The volatility genie is out now and is unlikely to go back in the bottle as late cycle fiscal expansion in the US, combined with higher global funding rates will have markets on their toes going forward.
The liquidation of the short volatility fund XIV (Velocity Shares Daily Inverse VIX) in February 2018 could be the Bear Stearns peek behind the curtain before a larger Lehman crescendo. The now-liquidated XIV product did exactly what it was designed to do, making a small amount of money each day for being short volatility until in one single day everything was lost. Any ETF owners of risky assets (particularly credit ETFs) should be wriggling in their chairs right now, for the XIV was totally a victim of its own success. The volatility community knew full well the thresholds required to trigger a XIV liquidation, and surely helped itself to a grand feast pushing volatility higher and higher until the XIV fund was forced to enter the market and cover risk at high prices, thereby guaranteeing its own death spiral.
Credit ETFs have systemic weakness too
We have long argued that higher funding costs will be a huge problem for lower quality assets in a highly leveraged world, as higher funding costs not only create an income shock in the near term, but also lift refinancing hurdles over time.
As funding costs are rising and liquidity is being withdrawn (illustrated with LIBOR rates rising), investors need to think through liquidity sources, their individual liquidity needs going forward as the tide goes out, as well as the asymmetry of some current portfolio holdings.
Certain parts of the credit market (particularly ‘perceived’ high returning liquid credit and high yield) often re-price in an asymmetrical manner. We need look no further than a well-known highly leveraged US infrastructure fund that recently lost around 40% of its value in one day after provisioning for higher funding and debt obligation costs.
Warren Buffet’s famous quote, “You never know who's swimming naked until the tide goes out”, is a perfect illustration for the current leveraged environment. In adding large US fiscal deficits to a late cycle environment, plus the addition or continuation of higher funding pressure via US rate hikes, the tide is most certainly going out right now for certain parts of the credit spectrum (i.e. lower parts of the capital stack). Often at the end of a cycle, we get a systemic shock: a company or group of companies that fail unexpectedly from sailing too close to the wind.
The danger for credit ETFs comes from the massive credit liquidity gap that now exists between credit debt outstanding (which in the US has roughly doubled since the GFC) and primary dealer inventories which have shrunk more than sixfold. To put that in context, the credit liquidity gap is now twelve times the size it was going into the GFC, when credit products froze and were gated for long periods, on one twelfth of the liquidity mismatch. The rise of credit ETFs gives the market a host of products that they can collectively target in adverse circumstances, forcing them to rebalance into weakness without any circuit breakers seen in equity markets.
Good news velocity turned negative as higher rates are biting
We retain our view that the US Federal Reserve will likely hike interest rates three times in 2018 (this alone will keep pressure on low quality risk assets via funding costs), however, the extrapolation by some pundits of the late 2017 environment is short sighted. We need to consider the ‘flow’ of markets rather than just focusing on the ‘stock’.
Global economic data has been nothing short of great over the later part of 2017 and early 2018. However, the velocity of that data has now turned negative and the sell-off in US bond markets is having an impact. Some isolated recent global data to indicate this include: US durable goods orders -3.6%, US factory orders -1.4%, Germany factory orders -3.9%, and very weak global retail sales. London house prices dropping at the fastest pace since 2009 (Wandsworth/Fulham lost 15%), and US mortgage applications -6.6%. Data has been decaying quickly with a large geographical reach.
Quantitative tightening needs a bond buyer
Calendar 2018 is shaping to be a pivotal year. Political policy is changing, monetary policy is being normalised and asset markets will be asked to stand alone with less central bank intervention. Higher volatility is almost certainly here to stay, making investors demand more in return for the higher volatility risk they must endure.
There is widespread market concern about the withdrawal of global central bank balance sheet accumulation, known as Quantitative Tightening (QT). This term was first used in early 2016 when the Chinese central bank was selling $100 billion dollars of US Treasuries a month to stem capital outflow from China. Many then wrongly assumed yields would rise sharply given the world’s biggest bond buyer had become a net seller. In fact, yields fell and bonds rallied through this period as a ‘flight to quality’ bid emerged from the private system as other risk asset markets decayed.
Fast forward to 2018 and QT is again topical, as central banks have telegraphed a decline in balance sheet growth. However, that isn’t the full story for the bond market, because the existing ‘stock’ of previous Quantitative Easing (QE) actually creates new ‘flow’. When bonds on central bank balance sheets mature, their proceeds have to be reinvested just to keep the 'stock' of balance sheet from shrinking. In other words, even in QE the 'stock' itself generates 'flow'. And as the stock gets bigger, so do the reinvestment flows: in 2018 total QE reinvestment flows will be some US$990 billion, vs US$600 billion in 2016 and 2017. Those reinvestment flows already outstrip balance sheet expansion, with global central bank balance sheet expansion slowing down, reinvestment flows have already become larger than 'new' QE flows.
AUD bond rates below US Treasuries
Our expectation is that the RBA remains firmly on hold in 2018 whilst the US Federal Reserve continues to lift interest rates. We expect this interest rate decoupling to continue and as a result pressure to build on the AUD currency over the year.
The huge fiscal expansion in the US (despite being in the 10th year of recovery) has forced US bond yields higher due to vastly increased US bond supply. This has taken Australian interest rates below that of the US across all key maturity points on term structure curves for the first time since the year 2000. The continued de-coupling of US and Australian interest rates reflects the vastly differing economic outlooks and budgetary positions between the two nations. Interestingly the last time these yield differentials were negative, the AUD was around 0.50 cents to a USD, rather than today’s 0.78 cents.
Charlie Jamieson is Executive Director and CIO of Jamieson Coote Bonds. This article is general information and does not consider the circumstances of any investor.