Karen Petrou’s memorandum to Federal Financial Analytics Clients on how the FRB might make markets even riskier.
TO: Federal Financial Analytics Clients
FROM: Karen Shaw Petrou
DATE: August 28, 2015
Abacab Fund Sees Mispricing In Options As Black-Scholes Has Become “Inadequate”
Abacab Asset Management's flagship investment fund, the Abacab Fund, had a "very strong" 2020, returning 25.9% net, that's according to a copy of the firm's year-end letter to investors, which ValueWalk has been able to review. Commenting on the investment environment last year, the fund manager noted that, due to the accelerated adoption of many Read More
Much of the talk this week as markets plummeted focused – indeed was transfixed – on the U.S. Federal Reserve’s next step. Would it walk rates up a tad in September, stand pat, or even walk back to a QE4 position? I will leave for later what the central bank might do, but one thing is clear: whatever that is, the FRB now must understand that traditional monetary-policy tools are blunt because of the structural transformation of financial markets since 2008. If U.S. monetary policy is the fulcrum of global finance, then U.S. financial-market structure dictates its transmission channels. These are going haywire because the largest U.S. banks – the market’s mainspring – no longer act as efficient market intermediaries. This may well make the financial system safer, but it also makes it very, very different. If the Fed doesn’t get that – and its statements suggest to me it doesn’t – then we’re in for a very rough ride.
The fundamental, bedrock question of what’s going amiss in all the QEs is why huge demand for safe bank deposits is not stoking a like-kind supply of productive lending. Excess reserves held by banks have gone up 1,300 times since 2008, while large-bank lending is flat or even down. Regional banks are doing their bit, but banking assets remain heavily concentrated at the large end of the industry.
For the biggest banks, a lot more than excess-reserve balances has changed since 2008. In my view, their fundamental business proposition is radically different because of the combination of new rules and self-imposed restraint. The FRB can spike its punch bowl with 150-proof liquor, but big banks either can’t or won’t drink from it.
Others, though, are bellying up to the bar. The lower rates go, the more yield-chasing there is and larger grow the balances in shadow liabilities and in higher-risk assets held for longer durations with complete disregard for interest-rate risk.
Market structure is thus changing not only because big banks aren’t intermediating, but also because fund flows are largest in assets with little long-term productive value. Current yield-chasing investments are generally not promoting household consumption or long-term business investment. Instead, they’re going into leveraged loans, emerging-market bond funds, and all sorts of other places that we learned all over again this week pose all sorts of investor and systemic risk. Banks and others resisting yield-chasing temptation are housing more and more funds in cash-equivalent assets, but this does nothing for economic growth even as it stokes greater market illiquidity under stress.
The U.S. could have a sound, intermediating financial system with fewer, smaller banks, but fewer, smaller banks without a sound regulatory system for the rest of the financial market is a recipe for boom-bust cycles of cataclysmic proportions. Hopefully, we dodged one this week. If so, the FRB should take heed of the loud warning buzzers and balance monetary-policy actions with financial-stability projections. If it’s too late and markets are already on the black-diamond ski jump, hold on. We’ve never seen this before.