9th September 2016 by Chris Iggo
Al’right guv? – Central bankers were centre stage in terms of the media this week with Mario Draghi telling reporters at the European Central Bank’s (ECB) post-governing council press conference that he and his colleagues had not discussed extending quantitative easing (QE) in Europe, and Mark Carney telling the Treasury Select Committee that he felt “serene” about the way the Bank of England (BoE) had prevented post-Brexit economic disaster. In my view, central bankers are almost as entertaining as football managers with that air of “we know best”. Almost (I think Pep and Jose might be more entertaining on Saturday). They remain more or less in charge of bond markets. There is still scope for more QE from the ECB in the months ahead if the economic situation warrants it, but it seems that the governing council wants to make sure that any additional stimulus is well designed and can deal with some of the constraints that the current policy is running up against. These are essentially determined by the modality of the asset purchase programme which currently prevents the ECB from buying bonds that yield less than the ECB’s deposit rate and also tends to favour purchases of core government bonds relative to peripheral. The short term response was a sell-off in bonds but the reality is that the ECB will keep on buying and that soon the BoE will also join the credit party by starting to purchase sterling corporate bonds. Any short term weakness in bond markets is likely to be driven by changing views on the global economic outlook, shifting views on whether the Federal Reserve (Fed) will raise rates in September or December, and simply some profit taking as investors lock in the tremendous gains that they have accumulated in global bonds so far in 2016.
Complacency? – A bearish longer term view on bonds is predominated on valuations and the compression of risk premiums in both interest rate and credit markets. At these very low levels of yield the probability of losses in bond portfolios is higher should there be an increase in volatility. And that is the interesting thing at the moment. Up until the bearish reaction to the ECB’s lack of additional money printing, volatility in bond markets had been very low. Since the beginning of July the range on the 10-year US Treasury yield has been a mere 29 basis points. A similar pattern is observed in the German bund market while gilts have been a little more active as a result of the shift in BoE policy in August. Volatility has been low in other asset markets too, with the S&P500 delivering an extended run of daily price movements of less than 1 percent. Foreign exchange markets have been relatively quiet too, with the dollar/euro exchange rate trading between $1.10 and $1.14 since the early summer. Oil and gold have also been relatively stable compared to the moves seen over the last couple of years. This calmness in markets has been reflected in measures of volatility with the VIX index trading at low levels. I guess one explanation is that market stability reflects a stable macro outlook with growth and inflation at low levels, monetary policy largely on hold and, for the moment, an absence of any actual political developments that demand an uncertainty premium. Or it could be that markets are just extremely complacent.
Systemic risk – Last week I started to think about financial stability. I started to read a research paper from the Fed which discusses how financial stability can be monitored. The paper was written after the financial crisis (2013) and so could be accused of attempting to close the stable door after the horse has bolted, but nevertheless it provides some useful guidance on how to think about the vulnerabilities in the financial system. The more vulnerable the financial system is, the more at risk it is from an external shock and, in turn, the more damage that can be done to the real economy through wealth losses and disruptions to credit availability. The vulnerabilities in the system can come from the pricing of assets (risk premiums), leverage, liquidity and maturity mismatches, inter-connectedness of financial counterparties and complexity of financial products and relationships. You don’t have to think for too long to see how these characteristics were very much in evidence in the run up to 2008. Moreover, much of the tightening of the regulatory environment since the crisis has been in response to these factors, especially around leverage, interconnectedness and complexity.
Hard to monitor – Articulating the conceptual framework for monitoring financial vulnerability is one thing, monitoring it in practice is quite another given the constraints of data, the fact that data is mostly backward looking and that market based indicators of risk are themselves subjective and affected by the current overall level of risk premiums. One area for us market practitioners is clearly asset pricing. The compression of risk premiums – to a large extent being the result of QE – means that asset prices are vulnerable to a sharp drop should there be an external shock (change in monetary policy, slowdown in growth, political crisis). A market correction in itself has potential negative implications through the wealth effect and the impact on business and consumer confidence. However, other factors should also be considered, including the degree of leverage amongst borrowers and investors, the degree of maturity mismatch (i.e. the extent to which long positions in asset markets are funded by short term liabilities) and the degree of liquidity mismatch (a potential issue for mutual funds and ETFs where the liquidity of units in the investment vehicle is greater than the liquidity in the assets that the vehicle owns). Typically in periods of suppressed risk premiums and increased leverage there is evidence of lower underwriting standards for new issues and increased borrowing by lower credit rated entities. In the event of a shock there could be forced selling of such assets which ultimately can impact on capital and the ability of the credit channel to operate. Certainly during the financial crisis the issues of interconnectedness and complexity added to the severity of the financial shock – the degree to which banks were connected through derivative positions, the funding of special investment vehicles that held complex securitized assets and the inadequacy of capital and liquidity backstops in many parts of the market.
Watch leverage if yields remain this low – It is hoped that many of the vulnerabilities that existed in 2008 have been reduced by tighter capital requirements and other regulatory developments. My concern is primarily about the compression of risk premiums. The Fed’s paper associates such a development with a worsening of the other causes of vulnerability – leverage, loosening of standards, liquidity and maturity mismatches and, potentially, increased complexity (you can imagine how products may emerge in a low yield world that promise higher yields or returns through increased use of derivatives or more leverage, for example). Assessing how bad the situation is goes beyond the scope of this blog but my gut feeling is that the situation around leverage, credit standards and complexity is not critical at this stage. Yet it is worth keeping an eye on such things if risk premiums remain compressed. There has certainly been an increase in corporate bond issuance since the end of the summer – even the sterling market has seen some new borrowing. The pressure on banks to increase lending must result in some increase in leverage and higher loan to deposit ratios, even if capital buffers are much stronger today. Furthermore, liquidity has been a constant concern in the bond market as investors in sectors like high yield worry about their manager’s ability to sell bonds and raise cash in a bear market, especially with the growth of ETFs. The financial system is no doubt safer today than it was in 2008 and the potential for amplification of risks is reduced, but risk premiums are more compressed today and the biggest fear for most investors is firstly the correction in asset prices and secondly what that could do to the broader financial and economic landscape.
More caution needed? – There is a lot more to this subject than merely asset prices. At the macro level there are aggregate trends in household debt, corporate leverage and the fiscal situation of governments. None of these are a cause for concern at present as de-leveraging has been the name of the game in the most part in recent years. Housing markets are generally doing better and measures of housing related stress, such as mortgage delinquencies continue to decline in the US. The BoE’s prudential policies have dampened activity in the housing market, although price levels are still elevated and still increasing, albeit at a slower pace since changes to the level of stamp duty earlier this year and because of the impact of Brexit on confidence. But all these things are inter-connected. Any decline in asset prices, hitting wealth and reducing confidence, could spill over into house prices, demand for credit, lending standards and the ability of borrowers to roll over funding. The financial economy is a complex organism and economists still don’t fully understand it nor can they accurately model all the different relationships that exist within it. So what do we do? We focus on what we can see, what we can hear and try to protect our portfolios from an unwelcome correction. Given current levels of risk premium in the bond market that generally calls for reduced duration exposure, higher quality credit exposure, holding some cash relative to negative or low yielding bonds and some protection against a rise in inflation.