Wednesday, 3 February 2016

Attack on leverage clears the air.

Part 1 -

"One PMI does not a recession make nor one down day; similarly one day or brief time of disappointing data does not make a recessionist entirely happy" Aristotle 

Today’s price action has been very different to the type of market selling we saw in January. Last month saw a theme of concern that saw China killing growth, oil killing high yield in a contagious manner compounded by a fear that the Fed are on a hiking cycle  ahead of its time - all of which was pointing to a slowdown.  A spore of the R word 'Recession' had hit the richly primed petri dish of market belief. This lead to a USD rally and a hefty sell off in stocks with a grinding fall in bond yields. The sell-offs were dramatic and scary but they were understandable as things correlated as expected.

Today is different. We have seen the trail of assumed future disaster lead to the doors of the banks where twisting yield curves around the zero bound are making their lives a misery. The market is beating on those doors with a determination that has your average punter scrabbling for their 2011 or 2008 play books. Those play books are usually only read for a couple of chapters before they scare the bejeezus out of themselves and panic out of every position, failing to get to the relatively happy ending.

This is where I feel we are - the ‘Help I’m a consensus trader, get me out of here’ stage. Today is smacking of uncorrelated panic focused around leverage. That leverage attack can be seen in the way banks, the home of leverage, are being attacked and in technology which is leading the way down to the point of Unicornicide.  Although the Fed’s Dudley did his best to sound responsive to market turmoil he just managed to trip the dollar up and fast incubate that petri dish of recession belief. Then came the US services PMI which triggered that recession belief to fruit and spore.

Boom! Biological, economic and nuclear financial armageddon all foreseen at once. At which point the markets threw January’s correlations to the wind and just wanted out of their own leverage. How else can one explain maximum recession calling and a collapse in bank confidence fitting with a 10% (at time of writing) rise in the price of oil, which is as plentiful as great crested newts on a UK infrastructure building site?

The market has followed its own form of logical extension to the point of scaring itself out of the very positions it established based on its original beliefs. Yet the real world carries on. PMI data may be slowing but its not in recessionary territory and I do wonder how much of a feedback loop there is with market turmoil causing uncertainty that is reflected in the data which the market then reacts to with more turmoil.

Two days ago I didn’t like holding risk as I couldn’t understand what was happening so ejected it, waiting for something I recognise to  return. I now think I understand. Today saw the wave of market angst culminate by crashing into the beach in a spray of noise and turbulence. If you don’t like that analogy, let's just say it’s had its boil lanced.

And now? Well now I am happy to buy again in the belief that a break down in correlations and such diverse asset price moves to such an extent indicate a panic blow off. There has been a change, but not the massively negative one that most are reading this as.

Part 2 -

Now that market have simmered down a bit let's mull the mad world of negative interest rates, but not so much from the complete absurdum point that I usually highlight but the more rational 'here and now'. This part has been stimulated through conversation with an old friend. The following thoughts are as a result of our conversation.

We agree with the consensus view that this is not a stimulus, at least on its own.  It could be part of a stimulative package if it is combined with a fiscal spending program, because negative rates are arguably a very progressive tax on assets.  Given that 85% of global assets are owned by the 8.5% of the population with > $100k, you can see how this is pretty new.

Before I go on I must note that wealth measurements can be exceedingly misrepresentative. The poorest poor are at 0, yet a US person in a nice house with a nice car and nice lifestyle can be in debt to more than the value of their asset and so be at negative wealth on a net asset value basis. Less than the starving destitute. True wealth measurements really needs to include some PV of future income but of course, no one knows how to measure that, especially not in the times of negative rates.

But also very interesting is the fact that negative rates also tax offshore money.  All the wealthy folks' cash in USD, EUR, whatever in Guernsey or Cayman Islands will be affected by negative rates, no matter how many tax lawyers they have.  So we can see it as part of a creative stimulative package in the event of a recession.

In the near term though, it's hard to see how negative rates will whack growth, unless it's by stymying bank money transmission through the cost of reserves.  But it's worth remembering that central banks are ultimately political constructs and as such will only be able to go down this path as far as the electorate will allow.  If we do begin to see negative effects, as seems likely, policy makers will likely stop at their own volition or will be forced to by the electorate in some way.  For example, if JPY retail deposit rates become noticeably negative, Abe's approval ratings may drop sharply enough for him to tell Kuroda to stop or resign.  In the case of the ECB, a number of voters already seem skeptical of further easing.  Given how the Yen and Nikkei have reacted to negative rates, perhaps Kuroda is already regretting his decision.

The offshoot is that there seems to be a reasonable chance that the immediate tightening effects of negative rates will be limited.  At current prices, one could argue that a lot is already priced in.  For example, Japanese banks are now trading at barely half of book. For the banks that are truly interested in maximizing shareholder value, they could simply let all their loans expire, return the deposits, and pay back shareholders at book value... an almost 100% return.  Whether they will of course is a different story!

Finally - After today's price action, the financial version of the song 'January February' becomes even more apt

1 comment:

Agent Mulder said...

Yep, you're right. Today is different. Markets are turning here and I believe you're going to make big money on this trade.