Thursday, July 29, 2021
Tuesday, July 27, 2021
Chimerica no more? One of the great investment events for any country is the inclusion of your equity and debt in major global benchmark indices. Index inclusion is a game changer. You have arrived. Index inclusion means that every global investor must hold your assets in his portfolio. To not hold a position is a bet against the performance of that country. This index effect for China especially in fixed income over the last two years has generated significant foreign investment flow not just from China experts but from passive investors. There is a time delay between any announcement, the actual rebalancing, and the impact on financial markets, but the longer-term effects are real.
The inclusion of China equites in benchmarks has been established for several years. The MSCI global equity index added Chinese A shares in 2018 and mid-caps in late 2019. The inclusion of China debt in the JP Morgan EMB benchmark was announced in 2019 for inclusion in 2020.
Firms have ramped up their equity and debt exposure, and now we are having a great decoupling of financial regulatory policies which has created a large disconnect country performance disconnect.
The difference between EEM and EEM x China is over 6% this year as of yesterday. The differential between the US and Chinese equity benchmarks is over 30% (SPY vs MCHI) this year. What should have brought the countries closer together is now having negative financial impact on global investors as the rules have the game change. Holding Chinese financial assets were considered a country and global trade play and was not viewed as a strong play on regulatory and political systems. The world has changed.
Hard to believe that terms like "Chimerica" - the Niall Ferguson and Moritz Schularick word for the symbiotic relationship between China and America seem so outdated.
Monday, July 26, 2021
The US is different from other financial markets because so much of financing is outside the banking system. Bank lending is more important in other countries. Capital markets are the driver of finance in the US which means there are special needs for collateral with lending and leverage.
The capital markets cannot work efficiently if there is a shortage of collateral regardless of how much excess reserves are in the banking system. The spike in reverse repo, while an overnight offset to the impact of QE as measured through changes in the Fed balance sheet, is a reaction to changes in the micro plumbing of financial markets. Recent increases in reverse repo have been a response to the elimination of SLR (Supplementary Leverage Ratio) relieve for banks, the drawdown of the TGA (Treasury General Account) at the Fed, actions to the debt ceiling statutory ceiling at the end of July.
In general, structural changes cause changes in the demand and supply of deposits at banks. At times banks want to hold less deposits for regulatory reasons. This constraint by banks causes money to flow to other short-term investment like money funds. The overall flow to other parts of the financial system creates collateral shortages which generates rate stress.
In the case of collateral shortages, rates can spike because there is inelastic demand for necessary collateral especially early in the day. If risk increases, flow to safe assets increases, or there is a price dislocation which creates the demand for collateral, the available safe assets are constrained even with the Fed balance sheet (QE) increasing.
Investor should care about plumbing because disruptions in the most liquid market for safe assets, Treasuries, will create the perception market dislocations. Increased risk perception concerning collateral will generate a build-up for portfolio safety and risk-taking should diminish. Hence, we should see a portfolio rebalancing out of risk assets. A collateral repo disturbance will increase the desire for a safety reserve.
Sunday, July 25, 2021
The risk aversion strategies are negatively convex or convergent strategies that underperform during market extremes. The behavioral premia are positively convex and like market divergences. The behavioral premia are often associated with market anomalies caused by behavioral biases which should not last. Behavioral biases associated with trend or momentum need liquidity given they will buy into strength and sell into weakness. Risk aversion strategies will buy into markets where there is higher risk aversion. In these cases, investors will be compensated for skewness or risk from expected extremes.
Investors who believe there is a greater likelihood for market divergences must act early with buying behavioral premia because the liquidity costs will be higher if you buy late. Risk aversion investor must make the judgement that markets will be or remain calm. Negative market moves will generate underperformance. The choice is a play on uncertainty which impacts liquidity.
Thursday, July 22, 2021
Wednesday, July 21, 2021
A more well-defined and selective risk premium will more likely be subject to crashes. For example, G10 carry is well-defined and highly selective. A change in carry opinion will lead to a strong reversal of returns. A strategy risk premia that is more diversified across asset classes and harder to define will have less likelihood of crashes. For example, a carry strategy that is applied across asset classes will have smoother returns with lower return and risk. The market portfolio as a combination or bundle of long-only risk premia provides diversification from the crashes of a single premia.
Tuesday, July 20, 2021
Monday, July 19, 2021
There are known knowns. These are things we know that we know. There are known unknowns. That is to say, there are things that we know we don't know. But there are also unknown unknowns. There are things we don't know we don't know. Those tend to be the difficult ones.
- Donald Rumsfeld
Donald Rumsfeld, best known as the former US defense secretary, died last month. Smart, arrogant, and a man who would not suffers fools gladly, Donald Rumsfeld will always be connected with one of the all-time great quotes on uncertainty. Love him or hate him, he will be known as the "unknown unknowns" guy. I cannot count the number of times I have used the quote and have applied it to a sticky decision problem. It is important to often step back and determine what is known, unknown, and could be known.
Most recently, I posted about the uncertainty gap, the distance between what we know and what we need to know. Good decision-making focuses on closing the unknown gap. (See - Uncertainty - the gap between what we know and what we need to know)
He could have followed at key times his own advise on unknowns, yet he likely made those around him smarter especially if they were willing to face the unknown challenge.
Friday, July 16, 2021
Thursday, July 15, 2021
The yield curve as measured by the 10-year minus 2-year Treasury spread has seen a significant reversal from the big reflation trade to a flattening move under the expectation of a Fed who will push policy action slightly forward (six months) and will be conduct more normalized behavior to tame inflation. There is also a view that inflation is transitory, and we have reached peak growth. Whether these themes continue is subject to debate and will dominate the fixed income narrative.
Before significant judgments are made on what is the correct curve moves, there needs to be some historical context. The one-week changes in the 10-2 spread are not at extremes. What is at extremes are the combination of one week changes across the last 4- and 8-weeks. As a measure of extreme, we calculated the 4- and 8-week changes since 1976 and gave each a percentile rank. We used percentile measures given the non-normality of curve changes which have very fat tails. Earlier this year, we have had some of the largest curve steepening by rank for both 4- and 8-week periods. In the last few weeks, that extreme has completely reversed. We now have some of the greatest flattening moves. What is clear is that fixed income sentiment has moved from a reflation extreme to a possible "peak growth" extreme.
However, these switches between extremes are not unusual and the size of the 10-2 spread move to be in an extreme are actually quite small. For example, the 36-bps flattening over the last two months (July 12, 2021) places it in the 7th percentile while a 50-bps steepener is in the 95th percentile of moves and occurred in early April 2021. It does not take much to reach what would be called big moves in the curve trades.
Nevertheless, investors should remember that yield curve trades can bounce between extremes in the short run (inside two months) but have very long-term trends based on long-term monetary policy.
It has been tried before and failed, but is it time for an inflation futures contract? Transitory inflation may last longer than we think, and transitory does not mean that we get that purchasing power back. Real wealth has been eroded. In a stable world of 2% inflation targeting, a futures contract may not serve an economic purpose but now may be different.
Bond futures have a strong expected inflation component, but there may be a need for an exchange cleared product. There is an active TIPS markets albeit no TIPS futures. However, a hedge or method of trading CPI over the short run is not direct or exactly easy. Of course, we have a strong inflation swaps market. An inflation swap can be cleared through an exchange so some of the futures benefit can be received without a futures contract. However, investors who want a direct inflation hedge may like more choices.
Previously, I was an economist for a futures exchange working on contract development and I will tell you it is not easy to launch a new futures contract. Most will be failures. A contract success will be based on a strong set of active buyers and sellers as well as a high level of volatility and uncertainty that must be hedged.
Many will say that you will be able to get close through buying a commodity basket, gold, or oil futures, but any close look will show that the variation between inflation and commodities can be volatile and the correlation has declined as the US economy has changed to be more service focused. For businesses and investors, an inflation futures market could be useful and the cost of managing a contract in an electronic world is substantially less. This is worth a more serious discussion.
Monday, July 12, 2021
Sunday, July 11, 2021
All the Fed talk and investor buzz has been about tapering, but the discussion should be divided into two parts: one, the signaling of future monetary policy as either being hawkish or dovish, and two, the impact on credit expansion and economic activity. The economic impact of a tapering may be minimal. The signaling issue of bringing an end to QE and sooner increases in rates can be consequential for financial markets, less so for real markets.
It could be argued that with the significant amount of reverse repo, excess money is being drained from the system and thus offsetting Fed purchases. There are technical and curve components to the reverse repo activity, but there are just excess funds without a home at a current level of approximately $800 billion a day.
Another way of thinking about the limited impact of QE in the current environment is to look at the difference between the monetary base and reserves. The difference has had remained constant for the last year. While liquidity was needed in March, it is less clear whether it is necessary to support the bank lending channel now. The issue is now centered on whether there are good investment projects not whether there are funds available.
With mortgage rates at five-month lows and housing prices reaching highs, there is even less reason for the Fed to be purchasing mortgages. A scaled reduction will not impact economic activity and provide some rationality to the MBS market. Fiscal policy and regulation will have more impact on sustaining economic growth than more money from the Fed.
The signaling that the Fed will provide less liquidity yet is not tightening is a different issue. Perhaps the reflation trade was overdone, but wording and signaling on intention with respect to inflation will have a greater impact on forward expectations. There may be an immediate negative reaction to tapering, but for the real economy and loan activity, it will be a non-issue. Pushing forward Fed rate increases will have a very different and negative impact.
The Fed would like to walk a fine line and start tapering but assuring markets that low rates will continue.
Thursday, July 8, 2021
Wednesday, July 7, 2021
Preparing for the annual Russell reconstitution announcement is second nature for passive index managers, but it should also be a natural part of any active manager discussion, even for global macro managers. The reconstitution problem is not just a Russell index issue.
It should be obvious that the characteristics of equity and bond benchmarks today and not the same as a few years ago. They will be similar but not the same, so all the factor sensitivities to these indices will be slightly different. There will be error in any beta calculation to macro factors given index characteristics are changing. For example, the sector weights for an equity index may vary, so growth or inflation betas may differ through time. For fixed income, duration changes will impact rate sensitivities.
Investment skill must sweat the structural details. There is no room for the dilettante who is not versed with market details because knowing the details converts into "loose change" and the summation of these pennies becomes real in a low-rate environment. Knowing the details is not a matter of being able to engage in market conversation but understanding that the craft of asset management requires a focus on getting all the structuring associated with a trade idea and execution correct.
A good idea executed badly may generate less return than an average idea executed well.
Tuesday, July 6, 2021
- What does a more hawkish Fed really mean for markets and the economy?
- Is inflation transitory, and will we see an inflation pullback in the second half of 2021?
- Growth reflation has occurred, but will it continue at the current pace?
Monday, July 5, 2021
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.
Sunday, July 4, 2021
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.