Flowmageddon

Credit: ESA

For the bears amongst us, this week looks like vindication in the making, as calls for an overvalued market to see a correction rise up against the equally vehement lobby of “BUY THE DIP” and “STOCKS ONLY GO UP”.  

Yet even there, calling out valuations as the reason for the correction misses the point: this is a problem of market structure. Yes, valuations are stretched, in some cases to ridiculous levels, but the very fact that they can be stretched is also a function of the structure of the market. 

There will undoubtedly be many post-mortems written about this week – to be honest we’re not sure if this is even “post” the “mortem” yet as this could well continue. But if it does continue, at least we will have laid the groundwork for everyone to gain a better understanding of what exactly happened this week. 

In fact, this isn’t even an “equities-only” phenomenon. In many ways, this was a confluence of cracks in the plumbing between fixed income, rates, liquidity, banking, passive flows, option flow, hedging… We are pretty sure that this will at the very least make for an extremely interesting case study of market structure gone awry when it is all over.  

Some of the issues we will raise are issues that we have discussed before, especially in relation to passive investments and more recently involuntary, hedging-driven flows. Putting them all together makes for a fascinating tale to tell. 

But for now, here’s our take. 

Let’s start with Inflation 

Pinpointing a “start point” for this is a fallacy, since the market we find ourselves in is the result of decades of layering and structuring, partly driven by financial engineering and innovation (both good and bad) as well as policy. Everything is interconnected, so let’s just arbitrarily pick an obvious candidate: inflation. 

The inflation narrative has been one we have been watching for over a year now. Prior to mid 2020, inflation was nowhere in anyone’s thoughts. Why would it be? For almost two decades, inflation had been tamed, thanks to a multitude of factors including exported deflation from China’s globalisation to the widespread productivity gains from technology, which allowed decades of growth without any visible inflation. 

Some could even say that inflation was DEAD – after all, given the amount of money collectively printed by central banks all around the world, surely inflation would’ve reared its head if it were alive. Turns out inflation did get the message. 

The inflection point came at the US election, when the market collectively decided that whether it was a blue wave (big stimulus) or more Trump (big stimulus too), the conclusion of the election would see the return of inflation in one form or another. Indeed, the election did come to pass (yes, it happened, and there was a result), and the inflation narrative took hold. 

Post-election, the COVID vaccines came along, and suddenly reflation become a reality: people were going to get vaccinated to COVID and be able to head out again and spend money. Jobs would be created, life would resume and the corollary to that was that inflation would return. 

Suddenly, for the first time in more than a decade, people started to care that the Fed might have actually printed too much money for its own good. Hard commodities caught the bid: Gold already had a run earlier in 2020 but got tripped up as an over-leveraged and premature inflation trade turned into a selloff from its highs, but Copper was the biggest winner, with prices bid from multi-decade lows all the way back to all-time highs within the space of a couple of months. Even US TIPS yields on the 30 year TIPS peeked above zero for the first time since last June – the inflation story is well and alive. 

At the same time, assets like Bitcoin got wind in their sails, as the narrative around fiat debasement caught hold and Bitcoin was sought out, supposedly as a new store of value, more than quintupling over a period of about half a year. 

While all of that was happening, the near-unending liquidity being driven into the market by the Fed’s continued QE efforts meant that no rotation was necessary per se: SPACs were all the rage, as markets crowded into IPOs of promises to use the money to buy something. The Growth trade, which had been on for years, seemed invincible: yes, “value” was having a run, but “growth” didn’t sell off either. The fundamental analysts calling out crimes of valuation were mocked and ridiculed for being prudes, but the irony was that while they were wrong about valuations mattering, many of those who mocked them saying valuations were justified in a new world order were also wrong. 

Liquidity

By now, the surplus of liquidity provided by the world’s central banks has become common knowledge, not just for market participants but also everyday investors. That surfeit of liquidity has not stopped. On the surface, therefore, there is little reason to think that the brakes could be jammed on the market’s trip to the moon as violently as they were this week. 

What does escape the market is HOW this liquidity gets distributed. Rates moving to 1.5% are the symptom of a deeper problem, but they also become the cause of the start of another spiral.

For those who want to get deeper into the weeds, this post has an appendix at the end – additional notes there.

Yes, 1.5% on the 10 year treasury is a miserable amount of interest to earn. But it’s also 3x what it was last year, AND a clear reversal of the multi-decade trend of falling rates. Incidentally, rates in Europe are also rising, even though the ECB continues to slow bond purchases while remarking that a steepening yield curve is “unwelcome”. 

While all of this is happening, liquidity in the fixed income market continues to dry up, setting the stage for even more violent and sudden moves: 

To be clear, the consensus remains that resolving this bottleneck in the liquidity system is simply a matter of policy: The Fed could easily extend the SLR relief, although this has itself developed into a highly politicised issue with the Democrats pushing for the SLR relief to be left to expire.

The reason for the pushback is equally justifiable: allowing leeway on the SLR allows more leverage to be created within the stock market, which has itself been the driver for the less-than-sensible episodes with Gamestop/AMC etc. All of this leverage is built on top of balance sheet capacity and taking markets off the boil (especially after the recent episodes of irrational exuberance) is much preferred to letting markets spiral out of control on their own. Arguably, the Fed has already been extracting liquidity from the markets via reverse repos, most recently at the end of February as well as this week.

The Fed giveth, and the Fed taketh. Relieving the leverage situation seems feasible, with the Fed able to use its other liquidity tools to address it – the problem is that having been left to rear its head, this might have triggered something bigger.

Butterflies and hurricanes 

The idea that a small hiccup in the plumbing somewhere can trigger a global implosion is not entirely absurd, especially given the interconnectedness of our current financial system. But more important than interconnectedness is reflexivity – we’re in a market that feeds on its own momentum.  

It’s great when it goes up, not so great when it comes down. And no, this isn’t an equities-only problem. 

Within the equities space, we’ve written about the impact of reflexivity and momentum multiple times. Our view has been pretty clear: when the numbers are going up, buying more of the same spurs the rally on, and everyone makes money; the same unfortunately applies when the numbers are going down. Essential reading on passive effects here, and on involuntary hedging flows and equity option gamma hedging here. 

But reflexivity exists in the fixed income markets too, and while we don’t actively trade in them, it is always our view that we have to know what’s going on. 

Instead of equity option gamma, the number to watch in the fixed income space is duration hedging. But if banks are filled to the brim thanks to QE with Treasury securities, aren’t those durations largely fixed?  

Not exactly. As part of the Fed’s expanded QE programme, they have started to buy Agency MBS as well, with the result being that US banks’ have a record 15.8% of assets of combined balance sheet exposure to Agency mortgage backed securities. The Bloomberg article we’ve linked to calls Agency MBS instruments with “virtually no credit risk” – that’s something we won’t comment on; what there is definitely risk of there is duration risk and its reflexivity with respect to interest rates. 

As yields in the broader market rise, yields on mortgage refinancing also rises. The following chart was posted by Kris Sidial (@Ksidiii) on Twitter, showing the 30 year conventional MBS yield spiking in response to the global hike in rates. 

He goes on to explain in this thread how a spike in refinancing rates leads to lower refinancing rates on mortgages, the duration of a portfolio of MBS moves further out. 

And just as options dealers hedge their option books to neutralise gamma and delta, fixed income dealers also hedge their books to neutralise the impact of duration changes. As duration goes further out, what does a dealer do? Sell long duration assets i.e. sell the MBS (further pushing rates up) or sell US long dated treasuries (further pushing rates up). 

And what of the dollar? 

Interestingly the dollar has not yet moved aggressively, although it is off its recent lows. On one hand, if the US Dollar is still seen as a risk-off asset to own, then rising rates should help significantly. On the other hand, perhaps as highlighted again by Zoltan Poszar in this note regarding the Treasury’s $1.5tn credit at the NY Fed, the drawdown of these balances could have temporarily suppressed the upside in the dollar. 

On balance, all the signs are pointing to an appreciating dollar and higher rates, caused by some degree of cross-asset deleveraging in a highly reflexive financial market set up. 

As always, we don’t profess to be able to tell the future. But as it stands, EM FX seems to be on the brink, along with other risk assets like crypto – yes, while we are long-term proponents of a decentralised financial system and the potential of non-sovereign controlled money supply (Bitcoin, perhaps), the truth is that in the near term these remain speculative risk assets.  

There is a time for risk and there is a time for caution. 

Back to the land of equities, the one last chart we would want to leave you all with is this one from Squeezemetrics: 

The green line is the S&P 500, while the yellow/purplish (great colour scheme!) line shows option dealer gamma exposure (GEX). The read is simple: positive dealer gamma means that dealer flow attenuates market flow (i.e. the brakes are on); negative dealer gamma means that dealer flow amplifies market flow (i.e. pedal to the metal). 

Gamma positioning doesn’t determine direction, but it determines how quickly and how far things can go. At -$4bn of gamma exposure as of close on the 4th of Mar, this is 30% MORE negative gamma than the market’s position in March 2020 (28 Feb 2020 - -$2.958bn of negative gamma). Whatever the push the market gets now, it gets an extra boost. 

Things are about to get quite interesting. 

Appendix: On liquidity and system plumbing

For those who remember the happenings of end 2018, when the market bottomed out just as it reopened after Christmas, the current state of affairs is a confluence of a market plumbing issue and participants trying to feel out the pain points of central banks. Why are they doing that? It’s their job – it’s called “price discovery”.

The key to understanding this is to understand the nature of the clog in the plumbing of the market.

In 2018, liquidity in the US interbank market almost ground to a halt despite the copious amounts of liquidity being handed out under the Fed’s QE programme. The reason for it was that JP Morgan, faced with an ever-burgeoning balance sheet, was no longer willing to lend (despite the abundant liquidity available), simplistically because of capital restrictions. This may be a gross oversimplification but short of turning out a long essay on monetary transmission, the short story was that the bank would need to put up MORE capital to back new loans they issue. And because they didn’t want to, they didn’t issue more liquidity, threatening to freeze up the interbank market.

And that was why then Treasury Secretary Mnuchin had to come out to say that there wasn’t a liquidity issue in the markets. Did anyone THINK that there was a liquidity issue? Probably not until he mentioned it in the first place.

Amidst all of that chaos, the work of the brilliant Zoltan Poszar at Credit Suisse seemed prescient, warning in October 2018 of the impending interbank liquidity crunch.

Why is this all relevant? Because Zoltan Poszar strikes again, warning last month of what has now come to pass, another blockage in the plumbing that interestingly is again the result of too much liquidity.

The background, dramatically simplified is as follows: In 2020, when COVID struck, expectations were for a huge fiscal stimulus package to be passed within the year. As a result, the Treasury started to accumulate a balance in its bank account with the New York Fed (called the Treasury General Account) in preparation for these disbursals. 2020 came and went, and while some stimulus has been disbursed, the account remains in huge credit to the tune of US$1.5tn, and is expected to be drawn down this year.

A couple of issues came up as a result.

Firstly, a massive surplus in the Treasury’s account meant that they didn’t need to issue short-dated debt to fund near-term expenditures. This led to a shortage of debt for banks to own as collateral on the short end, leading to exceptionally low short-term yields.

Secondly, in order to create the capacity in 2020 for banks to own the copious amounts of debt issuance that was to come, the Fed approved in April 2020 a temporary relief in banks’ calculation methodology of their Supplementary Leverage Ratio (SLR). In essence, this relief excluded Treasury deposits and treasury securities from the denominator of the ratio calculation, allowing banks’ balance sheets to balloon without requiring extra Tier 1 capital (mainly equity) to be put up. This relief is scheduled to come to an end at the end of March 2021, and is one of the factors causing anxiety in the liquidity market.

Thirdly, the abovementioned development of the inflation narrative has started to feed on itself, flipping the market’s sentiment from “What would make the Fed do more to ease?” (which drove the bull market) to “What would make the Fed tighten earlier than expected?”. Inflation expectations are rising, and as a result longer-term yields are following suit. This adds to further pressure to bring the duration of fixed income balance sheets in, especially with balance sheet constraints as per point 2 above: sell long-dated debt and buy short-dated ones. Added to point 1 above (shortage of short-dated securities), and a different issue arises: a steepening yield curve.

The absence of any possible measures to relieve the pressure at the short end of the yield curve from Fed Chair Powell’s speech at the WSJ conference this week added fuel to the selling, as fears of a short-term liquidity squeeze grew, at the same time as rising yields pressure balance sheets and hedging strategies built on assumptions of ever-falling rates.