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11 10 2015 | by Victor Xing | Capital Markets

What would lead to the next major systemic disruption?

I believe our investment management industry will be “ground zero” of the next major systemic disruption.  Rapid sell-off in the bond market due to rising inflation can sharply raise borrowing costs and tighten financial conditions.  Asset managers with large bond portfolios that are sensitive to credit and interest rate risk will be forced to liquidate their positions, creating a vicious cycle of forced capitulations.

The much-demonized banking sector under years of tightened financial regulation will no longer cushion the fire sale with their constrained balance sheet.

Consequence of policy-induced financial repression

Years of central bank induced financial repression forced professional investors to move away from shorter-maturity, liquid, high quality fixed income assets and into lower quality corporate debt (including High Yield debt), equities, and less liquid alternative investments.  Out of which, bond funds grew significantly following the financial crisis. Not only investors are holding larger quantity of lower quality bonds, they have also increased their average portfolio duration in their pursuit for yield (taking on more interest rate risk).

systemic disruption - bond funds have grown rapidly
Growth of bond funds (source: Lipper, Bank of International Settlements) – a potential source for systemic disruption

I subscribe to former Federal Reserve Governor Jeremy Stein‘s “Fed recruitment” view, that central bank policies have “pushed” investor into taking higher risk in-order to induce faster economic recovery:

An alternative hypothesis is that our policies were indeed responsible for the very low level of long-term rates, but in part through a more indirect channel. According to this view, real and nominal term premiums were low not just because we were buying long-term bonds, but because our policies induced an outward shift in the demand curve of other investors, which led them to do more buying on our behalf–because we both gave them an incentive to reach for yield, and at the same time provided a set of implicit assurances that tamped down volatility and made it feel safer to lever aggressively in pursuit of that extra yield. In the spirit of my earlier comments, let’s call this the “Fed recruitment” view.

Speech by former Federal Reserve Governor Jeremy C. Stein on financial stability risk, September 26, 2013

As a result, investment managers’ holdings are more risky than before.  This reduces their risk tolerance and make them more sensitive to large scale rises in bond yields (which can happen when other more risk-sensitive asset managers sell their bonds) amid averse market conditions.

The “search for yield” and financial repression is not a U.S. phenomena.  Investors across the globe have been buying German sovereign bonds at negative yields, and Global asset under management has been rising.  Higher value at risk and diminished capabilities of managing risk may lead to another systemic disruption to the financial sector.

systemic disruption - rising global AUM
Credit: Bank of England Financial Stability Report, July 2015

The inflation story is complex and nuanced

The catalyst for a bond fund sell-off may very well be higher inflation.  It is true that many investors, economists and central bank officials express concerns about overall level of low inflation, but rental cost (gold line below, expressed as Owner Equivalent Rent) and Core Inflation (inflation ex-energy and food) have been rising.

Falling energy and durable goods prices have offset considerable rise in services (including rental) cost.  This means any reversal in energy and commodity prices can produce a dramatic lift on overall inflation.

Systemic disruption - inflation
Higher inflation may be the catalyst for sell-off in fixed income instruments, triggering systemic disruption to the financial markets

If the Federal Reserve signal faster than expected (pace, not timing of) rate hike to combat (unexpected) rise of inflation, investors may stampede their way toward the exit, and many risky portfolios will unwind.  If this goes on unchecked, asset managers will be forced to sell other assets (currencies, equities, etc) to meet investor redemption, leading to the next major systemic disruption.


Next article11 09 2015 | by Victor Xing | Economics

October Payrolls (Nov 6th) and FED policy implications