‘What about the fact that maybe most of the collateral you need for normal trading is all tied up now? What about the fact that the big investment dealers have got inventories that are 20% of what they were in 2007? When things start to move, the inventory for the market makers might not be there. That’s a particular worry in fields like corporate bonds, which can be quite illiquid to begin with.’
William R. White, former economic adviser at the BIS, in a recent interview
This point echoes one I made recently regarding HY debt liquidity risk and the BIS as the ‘central banker’s central bank’ has been one of the most prescient and objective observers of macro events in recent years from the emerging market debt build-up to the Eurozone crisis. As any bored (and increasingly paranoid) swaps trader wiping the dust from their Bloomberg keyboard can attest, the defining issue for markets currently is the lack of volatility, even in response to non-consensus US data as we saw recently. Or as famed macro investor Paul Tudor Jones put it this week, “manic depressive trading in a volatility-compressed world.” Of course, one side effect of QE was to suppress volatility by curtailing macro tail risk etc., but the Fed’s unwind has coincided with a burst of global disinflation which has at least postponed the widely expected yield spike trigger for a reversion to mean volatility shift.
Indeed, the other defining issue as covered previously is low nominal growth globally, which is capping bond yields against consensus expectations but also forward equity earnings growth. With an eerie calm having descended on key markets in recent months, it’s not surprising that investment banks have seen revenues tumble in their trading arms; the 10-year yield has moved within the narrowest range for the most sustained period since flares and the Village People were in fashion while volatility in currency markets (ex EM) has been lower only a couple of times in the past 20 years – the JPY/USD cross has barely moved over the past month. However, the underlying liquidity deterioration means that when we get a paradigm shift in investor perceptions, the move will be unusually violent.
In commodities, Brent oil has traded in the narrowest sustained percentage range since 1985. The S&P 500 has been playing ping pong for a couple of months within about a 50 point range, despite a significant sector rotation beneath the surface. Range trading could carry on for a bit longer, but I’ve described this as the pivotal year for the QE experiment. Either it starts working in the real economy as reflected in US wages and capex accelerating (and Treasury yields break upward through 3%) or we face a crisis of confidence as inflation globally ex-Japan continues to downtrend and central bankers fall off their pedestal. One problem is that as the utilization rate in the US creeps toward pre-crisis levels, it’s been plunging in China as reflected in April’s -2% y/y PPI . Another is that the still highly leveraged US economy is very sensitive to rising long rates, as seen in the housing slowdown, an issue I covered recently and which Janet Yellen highlighted as a downside risk this week. Despite the lack of headline volatility, beneath the calm surface there has been some dramatic rotation within asset classes, notably within US equities.
The Russell 2000 small cap and Nasdaq Internet indices have slumped since March as momentum inflows reversed – Twitter having halved is still on 85x consensus 2015 EV/EBITDA, Amazon on 20x although Google and Ebay are back to about 10x, which offers a benchmark for the Alibaba IPO pricing. It’s notable that popular frontier emerging markets like Vietnam are now also starting to slide (although squaring up to a belligerent China isn’t helping). In other words, volatility has been building since March in corners of the global markets which were among the biggest beneficiaries of excess liquidity flows. The question is whether that’s simply a late cycle healthy rotation toward value from momentum strategies or a harbinger of wider volatility this summer. A trigger such as the ECB falling short of expectations in June could lead to some very crowded credit momentum trades from peripheral Eurozone sovereign debt to junk bonds reversing hard – liquidity risk in fixed income looks mispriced, particularly given that bond dealers no longer have the balance sheet capacity to warehouse risk during a spike in selling volumes.