Covid-19 may or may not trigger
Here’s the conundrum: invest with the madness or against the madness? Credit and ﬁnancial markets have become increasingly reﬂexive as central
A recent Bloomberg Businessweek feature described the heavy concentration of the US fund management industry, where the big three ﬁrms own 22% of a typical constituent of the S&P 500 index, up from 13.5% in 2008. The determination of the US Federal Reserve to ‘ﬁrst, do no harm’ to the US economy has convinced investors that 2020 will be another year of bumper returns as interest rates fall and the Fed’s balance sheet expands.
Voices of caution tend to be drowned out by the chorus of self-serving bull market opinion. The polarisation of political life is mirrored in the investment community, where conﬁrmation bias is rife. Indeed, the invisible algorithms that run on our devices are carefully curating the messages we receive to give us more of what we like, and less of what we don’t.
Famously, in July 2007, Chuck Prince, then chief executive of Citigroup, told the Financial Times that global liquidity was enormous and only a signiﬁcant disruptive event could create diﬃculty in the leveraged buyout market. “As long as the music is playing, you’ve got to get up and dance,” he said. “We’re still dancing.” Testifying before the Financial Crisis Inquiry Commission in 2010, this quote came back to haunt him. Prince’s rationalisation before the panel could be summarised thus: it was a race to keep up with competitors who kept loosening lending standards and Citi couldn’t aﬀord to drop out.
These same dynamics are in ample evidence today in the US corporate junk bond, leveraged loan and private equity markets, but the world of ‘new monetary policy tools’ has aggravated reﬂexivity and turned ﬁnancial markets even more toxic. As Helen Thomas of Blonde Money observes, quantitative easing and the passive money machine have transformed the process of asset price formation. “Prices of assets used to reﬂect the probability of future risks and react accordingly when information changed. Now, it is only proﬁtable to assume that everything is wonderful, until a risk becomes so immediate that the price adjusts suddenly in a step change,” she says.
In this brave new world, most of the time, it is highly lucrative to sell volatility using derivative instruments. While the Fed ‘has your back’, liquidity is plentiful and nothing goes wrong, then equity market put options will expire worthless and the premium becomes proﬁt.
To asset managers, buying protection against adverse market moves seems just a waste of money and a drag on investment performance.
However, all this volatility selling leaves market makers with something called a long gamma position. As Blonde Money’s Thomas explains, whoever is left holding volatility must trade every day to cover the time decay inherent in their options.
They must buy every dip and sell every rally, and as trading ranges shrink, they must do so more often and in larger sizes to avoid a constant drag on their proﬁts from ever-decreasing volatility. A mere 1.5% move in the S&P 500 index can turn (proﬁtable) positive gamma into loss-making negative gamma. Everything is on a knife-edge. Similarly, BBB-rated and BB-rated corporate bonds can price close to perfection one day, only to fall oﬀ a cliﬀ at the merest whiﬀ of impairment.
On 3 January, former Fed chairman Ben Bernanke (remember him?) delivered a punchy speech at the Brookings Institution, singing the praises of the ‘new monetary tools’ which have been extensively deployed in the past decade. Bernanke is a cheerleader for the eﬀectiveness of said tools, believing that the Fed has more than adequate ﬁrepower, in the form of QE and forward guidance, to ﬁght the next recession.
He conceded that other tricks – constructive ambiguity regarding negative nominal interest rates, yield curve control or a moderate increase in the inﬂation target – might also come in handy. What he seems not to have considered is that the manipulation of ﬁnancial conditions might already have lost its ability to transform economic outcomes.