Comprehending The Brexit Premium
For participants in financial markets a liquidity squeeze that lasts for a prolonged period is one of the most difficult environments to cope with. Correlations break down, markets trade in a vacuum, small trades lead to disproportionate price moves, relative value goes out of the window, panic sets in, selling is indiscriminate. This is where we have been for the last two weeks. So we thought we would share some of these experiences with you and try to rationalise why it is happening and when it might end.
Markets had been very challenging throughout March, but on Monday, March 9, we came in after a weekend when an oil price war had erupted and added to the mayhem in the markets. We tried to sell a modest position in 30-year US Treasuries, which a week before had been yielding 1.75% and that morning were quoted at 0.75%. We asked three primary dealers early morning London time, and two refused to bid. This was extraordinary, and unprecedented in our experience in the size that we were trading in. We initially put this down to pure volatility and dealer appetite for risk in the early London hours; after all a 100bp move in the 30-year UST is around 25 points in price terms. Anyway, since that Monday we have had a slew of incredibly bad news and wild market reactions, during which time you would normally expect to see a strong risk-off rally. However, the 30-year UST as I write is back at a yield of 1.64%. Risk parity appears to have broken down. We quickly realised that correlations had broken and uncomfortable times were going to escalate.
A second example also comes from government bonds, and again is highly irregular. This time in Australia, where we had felt that the policy rate was about to reach its lower bound (0.25%) and with a modestly positive yield curve, which the authorities would like to see maintained if possible, we felt that five-year Aussie government bonds had really served their purpose for us, so we decided to sell a reasonably sized position. It took us in excess of a week to complete our trade in the five-year benchmark. I hope that this message finds its way to the Australian Office of Financial Management and the Reserve Bank of Australia, since both are very astute observers of their market that they have worked so hard to globalise.
The third is in FX hedging, and here we had another new first. The way that we hedge currency exposure is via a spot FX trade to buy the target currency and a forward (usually one month ahead) sale to hedge. These are then rebalanced and rolled, as we aim to maintain perfect hedging. This exercise is very simple and incredibly liquid – usually. We decided to move this out to two months, just to be super safe. Anyway, we had to work the trade via order in several pieces rather than electronically only. It took over an hour. The currency pair that I am describing is not an emerging market, it is Cable (GBP/USD).
None of the above may seem particularly alarming, but to us they are all extreme occurrences and indicators of a market in extreme distress.
The part of the market that should feel the liquidity stress most is credit, and it has. The stress in credit is absolutely as bad as it was in the depths of the financial crisis from what we’ve seen. Except back then dealers were still used to trading for their own accounts, we did not have ETFs, risk parity trading was a fraction of the size it is today, and asset managers have grown enormously. One good thing we can say is that leverage is massively lower today than back then, so margin-induced selling is still there but nothing like we saw 2008 and 2009.
What we have seen is some high yield bonds quoted on 10 point bid-offer spreads, small £1m trades moving prices down by several points, and bonds that have been called and set to redeem (in around a month’s time) trade at discounts to par of five cash points or more, resulting in what we would call utterly ridiculous yields. A whole host of household name securities are trading 20 to 40 points lower in price today than they were at the beginning of March. The liquidity vacuum has resulted in bond prices falling to these levels at a pace that we have never seen before. While this is a horrible environment to manage portfolios in, and painful for investors, perhaps in some way it has been a good thing as investors probably should not be selling yields of this magnitude. The pace of the moves will in many cases have prevented them from doing so, which should be the driver of a long period of much better performance.
The rationale for all of this is simple: investors are in a dash for cash and are hoarding it like shoppers are hoarding toilet paper. They are selling what they can and perhaps not what they should, as they know they might need their cash in the near future. This could be prudent, for a while, but longer term it is somewhat irrational and might contribute to a powerful rebound.
From a fixed income standpoint, we would rather hold cash now than government bonds. This is not due to liquidity, despite my comments above, but more to do with government bonds not doing their job in the future in the way that they have done in the past. Remember we will also have enormous government bond supply in the years to come due to COVID-19 related spending, and we can’t be sure that the longer term effect of enormous fiscal stimulus will not be inflationary. So government bonds will still be ‘risk free’, but they will probably also be return free and not volatility free. Cash is king, for now at least.
One final set of stats comes from US mutual fund flows. A record $55bn was moved out of IG bonds on Monday, a record $19bn from EM debt on Monday, a record $5bn out of US mortgage-backed securities this week, a record $11bn out of muni bonds this week, and a record $3.6bn from US TIPS. Most of this has poured into cash.
So when might this end?
We certainly don’t have a crystal ball, or in fact a target price or yield in mind. We are already at levels that we think will prove to be the best entry point for the next decade. We have seen an incredible volume of flow in a very short space of time and asset prices have reacted and overshot, which always tends to happen. What we are monitoring most closely is the forced selling and cash balances. We think the best barometer for when this will be over is when the forced selling comes to an end or is overwhelmed by opportunistic buyers, and simultaneously that investors have their cash balances at levels where they are comfortable again. US mutual funds have added $95bn to cash balances this week alone, so we are on our way there.