Nuance and framing is important to put the logic of central bankers into perspective. Don’t be alarmed by New York Fed President William Dudley’s comments August 16. Even though the markets sold off on the mention of the potential of stimulative withdrawal, pay attention to the written word, a Bank of America Merrill Lynch report says. That way it’s not as bad as it sounds. But perhaps what is most interesting is not the talk of an interest rate hike, but the Fed’s own recognition that stimulus may be building asset bubbles.
Official concern over stimulus withdrawal spread from hedge funds to central bankers
Perhaps the biggest secret that really isn’t a secret is the professional concern that quantitative easing has created a market dependency. Last year as a potential rate cut was being pondered, multiple hedge funds with whom ValueWalk had spoken both publicly and privately had expressed concern. Balyasny Asset Management, for instance, adjusted the dial on their long / short ratio so as to reflect a noncorrelated portfolio bias. After this brilliant noncorrelated analysis the fund’s assets under management nearly doubled to over $10 billion, benefiting from the withdrawal of S.A.C Capital Advisers from managing money.
Balyasny wasn’t the only one expressing concerns over artificial control over markets. When markets are manipulated too hard for too long, just like noncleared big bank derivatives, there is highly volatile potential.
The more polite and refined central bankers, of course, used different verbiage, duly noted by BAML credit strategy analysts Hans Mikkelsen and Ujjwal Pradhan. “Interestingly the (FOMC) minutes revealed some more explicit than usual concerns about financial stability,” noted a BAML Situation Room report titled “Fed’s reach for yield trade.”
FOMC appears to express concern over “financial stability” due to stimulative efforts
The Fed is perhaps the largest hedge fund of all, and right now they are on the trade of their lives. Although she often is not given credit, Janet Yellen is in the midst of delicate surgery. Pulling off a rate hike last December and having the stock market trade higher on a short term basis was a surprise. Sure, there were unintentional scares in January and February — and separately there was Brexit — but the markets recovered. It doesn’t matter as much the methods of that recovery in the short term, but the concern is that longer term issues with manipulated markets might come back to haunt “magic people.”
Fast forward to recent FOMC minutes and what stood out was a quote recognizing the risk issue and how numerous central bankers were speaking publicly regarding market stability.
Several FOMC members in the meeting “expressed concern that an extended period of low interest rates risked intensifying incentives for investors to reach for yield and could lead to the misallocation of capital and mispricing of risk, with possible adverse consequences for financial stability.”
BAML’s response? “We agree.”
When could the “possible adverse consequences” materialize?
It might be a smart move by the Fed to get this issue into the public. Certain people who study potential volatility and market crashes — a perverse hobby among some inside the algorithmic investment industry — believe that under certain circumstances discussing potential volatility in public mitigates or reduces the impact of the volatility. Separately, when one understands that volatility is by definition surprise, the Fed may be working to subtly get a message out that won’t surprise markets. Eliminating surprise, from an algorithmic standpoint, reduces the potential for a flash crash — one of the few, if only market environments, that bedevil most if not all of the primary noncorrelated investment strategies.
The BAML report considers the consequences, but like true traders they see opportunity in the short term. While both the Fed and BAML see another train approaching on the single track, BAML, for its part, seems to say “I think we can ride this trend just a little longer.”
“Don’t jump off the train just yet, we have a few more minutes before impact.”
BAML has been bullish on High Grade corporate debt. Interest rates across the yield curve will be adversely impacted if interest rates rise to far, too fast. Even High Grade corporate bond spreads are impacted if other interest rate products are available at a comparable yield with lower perceived risk.
But that only happens when interest rates rise. Right now the trend continues to move ahead.
“Because we are still in the reach for yield phase we remain bullish on HG corporate bond spreads,” Mikkelsen and Pradhan recommended.
Translated that means: There is another train coming on the track and we made collide with it. But judging from my best guess, we have another three minutes before this trend comes crashing down.”
For their part, BAML doesn’t think Duddley’s comments are serious and the FOMC minutes, which “provided relief and revealed no urgency to hike rates.”
The trend is the friend, and we’ll believe it once we see it, is another way to say that.
From one perspective BAML might be following an interesting probability path. The key issue regarding timing is when does the Fed raise interest rates?
Separate analysis indicates hiking interest rates before a populist election – or having derivatives issues implode when one candidate promised Wall Street would never again wreck the economy – is not a smart idea. The whisper concern is that a “big issue” could derail Clinton amid what now looks like a more polished Donald Trump, even if a transparent statue of him was unveiled in a New York City park recently. From the Fed’s standpoint, one candidate appears to like Janet Yellen and might even have a preference to keep on the stealth reformer Loretta Lynch for another four years. The other presidential candidate has publicly proclaimed he wants to end the Fed and isn’t trusting of intelligence reports.
In other words, BAML might be right on institutional support for the trend extending at least until after the election. What will be interesting is watching their timing when they jump off the High Grade corporate bond spread train.