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10 17 2017 | by Victor Xing | Capital Markets

How we learned to stop worrying and love the “fake markets”

Executive summary

  • Some investors cited Fed policy intervention in creating “fake markets” where asset prices no longer correlate to measures of risk, and prevalent “yield seeking” strategies support buoyant risk assets and dampen borrowing cost
  • Other economists maintain a double standard on “fake markets” depending on the intervention actor: China’s capital control is generally perceived as “bad,” while QE is “good” even though both induce financial repression
  • Prudent investors face significant upside as central banks’ desire for a policy soft-landing (opposite to their “Shock and Awe” entry) will make the markets more “real,” while broader markets continue to expect current status quo
  • Market interventions should be immaterial to investors for they have existed since the dawn of time; instead, they should focus on risks hidden beneath the smooth liquidity-façade as the tide of unconventional easing recede

Risks of “fake markets” and academia’s double standards

Truly “free” and “real” financial markets perhaps only existed in the dreams of Mises and Hayek, since policy intervention had existed prior to the advent of monetary authorities. Thus, recent comments by prominent market participants on “fake markets” largely highlighted the unprecedented magnitude of market intervention over the past decade by major central banks, and how far asset prices have decoupled from measures of risk. These dangers to investors are perceived to be diminished as excess liquidity allow even highly risky business models to be sustainable, as well as suppress high quality asset returns to spur market participants to move up the risk ladder. Prudent investors focusing on the “real market” and ignored “attractive opportunities” would trail their peers and be paradoxically branded as “imprudent” under the “new normal.”ruly “free” and “real” financial markets perhaps only existed in the dreams of Mises and Hayek, since policy intervention had existed prior to the advent of monetary authorities. Thus, recent comments by prominent market participants on “fake markets” largely highlighted the unprecedented magnitude of market intervention over the past decade by major central banks, and how far asset prices have decoupled from measures of risk.

Interestingly, prominent economists have readily embraced the “fake markets” of prolonged unconventional easing, but other types of market intervention were staunchly criticized as “anti-free-market.” A recent WSJ editorial featuring PBOC Governor Zhou’s call for freer trade and an end to capital control highlighted this paradox:

Mr. Zhou is right that a convertible currency – the yuan – is key to rebalancing China’s economy from its long-time dependence on high savings and investment. Capital controls keep savings within China’s financial system, depressing the cost of capital and subsidizing investment at the expense of household income.

This combination, known as financial repression, has contributed to the massive increase in lending over the past decade. Total debt in the economy soared to 280% of GDP by some estimates. Moody’s and Standard & Poor’s downgraded China’s sovereign debt this year because of the rapid increase in borrowing, which is historically linked to financial crises.

Compared to the effects of capital control, QE also induced excess liquidity in the financial system (similar to China’s savers), depressed the cost of capital and subsidized highly risky investment at the expense of household income (in terms of fixed income returns to bond investors and savers). This is also known as financial repression, and it has contributed to massive increase in shadow bank lending (a bloated bond market where asset managers play a dominant role in corporate and consumer financing) over the past decade. Yet, economists are generally supportive of QE and ultra-easy monetary policies despite their unintentional social, economic, and political impacts, but China’s version of financial repression would solicit a consensus outcry that it would distort markets, sap economic potential and weigh on growth.

Accepting market intervention as a global phenomenon

Fake or not, interventions by non-market forces should be accepted by professional investors as a norm, and markets have always existed in various shades of grey between two ends of the “fake or not” spectrum; furthermore, policies by foreign central banks can also exert significant influence on domestic asset valuations (“fake markets gone global?”).

Recent discussions of ECB “taper-extension” halving asset purchases to €30 billion per month but maintain the program into September 2018 further reinforced the sentiment of “QE for longer” among some market participants, and financial conditions eased further on the follow. Long-term Treasury bond yields declined in sympathy with rally in Bunds, consistent with Fed Governor Brainard’s policy view that high quality sovereign bonds are close substitutes of each other, and a decline in German bond yields can create knock-on impacts on long-maturity Treasuries:

Finally, in circumstances where a major central bank is continuing to expand its balance sheet or maintaining a large balance sheet over a sustained period, this policy would likely exert downward pressure on term premiums around the globe, especially in those foreign economies whose bonds were perceived as close substitutes. Indeed, until very recently, it had been notable how little long yields moved up in the United States even as discussions of balance sheet normalization have moved to the forefront. This likely reflects at least in part the expectation that ongoing asset purchase programs in other advanced economies would continue holding down long-term yields globally.

Recent Federal Reserve staff analysis suggests that cross-border spillovers have increased notably since the crisis and are quite large. For instance, European Central Bank policy news that leads to a 10 basis point decrease in the German 10-year term premium is associated with a roughly 5 basis point decrease in the U.S. 10-year term premium; by contrast, these spillovers were smaller in the years leading up to the crisis.

Global long-term bond yields are strongly correlated to echo Fed Governor Brainard’s “substitution thesis:”

Fake markets

Markets may be “fake,” but investment opportunities are real

Given the impacts of policy intervention in financial markets, investors attuned to policy developments have an edge as global monetary authorities look to implement a “soft landing” in unconventional policy easing. Nevertheless, many market participants, especially new entrants who entered the industry following the financial crisis, continued to view the current low volatility regime as a “new normal,” and the low long-term interest rates that justify high asset valuations will persist for longer.

It is true that shorting the equity market have proven to be costly to investors (from the rally as well as negative carry), and bond bears have been battered under years of financial repression as investors coalesced around bullish “risk-parity” strategies (bullish bonds, bullish equities, bullish easy financial conditions), and some hold the view that for as long as policymakers maintain an accommodative stance, asset valuations would be “bullet proof.”

With the aforementioned ECB “soft” taper and Federal Reserve’s balance sheet normalization on “autopilot,” the medium-term trajectory of unconventional policy is on a path of “quantitative tightening,” and this trend will likely push up long-term rates across multiple countries (bearish term premia), raise funding costs and threaten already-lofty asset valuations.

Given the current market complacency on risk assets and long-maturity bonds (but renewed vigilance on Fed’s rate path), we continue to express our positive-carry (hence highly durable) secular bullish volatility thesis in 5s30s curve steepener:

  • Effective tightening in financial conditions requires higher term premia, and curve flattener correlates with the low volatility and bullish risk-parity status quo
  • Curve steepener expresses views of higher global long-maturity rates as major monetary authorities pare unconventional policy accommodation, thus pushing up term premia
  • Higher funding cost would dampen risk sentiment and reduce institutional investors’ desire to “reach for yield” (funding risky endeavors), and consensus bullish risk-asset positions reflected in record inflows into passive funds indicate growing “powder keg” of risk capital with the potential to trigger “shadow bank run”
  • Lower risk sentiment would tighten financial conditions and induce markets to price in a less steep rate path (thus bullish 5s part of the curve), but balance sheet normalization on auto-pilot is a durable policy, and it would likely persist until realized volatility begin to shake Fed policymakers’ resolve
  • At 84 bps, the 5s30s curve has partially priced in Fed policy optimism on inflation as well as heightened probability of a hawkish Fed Chair (skewed risk to the upside if developments do not meet investor expectations)

This secular position does face its own risks, namely a continuation of the low volatility status quo would invite hawkish Fed policy reaction (via active policy tool such as the rate path), as well as further ECB dovishness would delay the normalization of long-term interest rates (or even push the curve flatter), and these risks can be partially offset via the following currency positions:

  • Long dollar vs. euro and pound sterling would protect the curve steepener position against hawkish Fed policy surprises
  • Long dollar vs. euro has the additional benefit of guarding against potential decline in global term premia (bull flattener catalyst) due to ECB policy caution
  • The portfolio’s long dollar thesis does not cover USDJPY, for a decline in risk sentiment would strengthen the yen

Facing these potential upside risks, prudent investors positioned for a break in current market paradigm should welcome “fake markets.” The more bullish investors are toward long maturity bonds and passive index funds, the more “potential energy” for the upcoming crisis. The height of tension during a roller coaster ride is often not the twist and turns, but the slow climb to the apex, knowing the riders and vehicle are accumulating more potential energy with every rising inch, ready to be released at the coming moment.

Next article09 20 2017 | by Victor Xing | Central Banks

QE’s distributional effects a political liability