Market Insights

BoJo Resigns. What Happens Next? (Pt 2)

BlondeMoney View:

TM is strengthened in the short term. Emboldens hardcore Brexiteers. Crystallises risks of either “Brexit In Name Only” or “No Deal” for Q3.

(Nice of him to let the cameras in for when he signed his letter of resignation…)

  1. Another one bites the dust. But as a proven election winner, Boris Johnson is the only one who could potentially threaten to achieve 159 Tory MP votes versus the PM.
  2. The numbers and momentum are not (yet?) strong enough however. He has stretched credibility with his absence from the country on the recent Heathrow runway vote, despite promising to ‘lie down in front of the bulldozers’ if it were passed, not to mention writing two articles, one pro-Leave, one pro-Remain, back in the heat of the days of the referendum. It plays into the narrative that the boy who told his parents he wanted to be “the World King” is only out for himself.
  3. All politicians want power, of course. Boris, as a Classicist, is no doubt aware that if you grasp it too hard, you’ll lose it. The Brits in particular cannot stand a triumphalist. Hence no comment from the big man about taking the reins. He will not light the match on a leadership election. His resignation does mean, however, that, in his own words of five years ago, he will be available to ‘pick up the ball if it came loose from the back of the scrum‘.
  4. A scrum is most certainly coming. His resignation does have the effect of emboldening Brexiteers, with two more junior minister resignations yesterday. But it’s clear the battle is now over the final deal, not over whether TM is PM. And Brexiteers who prefer No Deal to Any Deal will be joined by Labour Party MPs keen to bring down the government.
  5. If they argue hard for No Deal, but don’t get it, they can continue to be an effective protest group for people’s ongoing anger at liberal elites. If they do get it, capital leaves the country, markets tank, and – guess what – an emergency summit is called whereby the EU and TM manage to thrash out a ‘better’ deal and/or indefinitely delay the transition period. We can then get a situation like 29 September 2008: the TARP bail-out programme is voted down, the Dow drops 777 points, only for Senators to vote it through 48 hours later, stabilising the market.
  6. Remember, politics is about what sells. Unlike a successful negotiation, which is coming to a solution that neither side likes. BoJo realised the Chequers Deal was the latter, and therefore not the former. DC likely realised it on the morning of June 24th 2016. Old Etonians, blessed with charisma and confidence, know when to get out if they can’t win.
  7. Theresa May is therefore unexpectedly perfectly placed to deliver the deal. Her botched General Election leaves her, Millwall-like, as the leader no-one likes but she doesn’t care. She has a job to do and she’s damn well going to do it. If, in a year’s time, the public complain about too many Bulgarians stealing their jobs and not enough money for the NHS, she can say the alternative was No Deal and no money for anyone. She doesn’t need to sell the sunlit uplands; Boris had to. Hence his resignation letter talking of dreams dying and the snuffing out of hope.
  8. We are still in the stalemate of yesterday. No one has the numbers to get what they want. Unless public opinion changes.
  9. But the potential outcomes are crystallising, and these risks should be reflected in the market. It’s either Brexit In Name Only, or No Deal. And the crunch is coming after the summer.
  10. In the meantime, the PM is strengthened. She has purged her Cabinet of non-believers, and no-one is bold enough to challenge her directly. The four great offices of state are now held by Remainers. But she retains in the Cabinet senior Brexiteers like Michael Gove, and Dominic Raab taking over as Brexit Sec. The difference is that these Brexiteers are realists. That splits the Brexiteer Bloc, at least for now. GBP can rally from here, but a risk premium should be built into longer-dated Gilts and options market volatility from 2 months onward.

DD Resigns. What Happens Next?

BlondeMoney View:

TM will survive unless angry Brexiteer and Remainer MPs number more than half the party (159 MPs). That’s unlikely. Instead they will seek to frustrate the Chequers “Brexit In Name Only” deal via parliament. Blow-up of No Deal still on track for Q3.

(Also, here is a reminder of David Davis’s failed 2005 leadership bid…)

  1. Silence so far from the other big Brexit beasts, specifically BoJo and Gove. DD has already announced he wouldn’t be running for leader (although things can change), so the Brexiteers need a candidate to rally round. JRM would be the obvious choice. He wrote in the Telegraph today that he would be voting against the Chequers Plan.
  2. But he is a divisive figure. There are Brexiteer MPs for whom JRM goes too far, and he’s certainly too far for the pragmatists/Remainers. They would fear the membership could vote for him if he made it into the final round of the leadership contest. And so they would prevent that contest ever taking place.
  3. If the Leader of the Conservative Party doesn’t resign then 15% of Tory MPs must submit letters to the backbench 1922 committee to bring a Vote of No Confidence against her. With up to 60 MPs in Jacob’s Brexit-loving European Research Group, there’s more than enough to get 48 letters to go in. But TM would need 159 MPs (half the parliamentary Conservative party) to be forced out.
  4. If TM survives a No Confidence vote, they don’t get to call another one against her for 12 months. If she doesn’t, then it goes to the ballot of MPs to pick 2 choices, which then go to the party membership.
  5. We then get weeks if not months of the UK being leader-less as the clock ticks down. The March 2019 date could of course be delayed, but it’s not clear the public would be happy about any of this. They have had 2 years to get their Brexit sh1t together, after all. Would the general public ever forgive the Conservative Party for this abnegation of duty?
  6. Not to mention that the leader would ultimately be chosen by only ~125,000 people. Could the general public stomach that, in our pan-global era of foot-stamping demands for democracy?
  7. This has always been the calculus behind those who may not like TM but see no other alternative. Try and take her down and be branded saboteurs not just of Brexit but of Britain. At least half the party would not want to take that risk, therefore she could survive a no confidence vote; therefore no point in bringing one.
  8. Unless you’re an ideologue who wants to stamp on history that you didn’t agree with any of this: the hardcore Brexiteers and Remainers will still be interested in bringing a vote. But together they are no more than half the Party.
  9. And so we are in a stalemate
  10. Unless public opinion changes. As we wrote on Friday, people are not all that happy with the Brexit process, and now we have England in the semi-finals of the World Cup along with the biggest heatwave for decades. The general public right now would simply say “is David Davis our new left back? Pass me a beer mate”. Theresa May is consistently out-polling Corbyn as best candidate for PM, although a third of the country aren’t sure who would be best (or more likely don’t give a ….).

Today:

  • TM meets the Conservative Backbencher committee. No doubt this will be tough but will the MPs be able to agree amongst themselves? If they bring the vote of no confidence and she wins it, they can’t challenge her again for 12 months. Better instead to try to do battle in parliament on the detail of the policy.
  • The PM’s Chief of Staff, Gavin Barwell, has invited Labour MPs to a briefing on the Chequers deal today at 2.45-3.30pm. If you can’t rely on your own side, threaten them with numbers from the other.

In conclusion:

The Chequers deal has annoyed both Brexiteers and Remainers. Therefore, it’s the least worst solution.

  • For Conservatives, neither side has the numbers to replace the PM with one of their own. There is (not yet) a clear new rallying uniting figure.
  • For Labour, they can let the Tories tear themselves apart over Europe (again), but they have their own divisions
  • Everyone is waiting to cover their own back and emerge victorious from the ensuing mayhem. That means no-one lights the fire, they wait until afterwards to blame someone else for starting it

GBP is therefore understandably unmoved. Not to mention that our old friends PermaQE and PassiveMoneyMerryGoRound mean that unquantifiable risks are going under the radar. If TM survives the next 24 hours without any big resignations then she stays. We move forward with Brexit In Name Only, leaving the antagonists on either side who despise that outcome with the only option: go for No Deal. We continue to believe this will come into full relief in October as increasingly desperate Remainers and Brexiteers go for broke. At which point GBP assets should contain a significant risk premium. GBP/USD can go from 1.3000 to 1.4500 before that happens.

It’s Always Darkest Before…

We here at BlondeMoney try to neither be optimistic fools nor fatalistic doom-mongers. Either could garner us more headlines but neither is useful in a world of cold-headed investment decisions. You know by now what’s going to cause the next crisis, so how about a dose of good cheer. It’s always darkest before the dawn.

1 Euphoric Equities

The Nasdaq hit a new all-time high and the FANGs are back baby yeah! Here’s the FANG+ index, on which you can trade futures and options, which just about says it all:

The rally was allegedly due to Goldmans upgrading Tech to overweight; we prefer to think of it as Momentum Is The New Safe Haven. So let’s not mistake this euphoria for an all-round “coast is clear” risk-on rally.

2 EM Excited

It will look like that, however, because we are now all so embedded in the game of prices telling us the story. Emerging Markets might just get the buy-the-dip boost they’re looking for, with the astonishing timing that Argentina has been upgraded back into EM status, from mere Frontier, by MSCI. It’s been in the Frontier for almost a decade and despite its recent woes, MSCI still decided to grant it the full-on emerging market accolade. Where it goes from here will be a fascinating test of our hypothesis: inclusion into an index creates a full-on demand for a country’s assets from the passive index-trackers. Will their flows dominate the active discretionary guys who still fear for Argentina’s health?

Even more excitingly for our hypothesis, MSCI have retained the caveat that they can kick Argentina out again:

‘However, in light of the most recent events impacting the country’s foreign exchange situation, MSCI also clarifies that it would review its reclassification decision were the Argentinian authorities to introduce any sort of market accessibility restrictions, such as capital or foreign exchange controls.’

If that were to happen, then the passive outflows would join in with active outflows, creating an automatic increase in selling on assets already under pressure. Just the kind of feedback loop we hypothesize that passive investments embed into the system.

3 ECB Easing

Our favourite Irish farmer-investor, @LorcanRK, flagged up the key points from the ECB officials’ leaked story to Bloomberg yesterday. The ECB “could consider relaxing the rules on buying” for its reinvestments. As they have a 3 month autopilot right now, this means they could pause and build up a warchest of cash before plunging it back into the market. It certainly gives them flexibility to smooth out any wobbles in the market once they pull back from QE proper. And – Draghi must love this – it could be done any time, without a monetary policy meeting. No wonder Mario called this “an important decision… not a marginal one at all“. It’s his get-out-of-jail free card as he goes into his final innings as President. But it also means some permaQE could be a little bit more “perma” than we first thought.

4 Brexit Back In Its Box

These parliamentary votes of the past two weeks were supposed to deliver high drama. Government defeats, battles, bish bash bosh. In the end, neither Brexiteer nor Remainer rebelled, the government persists, and the boil has yet to be lanced. Is it possible now that Theresa, like The Donald, has become an accidental master of three-dimensional political chess? That the UK will end up with the ideal negotiating outcome where nobody is pleased but those displeased are too divided to do anything about it? If so, then market expectations of a muddle through will be the right one.

This chimes in with the general euphoria we have so far described. It’s a funny kind of euphoria; the kind that comes from the absence of dark, rather than the presence of light.

As one of our clients says, it’s always darkest before… it gets really dark.

Catalyst for a Financial Crisis…

BlondeMoney CEO and founder Helen Thomas has been interviewed by LiquidiTV about what she believes is the biggest vulnerability in the market.

Below is her interview, although should you want the PDF version you can find that by clicking here.

If you have any questions about the follow, please email us.


Normally we have our new segment ‘getting to know the industry’ here, but thanks to a fascinating markets conversation with a good friend (whom we met through our last hedge fund), we decided to hear her thoughts on the catalyst for an coming financial crisis i.e. ETFs.

Helen Thomas is one of our regular experts for our fortnightly question and is the Founder of BlondeMoney, a macroeconomic consultancy and research specialist company she launched in 2017. Having graduated from Oxford, she worked at Merrills in FX, was a partner at a Global Macro hedge fund and advised the Chancellor of the Exchequer George Osborne during that little financial crisis we had in 2007/2008. Currently she is a board member of the CFA, UK and a few years back was the lead researcher for the book “Masters of Nothing”.

What do you think the issue is with ETFs?

ETFs were a great idea. They combined the investment into a fund with the ability to trade it at any time on an exchange. Instead of buying 500 stocks in the S&P, you could buy the SPY ETF, which closely tracks the performance of all those stocks. Same returns, but cheaper and more efficient; what’s not to like? The reality is that they contain a design flaw. The tracking process comes about because market makers arbitrage away differences in price, between the underlying and the ETF. If they deviate, there should be a risk-free return because they’re the same thing, right? But, arbitrage only works when there is liquidity. And the liquidity in an ETF is dependant on the market makers and their creation agents, the APs (Authorised Participants). They aren’t obligated to make a price, and if it’s too hard to get hold of, say, a high yield bond, then they step away from pricing, say, the HYG ETF. It’s nothing to do with Blackrock or Vanguard; they’re just the shop front. If you go in to buy some chewing gum, it won’t be there if the suppliers stop delivering.

What alarms you about the current situation in the ETF market?

In 2007, CDOs equated to one-fifth of the market capitalisation of the S&P500. The ETF market, at 6 trillion, is now of a similar size. The ETF market is now just too unwieldy. The hedging process that allows the APs to provide ETFs means that their flows are dominating the market: they’re all the same way, all at the same time. The hedging is usually done automatically, so the orders hit the market in milliseconds of receiving the risk. The hedging process relies on correlation. Even Latin American equity ETFs, such as the ILF, have a 70% correlation with the S&P500. That means you can clear 70% of the risk immediately by trading an S&P500 future. Or, why not use the SPY ETF? Yes, ETFs are used to hedge ETFs.

Managing all of this risk are the Delta One trading desks of banks and brokers. They can make decisions on whether to hedge the remaining 30% of that ILF flow, for example. If they choose not to, they are taking prop risk. Banks are taking on hidden leverage on the back of ETF flows. Oh, and their capital charge is lower if the risk sits on the Delta One desk, because those positions are for ‘market making purposes’.

Hidden leverage and unpredictable liquidity are the hallmarks of every financial crisis we have ever seen.

How do you see markets unfolding down the track if things don’t change with ETFs?

So ETFs depend upon functional liquid markets.  We are now at a turning point when central banks are turning off the Perma-QE taps. Liquidity, having been pumped in, is being sucked out. The virtuous circle where QE drove money into passive investments which compressed credit spreads, lowered volatility, and led money back into risky assets – that’s about to turn into a vicious one. We have already seen the tremors. The “Volmageddon” of February has set the process in motion. Volatility begets volatility as it feeds into risk models of long-term money managers as well as option delta hedgers. We are seeing drive-bys in market after market: Facebook, Russia, Argentina, Turkey, and now Italy. Everyone has to adjust their exposure to risk. Which changes the price of risky assets. Which is used to calculate risk. And so on.

There are no macro narratives now, only the unwind of an unstable market structure.

What Event Risk?

Exhibit A: ECB changes from the last meeting to this meeting

Previously
: no discussion of QE ending
Now: anticipates it will end in December 2018

Previously: rates unch ‘as long as necessary’
Now: a hike in >12 months time. If you had read the above changes a couple of months ago it would have looked as hawkish as you like. Instead, EUR/USD had its biggest daily down-move in two years.

But you, faithful BlondeMoney reader, know why, right? You read Thursday’s note and you know that it is that spooky short gamma stuff again. In layman’s terms it just means that options market-makers leave stop-losses in the market, so that when something goes, it really goes. We’ve seen a lot more of this since the February volatility blow up, as hedging behaviour has had to take the extra volatility into account.

We also know that it means we get violent moves, more protracted than a flash crash, but which eventually reverse. So let’s see if EUR/USD can bottom out around 1.1500.

It may be challenged by the fact the US Dollar is back on another tear as the EM sell-off continues. We know about that one too, don’t we? It’s genuine flow-driven risk-adjustment. Just as the options guys altered their hedging behaviour, so the longer term investors got the same signal that higher volatility means trimming of positions. That means “hey just take some EM off the table and put it into, I don’t know, something with momentum… what’s been going up a lot, came off and going back up again…? Facebook you say?”

Yeah that’s the second biggest weekly inflows into the tech sector ever folks. Just as $10bn came out of EM in the last six weeks, according to BAML. The shares outstanding in the largest ETF on Brazilian stocks, the EWZ, have maintained their highs even as the ETF value plummeted – meaning the shares are in demand to lend out as shorts:

And so the EM rout continues. It’s like the event risk is the pause before the real story comes back. Which is that the cheap money party is over and liquidity is being sucked out of every asset class, one by one. You knew this story, you read these pieces, and hey if you don’t, you can read them on the Market Watch column which featured your favourite Blonde yesterday:

It’s no wonder the “50 cent” VIX trader is back, buying VIX call options with a strike price of 28 that expire in August. It’s likely to be the tail hedge for a portfolio, but it suggests they’re aware that our two main driving factors of liquidity and leverage are more likely to be exposed over the summer.

Event risk merely provides the opportunity for us to see the skew in the market that already exists. Facebook, Italian bonds, Russian stocks, Argentina, Turkey, Mexico, South African Rand – they were all just too expensive. At least they are when political risk is so high and the free money methadone being withdrawn.

We still wait for the shoe to drop on our two other favourite overvalued assets: Credit and GBP. The former has had a small wobble with those SHYG outflows but much more is to come now the Fed are on course for another 4-6 hikes in 18 months. The latter should get a shake from another Parliamentary vote next week. It turns out the amendment the Remainers agreed to is one that can’t be amended. A vote now to let Parliament have a meaningful vote later would only allow Parliament to vote Yay or Nay rather than amend what they’re voting on.
If that makes your head spin, you only need to ask yourself this: where should UK assets be priced if parliament spends it time amending amendments rather than agreeing on a deal? 
Right now the answer is that their pricing is confidently unchanged because the parliamentary stasis means the UK will just end up accepting a status quo transition. If that supposition should change even slightly, then long-term flows and options trades could rapidly alter the picture.

A loyal reader reminded BlondeMoney of this chart from the BOE, depicting the order book in GBP/USD during the flash crash of October 2016:

The bits without colour are where the bids just disappeared. Instead of volumes of £50m every second it dropped to less than £2m.

Event risk is just the excuse to shine a searchlight on where those gaps of white lurk beneath the surface. Get out the torch folks and get hunting…