Negative Yielding Sovereign Debt – You’re Not Sorry by Jeffrey Miller, Miller’s Market Musing
All this time I was wasting,
Hoping you would come around
I’ve been giving out chances every time
And all you do is let me down
And it’s taken me this long
Baby but I figured you out
And you’re thinking we’ll be fine again,
But not this time around
Taylor Swift, You’re Not Sorry
This letter is going to be full of weird mismatched analogies. I’m sure you’ll be ok. It goes with this weird, mismatched market we are forced to navigate. Some weirdness we’ve discussed at length: trillions of dollars of negative yielding sovereign debt, a Swiss yield curve negative out to 30 years, corporates issuing debt at 0% interest, and a Federal Reserve Board that is clearly lost and afraid of its own shadow. While central banks around the world are doing really inane things, the Fed is caught in a vicious feedback loop that it doesn’t even seem to understand it created. It gets spooked by every little downturn in the market, every reaction to a speech or meeting minutes release. In short, it’s a Hawthorne effect experiment gone bad. The Hawthorne effect (also known as the observer effect), is when individuals modify their behavior once they become aware they are being observed.
When the Fed was (or at least, said they were) focused on data points from the real economy in making their rate decisions, then the market could watch those same data points and make its own determination about whether or not the macro environment favored one type of investment or another. However, ever since Greenspan started playing God with the markets and focused on asset prices in securities markets as a means to create a wealth effect and increase economic activity, the Fed has been sliding down a slippery slope of reflexivity and feedback loops. By trying to cajole markets to do its bidding without actually moving rates or following through on its statements, the Fed has become a Frankenstein’s monster of the boy who cried wolf and Schrodinger’s cat. No one believes anything a Fed official says anymore, and the Fed is both alive and dead at the same time.
The annual Jackson hole retreat for Federal Reserve officials is this week, and Janet Yellen is giving a much anticipated speech. Market pundits keep writing that the speech will be eagerly parsed for signs that the Fed will raise rates sometime later this year. My view is that no matter what Chairwoman Yellen says, no one will believe her. She could stand at the podium and say “I fully believe that rate hikes are going to happen this year” and the market likely will do nothing. Why? Because Fed officials like Yellen and Dudley have lost all credibility. They’re like the little boy that cries wolf. Six months ago, the situation was different. But after so many contradictory speeches since then, the market now knows that if Yellen says she’s raising rates, and the market sells off, then they won’t raise rates, so the market will rise again. But not this time around. After wasting all this time, markets are done hoping the Fed will come around. That’s what happens when all you do is let someone down. Eventually, they figure you out.
Looking so innocent,
I might believe you if I didn’t know
Could’ve loved you all my life
If you hadn’t left me waiting in the cold
And you got your share of secrets
And I’m tired of being last to know
And now you’re asking me to listen
Cause it’s worked each time before
Taylor Swift, You’re Not Sorry
I think markets are getting tired of being left out in the cold by central banks around the world manipulating securities prices to engineer economic growth. It appears to me that this acceleration into negative rates in the past few months has been driven by a capitulation on the part of income investors who never believed that rates could get this low, so they held back, afraid of locking in (at the time) historically low rates. Then they watched with shock and horror as NIRP replaced ZIRP – and FMO (fear of missing out) kicked in. But at some point, you reach that last marginal buyer. When will that happen? Nobody knows. Central banks keep reloading and doing dumber and dumber things, and since their stupidity seems to know no bounds, I’m willing to say that I don’t know how dumb things will get before they stop. What I do know is that locking in a guaranteed loss on bonds that are held to maturity is not a good way for investors to meet their long-term liabilities. Think pension plans and insurance companies for example. Central banks are eviscerating them. How insolvent pension systems and life insurance companies can be good for the global economy is beyond my pay grade, but then again, I don’t have a Ph.D. in economics. (As an aside, I did take quite a lot of economics, including in graduate school, but quickly figured out that logic and reason had no place in the discipline. When I pointed out an obvious flaw in a professor’s work (outside of class, privately) he admitted that I was correct but that the flaw was needed to make the math work. That’s when I decided to be a history major instead.)
The Fed wants markets to believe that every meeting is “live” for a rate hike, but markets know that that is simply not true. But the Fed doesn’t know that yet. Like Schrodinger’s cat, the Fed exists in a state of quantum uncertainty in which it is both alive and dead at the same time. It thinks it can move, but it can’t. And now that it knows it’s being observed, it’s stuck. Ironically, Einstein’s letter to Schrodinger in 1950 could easily be describing the state of monetary policy today. Simply replace “physicist” with “Federal Reserve Board Member”:
“You are the only contemporary physicist, besides Laue, who sees that one cannot get around the assumption of reality, if only one is honest. Most of them simply do not see what sort of risky game they are playing with reality—reality as something independent of what is experimentally established. Their interpretation is, however, refuted most elegantly by your system of radioactive atom + amplifier + charge of gunpowder + cat in a box, in which the psi-function of the system contains both the cat alive and blown to bits. Nobody really doubts that the presence or absence of the cat is something independent of the act of observation.”
So what’s an investor to do? I suggest building a robust portfolio. What’s a robust portfolio? A portfolio that can survive exogenous shocks to the market systems and survive. Think Jason Bourne. All sorts of bad things happen to him, and he survives. He can get shot, thrown off a bridge, chased across continents, and he survives. He’s robust. He’s the opposite of an effete central banker sipping wine in Jackson Hole this week. For the central banker, even a hint of something amiss, a tremor of market volatility, and they run away, hiding behind “uncertain market conditions” or some other such excuse. They panic. They make a bad situation worse, and they don’t know how to protect against unforeseen outcomes. They are, in the words of Nassim Taleb, fragile. Don’t be fragile.
Am I saying a market crash is imminent? No. I’m saying that all the conditions for a market crash are in place. Volatility selling has pushed down implied vols to a level that will exacerbate any market downturn of about 3% or more, by my estimation. Investors desperate to generate return have taken to selling calls against their portfolios to create income, but they aren’t hedging their downside to protect against a market decline (a very low equity put-call ratio shows this). In the near-term this can work to create a false sense of calm, as investors who have sold calls can’t really sell the underlying without being left naked short, something that mutual funds are usually restricted from doing. But this low-vol environment can entice traders reaching for return to short puts as well, which can quickly become problematic and cause a cascade of selling if and when they rush to hedge their downside exposure.
Even more troubling, is that this recent period of extremely low volatility is setting us up for another VAR shock, reminiscent of last summer. I wrote about this almost exactly a year ago in response to the S&P 500 diving 6% in a week. We could be in for another round of VAR shocks creating feedback loops that take markets by surprise. The conditions are all set for it. All it would take is a misinterpretation of a Fed speech, a comment from a Chinese finance ministry official about exchange rates, anything really. With 33% of the market invested in passive vehicles and ETFs viewed as a ready source of liquidity, a small market dislocation has the potential to create flash crashes in various asset classes. I’m only short ETFs, not long them, and running a market-neutral book. In short, I want my portfolio to perform like Jason Bourne. We may get beaten up, but in the end, we’ll survive.
So you don’t have to call anymore
I won’t pick up the phone
This is the last straw
There’s nothing left to beg for
And you can tell me that you’re sorry
But I don’t believe you baby
Like I did before
You’re not sorry, no no oh
Taylor Swift, You’re Not Sorry
In my last letter I laid out some charts and said that I thought there was a lot of churning going on beneath the surface of an unusually calm market. In particular, I said that I thought banks could move higher and that utilities and staples were rolling over. Well, since then, the KBE (KBW Bank ETF) is up about 5%, the XLU (Utilities ETF) is down over 3%, and the SPY (S&P 500 ETF) is up about 1%. Rising LIBOR (also discussed in the last letter) was flagged as a reason for optimism about U.S. banks (Japanese banks are cooked if this continues, but that’s a story for another day) and pessimism about bond proxies. There’s no sign that this LIBOR squeeze will abate before the October change in money market fund regulations, so don’t fight it.
That said, I think it’s time to play some defense again. I’d sell half the bank position from a few weeks ago and go to cash with it. I’d stay short the utilities and staples, and pare back your tech bets. I’m still long some stocks, but fully hedged. Keep some dry powder so you can take advantage of any severe market dislocations.
This week’s Trading Rules:
- Once everyone knows what the game is, it’s over.
- Being able to suspend disbelief and play along with the market consensus works really well until it doesn’t.
SPY Trading Levels:
Resistance has moved up a little, to 219/219.50. Not much above that.
Support: 217, 216, small at 212, a decent amount at 210, then 205 and 185. On a selloff of more than 1.5%, first stop will be 212.
Positions: Net neutral long/short. Long U.S. Stocks, short U.S. stocks, short XLU, SPY, XLP, and BWX.