We’re all passive now

The latest leg lower in the US Dollar has been attributed to an (over reaction?) to last night’s Fed meeting. The nuanced dropped words in the statement of “inflation has declined recently” and “running somewhat below 2%” apparently did enough to be interpreted as dovish, with the market expectation of another hike this year now down to 40%. Currencies are a relative game of course, and the point isn’t really that the Fed are dovish, just that they are less hawkish than earlier this year – just at the same time as a bunch of other central banks, such as the ECB and the BOE, have turned hawkish. The surprise shouldn’t really be that the US Dollar is weak, but rather that it’s not weaker, quicker.

The massively suppressed volatility across markets is lulling us into thinking that this isn’t a significant shift. It’s no wonder, when the VIX has printed a new record low of 8.84. There’s almost a resigned sigh that the US Dollar is taking a bit of a break for now from the monetary divergence story. With US 10 year yields sitting in the middle of the month’s 2.23-2.38%, and the 2 year only registering a range for the month of 0.10% (see below for the narrowing ranges), it just doesn’t feel like much has changed:

And so the Euro merrily ploughs on upwards, with 1.2000 easily now in sight before the ECB actually meet again on the 7th of September. It was trading on a 1.0500 handle as recently as April, just over 3 months ago. A 10% move for a quarter of the year would be regarded as a decent move in anyone’s book, let alone in a year when so many implied volatility indicators are hitting new lows. Indeed, absent the actual move in the market, it would still be headline-worthy to speculate on the reversal of central banks from “lower forever” to “let’s get normalisation going”. That’s a secular shift, not just from the last few years but from the decade since the response to the financial crisis. Even more so, given that the 2013 taper tantrum was supposed to be a cautionary tale, meaning that a) interest rates couldn’t be hiked without causing severe volatility and b) real economies were not strong enough to have the monetary medicine removed.

So what has changed in the past 18 months that has shifted the narrative?

The answer is that we are all passive now. We already knew that passive fund inflows were huge and have been growing over the past few years. But it’s in the past year or so that it has really accelerated. Partly this is just a vicious circle: Active funds are expensive –> money flows into passive –> opportunities for Active are eclipsed by constant “Buy the Dip” –> volatility is suppressed –> fewer active opportunities –> Active funds look even more expensive, and so on. Macro hedge funds are now on their knees, with many of the big names such as Caxton, Brevan and Moore still in the red this year, according to the HSBC funds report. Meanwhile BlackRock has taken in as much new money YTD as it did for the whole of last year. (A mere $141bn, no less). Passive ETF assets surpassed hedge fund assets two years ago and since then the gap has increased:

If passive assets are growing at an almost Moore’s Law exponential rate – and the BlackRock figure suggests it is potentially doubling each year – then it’s no wonder that any interest in the fundamentals is so depressed. The virtuous circle is complete. The more that assets go up, why bother with a stock picker? Instead, invest in the index at a fraction of the cost. It’s as if passive money is crowding out any interest in active money. But it’s not crowding out the opportunities. As just mentioned, EUR/USD has rallied significantly for entirely understandable reasons. The Fed is coming towards the end of its hiking cycle, not least because Trump might well force its dovish hand when Yellen is replaced next year; meanwhile the ECB no longer needs extremely stimulative policy with inflation returning, and faces similarly political pressures with a German election coming up.

The passive money is skewing the classic risk/reward equation that underpins all investments. Free money shouldn’t exist. Achieving big returns should require a concomitant increase in risk. But now, we are in a situation where stocks keep going up, credit spreads keep on narrowing, and bonds are bought even if they yield negatively.

The central banks started this Alice in Wonderland world. Deliberately, no less. Their easy money policies were designed to lift animal spirits out of their slump. The financial crisis had skewed the risk/reward equation too far in the other direction. No risk was being taken, despite the potential for return, heightening the chances of deflation and depression. They had to do something, and making the risk-free rate zero, or even negative, not just now but along the yield curve, was the Dali-esque shock required to shake the market out of its funk.

Now, with economies looking more stable, and the market mood less funky, they can pull back.

But oh dear… their skewing of the risk/return equation had its consequences. It paved the way for the passive/active imbalance. Which in turn, has skewed the risk/return equation too far in the other direction. It has become entrenched. Staving off the depression risk has now mandated an almost deliberate and inescapable euphoria.

How can you break a virtuous circle in which cheap money always wins? Introduce a risk that passive investment cannot measure. Political risk, as we have been discussing for some time, is the key suspect. Like the Truman Show, utopian life can continue until the exact moment you realise you’re sailing into a brick wall.

 

So, the biggest stories of the past few days? It’s not really the Fed or the ECB. It’s the fact that Trump’s administration is coming apart at the seams, as he rotates his patronage, most recently calling his Attorney General “very weak”. It’s that the Senate is still tied up in being unable to repeal Obamacare, pushing back further the opportunities for tax reform. Or in the UK, the fact that the Prime Minister has now lost her strategy director and writer of her ‘Hard’ Brexit Lancaster House speech.

The difficult part is that whilst you monitor this, you have to continue to think passively. A virtuous circle is tough to break. It will take a few attempts. But September looks a good bet for a crack to emerge, with the withdrawal of cheap money picking up as the Fed and ECB pull back from balance sheet expansion, and politicians returning from the beach. Until then, enjoy the unexpected ability to find returns while taking unusually low amounts of risk.

 

 

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