With mayhem in the financial markets, what better way to find out what’s really going on than hearing from retired City trader, Anthony Peters, in his new weekly column. Anthony, who describes himself as an “old bond dog”, worked for more than three decades in most areas of the international bond markets and for some of the City’s best known firms. His first hand experience of booms and busts, heydays and crises should be of invaluable help guiding us through today’s volatile markets.
At the end of last week, the world as we knew it was just about to come to an end. By September 30th, the Dow had fallen from its August 16th high of 34,152 pts to 28,725 pts. The central banks were going to tighten monetary policy until the pips squeaked and everybody was about to get wiped out. Then the LDI crisis in the gilts market struck, which in turn prompted the Bank of England to blink and to counter LDI with CDI, Crisis Driven Intervention. All of a sudden, markets appear to have decided that central banks were not packed with heartless monsters, hell-bent on wealth destruction and that the end of the tightening cycle might just be that little bit closer than rate setters’ rhetoric would have us believe. We’re at the bottom! Risk on!
Thus, and after a bout relentless buying, the Dow yesterday closed 285 pts or 2.80% to the good at 30,316 pts. In two days of trading over one third of the heavy losses of the previous three weeks – on September 12th the index had closed 32,381 pts – had been reversed. The mood out there is ebullient, and talk is rife that the bottom has been seen, that the time has come to begin shipping it in again. I’m sure I heard exactly the same prattle in early July at the beginning of the summer’s big bear market rally and where it took more nerves not to step back in that to simply close one’s eyes and jump on board the moving train. At the time I was reminded of the legendary assessment of a young officer by one of his superiors in which the latter is said to have observed “His men would follow him anywhere, if only out of curiosity”. It will take a lot more to convince me that we have passed the low point for I have yet to see what is known as the capitulation trade, the moment when the last hanging on optimist finally throws in the towel. The quantum of leverage in the market remains high, especially amongst US retail investors, and it will not be until the rising cost of borrowing has finally flushed them out that we will know that the low point is close to having been reached. I shall continue to wait and watch.
One should not speak ill of the dead although the name of the late house of Lehman Brothers is all over the media and is being bandied about with gay abandon. A Lehman moment here and a Lehman moment there. Italy is close to a Lehman moment. Last week it was the UK which was facing a Lehman moment. Then it was the benighted Credit Suisse. There cannot be another Lehman moment because there only ever was one Lehman. I was standing right in the middle of the storm in 2008 and I can assure you, there is nothing in markets today which even vaguely compares to what was swirling around us then. As I have repeatedly remarked, Lehman was not choked off by the cost of funding its book but by the freeze which had affected the interbank money market. Lehman Brothers was an investment bank which had no access to the Federal Reserve’s discount window – the funding source of last resort for licensed banks – and it was asphyxiated by that inability to draw that form of emergency finance. Lehman’s fate prompted most of the other big firms on the Street, notably Goldman Sachs and Morgan Stanley, to take out full banking licenses and to place themselves under the regulatory eye of the Comptroller of the Currency.
Conventional wisdom has it that Lehman died due to the fierce collapse in the price of assets in a market full of sellers and a dearth of buyers. That was only true for forced sellers of which Lehman was unfortunately one. For those in a position to out hold out, none more so that J P Morgan, the pickings were rich. Because the GFC was not driven by defaults, the recovery was fairly swift and the lasting economic damage in fact only limited. Falling asset prices was the effect, not the cause which put paid to Lehman.
What we also learnt during the GFC is that the most painless way to cope with over-indebtedness is to lend some more. The easiest way, however, need not be the one which resolves the underlying issues, and it ultimately fights the symptoms rather than the causes. There is a largely unresearched inconsistency when debt to GDP is growing faster than GDP itself. “Ah!” I hear you cry, “Debt to GDP only measures the increase in public sector debt to GDP whereas the GDP figure itself includes both public and private sector output”. That would be true and one of the key features of the GFC was the mutualisation of excessive private sector debt for which quantitative easing was the appropriate tool.
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Shoring up the banking system after the great bailout by way of tighter risk capital ratios and consistent stress testing looks good on paper and once again, as is the case for most regulation, does more to protect the reputation of the regulator than it does for the end user. Post-GFC regulation and accelerated disintermediation has driven trillions of dollars of lower quality debt off banks’ balance sheets and into both the bond and the private debt markets. There the risk sits in high yield mutual funds, exchange traded funds (ETFs) and structured credit products such as Collateralised Debt Obligations (CLOs) which are not covered by deposit guarantee schemes and where, if a wave of defaults were to ensue, private investors would like lambs to the slaughter be exposed to the full force of losses without the benefit of government support. That said, the decline in the market value of a managed credit fund never makes the same headlines as dies a bank’s reported loan losses and concomitant collapse of the share price.
It is said of motor racing that the objective is to win the race, to be first cross the finish line, at the lowest possible speed. In the same way, the art of investing is to achieve one’s return objectives whilst sitting the smallest quantum of risk. It has been a long time since minimum risk assets have offered a sociable return and it will surely take a while for the concept of being able to book a 4% or even higher yield on risk-free government securities will gain traction. Over time, however, money should organically begin to flow out of higher risk into lower risk assets and there too it will be the hangers on who will bear most of the pain. Remember that it those who are first in and first out who make the money and those last in and last out who provide it.
The price of risk assets does not decline without the inherent risk increasing. That’s not rocket science. What is beyond rocket science, however, is that identifying, processing and pricing all those risks makes three-dimensional chess look like tiddlywinks. In other words, it cannot be done, which turns the pricing process into not much more than educated guessing. It works in practice, but does it work in theory? We find ourselves surrounded by models which try to do just that which is to make an estimation look like a mathematically derived result. In markets one talks of being able to smell the fear. On that basis alone, a good nose is worth a fortune and certainly more than a clever brain.
By pussyfooting around, the central banks have made the situation worse. They have tried – whether they truly believed it could be done or not is moot – to bring about a positive outcome in both the short and the long term. The trade-off has not worked and we find ourselves in the midst of a sharp reversion the mean in the process of which somebody, somewhere is going to end up under the bus. Over-indebtedness can be met by only one of two solutions, both of which are extremely painful. One is provided by Mr Inflation and the other by a swathe of defaults. The low inflation, ultra-low interest rate option is surely discredited.
The performance of both debt and equity markets over the past two days points towards a bunch of people convincing themselves that a Panglossian outcome remains probable. There is nothing I’d be happier to concede than that they are right and that I am wrong. It’ll take more than a couple of days of risk asset rallies for me to be convinced. Fed Governor Philip Jefferson has been on the wires reiterating that the objective remains to bring inflation back down to 2%. I am on record as having suggested that the 2% target is an illusion and that the best thing the central banks – that’s the Fed, the ECB and the BofE – could do would be to ditch 2% and to adopt a more realistic long-term inflation target of, to pick a number as random as was 2% at the time, say 4%. With inflation being generated both domestically and externally but monetary policy only applying domestically, central banks are turning up with a knife to a gunfight. If a return to low inflation and low rates were to prove to be an illusion, then Mr Inflation or rising defaults will return centre stage. Pays yer money, takes yer choice.
British lawyers will be well acquainted with Mr Justice Alfred Denning, later to become the inimitable Lord Denning, and the High Trees House judgement in which he ruled that the promissory estoppel could be used as a shield but not as a sword. In the same way and in the current environment, interest rate policy would best be used as a defence against rising inflation but not as a weapon with which to wrestle it to the ground and to kill it off. It won’t work. For too long central bankers have been expected to stand in the way of economic cycles and the longer they continue to do so, the fiercer the ultimate snap back will be.
The author is a retired City trader specialising in fixed income who now works as a freelance strategy consultant.
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