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The Healing Power of Quarter-End
Ah, it is so nice to be in this illiquid period right before quarter-end, when interested parties can easily ramp up prices to where they need them to be in order to get good end-of-period marks. One would think this game would diminish somewhat, given the crusades against the LIBOR and possibly FX price-setting conspiracies, but there’s no conspiracy here. There’s no need for investors and dealers to discuss putting the stock market up; everyone knows it happens and everyone knows why. The hedgies who flush microcaps higher because they can ought to be stopped, but there’s no way to stop the general tendency, especially when you have very clear indications of when that trade is supposed to begin…such as when Fed officials show up and start chanting “stocks shouldn’t go down!” in unison.
For the last couple of days, Fed officials have been out in force saying that the “market overreacted.” (Mostly, they mean the bond market, but for many people “the market” equals “stocks” because they think CNBC is about “markets” rather than “stocks”.) Today, New York Fed President Dudley, Fed Governor Powell, and Atlanta Fed President Lockhart pursued the overreaction theory in separate speeches, echoing Minneapolis Fed President Kocherlakota’s sentiment from yesterday. Yes, yes, we all know that everyone else will treat that as a signal to get long again (both stocks and bonds) into quarter-end, but what it really shows is that utter cluelessness of the people in charge at the Fed. Powell said that “Market adjustments since May have been larger than would be justified by any reasonable reassessment of the path of policy.” Well, duh. As I pointed out a while ago – before the real selloff – such a virulent selloff was entirely to be expected at some point due to convexity demands. The most-virulent part of the selloff may have coincided with Bernanke’s statements last week, and that might have triggered some of the convexity selling, but the degree of selloff had nothing to do with the Fed.
Someone should tell these guys that not everything is controlled by the Fed. Sometimes, rates move for other reasons.
To be sure, the Fed is correct about the fact that their communication is helping to cause the volatility. But it isn’t because they haven’t been clear enough, or that what they said was misinterpreted. The problem is too much communication, and making the path of policy (and any inflections in that policy path) crystal clear. When policymakers are opaque about monetary policy, then investors change their opinions stochastically, at random intervals; when policymakers set off a flare for every minor change in the trajectory, all investors change positions simultaneously. Transparency not only doesn’t reduce volatility, it is a prescription for creating volatility.
Clarity on the fiscal and regulatory front, incidentally, is quite different. Volatility in business ventures is high enough already to ensure that entrepreneurs don’t have an incentive to get too far out over their skis no matter how clear the regulatory environment, and decisions made in a business context don’t have the hair-trigger half-life of decisions in financial markets. Uncertainty, when long-term decisions have to be made, impairs that decision-making. But uncertainty is good when decisions are easily reversible and the cause of volatility is that consecutive orders to sell aren’t spread out enough. For stable markets, you want buys and sells to come all jumbled up, rather than all the buys together or all the sells together. For maximum economic growth, you want risk-takers to have the ability to make long-term decisions with confidence.
So while equity markets have rallied as we approach quarter-end, I don’t think this rally will far outlast quarter-end, because there are just too many negatives at the moment for equities – high multiples, rising interest rates, softening global growth, a less-benign regulatory environment etc. The selloff in stocks was never very bad (compared to bonds), because there’s not the same kind of convexity problem in stocks, but it also has a lot further to go than bonds do.
Fixed-income markets have rallied along with stocks, with TIPS leading the way up as they led the way down. The interpretation here is different, because in the case of the bond market we are looking at the well-known phenomenon of convexity selling. My advice for fixed-income investors, from long and painful experience, is this: don’t jump in with both feet yet. These bounces are normal in this kind of flush. It does probably mean we are closer to the end of the flush than to the beginning, but usually you need a period of a couple of weeks of sideways action before you can start to retrace the “convexity selling” damage and get back to something like fair value.
The healing period is necessary because every prospective bond buyer knows (or should know) that there are large trapped sellers out there who are waiting to pitch bonds overboard (at the new, improved levels!) if there is any sign of further market weakness. The rally over the last few days is fast money, doing what they think the news is telling them to do, and they will be back out as quickly as they got in.
We’ll see what happens next week. On the one hand, dealers will have more ability to hold positions (although they’re not supposed to, under the Volcker Rule); on the other hand, quarter end will be past and any inclination to hold off to avoid making a bad situation worse will be past as well. It will still be fairly illiquid, with a half-day on Wednesday, the Independence Day holiday on Thursday, and then Payrolls on Friday. I suspect we will see a resumption of prior trends in fixed-income and equities – although I hasten to add as a reminder that there will eventually be a rally off these rates. I just don’t think we’ve exhausted all of the sellers yet.
What If There Was No Cash?
Bonds, stocks, inflation-linked bonds, commodities, real estate, MLPs, hedge funds, and cash. That is essentially the asset class universe we face as investors. Now, before reading further, think about what you would do with your investments if it were no longer possible to invest in cash, or if some aspect of “cash” made it inadvisable to hold. What would you do with your wealth that is currently sitting in money market funds?
You would clearly invest in riskier assets, since (with the exception of inflation-linked bonds held to your investing horizon) there isn’t a less-risky asset than cash in most cases. You may choose to buy a short-duration bond fund, or you might trickle some extra funds into stocks you feel are undervalued or into commodity indices that I feel are undervalued.
The reason this is a relevant thought-experiment is that the New York Fed, in a little-covered report issued last week, has recommended that investors in money market funds be prohibited from withdrawing 100% of their funds without significant advance notice. The staff of the New York Fed recommended that 5% of an investor’s balance in a money market fund be stuck for thirty days, in order to “protect smaller investors” from the sort of runs on money funds that caused investors in the Primary Reserve Fund to lose the awesome sum of 1% of their money when Lehman obligations went bust in the worst credit crisis in a century. Furthermore, they “suggest a rule that would subordinate a portion of a redeeming shareholders MBR [what the Fed calls the “minimum balance at risk”], so that the redeemer’s MBR absorbs losses before those of non-redeemers.” In other words, if you hear that your money fund is 100% invested in Lehman 2.0 as it teeters on the edge of bankruptcy, you get to choose between taking 95% of your money out now and potentially losing the rest before anyone else loses money, or leaving it all in the fund – in which case you’ll get the second loss, but all of your money is at risk.
Clearly, the New York Fed’s suggestion is a solution in search of a problem given the historical rarity of losses and of the insignificance of those losses, but it is chilling for a couple of reasons. Reason number one is that it pretty much eliminates the main reason for holding a money market fund, which is ready access to cash. People aren’t holding assets earning 0.01%, with 2.2% inflation eating away the real value every year, because they like the return. If you tell investors that they need to have 5% of their principal at risk, and that they may have to choose a gamble between a high-likelihood loss that would be capped at 5% and a lower-likelihood loss that is capped at 100%, the rational investors will simply leave. They may invest in short bond funds, commodity funds, or equity funds where there is much more risk, but at least their money is available with no advance notice. While this development is in a sense bullish for all other assets since it pushes potentially trillions of dollars out the risk spectrum, it isn’t clear to me that our biggest societal problem is that investors aren’t taking enough risk.
Reason number two that I hate this idea is that one destination for money market fund cash will be bank deposits. However, savings deposits are time deposits, and technically can be subject to similar sequestration. Some of the money will go into checking accounts, where it will doubtless burn a hole in many investors’ pockets. The biggest question about the inflation challenge that has been rising over the last year or two is, “how fast will velocity rise, when it rises?” If the Fed effectively forces money into checking accounts, among other things, the velocity of money will surely rise and the pace of the rebound in velocity will become that much more difficult to predict than it already is.
Speaking of velocity, Friday’s GDP figures allow us to make preliminary estimates about what M2 velocity was in Q2. The velocity of the transactional money supply last quarter fell slightly, to 1.5766 (Bloomberg calculation that closely matches my own). The pace of decline is slowing. The quarterly decline was -0.5%.
It doesn’t make a lot of sense to focus too much on quarterly wiggles, but since the big risk here is that velocity abruptly begins to rise (contributing to, rather than blunting, the rise in transactional money in terms of generating inflation) it is worth keeping in the front of our minds. Of course, velocity is a plug number so this doesn’t tell us anything we didn’t already know: we deduce it from the M, the P, and the Q. The trick is in knowing when V is turning and has turned, and as I have said before (see here, for example) there are some reasons for concern on that score.
Going back to the NY Fed study that I discussed above, here is another thought to ponder. Remember that the biggest single objection that the Fed has made against dropping the interest on excess reserves (IOER) charge is that it might damage the money market fund industry by making it impossible to preserve “the buck” if there are no instruments with yields that exceed the cost of operating the fund. And yet, this proposal puts those very same money funds precisely in the crosshairs. Personally, I think it would be just fine to have good-as-cash funds that didn’t guarantee a $1 price and indeed had a negative yield over time, so I don’t think dropping short yields would kill good-as-cash funds even if they weren’t technically money market funds because they traded on price. But changing the contract so that investors can’t get their money back immediately – that’s much worse, in my view; moreover, I don’t know why the reasoning couldn’t be extended to bond funds which are, after all, just as vulnerable to runs. That slippery slope makes me nervous.
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Price action on Thursday and Friday in bonds and stocks was surely frustrating to observers of the macroeconomy. Weak economic data on Thursday and uninspiring data on Friday didn’t prevent 10-year nominal bond yields from rising 15bps (to 1.55%), real 10-year note yields yields from rising 7bps (to -0.61%), and equity prices rising 3.6% (basis the S&P). ECB President Draghi’s apparent determination to support the Euro with every tool at his disposal is mainly to credit for the mid-week about-face. The question that the markets have to consider, and Mr. Draghi as well, is the question of what that toolkit actually contains. There is some evidence that the Bundesbank doesn’t believe Mr. Draghi has quite the authority he thinks he does, and this weekend Draghi and the Bundesbank President are meeting to discuss their differences.
I think that equity markets are overvalued and are over-anticipating QE3 (although I agree that it is coming soon). There isn’t much going for stocks other than QE3, although if the Fed starts taking potshots at low-risk investing alternatives it will help them. I can come up with arguments for extending this rally further, but they all depend on a bunch of faith and a little luck. I am trimming what small equity investments I have, and raising cash allocations. Since the VIX is also quite low considering the kaleidoscope of large risks, I may also buy puts on the S&P.
