Is the market breaking apart?
Published on: March 17, 2020 • Duration: 17 minutes
This week we look at the breakdown in the fabric of global markets. Has the economic slowdown now morphed into an unwind of smart beta style funds? A number of other liquidity providers are under excessive stress and central banks haven’t yet worked out the solution. Could it be that they need to close markets?
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[00:00:04] Markets are reeling from the economic impact of coronavirus, and last week we also had the oil shock which revealed some of the fault lines. By the end of the week, there were funding issues coming through and also value at risk, VAR shock is reeling through the market as well. Central banks are trying to act and we're going to discuss what they're doing and why they're doing it in this episode of The Big Conversation. So clearly, things are moving very, very quickly, there's a lot of volatility in asset prices out there, and I think if we start off with just looking at the economy and the real economy, how that's being impacted and how it will get impacted going forward from there, we're going to look at things like funding and value at risk (VAR shocks), because this is really where I think we've now morphed from, which is the economic crisis into a market framework and market structure crisis that I think was really kind of unleashed when we had that big move in oil last week. In terms of the real economy, it's obvious. I think everyone can see the numbers that came out from China just this morning. Retail sales fell by around 20 percent. It was expected to fall 3 percent. Industrial production down 13 and a half percentage is expected to fall about 3 percent as well. So these are big numbers even versus the expectations and shows just how much of a lock down the world is going through. And these sorts of numbers will be repeated in Europe because clearly Italy and France and Spain are near virtual lockdown with the streets completely empty in Paris, in Rome and all these other major cities. So the demand part of the equation, as we know, is falling off a cliff. So markets already reacting to that. We can still see that going through in commodity markets. Oil prices are falling again. The differential between Brent, which is the global benchmark, the UK traded global benchmark and WTI, which is the US one that spreads been narrowing because that premium for global versus the US because of the US was pumping a lot of oil when the oil price was higher. That is coming in, but both prices are still falling. This morning we had a 20 percent decline in platinum. We had a 10 percent plus decline in silver. Gold is doing a little bit better, but gold's still got a lot of length via the futures market. So this is a commodity which should do well eventually. But in the short term, it's a commodity where people are very, very long via futures. Gold has had its problems as well. And you can see there's even more in the gold miners, the gold miners, the HUI that collapse. And it's been unfortunate that it's been helped on its way down by unwinding of some of the ETF, such as the three times levered long ETF on gold miners, which has gone from around about a price of 100 to a price of four and a half over the last couple of weeks. These things have got absolutely killed because they're levered plays. So we can see throughout the commodity complex that the real economy is still under a lot of pressure. When we look at the foreign exchange markets, similar sort of thing. We talked about this last week. The two buckets are still relatively active. EM and commodity currencies are still very much on the backfoot. We're starting to see bigger moves now in some of the open manufacturing economy. So we started to see weakness in the Swedish krona. Yen's going a little bit two-way. This is the Japanese yen. It's a risk off currency. But at the end of last week, something we did in one of our flash updates, we started see the dollar move. And this is where we started talking about the dash for cash and funding issues which will come onto. Yen still a bit two way. It's been stronger this morning versus the dollar, but the dollar has been strong versus pretty much everything else apart from maybe the euro and the yen. But we've got to look at here and I think this is the key element is the volatility in some these currencies have gone through the roof. The Japanese vol Japanese yen versus dollar vol 1 month out is is only marginally below the levels or is sort of fairly similar to the levels we saw in 2008. And what's been amazing here is the speed with which everything has moved. We've been talking and it's been only a couple of weeks to three weeks that this whole thing started. And we've obviously fallen significant amounts in many, many asset classes. So the real economy is still biting. You can see it in the currency markets. But I think what's really interesting here is that we're now starting to see problems in funding markets. They're already appearing last week, but they're really starting to play a pivotal role now. And we're also seeing these issues with certain funds, certain players in the markets, really not the banks, but other players who are in a lot of trouble. And because of the problems that we've seen through the market, because the Corona virus is now creating a fundamental structural problem to the market, it's starting to rip it apart at the seams. So we'll go into those now. So I think the context first for this market is, is where have we come from and why have we got this strange market that we have today? And I think a lot of it is because of the changes from 2008 to where we are at this juncture. Firstly, in 2008, the big players were banks, the prop desks, so massively leveraged because of the problems, the banks had been at the epicentre of that drawdown in 2008. Regulation over the last 12 years has meant that banks take less and less risk. In fact, the prop desks have disappeared pretty much entirely and banks are there to facilitate. They can't really hold much risk themselves, and where they could hold risk is much, much lower than it was before. So they've left the building in terms of being liquidity providers. Other people have come into the breach and those have been specialists. They've often not been banks, but big specialist market makers or they are funds using using this opportunity to actually make a decent edge. But as with the banks in 2008, this requires a lot of leverage. So a lot of leverage has been used by these players. The other thing that's key as well is that this market was dominated by active managers, so active managers is me, you, fund managers. They they have emotions, they trade the downside. They carry a bit of cash. When the market sells off, they buy that dip. Sometimes they'll hold off. And this is where you get really emotionally charged action from. Those active managers have seen lots and lots of their funds disappear. They've been bleeding funds away from active towards passive. And we talk about passive. What we really mean is rules based smart beta is risk parity. And this is where a lot of institutional pension for money has gone. Sovereign wealth money has gone there and a lot of the whole framework is now built around these rules based systems. Now, these rules-based systems also don't carry any cash. Same with passive funds. A passive fund which might be tracking an index has to track the index. If it carries cash, it underperforms. They don't carry cash. These are now the dominant players in the market. So what we've seen is this very, very unusual price action where we've fallen from an all time high to where we are today. There was no stopping points really on the way down. We had a little bit of a breather in the US on Friday. But overall, we've seen very little stand in the way of this decline. And it's because these are rules based funds where the switch has gone from being buy mode to being sell mode and there's no override because they're rules based. And at the same time, some of these players were also in the funding game and the funding game has got a lot harder. Now, what we can see in the market is that the US Federal Reserve is watching this and is trying to deal with it. They promised 1.5 trillion of additional repo. They're offering $500 billion on Thursday, 500 billion on Friday. Problem is, the people who really need that money couldn't get hold of it. And the banks who can't get hold that don't want it and don't want to lend it at a high risk. So actually, the uptake was quite low. Even though the Fed has pledged up to 3 trillion over the next few weeks, it looks like it might not get used in its current format. Things like FRA OIS we talked about over the last couple of weeks. This is the forward rate agreement versus overnight index swaps. It's effectively Fed funds, government funds vs. the way banks lend to each other. That's why that's the highest level since 2008. It's been widening out over the last couple of days. It's another indication that there are some tensions in the system. We've also seen the ability to get hold of dollars. We talked about the dash for cash on Thursday. Well, the desire for dollars has been there. On Thursday was a pivotal day because the dollar started rallying against everything and it did that for a couple of days. There is a demand for dollars to cover some of the issues out there, some of the funding issues that people have. And we saw this quite dramatic move. But the Fed is there promising liquidity, but no one is taking it. It's because the players who need it can't get hold of it in the current format, as mentioned earlier. At the same time, we're also seeing is that this very framework that's built up over particularly the last five years. So these rules based funds have been particularly active since 2015. They would based a lot of time on volatility. So if volatility is low, these positions build up. It's always been the same. Low volatility begets leverage. More leverage in the same sort of positions, keeps the system going, makes great the illusion that everything is good until you reach the Minsky moment where everything wobbles and falls over. I’m misusing the Minsky moment phrase now. But it's sort of relevant. So what we've seen are that these funds have been building up these positions and using leverage. And what it required was that central banks suppress volatility every time we had a little bit of a problem. The central banks would come in and they would buy the market where volatility was picking up. So the FX vol fell. They capped oil vol, they capped GDP growth of all the basic cap volatility of almost everything and off the equity vol. Well, clearly volatility has exploded everywhere. We've seen it in oil. We've seen eating in pretty much all commodities. In the FX markets. In the bond markets as well. This cap on vol has gone. And that's one of the reasons why many of these funds are now sellers. Either the rules required a lower level of realized volatility and now they are sellers of equity. Also when volatility goes up, people's risk limits have to fall. So the risk limits are getting drastically cut. They're getting cuts at banks. So banks, which used to be the ones who provided liquidity back in 2008, are no longer there. They're in small size anyway because of regulations and an even smaller size now because of that volatility. At the same time, that volatility means these funds that had huge leverage are being forced to unwind their positions. And because funding has gone up and that funding was very much levered as well, it's forcing these these major players to unwind their positions. And I think that's what the Fed is worried about. And that's why they again, acted over the weekend and they came in with a 75 basis point rate cut. They also came in with cutting the cost of dollar swaps. They also put swaps in place with five major central banks. So they are really keen to make sure that there is dollar funding available for all. And yet here we are Monday morning with the S&P down limit down again. And European markets having fallen as much as 8 percent in the first half of the day, with banks down another 10 percent. Clearly, there is a major problem here, and part of that problem is that, as I mentioned, the banks are no longer providing liquidity. They're no longer the main players to create stability. And at the same time, retail's not really in the market anymore. The passive funds, not buyers, they don't have any cash. There is no buyers. So people are now thinking is that and the Fed will have to do maybe what the Bank of Japan has always been doing in the Bank of Japan is always in there buying the equity market. Well, the Fed has already said that they're going to do proper QE again. Over the weekend, they said 700 billion in QE, 500 billion of treasuries, 200 billion of mortgage backed securities. They're in the commercial paper markets that buying up in the corporate bond world as well. The corporates are in a sort of a problem because people who have positions on having to hedge themselves by selling equities are some of the equity of these relatively indebted companies is massively underperforming because the unwinds are coming through. There's a whole bunch of areas where these relative value trades, which look very, very tame and very easy going during normal times where they're all blowing apart and remains a lot of people of what happened in 1998 when Long-Term Capital Management was a single fund that had these huge relative value positions on board. And then after the Asian crisis, then particularly after the Russia crisis of '98, it drove and unwind many of these positions and it nearly brought the financial system to its knees. And that was one company. Since then, the whole market has sort of become one giant LTCM because everybody has been moving towards these rules based funds away from active funds and becoming smart beta or risk parity. And they've been using leverage to try and generate a small return on low levels of funding. All that looks like it's unwinding and it looks like we need more from central banks. So what will they do? Well, they're clearly going to continue to provide liquidity, but a lot of the issues here were rules based issues and rules based issues where regulation has come in and that regulations for many of the that forced many of the banks to step away from the market. It may be that they need to allow banks to come back to the market to provide liquidity. They may need to turn some of these funds in these these these companies that have been replacing the banks but aren't banks. They might need to give them banking licences so they can access the Fed liquidity window. It may be something that a lot of people are talking about. It may be that they need to close markets. And closing markets is obviously a very, very dramatic step. But given that there is this uncontrollable coronavirus issue anyway, that would be the excuse they need to lock things down. As investors, we need to worry about that. We'll think about that, because if you've got positions as let's say, options positions or futures positions with a specific expiry and they expire during a period where the markets are shut, you need to check the legal side of it to make sure that you'll get paid out or you might not, because there will be clauses that say that the people on the other side can't hedge and they can't hedge, then these things will get negated during the period of market lockdown. So check that. And if you have positions which are maybe hedged anyway, that's something else to look at because one side of your position may disappear during a period of market lockdown, leaving you effectively with risk on one side rather than a market neutral position. You suddenly got risk on. So these these comments where people are saying we think the markets will get closed down. It's not happened yet, but there's a sufficient number of people talking about it to potentially make it happen. And here's another example of why is that the liquidity that is not there anymore from the banks has been falling? Because if you were a trader, you are not allowed to trade from home. Again, this is one of the rules that has come in over the last 10 to 12 years. Traders in New York are being sent home. Some of them are ill. This will happen in London. It will happen in all the major centres. If they're sent home, they're not allowed to trade. That's even less liquidity. So there's a whole bunch of things which are all coming together in this perfect storm, which is why I think there is a risk that markets could get closed down. You need to think about that few risk positions. But more importantly, I think that central banks are pretty going to have to change the rules. They're probably going to have to buy more assets. And they're already doing probably going into the equity market itself as the Bank of Japan has done. They're going to continue to provide dollar funding. They're going to provide all sorts of currency funding, but particularly dollar funding is going to be out there in this environment. What is the end game of the end game is probably this demand, this eventual dash for cash. We saw the early stages of it on Thursday and Friday. Today, there's a little bit of risk off with the end strength. But ultimately, everybody who's short dollars, everyone who's got dollar denominated debt and we are at record levels of cross-border dollar denominated debt. According to the Bank of International Settlements or the BIS they have a number of 14 trillion. Some people double that with off balance sheet positions as well. That's a short dollar position that means that dollars are drying up because the economy is slowing down. Commodity markets priced in dollars are collapsing and there's been a repatriation of capital. Then there will be a dash for dollars. And that's one of the big risk that people still see out there. Otherwise, the reality of this market is it is super volatile. We've seen the VIX hit levels around about 70, 75, 80. We're now starting to see vol of Volatility, so this is the options on volatility starting to move. That's the sign that the structured products are starting to unwind their positions and these structured products are often short vol positions as well. Everybody was hunting for yield. The whole market was effectively short volatility either being through being long, the low volatility stocks or basic selling selling volatility itself on pretty much every asset. That's obviously changed and those positions are now having to be unwound. So we're in that phase. The Fed is being more active than most people have expected by this stage. But as of Monday, it's not had much impact. I still feel this could be the big week. It's the expiry week, though, because markets have sold off so much, we are way through the level of the highest volume of options. But nonetheless, this is the big rebalancing week after the expiry on Friday in Europe and the US. That often happens. If we got a big high volume low, I might be inclined to trade it. But with volatility at these levels, there is a reason why banks are taking less risk because markets can be 5 to 10 percent every single day with volatility at this level. In summary, the central banks are trying fairly hard to make sure they can deal with this and add that liquidity. But clearly with volatility up here, the genie is out of the bottle. Volatility has already risen and lots of funds are going to have to unwind. So basically, look at your own portfolios, look at your own positions. Check what might happen to those positions if the market closed down. Hopefully it won't. But given the size of these moves, given what's going on, that's a risk. It's all about checking on all the potential disasters that could before you hopefully never happen, but be prepared that they might.