Doug Noland: Wonderful Monetary Policy and Beautiful Deleveragings

“Generally speaking (depending on the country), it is appropriate for central banks to lessen the aggressiveness of their unconventional policies because these policies have successfully brought about beautiful deleveragings. In my opinion, at this point of transition, we should savor this accomplishment and thank the policy makers who fought to bring about these policies. They had to fight hard to do it and have been more maligned than appreciated. Let’s thank them.” Ray Dalio, July 6, 2017

I find his choice of words inflammatory, but I guess when you’re worth $16.8bn (Forbes) you can write what and how you please. In past CBBs I took strong exception with Ray Dalio’s “beautiful deleveraging” thesis. Data these days speak incontrovertibly to the fact that from a systemic standpoint there has been a huge accumulation of additional debt – at home and globally. The notion of deleveraging is a myth. It is the unprecedented inflation of “money” at the very foundation of global finance that is real. As for “wonderful monetary policy,” at best the jury’s still out. I’ll be shocked if we look back in five or ten years and tag this period’s monetary management in a positive light.

Dalio is somewhat of an enigma. Highly intelligent and hugely successful in the markets ($160bn hedge fund empire), he is one of this era’s foremost “deep thinkers”. I enjoy reading his analysis and share his concerns for social and geopolitical instability. But I see flawed monetary management – and resulting Bubbles/busts and wealth redistribution/destruction – as a major agent to these instabilities. Dalio sees “wonderful monetary policy” as a positive force, while I see radical policy experimentation with disastrous consequences.

It’s what Dalio doesn’t address that I find most intriguing: How much financial sector leverage has accumulated over the past nine years of near-zero rates and unprecedented central bank market liquidity injections and backstopping? How has the expansion of global financial sector leverage (including central bank balance sheets and speculative leveraging) distorted traditional indicators of systemic stability – such as corporate and household debt, debt service capacity and market risk premia.

Monetary policy and associated financial leveraging have significantly reduced debt service burdens for going on a decade, in the process lessening overall debt growth for households and businesses alike. I would also argue that Trillions of liquidity injections into the markets have flowed into real economies, again working to mitigate private-sector debt accumulation. The massive inflation of central bank and government balance sheets has indeed improved the outward appearance of private-sector finances. This has superficially “brought about balance sheet repairs” for traditional weak-link household and corporate borrowers. I’m just not convinced these remain the most germane structures for gauging global Bubble systemic fragilities.

Dalio has been a hedge fund “risk parity” pioneer. “Risk parity is a portfolio allocation strategy based on targeting risk levels across the various components of an investment portfolio… Risk parity considers four different components: equities, credit, interest rates and commodities, and attempts to spread risk evenly across the asset classes. The goal of risk parity investing is to earn the same level of return with less volatility and risk, or to realize better returns with an equal amount of risk and volatility…” (Investopedia).

Few strategies have so greatly benefited from nine years of radical monetary management. A portfolio of diversified asset classes (most notably equities, bonds and corporate Credit) – all enjoying simultaneous central bank-induced price inflation – has been a huge and surefire winner. The more leverage the better. And, importantly, no drag on performance from hedging or de-risking during recurring bouts of market instability, not with the inherent market “hedge” from managing a diversified portfolio with a significant bond component. It’s just been the best of all worlds.

“Wonderful Monetary Policy” has ensured that any successful strategy is inundated with financial inflows. Dalio’s Bridgewater has seen assets under management swell to $160 billion. Hundreds of billions more have gravitated to similar strategies. The proliferation of diversified multi-asset class strategies (leveraged and otherwise) has been a powerful force behind the synchronized inflation of prices for securities and corporate Credit across the globe. As central banks prepare to remove aggressive stimulus, I would expect many strategies that have enjoyed long (nine years!) and consistent success to now face significant challenges.

July 7 – Bloomberg (Dani Burger): “Hawkish signals from central bankers have punished stocks and bonds alike in the past week. Also punished: investors who make a living operating in several asset classes at once. They’ve been stung by the concerted selloff that lifted 10-year Treasury yields by 25 bps and sent tech stocks to the biggest losses in 16 months. Among the hardest-hit were systematic funds who — either to diversify or maximize gains — dip their toes in a hodgepodge of different markets all at the same time. Losses stand out in two of the best-known quant strategies, trend-following traders known as commodity trading advisers, and risk parity funds. CTAs dropped 5.1% over the past two weeks, their worst stretch since 2007, according to a Societe General SA database of the 20 largest managers. The Salient Risk Parity Index dropped 1.8%, the most in four months.”

Dalio: “Central bankers have clearly and understandably told us that henceforth those flows from their punch bowls will be tapered rather than increased—i.e., that the directions of policy are reversing so we are at a) the end of that nine-year era of continuous pressings down on interest rates and pushing out of money that created the liquidity-fueled moves in the economies and markets, and b) the beginning of the late-cycle phase of the business/short-term debt cycle, in which central bankers try to tighten at paces that are exactly right in order to keep growth and inflation neither too hot nor too cold, until they don’t get it right and we have our next downturn. Recognizing that, our responsibility now is to keep dancing but closer to the exit and with a sharp eye on the tea leaves.”

Fascinating analysis. “Central bankers have clearly and understandably told us that henceforth those flows from their punch bowls will be tapered… that the directions of policy are reversing… Our responsibility now is to keep dancing but closer to the exit and with a sharp eye on the tea leaves.”

The problem is that tea leaves reading “head for the exits” risk inciting a stampede. These fund complexes and speculative strategies have become gigantic within an overall marketplace structure more vulnerable than ever. In what will now be a common theme, who will take the other side of the trade when the enormous “risk parity” crowd moves to de-risk. Who will have the wherewithal to step up and buy when asset prices across the board come under pressure? How quickly will perceived low-risk strategies face major redemptions when performance turns sour? This has become a systemic issue, recognizing the massive flows into equities, bonds and corporate Credit – with the ETF complex surpassing $4.0 TN of assets. There has never been anything similar to trend-following (speculative) finance so dictating market dynamics.

This is not some nebulous issue going unexplored by market players. There are, however, three key aspects to this issue that are unknowable – and have, to this point, been easily dismissed in the exuberance of a central bank-administered marketplace: First, how much leverage has been employed throughout the securities markets – in the U.S. and globally? Second, how much embedded leverage has accumulated in global derivatives markets? And third, what is the scope of market risk that has (or expects to be) offloaded to dynamically hedged derivatives trading strategies (that will be forced to sell into declining markets to hedge exposures)?

And a few thoughts on Dalio’s, “The beginning of the late-cycle phase of the business/short-term debt cycle, in which central bankers try to tighten at paces that are exactly right in order to keep growth and inflation neither too hot nor too cold, until they don’t get it right and we have our next downturn.”

I have issues with such analysis. “Central bankers” trying to get things “exactly right”? The next downturn comes when they “don’t get it right”? Well, let’s not lose sight of the reality that central bankers are nine years into an unprecedented reflationary experiment. To this point, rightly or wrongly, they’ve orchestrated historic securities and asset market inflation. Yet central banks will at some point lose control of the global financial Bubble, at which time they will have fully lost control of inflation and growth dynamics. The notion that this continues so long as they “get it right” really suggests that central bankers must remain pro-Bubble.

It’s these days not difficult to explain how the structure of the U.S. household balance sheet appears in good shape (net worth approaching $100 TN!). The structure of the corporate balance sheet is surely solid as well, at least from the perspective of strong earnings and cash-flow. With rates so low and markets abundantly liquid, it’s easy to argue that the federal government balance sheet, while having ballooned massively, remains quite manageable. Conventional analysis, then, views the entire structure of the greater U.S. balance sheet as solid and immune to crisis dynamics.

Yet traditional analysis misses the prevailing vulnerability that emanates from this most unusual of Credit and Speculative Cycles: The Structure of Global Financial Market Risk. Central banks inflated an unprecedented market Bubble, slashing rates, adding Trillions of liquidity and repeatedly intervening to stem fledgling “Risk Off” Dynamics. Perceptions of low risk have over years stoked the accumulation of unprecedented systemic risk (including price, liquidity, Credit, counterparty, policy, economic, social, political, geopolitical and so on)

Over nine years, this has led to deeply embedded market misperceptions, perhaps most importantly that risk assets enjoy money-like attributes of liquidity and safety. Moreover, that central banks will ensure rising asset prices. These misperceptions have spurred Trillions of flows, with a major chunk jumping aboard the equity and fixed-income bull markets via the ETF complex.

Within the leveraged speculating community, hundreds of billions flowed into “risk parity,” CTAs (“a CTA fund is a hedge fund that uses futures contracts to achieve its investment objective”) and other trend-following strategies. Meanwhile, zero rates and central bank control over securities markets have ensured a derivatives boom like no other – derivatives to leverage securities, to employ international “carry trade” speculations, to exploit Credit spreads, to write myriad variations of market “insurance,” to hedge risk and to implement about whatever strategy imaginable.

I would posit that global market Bubbles today rest tenuously upon the false premise that central banks can get it right when it comes to managing market risk and liquidity. In reality, central banks have created an Unsustainable Market Structure with increasingly acute latent fragilities. It’s impossible to “get it right,” because Bubbles are by their nature unsustainable.

Today’s global Bubble works only so long as securities values continue to inflate. Market inflation is dependent upon unrelenting central bank stimulus and backstops. It will all falter badly in reverse. And all the “money” that has chased central bank-induced market returns – from “risk parity” to corporate bond and equity index ETFs to derivatives strategies – creates vulnerability to an abrupt shift in perceptions, followed by illiquidity and market dislocation.

Markets this week were again showing indications of vulnerability. Global yields remain on the rise. German bund yields jumped 11 bps to an 18-month high 0.57%. French yields rose 13 bps to 0.94%. The largest yield spikes, however, were at the “periphery.” Italian and Spanish 10-year yields surged 19 bps to 2.34% and 1.73% – with Italian yields near two-year highs.

It’s also worth noting that emerging bond markets faced increased selling (EM bond ETF down 1.3% this week). Local EM bond markets were under heavy selling pressure. Ten-year yields surged 28 bps in Turkey, 21 bps in Indonesia, 21 bps in Russia, 22 bps in Colombia, 12 bps in Brazil and 11 bps in South Africa. Dollar-denominated EM bonds were not spared. Yields rose 20 bps in Turkey, 19 bps in Argentina, 13 bps in Brazil, 12 bps in Mexico, 15 bps in Colombia and 10 bps in Russia.

July 6 – Bloomberg (Liz McCormick and Lananh Nguyen): “With yields surging across major economies as more central banks hint at joining the Federal Reserve in tightening policy, strategists are pointing to a likely loser: emerging-market currencies. The fallout is already being felt in the foreign-exchange market as investors eye the end of an era of unprecedented stimulus. An MSCI index of emerging-market currencies hovered near a seven-week low Thursday as yields on Treasuries and bunds rose to fresh highs. In 2006, the last time investors braced for steeper borrowing costs in the biggest economies, the index lost almost 5% of its value in a span of weeks, while developing-market stocks plunged.”

When it comes to Market Structures vulnerable after nine years of runaway global monetary stimulus, look no further than EM. Despite all the corruption, fraud, political turmoil and nonsense that one would anticipate from a prolonged period of egregiously easy “money,” finance has nonetheless flowed lavishly to EM (with its relatively high-yielding debt markets and growth opportunities). Over recent months, with blow-off dynamics enveloping risk markets worldwide, huge flows gravitated to EM. Much of this “money” was intermediated through the ETF complex. How much was purely trend-following?

While traditional analysis would look first to U.S. economic fundamentals (including household and corporate debt, earnings, employment and inflation) for indications of underlying market vulnerability, I would point instead to Global Market Bubble Dynamics – while reminding readers that the current backdrop is distinct to previous Bubble experiences. As such, market indicators this week at the periphery – EM as well as European – were flashing heightened susceptibility to de-risking/de-leveraging and the potential for liquidity challenges. Considering the enormity of recent flows, perhaps EM will provide an early test for the thesis of Market Structural Vulnerabilities.

Here at home, 10-year Treasury yields rose eight bps to 2.39%. In equities, there was more of this choppy topping-action rotation away from tech/high-flyers and into financials/laggards. Corporate debt markets are beginning to feel the strain of rising global yields. High-yield bond funds saw another $1.1bn of outflows, though investment-grade corporates are still attracting large inflows. The high-yield ETF (HYG) traded near a two-month low. Commodities, as well, seemed to support the thesis of fledgling “Risk Off” and waning liquidity. With crude down almost 4%, the GSCI Commodities Index dropped 1.8%. Copper fell 2.4% and gold lost 2.3%. But it was wild trading in silver (down 7.2%) that might have provided a harbinger of more general market liquidity issues to come.

That Treasuries, equities, corporate Credit and commodities all seem to be indicating a (thus far subtle) shift in market liquidity, we can look to “risk parity” – and similar multi-asset class strategies that incorporate leverage – as a possible weak link in a Vulnerable Global Market Structure. And we’re supposed to savor this moment and pay a debt of gratitude to courageous central bankers? Strange world.


Original Post 8 July 2017

Categories: Perspectives