AWAY FROM ALL the vagaries of economic news and bouncy markets this week and missed by many, there was an article published in the Bank for International Settlements’ Quarterly Review that looks at some of the danger inherent in that bugbear of mine – forward guidance.
I believe that it has a strong point when it warns that investors will be tempted to take excessive risk if they feel that the monetary policy environment is predictable to the far horizon, thus creating a platform for future instability.
This is now the third cycle of unnaturally low interest rates that I have experienced in my career; the first being from 1992 to 1994 while the US was digesting the savings and loan crisis, the second being after Alan Greenspan hit the panic button in the aftermath of 9/11, and the third and current one, which was launched in order to help mop up the mess left by the second one.
The reversal of the first, which began with a 25bp tightening on February 4 1994, led to carnage – especially in the structured rates market, which had benefited from investors’ need for yield but blown apart by the snap repricing of forward forwards.
The second drove the next generation of yield hogs into structured credit, which in some cases took the form of CDOs squared and cubed, the outcome of which we all know and with which we are still living.
The third and current yield hunt has largely been played out in the so far untested and innocent-looking area of the capital structure of corporates and banks, where various levels of subordination and loss-absorption are being played around with as though they were Lego bricks. At least we have a jolly good idea of where the next blow-up will be taking place.
At least we have a jolly good idea of where the next blow-up will be taking place
We do not, however, know when, how and with what ferocity the blow-up will occur. Do not forget that in 1994 and in 2008 banks were still able to provide significant market liquidity. One might not have liked the price they showed when one was trying to get out of an unloved position but at least there was a bid price available.
Following Dodd-Frank and Basel III there will be, in all likelihood, no price at all. If a market is where buyers and sellers meet, then a place without a bid is not a market and that is what the authorities have unwittingly left us with in their transparent attempt to curry favour with their political masters.
MANY YEARS BACK, I coined the phrase that the door marked “Entrance” is many times larger than the door marked “Exit”. That Exit door – which in reality could never properly cope when put under stress – is now significantly smaller than it ever used to be.
The matter was picked up last week by my colleague Christopher Whittall in his IFR article titled “Fears grow over buyside’s liquidity mismatch” in which he writes: “Asset managers are revolutionising their approach to bond trading to counter growing fears over their ability to keep pace with redemptions in the event of a sudden pull-back from fixed income. The move comes as regulators are scrutinising the precarious liquidity mismatch of mutual funds invested in increasingly illiquid corporate bond markets while offering investors daily liquidity.”
In fact, investors should possibly be derisking while there still is a modicum of liquidity to be found. But who among them will have the guts to go to the boss or to the trustees and suggest that it would be wise to exit the room in which William McChesney Martin’s legendary punchbowl is kept, despite the fact that it is remains well topped up and also apparently unguarded?
When credit markets go into reverse, and into reverse they will go, the currently unfathomably hot CoCo or AT1 market (wittily dubbed “81” by my chum Bill Blain at Mint Securities) will probably be without a bid in any shape or form. Investors who believe that they will be able to beat the system and get out before it all goes wrong can be found by the thousand, but only one of them can be the first one – and the rest will quite possibly come joint-last.
ALAS, FORWARD GUIDANCE tells us that rates are not going to begin moving until early to mid-2015, so the world can rest assured that risk isn’t as yet too risky and that we can keep on piling it on. I am at last and for the first time hearing analysts suggest that some of the new CoCos – sorry, AT1s – are looking rather fully priced and yet they are massively oversubscribed and pretty much all of them trade at an at least one-point premium bid in the grey market.
The slalom for the visually impaired should be taking place in Sochi – and not on Wall Street or in the City. But if holders think that when the day comes the back-stop bid will be in the mid-90s, they haven’t had the pleasure of dealing with the distressed debt funds. Mid-30s maybe.
The BIS has made its point about the risks of forward guidance and all that I heard from the pundit community is that the BIS has got its knickers in a twist and that all we need is for the monetary authorities to gain some experience and to “fine-tune” their predictive powers. It’s not the central banks I’m worried about. It’s the investors.
As long as we continue to measure the comparative performance of our investment managers on daily, monthly or even quarterly returns, we will be faced with a culture of short-term risk-taking at any price and the fear of what occurs if a fund drops out of the top quartile.
I still wonder why I have never heard of any funds in the second, third or fourth quartiles. Perhaps I should have learnt in 2008 that it doesn’t seem to matter whether a fund goes to the dogs with all its investors’ wealth, so long as it firmly does so hand in hand with its peer group.