Sean Corrigan is Chief Investment Strategist, Diapason Commodities Management, Lausanne & London.
“Glaciers melting in the dead of night/And the superstars sucked into the supermassive.”
Matthew Bellamy, Muse
“…If monetary policy has played a dominant role [in the recent benign financial conditions], the rise in inflation that has been observed recently in many countries and the likelihood of a further tightening of global monetary conditions suggest that the current episode of low interest rates and tight spreads could end quickly. This could have an adverse impact on interest rate sensitive sectors of the economy and lead to a withdrawal of liquidity from precisely those markets that have benefited the most from low interest rates.”
Malcolm Knight, BIS General Manager, June, 2007
To the casual observer, the recent behaviour of financial markets is surely a cause for wonder.
Trading volumes and M&A activity sets new records with every passing month; buy-out targets become more and more ambitious (and the leverage taken on to achieve them grows and grows); hedge funds proliferate and - no longer content to pick over such mundane assets as stocks and bonds - branch out into buying rare earth metals, art works, footballers and violins; emerging market equity indices trade on higher multiples than Western ones; US margin debt hits new records both outright and as a percentage of market cap despite a sputtering economy; equity mutual fund managers signal their endorsement of the view from the bucket shops by allowing liquid asset ratios to hit new lows.
Then there’s the increasingly bullet-proof mentality among risk takers who reacted to an emerging market fall in May 2006 by slashing positions so deeply across the board it took six months for some of them to recover the loss; who then responded to a mini-China crisis in February with not so much a flight- as a feint-to-quality that only took six weeks to shake off; and who then greeted the latest Shanghai shake-out with such a yawn that new highs had to wait less than six days from a sell off which lasted not a great deal more than six hours!
Finally, there’s the fact that emerging market and junk bond spreads, as well as CDS premiums, are hitting new lows even though the investment grade universe is tracking inexorably higher from the generationally low real and nominal yields set as recently as this year (e.g., in the case of the UK).
In fact, the key to understanding all these marvels – which are part of a wider phenomenon also made manifest in the record prices being set for drab Modernist daubings, French wines, Swiss watches, and all the other Hyper-Bling accoutrements of the nouveaux riches – and also the clue as to what may bring an end to this Bacchanalia is to be found in a careful re-reading of that last paragraph.
We say this because the great, gaudy merry-go-round to which we nowadays so precariously cling is powered by a vast surplus of credit which is being extended – not so much by banks who might, after all, be subject to some restraints on their lending activities, however notional - but by virtue of such exposures being floated off largely to an unregulated non-bank sector whose own liabilities the banks do fund, since they are theoretically fully-collateralized by the over-priced assets they have bought.
That the carousel spins so fast is because these non-bankers have also been instrumental in financing both the private equity boom and the knock-on flurry of acquisitions, spin-offs, and share buy-backs carried out by the nervous executives of vulnerable public companies. Their complicity has arisen both because the non-banks have participated actively in the LBO mania and because they have depressed yields and spreads in general (by writing ever cheaper insurance on ever more issued debt, if in no other way).
Like all good asset-collateral spirals, the volume of cash flooding into both institutional coffers and private pocket-books as a result of all this debt-based buying has left the recipients scratching around for places to re-invest their windfall and so - Hey Presto! – they have come to cultivate an avid taste for ‘alternative’ assets as replacements.
Apart from sounding impressively à la mode over the dinner table, this has meant in practice that they have rushed to buy stakes in the same private equity and hedge funds who initially relieved them of their former, more traditional holdings. Amazingly, this seems to take place in the expectation that the bought-out will enjoy greater future returns just because they have surrendered charge of their assets to the buyers-out (instead of exercising firmer shareholder control over the pre-existing management, in the first place), regardless of the damage wrought to the targets’ balance sheets and despite the eye-watering levels of fees involved in playing the game.
Thus refortified with ‘equity’ returned from those they have just borrowed to buy out, the non-banks can now go scoop up another fistful of assets, financing a hefty slice of the purchase with yet another slug of margin extended by their eager prime brokers.
Thus, the inflationary screw takes yet another turn to the cry of Come back, Signor Ponzi, all is forgiven!
To get a sense of the scale of but one aspect of all this, consider the findings of a recent Fitch Ratings survey which revealed that assets of ‘credit-oriented’ hedge fund had exceeded $300 billion as far back as 2005, since when CDS outstanding have doubled to $35 trillion, suggesting a substantial increase in the tally of those assets, too.
As the agency points out, even that sum represented a gross understatement of these funds’ influence since the typical financial leverage they employ is of the order of five to six. Moreover, on top of this figure of $1.8 trillion-and-counting, we must not forget to reckon with the extra economic leverage intrinsic to the fact that these funds also tend to concentrate their buying on the more risky tranches created much lower in the capital structure when loans are sliced, repackaged, and sold on by their originating banks.
Given that Fitch reckons that 60% of the trading volumes generated in the CDS market can be attributed to such funds, we can get a sense of the thinness of the ice upon which the whole bootstrapped edifice is being built.
But we mustn’t be too parochial here for, in addition to the internal distortions being wrought by the unholy alliance of hedge funds, LBO merchants, and prime brokers via securitization and through the use of structured products and derivatives, all of this has also brought about significant real world effects, far beyond the fairy tale realm of the financial markets themselves.
Though much of the world’s upsurge in economic activity (and the concomitant rise in commodity prices) these past five years has a genuine foundation in the modernisation of Asia and Eastern Europe, among others, there is also a large, if unquantifiable, overlay of that excessive or misplaced investment which has only arisen because the markets and the central bankers who oversee them have ensured that the real cost of financial capital has remained far too low for far too long.
Here it is that we see the first signs of danger, for, in a world which has come to define ‘risk’ as the avaricious angst that one could be missing out on a fabulous gain if one is not fully committed to the pot, the whole whirligig of financial speculation and industrial hyperactivity depends upon one thing and one thing only – non-threatening bond yields.
Here we must track back a little to set matters in context.
For well over eighteen months, it has been our view that the inflation genie has been fully let out of the bottle (taking ‘inflation’ in the misleading modern sense of a rise in a consumer price index which a central bank finds it hard to ignore) and that, as a result, we would see nominal short-term rates move successively higher, while real short-term rates lagged behind.
Then, we felt, there would be some weakness evident in some over-extended, interest-rate sensitive sector or other - and housing, thanks to the enormities of this cycle, was always a (sub) prime candidate to fulfil that role. Then, a pause for breath would ensue, that hiatus itself being taken as a sign that the next move in rates would inevitably be downwards, paradoxically setting the market up for another anticipatory move to the upside.
Absent a direct financial contagion from some parts of, e.g., the housing market (worries of which were certainly an accessory factor in the February wobble), we have also long contended that the heady mix of solid, secular and shaky, cyclical global growth would be sufficient to tide things over and would not let any material amount of slack back into the system - and that nor could it until the credit tap was further considerably tightened.
We have also argued that, due to the peculiarities of the energy market – a heady cocktail of the CB policy of ‘ex’-ing their price indices, the public ownership of oil & gas resources, and the politics of petrodollars – high fuel prices were acting as a monetary pump, not as a picket line to hobble output. Lo and behold, Brent crude is back at $70/bbl and we have been off to the races again, these past few months.
We further warned that the biofuel movement would have far-reaching effects, not just for commodity investors, but for the ordinary householder and – at length – for the central bankers anxious to keep his wards’ ‘inflation expectations contained’.
Finally, we thought that the balance of probabilities favoured a scenario where the move which broke the uneasy cease fire on rates would be up not down.
So far all of this has just about come true – though in a world riddled with self-installed vulnerabilities at every level, our fingers are still firmly crossed when we say so.
So far, the only thing missing is the next upward shift from the central banks which did go dormant, though New Zealand, for one, has gratified us. In Australia and Canada, we can see that the wider market (if not yet the monetary authority) has come round to our viewpoint, since futures are clearly pricing in such an imminent resumption. In the UK, Sweden, and the EU, too, where official rates have continued to rise, futures are, if anything marching further away from them as they do.
Ominously, too, the violent sell-off in Eurodollars has even begun to push the red months up above the funds rate and back towards a more normal premium which would signal the dispelling of the last lingering hopes of a cut. Additionally, the far end of the US curve is starting to resteepen with the differential between Fed funds and 10-year Libor, for example, moving from a negative 35bps in December (a six-year low) to an 11-month high of +48bps and, to cap it all, break-even inflation rates are also starting to move higher, not just Stateside, but in the EZ and the UK, too.
Finally, the sell-off has seen US T-notes at last break the downtrend which has capped the classic, long-term distribution built since the ’87 Crash, meaning Treasuries have joined the angry-looking charts for Bunds, Gilts, Canadas, Ozzies, et al.
Here, too, we could see another feedback come into operation – this time one far less helpful to the speculative herd – for rising long bond yields are likely to be viewed by central bankers as a sign that either their self-proclaimed anti-inflationary stance is being questioned or that the implied rate of return on capital has risen. Either way, bond yields could rise for fear of more CB tightening and the CBs could tighten more because bond yields are rising.
All it would need then would be for a little mortgage convexity to kick in, or for some other from of dynamic hedging on all that derivative product to take place, and we could see the asset-collateral spiral swirling rapidly into reverse.
If so, it is a matter of reasonable conjecture to suggest that, given the sheer mass of positioning involved – as well as the unfathomable interlinkages between its innumerable component parts - we could well see a good part of the present, self-supporting nebula of ‘liquidity’ rapidly vanish over the event horizon.
What price then the ‘global savings glut’ or the worldwide ‘asset shortage’ so beloved of US academia and how large a quota of disastrous malinvestment will be exposed once the impressive divide between the employment of means and the satisfaction of ends is no longer disguised by the anti-gravitational force of over-abundant credit?
(A version of this commentary originally appeared as part of the June monthly report for the Labarum fund)