It has been so long since we have seen a significant risk-asset sell off, that this question might strike you as irrelevant. And in any case, some risky things have sold off recently, such as Turkish assets, or the South African Rand for example. In fact, you might agree with previous Blondemoney posts that we have spent years fighting the deflation demonor the Ghosts of Lehman Past, only now to emerge victorious. Deflation is dead; volatility is low and falling; banks are strong; growth is quietly upon us; everyone’s happy.
Exuberance indeed, but as always the question is when does it become irrational?
Regular readers know that the clash of politics into the economic world will be the tipping point. The NZD woke up yesterday to the fact that New Zealand’s new governing coalition want to revise the mandate for the central bank; while today the USD is strengthening in response to the leak that Trump asked for a “show of hands” on the new Fed chair from Senate Republicans, with (alleged hawks) Powell and Taylor in the lead. That’s lovely, although at some point the political interference with supposedly independent central banks should lead to a credibility risk premium upon the country’s currency.
These shifts at the margin mean that political risk is infecting every part of the economic system. Whoever becomes Fed Chair and whatever the RBNZ mandate will be, the way that those central banks operate will become much more uncertain. This does not sit well with the environment we have become used to in the decade since the crisis. Perma-QE deliberately removed tail risk. It mandated the hunt for yield. This hunt is now stuck in a methadone spiked virtuous circle of lower volatility and lower yields.
Ahh, but now US 10 year yields are back up at the highs of the year, on all the Fed Chair excitement:
Do investors now rush in to pick up even better yields? Or are we about to see a proper breakdown in the bond market?
The BOE have handily written a blog piece on this today. They look at actual transaction data in the GBP Corporate Bond market from September 2011 to December 2016, to find which part of the market exacerbated a sell-off:
This shows that most of the time, the market rushes in to buy bonds after a sell-off, to rebalance their portfolio weights, or to pick up more yield. Except during a crisis. Then things change for asset managers. During the taper tantrum, they just kept on selling. The authors argue this is to meet redemptions. They conclude:
‘Our results have important financial stability implications. The procyclical behaviour of asset managers during the taper tantrum, if repeated in future times of stress, could amplify asset price moves, potentially causing prices to fall below what would be implied by fundamentals’
The authors refer to a bigger BOE working paper on this topic, which produces these equally useful charts:
1) Redemptions are highly correlated to the VIX
Although the financial crisis data points are eye-watering, it’s useful to note that the VIX wasn’t horrifically high during the taper tantrum diamond, nor that the redemption amounts were that large, not even approaching a full 1%. As the authors of the report note, ‘The results indicate that a level of weekly redemptions from investment-grade corporate bond funds equal to 1% of total net assets (similar to those seen in October 2008 at the peak of the global financial crisis) would result in an increase in European investment-grade corporate bond spreads of around 40 basis points’
2) Oh but the system is much safer now, isn’t it? Well here’s a chart that looks at how the BOE’s simulated model compares to what happened to the widening of corporate bond spreads in 2008:
The first purple bar shows how corporate bond spreads widened 25bps due to worsening liquidity conditions in 2008. The green bar relates to the BOE’s simulation. But look at the middle orange bar. That is the BOE’s model but taking into account the 2015 size of the fund management industry. The liquidity squeeze takes the average bond spread out almost twice as much, to 40bp.
Yes, the banking system is much safer. But the fund management industry is much bigger. And, as the very first chart from the BOE blog shows, it is the part of the market that would likely have to sell in the event of a crisis.
So, while things are calm, then absolutely the buyers can rush in to hunt for yield as bonds sell off. But if the pendulum swings the other way, and asset managers face even a small amount of redemptions, then the market dynamic is likely to swing significantly towards sellers. And the size of that selling, despite not being leveraged, and despite not being anything to do with banks, and despite not being anything to do with complicated synthetic CDOs, could create severe liquidity issues.
The clash of economics and politics is building. We will take another step in that direction when the name of the new Fed Chair is released in the next 10 days.