Tight spreads, low volatility and a plethora of under-employed structured credit traders mean it’s time for investors to do just one thing – buy some synthetic structured products of course!
Citigroup analysts are recommending the trades over here.
Here’s the most important bit:
It’s been ages since the Federal Reserve last raised interest rates. Who remembers how that works? (Certainly not me, I was a baby reporter covering airlines back then) Here are some excerpts:
At least at the junior end, Wall Street is now peppered with traders and investors who possess no first-hand professional experience of an interest rate rise. Even for finance veterans, the habit of measuring one’s profit and loss on a day-to-day basis leads to notoriously goldfish-like memory spans and it has been six years since rates were last above the zero bound.
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Years of ultra-low interest rates have become integrated into the very fabric of markets. Asset managers live and die by their interest rate bets. Hundreds of billions of dollars have poured into riskier asset classes as investors seek out higher returns with borrowed money, or leverage, used to amplify profits.
Chances are, when you think of the repo market you think of banks and broker-dealers and the craziness that went down in 2008. This column, based on an amazing research paper by Zoltan Pozsar, suggests that’s a mistake.
(Bonus: It calls out Pimco on window-dressing its balance sheet)
Here’s an excerpt:
We know that banks and hedge funds a traditional sellers of volatility. But low interest rates and somnambulant markets have also encouraged asset managers (or “tourists” as the banks and hedgies sometimes call them) to take up the strategy as they seek to juice their returns. It seems … risky.
This story has a lot of stuff in it, including a smallish dive into the events of October 15.
Long the domain of professional speculators like big banks and hedge funds, “selling volatility” — as such wagers are known — became one of the most popular trades of the year as a much wider range of investors piled into bets that asset prices would remain stable.
Now, as the prospect of the Federal Reserve raising interest rates draws increasingly near, the concern is that market volatility will return with a bang in 2015 and those investors caught on the wrong side of the revival will suffer badly.
“Volatility is a zero-sum game — for every buyer there is a seller. But what has changed is the type of sellers,” says Maneesh Deshpande at Barclays.
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Bond inventories held by dealer-banks have halved since 2007 blah blah blah.
What gets far less attention than bank balance sheets in the bond market liquidity puzzle is the other side of the equation, and that is the astounding growth of bond funds.
This column, based on a big BIS paper, has some big numbers to go along with it.
The BIS estimates that the bond holdings of the 20 biggest asset managers have jumped by $4tn in the four years immediately following the crisis. By 2012 the top 20 managers held more than 60 per cent of the assets under management of the 300 biggest bayside firms in 2012, up from 50 per cent in 2002.
In other words, while asset managers are increasingly concentrated in bonds, the asset management industry, in turn, appears to be increasingly dominated by a select group of elite managers.
… The issue of decreasing levels of liquidity in the bond market was recently highlighted by the Bank for International Settlements, better known as the central bank’s bank, which last week released a 57-page paper with the rather dry title of “Market-making and proprietary trading: industry trends, drivers and policy implications”.
Yet the dearth of traditional market makers is only one half of the liquidity story.
The other is the astounding growth of big bond funds, which in recent years have ridden a wave of low interest rates and a period of huge debt issuance by governments and companies to grow their balance sheets by staggering amounts.Many of these funds have been herded into similar investment positions thanks to the increasing use of benchmarking, as well as ultra low interest rates, which have essentially encouraged them to “go long” on credit. Moreover, in an environment of one-sided demand for bonds, few fund managers have had to pay for their liquidity in recent years.
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Liquidity puzzle lurks within bond funds’ extraordinary rise
On October 15, prices of US government bonds – one of the most liquid markets in the world – whipsawed violently and sparked a wave of speculation on Wall Street as to the culprit(s) behind the wild moves.
Here’s a longish analysis of what happened. The key suspects: lack of liquidity, the rise of electronic trading, a classic gamma trap (possibly sparked by the scuppering of the AbbVie/Shire deal) and much, much more.
… On October 15, the yield on the benchmark 10-year US government bond, which moves inversely to price, plunged 33 basis points to 1.86 per cent before rising to settle at 2.13 per cent. While that may not seem like much, analysts say the move was seven standard deviations away from its intraday norm – meaning it might be expected to occur once every 1.6bn years.
For several minutes, Wall Street stood still as traders watched their screens in disbelief. Electronic pricing machines, which now play a bigger role than ever in the trading of Treasuries, were halted and orders cancelled by nervous dealers as prices see-sawed.
The events have sparked a financial “whodunnit” as investors, traders and regulators seek to understand what happened – and to determine whether October 15 was a unique event or a harbinger of further perilous trading conditions to come.
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So apparently everyone who is anyone has already read this book. Except me. It’s been sitting on my Kindle for months – untouched and unloved until very recently. But having started on this compendium of 1960s New Yorker articles just last week, I am now about a third of the way into it and all I can say is that this is the way business writing should be – full of fascinating and powerful narratives that tell you something about human behaviour as much as finance and markets and corporate intrigue. Oh, and the prose is to die for. You know, if that’s your thing.
Given recent events, one passage in the first chapter of the book struck me as particularly prescient.
Updated: October 17, 2014 given recent market events and sudden interest in all things liquidity-related. To be clear, the lack of liquidity just exacerbates market moves. The underlying problem is that complacent investors have been in the same (long) positions for the past five years, selling volatility and levering up to boost returns.
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A by-no-means-extensive list of my work on the changing structure of the bond market.
Goldman eyes electronic bond trading (March, 2012)
Finance: Grinding to a halt (June, 2012)
Dealer and investor talks over liquidity fears (June, 2012)
Goldman launches bond trading platform (June, 2012)
Bond trading model shows signs of stress (October, 2012)
Banks tout idea of sharing bond data (November, 2012)
Slow-drip bond sell-off masks a problem (November, 2012)
Markets on edge as investors seek exit (June, 2013)
ETFs under scrutiny in markets turbulence (June, 2013)
Markets: the debt penalty (September, 2013)
Digging into dealer inventories (September, 2013)
Verizon’s $49bn bond sale whets appetite for larger issues (September, 2013)
ETFs: Tipped as liquidity source (November, 2013)
Global liquidity: Buyers struggle to find a safe landing (November, 2013)
Big US banks back new bond trade venue (November, 2013)
Investors turn to ‘shadow’ bond market (January, 2014)
Banks are a proxy for credit bubble fears (March, 2014)
Taper tremors fail to deter ETF investors (May, 2014)
Checking out of the ETF hotel could be costly (May, 2014)
‘Patient capital’ ready to exploit bond market sell-off (June, 2014)
Fed looks at exit fees on bond funds (June, 2014)
Bonfire of the bond funds (June 2014)
BlackRock’s Aladdin: Genie not included (July 2014)
Investors in junk bonds face a Matrix moment (August 2014)
Finance: The FICC and the dead (August 2014)
Investors dine on fresh menu of credit derivatives (August 2014)
Yield-hungry markets overlook credit risk (September 2014)
US corporate bond traders go electronic (September 2014)
Gross exit from Pimco tests bond market (September 2014)
Wall St sheds light on Bill Gross reign after Pimco departure (September 2014)
At the risk of sounding like a broken record, expect more on this.
Sometimes, looking at your past work reveals not only the progression of a real-world trend but also a subtle shift in the narrative of the topic under discussion.
It used to be that the ‘shadow banking system’ encompassed a relatively select group of non-bank financial intermediaries – broker-dealers, the repo market, money market funds, SIVs, etc. That group grew enormously in the years before the financial crisis, but has since collapsed pretty significantly.
Nowadays the definition of shadow banks appears to have expanded to include a host of non-bank financiers like direct lenders, asset managers, hedge funds etc.
Here’s a selection of some shadow banking pieces that illustrates the trend.
Dazed and Confused’s famous “School’s out” scene starts with a warning from a rather candid teacher: “This summer when you’re being inundated by all the American bicentennial fourth of July brouhaha. Don’t forget what you’re celebrating and that’s the fact that a bunch of slave owning aristocratic white males didn’t want to pay their taxes.”
It came to mind as I was reading Scott Locklin’s review of the new Michael Lewis book. I’m a big Lewis fan (a highlight of my career was being CCed in on an email to Lewis, which perhaps says something non-flattering about my career), but amidst this week’s “brouhaha” over Flash Boys, I think Scott makes some very interesting points.
I know a few HFT type people. One of ‘em might be even be as rich as Michael Lewis. So far, all the ones I have met are clever and decent people, and I figure whatever they’ve managed to earn by the sweat of their brows, they deserve it. I’m not real pleased with the idea of a small group of decently paid, politically helpless nerds being the fall guys for a bunch of crooked oligarchs who don’t want to pay for their liquidity.