safe asset? Things to look for with a changing target

A safe asset yesterday may not be a safe asset tomorrow, yet the demand for safe assets could not be higher. We are in a risk-off environment, but investors would like some return even with safety.  

There are some measurable characteristics for a safe asset from the paper "The Fundamentals of a Safe Asset", but even here there has to be more thought on the meaning of safety:

• Low political risks - Extreme political risks are easy to spot, but the measures of political risks have become more uncertain. Safety has to be connected with policy uncertainty and future supply.
• Relative size of debt markets - The large debt markets usually attract large institutions that follow benchmarks and liquidity, but higher debt issuance leading to bigger market size has a tipping point. Too much supply can reduce safety.
• Past safe asset behavior - The inertia effect of past safety still is an attractive feature that will not be broken for many investors, but the connection between the past and future has been broken with the pandemic.
• Good real GDP growth - In a global recession, real GDP is declining across most countries. Safety may be related with which economies can get back on-line without structural damage. 
• Low public debt - As even large safe countries have seen their public debt explode, the concept of safety is changing. By this standard, Japan would not be considered safe, yet it has still played a safety role. The US should have diminished safety.
• Better current account - We have seen during this crisis a flight away from those countries with poor current accounts. The foreign reserves are now closely watched for strain and will have to be used to offset current account stress.   

Investors should create a safety checklist based on the above criteria and reorder their assessment of safe assets both domestically and internationally.

Forget cash flows and rating agencies - All good in corporate bonds

March saw a liquidity crisis, and the Fed, as the lender of last resort, was needed to stabilize markets. However, the lender of last resort as a liquidity provider is not supposed to reverse the economic realities of cash flows. Yet, here we are with the value of LQD, the corporate bond market ETF, now above levels from the beginning of the year and near the price at the beginning of March. 

Some of this price is related to the overall fall in rates but this is very interesting. There is no crisis in investment grade bonds. Bonds investors are saying there is more risk as measured spreads and overall yields received for bonds is higher than the beginning of the year, but financing levels are lower than the beginning of 2019 for investment grade and lower than the 2016 spike in high yield.  

Spreads have spiked but have started to move lower. The differential with high yield is double from what was seen over the last two years. This could be seen as the Fed premia between being a buyer of corporate debt and not a buyer of high yield. Forget the economic numbers and forget the concerns of the rating agencies and their downgrades. The Fed will buy these bonds at attractive levels for investment grade bondholders. 

A shortage of liquidity led to an overshoot in spreads in March and euphoria concerning Fed purchases is leading to an overshoot in the other direction for April. 

Life During War Times and Before the Treasury-Fed Accord

This ain't no party, this ain't no disco,

This ain't no fooling around

No time for dancing, or lovey dovey,

I ain't got time for that now

"Life During War Times" - Talking Heads 

Fed monetary and fiscal policies are the same that would apply to a war economy and currently going beyond anything from the Great Financial Crisis. Saying that we are at extremes has clearly been stated by many. We want to think about what happens next. What happens when the war is over? 

A short history of the Fed during WWII and the period afterward can be found here. 

When the United States entered the war, the Board of Governors issued a statement indicating that the Federal Reserve System was “. . . prepared to use its powers to assure at all times an ample supply of funds for financing the war effort” (Board of Governors 1943, 2). Financing the war was the focus of the Federal Reserve’s wartime mission. This mission differed from the mission of the System before and after the war...
To enable the Federal Reserve to accomplish its wartime tasks, the Board of Governors asked Congress to amend the Federal Reserve Act. One amendment enabled the Board to change reserve requirements in banks in New York City and Chicago, known as central reserve cities, without changing requirements for other banks. A second amendment authorized the System to purchase government securities directly from the Treasury. A third amendment exempted war loan deposits from reserve requirements for the duration of the emergency. 

The president also issued a series of executive orders that shaped the System’s wartime roles. Executive Order 9112, issued on March 26, 1942, established a program of guaranteed loans to industry for war production. Executive Order 9336, issued on April 24, 1943, expanded the scope of the program.

In the post-WWII world, rates were held artificially low so that the cost of the war debt would not sink the early post-war economy. The Fed would take its lead from the Treasury Department. There was an 3/8% interest peg for Treasury bills from 1942-1947 This "financial repression" of submarket rates was imposed given the debt to GDP was well above 100%. 

However, as the distance from the war grew and inflation increased, there was increasing tension between the Treasury and Fed. This period was fraught with political battles between the central bank and the Treasury Department which thought monetary policy should be an extension of Treasury policy. The Treasury wanted pegged rates to continue even in the face of increasing inflation and rising bonds yields. Rising rates would hamper the Treasuries ability to fund the debt. 

In 1951, the FOMC refused to follow the Treasury lead or the desires of President Truman creating a well reported break in policy agreement. The Treasury-Fed Accord of 1951 laid out the new agreement between Treasury and the Fed: “reached full accord with respect to debt management and monetary policies to be pursued in furthering their common purpose and to assure the successful financing of the government’s requirements and, at the same time, to minimize monetization of the public debt” from the Fed history. This marked what many consider the end of the WWII financing polices, the beginning of free bond markets, and a central bank following goals independent of the Treasury.

Right now, the Fed is taking the lead over Treasury with stimulative policy, but clearly, we are in a war financing pegged rate environment. As Treasury debt grows, there will be more pressure on the Fed to follow a low rates policy even in the face of inflation. History will repeat itself, but the answers this time may not be the same.

Commodities performance - Energy sector not the same as other commodities

No different than equity markets, commodities were hit hard with the global economic effects of COVID-19, this placed further pressure on markets suffering from over-supply. There is no worse combination than a demand shock in an environment suffering from large oversupply imbalances or excess production. However, the dispersion in returns have been huge in March and for the year. Energy markets are very different than grains or precious metals.  

Commodities are different than financial assets given that inventory builds can spread short-term market imbalances through time. Excess supply today creates contango which allow for storage to play a role in smoothing shocks; however, there are even limits to storage economics. We are reaching those limits in crude oil and refined products. There is real talk of negative oil prices. 

Investors need to go back to first commodity principles to create scenarios for this will be resolved. "Low prices are the solution to low prices." When prices reach levels where production is shut, capital finds new places to invest, and excess capacity is rationalized, prices will rise. Second, "commodities are logistics markets." An economic shock may see immediate price declines, but shocks also breaks logistics which will impact the ability to move supply to market. Prices need to rise to adjust logistical disruptions.

• Energy markets are being fundamentally altered with the end of cheap capital for marginal producers, consolidation to stronger hands, and a reconfiguring of geopolitical oil power. The price bottom may not be with us.
• Agriculture markets are not immune from the reworking of energy markets. The corn/ethanol/energy link is going to have to be rationalized. The same can be said for other oils and sugar used for energy.
• Trade logistics are in upheaval. From flows across the globe, dollar invoicing, and EM capital flows for commodity development, global commodity supply chains will change and that will push prices higher. 
• Project development will be reassessed even in an era of cheap money. Long-term projects based on poor price projections will be abandoned. Economic development will be impaired. 
• The price and supply of labor for agriculture will cut capacity and raise prices. Migrant labor is the driver for fresh food in markets twelve months a year. 

While currently in transition, a global economy that starts to recover may make commodities a good alternative to financial assets. This is a radical change from the post Financial Crisis period. 

Equity factor behavior in the first quarter - Consistency with macro environment

Consistency is not perfection, and long/short factor premiums will not always generate positive returns; however, as we review the first quarter, it is apparent that strategy factor behavior was fairly consistent with what was experienced in the macro environment. 

The tracking of long/short global equity factors from the Factor Research folks may not show pretty results but it tells an economic story that makes sense. Investors holding the size factor were hurt with a large negative shock. Being long small firms when there is a liquidity crunch shock is not going to be a good place for investors. Value is also not a good place to be going into a sharp recession. In contrast, quality and momentum were better places to be invested. Firms that were showing downward performance continued with that trend when the COVID-19 pandemic hit global markets. Quality investing served as a good place for safety. The low volatility factor did not offer protection after serving as the popular factor trade for a number of years.

Consistency may not offer solace for investors looking for alternative factor gains in equities. Investors would have found the protection desired by broadening the portfolio choices to other asset classes. Alternative risk premia in commodities, currencies, and rates not only provided diversification but positive returns from the pandemic shock.

Different types of liquidity crises - Defining the problem

Many market pundits will talk about a liquidity crisis, but they are not precise about what they mean by the term. A liquidity crisis can be broken into three different areas of focus in response to a negative economic shock. These liquidity shock alternatives will vary in strength and may resolve differently over time. This liquidity crisis breakdown may help with any discussion concerning current and future policy responses.  

A liquidity crisis will start with a negative economic shock and may follow three different liquidity shock channels: a pricing effect, an economic accounting effect, and a leverage effect. 

The pricing effect occurs when the negative economic shock impacts beliefs on pricing. If there is a strong common negative shock and expectations, there will be strong selling which can cause excess pressure to get out of markets at prices below fair value. With this forced selling buyers can only be found through giving them extra return for immediacy. This fall in price relative to fair value will be coupled with wider bid-ask spreads because dealers don't have the capital or risk appetite to warehouse assets. We have seen the impact of this pricing or market liquidity crisis in March especially with short-end rate spreads and off-the-run Treasuries. The Fed and other central banks through serving as the buyers of last resort and as providers of funds for financing reversed some of the extreme distortions seen in what used to be considered the most liquid markets. 

The second focus of a liquidity shock or crisis is with the economics of the firm. Some will call this accounting liquidity. A slowdown in sales from sheltering in placing and business closings will mean a lack of firm cash flow liquidity to meet ongoing business obligations such as rent, payroll, and accounts payable. If cash is exhausted, the business and household cost is high without any relief. This is being solved with fiscal policy. The question is whether it will be fast or large enough to offset any economic gridlock. 

The third liquidity shock focuses on the core function of capital markets and banking. Tighter liquidity conditions mean the cost of borrowing will increase. A negative shock will also see an increased demand for margin and collateral as the value of existing collateral is called into question. Tighter banking feeds back on the economic or accounting liquidity shocks while the higher margin requirements will impact pricing liquidity. This shock is where the Fed will step in with lending programs and changes in bank regulation.

We may be through the worst effects of the pricing gridlock. The lending and leverage effects are being worked through albeit far from solved. However, the economic effects on households and businesses may have the longest lasting and greatest negative effects. Stressed business and households cannot be snapped back like a rubber band. This is also where the impact of policy is most uncertain.  

When discussing this liquidity crisis, break the discussion into these three areas of core stress.   

Uncertainty and the COVID-19 recession - It is all about the uncertainty

What will be the impact on US economic growth from the COVID-19 pandemic? This is not an easy problem since we have limited history to make any comparisons or projections; however, it is still important to try and provide some figures to guide policy and investment decisions. A new forecast has been generated by Scott Baker, Nick Bloom, Steve Davis and Stephen Terry in their just released paper "COVID-Induced Economic Uncertainty". The authors are known for their construction of uncertainty indices. We have been avid follower of these uncertainty indices and tools and think this is a fruitful direction for forecasting.

The novel approach is to use real time uncertainty indices and a disaster analysis model to generate their forecast estimates. The authors use stock market volatility, newspaper-based economic uncertainty, and subjective uncertainty from business surveys taken through March along with a model that has looked at past disasters to generate their VAR (vector autoregression) forecasts. They are looking at a decline of 11% GDP by 2020:4 with a 90% confidence level. 

Clearly, these numbers can change as we receive more information, but their focus is timely and emphasis is on what may be the most important current factor, uncertainty. They estimate that 60% of the decline will be uncertainty induced. Uncertainty causes fear, creates a demand for holding cash, and kills the animal spirits of optimism that often drive investment decisions. In an environment where we are breaking new ground every day, this may be as good a starting place for further discussion as we can currently find. 

FIMA repo facility to the rescue - Solving the dollar liquidity crisis

There is a dollar shortage, or more critically, a dollar liquidity shortage. The disconnect in covered interest rate parity, (cross currency basis), signals that there is a shortage of dollar capital to meet the demand for dollars. The cross-currency basis widens or becomes more negative when there is large dollar demand. A negative basis means that a dollar borrower will receive less on his non-USD portion of the swap. This numbers were significantly negative in mid-March. This March pressure has been partially relieved because of Fed dollar swap lines, the swapper of last resort, and normalization of short-term lending. Unfortunately, some of this improvement is associated relative money market rates and not just a reduction in dollar pressure. 

In spite of all the increases in the Fed balance sheet and the cut in rates, the dollar has still gained because the size of the dollar liabilities that need to be hedged are large, dollar trade cash flows have fallen, and large outflows in foreign assets have looking for dollar safety. Some of this dollar pressure has fallen in the last week, but short-term global lending markets are far from normal. 

The Fed added swap lines like 2008 for major central banks, but the dollar liquidity problem is not just for a few of the large central banks but more broad-based. Many central banks have been selling Treasuries to meet some of this local dollar demand. Their large Treasury balance were grown just for this type of problem, a sudden stop in trade flows that reduce dollar cash flows. Nevertheless, what EM foreign central banks really need is access to dollar funding that does not drawdown their assets which sends signals of currency strain. 

A repo line that allows the central banks to use their Treasury holdings held in custody at the New York Fed could provide what is needed in a manner that provides global liquidity while the Fed gains collateral for providing their lender of last resort function. Thus, the Fed announced the FIMA (Foreign and International Monetary Authority) Repo Facility last week.

The Fed is now playing an even greater role as a global central bank and not just the central bank for the US. There is no international organization that can provide the necessary liquidity. Right now, what is good for global central banks is also good for the US, but this adds another layer of monetary complexity along with QE4, and domestic lending programs. The Fed balance sheet is not a US balance sheet, but an international monetary balance sheet.

Pandemic uncertainty off the charts, but high uncertainty existed going into 2020

These are unusual times, but there was significant economic uncertainty even before the globe was hit with the COVID19 pandemic. (See the World Uncertainty index and the new pandemic uncertainty index. The WUI is computed by counting the percent of word “uncertain” (or its variant) in the Economist Intelligence Unit country reports. It has been created by economists at the IMF and some of the same folks at Stanford University who generate the Policy Uncertainty Indices.)

This made the global economic more sensitive to an economic shock. We cannot say how this made the situation worse, but high uncertainty lends itself to higher fear. Higher fear translates into a desire for increased protection and cautious behavior. Uncertainty will reduce our ability to form strategies to mitigate any negative shock and thus creates anxiety. The fallback financial position is to increase cash and hold higher cash levels until uncertainty is resolved.

Any V-shaped economic rule that a sharp deep recession will be offset by a sharp steep recovery is unlikely if world uncertainty is still had high levels.

Bond vigilantes and central banks - Who rules which market?

Being righteous does not matter if you don’t have the right ammunition. Opinions are just musings without capital or the ability to move capital. Bond vigilantes used to have enough relative capital to move markets. That is not now the case because they are fighting a battle against central banks who have the power of money from printing presses. Actually, there will be two markets. One where central banks rule and the other controlled by the vigilantes where capital is scarce and disciplined by economic reality and profit

We are not arguing against the use of monetary policy in the current situation; however, the price of risks will not be determined by private investors but by policymakers in the places where they use their capital. Some of these dislocations based on liquidity shocks will be closed faster because central banks have more power than vigilantes while others will be allowed to persist. Dislocations and price differences will be closed not by private investors but by the choice of governments and central bankers. 

There will be two markets: One controlled by central bank printing presses their motives and the other by private investors and their profits.

• Commercial paper liquidity dislocations, if A1/P1 will closed by the Fe. If you are A2/P2, you will be priced by money market vigilantes and capital flows.
• Off-the-run Treasuries dislocations will be closed by funding from the Fed and outright purchases. Bond vigilantes will have to just follow the Fed.
• Agency mortgage risks will be deflated by Fed buying. Non-agency and other mortgage markets will be disciplined by the vigilantes.
• Sovereign bond risk across eurozone will priced by the ECB and not the bond vigilantes. They will have to be followers and anticipate the risk pricing of the central bank not their assessment of government finances.
• Investment grade corporates will have the Fed disciplining the market while high yield will be government by the vigilantes.

The bond vigilantes will not assess specific company or market risks for those sectors where central banks play but will focus on what policy-makers belief to be essential for their interpretation of properly behaved markets. In other places, it will be private capital driving decisions.

There will be two sets of rules, the law of the central bankers, and the rules of the vigilantes "West of the Pecos".