Market Thinking - Market mechanics beats economics most of the time

Market Thinking - Market mechanics beats economics most of the time

06 October 2017
  • A quiet holiday week for markets in Asia with a resulting slow start to the final quarter. Focus will be on the upcoming Chinese Party Congress and thematic investors will focus on policy for structural winners.
  • The switch back to a Trump Trade mix of assets appears to have been triggered last month by a deal on the budget and renewed talk of tax cuts, but may be just mean reversion.
  • Looking ahead to some risks for 2018, the unwind of QE may produce some unwelcome effects, especially in areas like mortgage backed securities.

This last week saw mainland China markets closed for Golden Week with intermittent closures across the rest of Asia. This is making for a slow start to Q4 in Asia and also helps explain the profit taking and window dressing that took place over the last few weeks. Credit Suisse report that after twelve months of net buying, international investors were net sellers of Asian equities in August and September. On the mainland the focus is obviously on the upcoming 19th Party Congress in two weeks’ time and in my opinion this may also be behind the statements from President Trump about now not being the time for the US to talk to North Korea. Everything we have seen to do with North Korea this year has been about putting pressure on China to deal with the problem. As such it does not make sense for the US to engage in bi-lateral talks with the Democratic People's Republic of Korea (DPRK), rather to wait until after the Party Congress when, presumably, president Xi has consolidated his power and is in a better position to act. Consistent with this is the planned visit by President Trump to China next month which President Xi recently told reporters will be “special, wonderful and successful”. Moreover the fact that the US aircraft carrier Ronald Reagan has just come to Hong Kong for a visit when requests earlier in the year were refused reveals the current (positive) state of US/China relations, perhaps also reflected in the fact that Korea was the best performing major market in Asia last month. Meanwhile, those (several thousand) naval officers and ratings will also provide a welcome boost to the Hong Kong economy over the holiday week.

The main policy news is that the Chinese authorities have announced an easing of reserve requirement ratios for banks (RRR) ahead of the Golden Week and the Party Congress, although they do not actually come into effect until next year. Interestingly the ratios appear to be aimed at diverting lending to areas regarded as under-served and it seems to us that the authorities are keen not to send an economy wide signal, rather a guidance towards micro and small lending, start-ups and so on. This is important since much of the rebound this year has been in state owned enterprises (SOEs) rather than small and medium enterprises (SMEs) and that it is the latter not the former that need help. A traditional RRR cut would most likely simply boost the SOE sector, which is not what is needed. Secondly, as my economist colleague here in Hong Kong Aidan Yao points out, the timing is likely designed to offset any tightening associated with new macro prudential regulations coming in Q1 2018. Requiring banks to include inter-bank borrowing in their macro prudential assessment (MPA) will likely curtail lending, especially in the shadow banking sector and this targeted RRR cut is likely to help offset some of this ‘tightening’ by encouraging the ‘official’ banking sector more into the SME space. This is all part of the ongoing rebalancing of the Chinese economy and the integration of shadow banking into traditional banking and perhaps not surprisingly this has led to some strong share price moves in the Chinese banking sector.  We suspect that there is something of a catch-up trade going on here, especially for international investors. As noted after the CLSA conference last month, there is a feeling that international investors are finally starting to build up positions in China beyond the American depositary receipt (ADR) positions in the internet companies. Banks are one area they are now looking at, as well as autos. The clean energy story that we have been discussing for some time now is picking up a lot of momentum and will no doubt continue to be a policy focus for the Chinese government. The poster child for this is battery and car maker BYD, whose shares have risen almost 70% since the start of September! My colleague here in the Hong Kong office is off to see them in Shenzhen next week on what will doubtless be a very crowded tour.

Meanwhile, investors here in Asia are relatively side-lined on the UK and Europe as the Brexit talks drag on, while being unnerved by further thoughts on the German election and the events that took place in Catalonia. The prospect of almost 100 Alternative für Deutschland (AfD) members in the Bundestag with a clear anti-immigration stance suggests a further blow to the perceived unanimity of the European Union (EU) project, while the troubles over the voting in Catalonia highlighted the regional tensions that exist not just in Spain, but across the EU as a whole. Top down control is becoming much harder. As of now, however, the spreads on peripheral bonds, which might have been expected to widen have not done so. This of course is an ongoing function of quantitative easing (QE), with the European Central Bank (ECB) continuing to support bond markets (Mario Draghi still doing “whatever it takes”) - one area of top down control that remains intact. Against this uncertainty, there has been more interest in a resumption of the so called Trump trade which dominated asset markets at the beginning of the year. The deal between President Trump and leading democrats to see off an impeding budget crisis at the beginning of September appears to be the proximate cause of the switch in sentiment back towards the stronger dollar, higher rates and higher bond yields set up that was dominant at the beginning of the year but failed to sustain. We now have the prospect of tax cuts thrown back into the mix and the sentiment appears to be back for a reflation trade. At this point I am not sure if this is in fact rather more of a simple mean reversion trade; having been long and wrong in Q1, the consensus flipped and ended up equally short and not wishing to be caught by the end of Q3. As discussed last week, we know that net positioning on the dollar, oil etc. had got very short, so right now would be wary of drawing too much of an economic conclusion at this point.

Indeed, one of the enduring concepts underlining Market Thinking is that of market mechanics, the idea that movements in markets tend to reflect their underlying structures and the risks being hedged or absorbed by their participants rather than any predictions about the economic environment. The return to the Trump trade feels like one of these at the moment. If we look at the back off in bond yields over the last month, do we really think that inflation and growth expectations have suddenly changed? While in theory bond yields reflect expectations of inflation, in practice short term (and even medium term) moves will tend to reflect the needs of the marginal buyer and seller which are very often little or nothing to do with the economics and much more to do with market positioning and hedging. This is particularly important when moving across asset classes, as to claim (for example) that  a rise in bond yields means that the bond market is forecasting a rise in inflation and thus we must buy cyclical stocks or commodities – or indeed vice versa – can lead to doubling up on a ‘bet’ with little real world evidence. The focus on indicators such as the volatility index (VIX) as a measure of confidence or the US dollar index (DXY) (which nobody actually trades) as a value for the dollar are also examples of finding charts on a screen and imputing a real world dynamic when one may not exist. Currencies are a particular issue. Is the dollar now stronger or the euro weaker?  Or is it just a retreat to the support at 1.175? Meanwhile, for those that like their currency Fibonacci charts, sterling looks quite interesting.

Chart 1: Sterling sitting on a Fibonacci retracement

Source: Bloomberg, October 2017

The notion of market mechanics has become particularly true in a world of QE, where central bank  action in bond and credit markets is producing all sorts of counter-intuitive signals, many of which the markets have learned to discount, ignore or simply treat with caution. The expectations of a fiscal boost in the US are consistent with an expectation of a steady unwinding of QE. This is likely to be the key priority for the new team set to take over at the Federal Reserve (Fed) early next year, with the bookmakers favourite to Chair the Fed, Kevin Warsh, a known critic of unconventional monetary policy. Shrinking the Fed’s balance sheet without seriously disrupting the economy is going to be their key task, but markets must also learn to adjust their models and reset their indicators to a world without Fed buyers in the fixed income markets. This will be a key factor to consider in 2018.

A classic example of this involves the moves under QE by the Fed into buying mortgage backed securities (MBS), which are now set to unwind, starting as early as this month. The situation is neatly described here in the excellent FT Alphaville blog.. In brief, and for those who can’t see behind the paywall, the point that they are making is that because the Fed is planning to shrink its holdings of MBS starting from this month, we may well see some significant market effects, in particular a rise in volatility. Initially the Fed will simply refrain from reinvesting some of the principal payments of maturing bonds into new debt, but unlike a position of refraining from re-investing into Treasuries, the characteristics of the MBS market are likely to produce different effects. The key point here is the concept of early repayment on long term fixed rate mortgages. This market and the MBS that backed them were, in my opinion,  a central characteristic of the US consumer during the 1990s and into the 2000s and the reason why they failed to collapse despite multiple predictions from the great and the good of the economics profession that they would do so. As I argued on many occasions at the time, too many econometric models of the US consumer had an assumption about interest rate sensitivity that failed to take account of the structural change in the way US mortgages were financed and thus rising short rates were assumed to cut consumption, when in fact they had little or no impact as rates were fixed. On the other hand, falling rates did indeed increase consumption as those fixed rate mortgages were simply repaid and new, lower cost ones taken out. This asymmetry of interest rate sensitivity not only had implications for consumers, but also for the buyers of the mortgage backed securities that underpin those mortgages because the bonds are effectively callable. This means that if interest rates fall, the value of the bonds can go down rather than up which is the opposite of the traditional bond model, as the bonds are more likely to be redeemed early. Specifically (and this is where the market mechanics kick in) it means that MBS have what is known as negative convexity, meaning that their duration (the standard measure of the change in the price of the bond for a given change in interest rates) lengthens when rates rise and shortens when they fall, which again is the opposite of traditional bonds. Now this may not be an issue per se, but it is important to recognise what traditional buyers of MBS tend to do to manage this negative convexity, which is usually to target a constant duration on their portfolios to manage their risk. This means that as interest rates fall (and their MBS duration falls) then they will hedge by buying duration, essentially appearing to bet that swap rates will fall further and vice versa. Thus they appear to be adding to swings. As Alphaville put it, “in few other markets does one hedge by buying on the way up and selling on the way down”.

This is all an excellent example of market mechanics, MBS investors selling duration to hedge their portfolios are not making any statement about higher US growth or inflation, but they are adding to the overall volatility of the US long bond. Now for the important bit; the Fed, who have been buying up a lot of the MBS recently, do not hedge their duration risk and as a result, the element of duration risk premium hedging traditionally reflected in both the level and volatility of US long rates has dropped notably because of the behaviour of the marginal buyer (the Fed). FT Alphaville estimate that the Fed own around a quarter of the market and in 2009, 2013 and 2014 bought about half of all new issuance and as they put it, “whether or not there has been a Greenspan put in the stock market, there has been a Bernanke straddle in rates”. The bottom line is that as the Fed refrain from buying new MBS, the interest rate risk and volatility that they have been absorbing will be returned to the private sector, as instead of effectively giving away free interest rate options, the Fed will be buying them back.

So to conclude, in Asia the politics is all on hold for a few weeks, with normal service likely to resume in November with President Trump’s visit restarting the Chimerica dialogue. As previously discussed, this is a world in which the G2 decide what is to their mutual advantage and the rest of the world has to fit in as best they can. Chinese medium term policy remains focussed on China 2.0 – the shift to a highly digital consumer – a strong commitment to anti-pollution measures and clean energy, ongoing development of the financial sector and of course One Belt One Road. Thematic investors looking to get exposure to China and Asia are taking their cues from these secular trends and buying thematic funds and exchange traded funds (ETFs) rather than country or sector indices. Meanwhile, as the high level country election cycle in Europe winds down, regional tensions are flaring, most notably in Catalonia, but also factions within countries like Italy and even Germany and investors are relying on top down intervention from the ECB to hold things together with an expectation that the ECB is still willing to do ‘whatever it takes’.

While the ECB is expected to maintain a tight grip, the Fed is widely expected to exit QE over the coming months and while their focus will be on limiting the damage done to the economy, market participants need to be aware of a new set of distortions in markets arising from the Fed stepping back from intervening in markets – especially in areas like MBS. Having adjusted models and signals to a world where the Fed was the marginal buyer, we will need to go back to some of the old indicators. Specifically bond yields and their volatility look set to rise as the Fed allows risk back into the markets.

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