The curious case of the vanishing bid, part 2

We left Holmes on Friday contemplating the curious case of the vanishing bid for risky assets. We pick up the story the following morning....

The next day dawned gray and cold, but at least the storm had passed. I was surprised to see Sherlock Holmes, normally a late riser, at the breakfast table before me. He was clad in an outlandish uniform that resembled nothing so much as the outfit worn by a professional golfer, except for the blazer worn over the shirt and V-necked sweater.

“Good lord, Holmes!” I exclaimed. “I didn’t expect to see you up at this time of day, and still less dressed like Charles Danforth Ogden!”

“Now, now, Watson,” replied Holmes, “how am I to find out what is ailing Ogden’s hedge fund if I don’t look the part myself? I’m off to a series of bank-sponsored investor roundtables. Perhaps I’ll discover what’s happened to the bid there. Here,” he added, passing a card to me over the table, “brother Mycroft knocked these up for me last night after you went to bed. What do you think?”

The business card, which featured the small likeness of a deerstalker in the upper left-hand corner, read:
“Moriarty Capital Management?” I inquired, raising an eyebrow at Holmes.

“Ah, now, Watson, just a little jest at the expense of an old adversary. Right, I must be off now. It wouldn’t do to be late for my first meeting.” And with that he strapped an unfeasibly large watch onto his wrist and strode out the door purposefully.

I was busy with my medical practice all day and didn’t see Holmes again until it was nearly time for dinner. At a quarter past seven he strode in the door with a weary mien. At my inquiring look he raised a solitary finger, murmured “All in good time,” and disappeared into a back room.

For the next few hours a fug of tobacco smoke and the sound of Saint-Saens on the violin were all that escaped from Holmes’ room. At last, Holmes emerged, a satisfied half-smile upon his face. When I attempted to question him on the case, he demurred with a wave of his hand. “Tomorrow, Watson, tomorrow. It’s been a rather long day and I haven’t the energy to discuss the particulars this evening. However, with a good night’s sleep and one of Mrs. Hudson’s breakfasts in my belly, I’ll feel ready to share the fruits of my enquiries with you and friend Ogden.

The next morning, Holmes awoke at his usual hour and clad himself in more fitting attire. However, he was no more forthcoming on the subject of Ogden’s case than he’d been the previous evening, squirreling himself away for most of the day to work on his latest monograph, which identified the seventy-six separate circumstances in which one might successfully challenge a citation from a City of Westminster parking warden.

As dinnertime approached, the front bell once again announced the presence of a visitor. At this, Holmes sprang from his room with surprising alacrity. “And now, Watson,” he cried, “your patience shall be rewarded!” When Charles Danforth Ogden entered the room, my friend gestured eagerly towards a chair. “Sit, sit, Mr. Ogden! I must thank you, sir, for a presenting me with a most stimulating case!”

“So have you cracked it then?” asked Ogden, a hopeful look upon his face. “Have you found the vanished bid? When will it return?”

“Not so fast, my friend. Allow me to explain my methods before sharing my conclusions.”

“Very well.”

“It was clear to me from the outset, Mr. Ogden, that the research piece upon which you had pinned your hopes was merely a red herring. That it worked for as long as a month is, quite frankly, a surprise."

“But...”

“While I am not a professional investor, this nevertheless allows me a welcome degree of detachment when observing the behaviours of yourself and people like you. Any clear-thinking person of reasonable intelligence could see that ‘buy stocks no matter what’ is a recipe for disaster, the triumph of hope over reason.”

“But...”

“Allow me to finish, I beg you. Yes, it’s true that, broadly speaking, the world remains awash with liquidity, and that all else being equal this should underpin risky assets. However, it seems quite clear that all else is not equal at the moment. Developed economies are slowing while food and energy prices are rising all over the world. The implication is that conditions which may have produced a stellar rally in risky assets six months ago will not necessarily do so now.

“I sat in on a number of investor roundtables today, including one, Mr. Ogden, that you were at, hosted by BigI-Bank.”

“What?” gasped Ogden. “But..but...I didn’t see you there!”

“Ah, Mr. Ogden, you were not meant to. I was travelling incognito, as it were. But shall I tell you what I discovered at my roundtables?”

“By all means, Mr. Holmes.”

“Very well. At a credit roundtable this morning, I found a very grave concern that the securitization process, as it has been conducted over the past few years, is very significantly impaired- perhaps permanently. The implication, Mr. Ogden, is that the supply of credit is likely to be more restricted in the future than it has been in the past. And what this means, sir, is that the credit cycle has decisively turned for the decade, and that spreads should trend wider moving forwards.

“Here,” he said, handing a piece of paper to Charles Danforth Ogden. “You see here a simplistic representation of what I refer to. Ten year swap spreads in the US have begun to widen...but history suggests that we are fairly early in the process, both in terms of magnitude and time.”

“But does this mean that the US economy is moving to recession?” asked Ogden.

“Eventually....yes,” replied Holmes. “And Inspector Lestrade of the Yard would probably tell you that we’re already there. But look closely, Mr. Ogden. The last two recessions didn’t begin until after swap spreads had already peaked- it takes time for tighter credit to arrest the economy’s growth. So I’d suggest to you, sir, that recession is more likely for 2009 or 2010 than it is for 2008.

“I then went to a government bond roundtable, which generated a rather interesting discussion about equilibrium rates, inflation, and what is priced into markets. Particular attention was paid to what a 2.5% trend rate of growth in the US might mean. Some participants argued that this downward revision to trend growth has lowered equilibrium nominal interest rates; however, I found much more persuasive the argument that it has actually raised equilibrium real interest rates, given the lower threshold for a growth/inflation trade-off.

“The question was then raised as to why the bond market is ignoring inflation. In my guise as a hedge fund manager, I suggested that the market is not ignoring inflation, but balancing inflation concerns with both recession worries and, in the context of the disappearing equity bid, capital preservation considerations. Unlike prior bond market rallies this year, TIPS are actually outperforming nominal Treasuries; 10 year breakevens are about 10 bps wider since the recent peak in nominal yields. Moreover, the curve has steepened sharply in this move; a wider term premium is exactly what you’d expect from a market concerned about inflation.”

“But Mr. Holmes,” said Ogden, staring intently at the second chart that Holmes had given him, “it looks to me that the last two times the curve has started to meaningfully steepen, the economy was pretty much already in recession.”

“Well spotted, Mr. Ogden, bravo! That’s one reason why I suggest that a recession is more likely for 2009-10 than next year; nothing is certain in this particular line of enquiry and I could of course be mistaken. But I suggest to you, sir, that the inflationary dynamic across the globe is considerably different now than it was in 1990 or 2000, which is why the curve is steepening earlier in the cycle: not only because of growth, but because of a secular change in the direction of inflation pressure.

“Next I went to a currency roundtable. There were a few interesting things to emerge there. The first was a general feeling that, from a medium term perspective, investors are not adequately compensated to finance the US current account deficit, shrinking though it may be; therefore, the dollar is falling. That, at least, must be known to you already. What was curious, though, was the sense that currency markets may be reaching in important inflection point. The carry trade, for example, which I believe you mentioned is in your portfolio, Mr. Ogden...?

“Yes, it is, Mr. Holmes.”

“Yes, well, the carry trade can be expected to work very well indeed during ‘Goldilocks’ periods, wherein growth is reasonably strong and inflation reasonably low. However, both points on the Goldilocks axis are moving in the wrong direction: growth is slowing and inflation is rising. This naturally begets volatility, which makes the carry trade inherently less attractive. If one takes a yen trade-weighted index as a sort of inverse measure of currency market risk appetite, one can see that after falling in more or less a straight line for the past several years, the yen has started to rise recently. As pure carry considerations become de-emphasized, perhaps markets may choose to focus on antiquated metrics such as ‘value’ and the like.

“And of course, sir, the very liquidity which has supported risky assets can ultimately sow the seeds of its own destruction. Consider that a major supplier of liquidity to global markets has been the currency policies of FX reserve accumulators. But look about you now, sir. China has its highest inflation rate since 1996. Taiwan has its highest since 1994. Singapore has its highest since 1991! And of course, the Persian Gulf countries are all experiencing uncomfortably high levels of inflation. All of these countries need tighter policy, which suggests, Mr. Ogden, that global liquidity conditions are likely to be less accommodative in the future than in the past. This should naturally beget a more selective attitude towards risky assets and increase volatility.

“And finally, sir, this afternoon I came from an equity roundtable, where I sat next to you in my guise as a portfolio manager at Moriarty Capital Management.”

Charles Danforth Ogden’s jaw dropped and he gazed at Holmes in amazement. “That was you?”

“It was indeed, sir. In my line of work the ability to appear as what you are not proves useful on occasion. And as you no doubt recall, we discussed a range of topics. Earnings expectations for next year are being marked down; however, the increased uncertainty over those forecasts has meant that, for the time being, index multiples have not expanded at the same time. More fundamentally, a greater degree of macroeconomic volatility may well beget lower multiples on a trend basis in the future than we’ve observed in the past.

“Of course, while credit market disruptions remain significant, the near-term prospect for buybacks has also waned, taking a large, relatively price-insensitive buyer out of the equation as well. The combination of weakening fundamentals, less visibility, and greater macroeconomic volatility are all a recipe for higher equity volatility...which as you know is what we have seen recently.”
“Oh no!” cried Ogden. “From what you say, Mr. Holmes, it sounds like the bid has gone forever! But still....you haven’t told me who is responsible for this catastrophe?”

“Now, now Mr. Ogden,” Holmes replied, a gentle smile on his face, “it’s not quite so bad as that. I don’t think it’s fair to say that ‘the bid has vanished forever’ or draw the conclusion that it is impossible to make money in risk assets. However,” he continued, leaning forward and looking earnestly at Ogden, “it may be the case that for this market cycle, the price-insensitive bid has indeed gone missing. What it means, Mr. Ogden, is that you will have to be more selective in your investments: do your homework, so to speak, be aware of what it is you are buying, who has bought with you, and how large the exit door might be should you all wish to sell at once.”

“But Mr. Holmes...you still haven’t told me who or what is causing all of this!”

“Ah, Mr. Ogden, you’ve still not figured out what’s happened? I’m sorry to tell you, sir, that there is no Moriarty at work, no individual or cabal whose apprehension can restore things to their 2003-2006 norms. Lestrade might tell you it’s the US housing market...but he’d be mistaken. How about you, Watson?” Holmes turned to me for the first time since he began his explanation. “Have you deduced the identity of the culprit?”

“It’s tempting to blame Voldemort or another distorter of market prices, Holmes...” I could detect the slightest trace of a grimace on my friend’s features. “...but somehow I think not. It looks to me like it’s the ineluctable return of...of...a financial market risk premium. The bid is still there, but for the time being it’s buying options, not assets.”

“BRAVO, WATSON!” cried Holmes, leaping to his feet and slapping me heartily on the back. “Spot on! We’ll make a detective of you yet!” This was perhaps the warmest compliment that my friend had ever paid me, and I confess to feeling a bit choked up at finally having fulfilled his expectations for me.

“The answer, Mr. Ogden, is simply that the free lunch is no longer free...at least for this market cycle. Buying the dip across risk assets mechanistically is likely to prove unsuccessful, sir, because undoubtedly some of them are dipping for a reason. Consider that wider credit spreads, steeper yield curves, a lower dollar, higher yen, and higher implied volatility are all symptomatic of rising risk premia. It would seem reasonable, sir, for each of these trends to continue, in one way or another, throughout the next year or so.

“I would suggest to you that the high, almost mindless correlations between risk assets will ultimately break down. We are moving into an environment where the cream will rise to the top, an environment where relative value trades may offer a higher risk adjusted-return than simple directional strategies, an environment where option volatility, rather than risk assets, is the ‘mindless’ buy on dips. In other words, Mr. Ogden, you’ll be required to buy that which is good and sell or avoid that which is bad, rather than merely buying everything.”

“But Mr. Holmes!” cried Charles Danforth Ogden, a tear in his eye, “we’re not a relative value shop! We are equipped to make money in a low-vol world, not a high-volatility world!”

“Then, Mr. Ogden,” replied Holmes as kindly as he could, “I suggest that you shutter your doors and pursue another line of work. I’d be happy to write you a reference to any of the banks I visited today. Perhaps once they’ve finally written off all of their subprime exposure, they’ll be in the market for a sales guy or an analyst. I can easily put your name forward.

“In the meantime, should you need of a bit of cash, I’m sure you and Watson here could come to some arrangement on that Ferrari F430 that I saw you drive up in.”

Charles Danforth Ogden shook his head mutely, and slouched out of our Baker Street rooms. We heard a few months later that his fund had closed, unable to meet a wave of redemptions at the end of the calendar year.

“Well, Watson,” said Holmes after the door had closed behind Ogden, “we can only hope that our pensions are being managed by people more astute than friend Ogden. And now,” he added, reaching for pipe and violin, “how about some Mendelssohn?”
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17 comments

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t
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November 26, 2007 at 11:47 AM ×

Bravo, Mr Macro. Bravo.

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CDN Trader
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November 26, 2007 at 12:44 PM ×

Whilst I agree that nominal interest rates are unlikely to remain at their current low rates for an extended period, I do not understand why slower real GDP growth would cause the equilibrium real interest rate to rise. Surely slower GDP growth should translate into less investment and therefore lower demand for capital.

Also, I recommend you read this: http://hussmanfunds.com/wmc/wmc071126.htm Only time will tell if he is correct, but it is certaintly intelligent thinking.

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Macro Man
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November 26, 2007 at 12:58 PM ×

CDN, lower potential growth implies lower productivity growth...which itself should encourage investment to improve productivity. The main point, however, is that given that a lower real rate of growth is required to generate inflation, the Fed should, all else being equal, maintain a higher real interest rate to prevent that from happening.

And I am not sure that Hussman and I are that far apart. The point I am trying to draw out is that we now look to be late in the (7-10 year long) financial market cycle; it appears to me that this stage typically lasts a couple of years, rather than a couple of quarters, before the onset of recession- hence the belief in muddle through next year before '09 or '10 sees the recession.

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Anonymous
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November 26, 2007 at 2:23 PM ×

Excellent stuff MM! I think any SH fan should appreciate it.

On a different topic. What do you think of EM real estate given whats happening to US housing? I cant help it but think that it's very bubly in many places despite conventional buble metrics not necessarily being achieved.

Cheers,

Bitr

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Macro Man
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November 26, 2007 at 2:29 PM ×

I'm not sure that "EM real estate" is an asset class, per se. There are markets that are driven higher by foreign investor demand (Cape Town beachfront in your neck o the woods), which may well suffer a bit if global risk asset markets turn decisively south.

Then there are markets driven by more local phenomena- Shangahi, Hong Kong to a slightly less extent- that will probably remain driven by thos factors.

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Maedhros
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November 26, 2007 at 2:29 PM ×

First of all, my compliments for your blog.
Not always agreeing with your thesis, but always reading it with a great pleasure.

"....but because of a secular change in the direction of inflation pressure."

I'm missing here the meaning. Could you please explain what secular changes in that direction we are in the midst of?

About the bond yields not showing up for inflation, and considering that inflation is the increase in the monetary base rather than the crap coming out from governmental statistic, I have a theory of mine:

"in a global and mature fiat-money regime, inflation results always in shrinking yields for the sovereign bond of the senior currencies!"


Another question I have is about the steepening curve.
Can I dare to conclude that the most dramatic ones seems to happen during the final phase of the assets bubbles, and that could be the case even now if history at least rhyme?
(we are in the initial phase of the increase)

And finally, speaking a bit of seasonality, and in consideration that the dollar's fall looks like a little overdone, could you see a 2008 resembling 2005 for the green boy.

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Macro Man
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November 26, 2007 at 2:37 PM ×

Good questions, Maedhros. The 'secular change' that I refer to is the theory that after 25 years of declining inflation, we are moving towards an era of increasing inflationary pressure as demand for finite resources increases dramatically.

That's pretty much my view on the curve...it's the beginning of the end...but that process can play out over a couple of years, which is what I expect.

On the buck, the big difference between now and 2005 is that the Fed actively wanted tighter policy and the market didn't expect it. While the Fed may want tighter policy than the market currently expects, it is less certain to me at least what the endgame is for FF, whereas in 2005 I was pretty sure they'd end the year at 4.25%.

So while I think there is every chance of a January rally for the dollar, at this point I think it's premature to say it will be a year-long phenomenon- that would probably require Europe to tank very, very hard.

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Bob Johnson - California
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November 26, 2007 at 4:27 PM ×

Wonderful - as an ACD fan I fully expect a follow-up paper proving the existence of fairies acting in the financial markets.

Thanks again for a wonderfully concise review of what is happening.

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david pearson
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November 26, 2007 at 6:00 PM ×

Brilliant post. Thanks.

I wonder if Holmes didn't leave a loose end -- an unexplained piece of the puzzle. What explains the low nominal long term interest rates? I wonder if flight to quality is a robust explanation. I'm not a bondo, but really, do people buy long term Treasuries when they are afraid? I would have thought short term rates. And if fear is driving the long end, then why the steepening?

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Macro Man
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November 26, 2007 at 6:13 PM ×

Great question, David. Three possible (admittedly ex-post) explanations:

1) Shoulder-tap short covering (!) Some surveys suggest that real money bond managers have been underweight US duration; perhaps this is "can't afford not to" coverin g of those shorts?

2) Unwinding of long credit positions; as the bonds are sold, the Treasury hedges get bought back, and spreads widen. All this seems to be happenign to one degree or another

3) Short gamma/mortgage convexity hedging. I find it difficult to credit that the convexity guys can be REALLY active, as the impact of lower rates should be offset by the deterioration in housing generally, so the duration mismatch should be limited. Nevertheless, I did hear some suggestions a few weeks ago that this might be a factor; anyone very close to that market, feel free to chime in...

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Anonymous
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November 26, 2007 at 6:26 PM ×

All very amusing.

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david pearson
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November 26, 2007 at 7:19 PM ×

Macro Man,

I can only say that if indeed the explanation is #2, unwinding of long credit, then short T-bonds must be one of those great selective bets that Sherlock Holmes spoke of. The hedge unwinds are potentially masking reserve country selling, so that when the unwind is done we should expect long rates to back up quickly. Of course, it may be awhile before the hedge unwind is done, and there's the rub. Still, where else can you buy vol so cheap?

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Macro Man
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November 26, 2007 at 7:27 PM ×

10 year EUR/USD vol offered at less than 7% looks like a tremendous re-coupling bet if structured along the lines of the "powerball" strip of one touches like I have in the alpha portfolio.

If I am right that a) financial market volatility is a buy on a trend basis, and b) next year might see the return of 'value' (not in growth vs. value, but as in not buying overvalued stuff) as an investment paradigm, then it looks to me like it's the cheapest thing going.

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OldVet
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November 26, 2007 at 11:50 PM ×

Coincident to unwinding credit theme, look at margin interest balances at NYSE. Peaked and heading, apparently, down. Look at 1990 to present. (I saw at Contrary Investor site.)

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Anonymous
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November 27, 2007 at 6:42 AM ×

Thanks MM, point taken. I give you another example, two cities an hour of a drive apart - Vienna and Bratislava. I have a hard time comprehending that the real-estate prices in the latter are in many cases ahead of the earlier already and keep charging up. Prague which is further few hours away as well, and i suspect similar case for the other regional capitals. Stories of UK and Irish investors snaping up whatever comes to the market are the order of the day. Where/when is it all gonna end?

Cheers,

Bitr

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Maedhros
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November 27, 2007 at 8:55 AM ×

That's pretty much my view on the curve...it's the beginning of the end...but that process can play out over a couple of years, which is what I expect.
------------------------------

But if this is the case, Macro, in the past the process playing out has seen also the blow off phase of the assets bubble.
And this seems a little odd with Mr. Holmes findings about the equity part of his investigation.

Not much regarding the volatility surge, which was pretty much present, but in respect of the avoiding of the overvalued/momentum issues.

Two words about the bond yields, apart from the contingent trading attitude of market operators:
as I think, the sovereign bond of the senior currencies are the only markets able to host the ocean of liquidity that a mature and global fiat-money system produces, in good and in bad times.
Maybe even more in bad times, as the lenders of last resort has then to monetize much more.

In bad times, it's not liquidity disappearing, but its unwillingness to chase all but the safest of the assets.
And only that market fit its requiring, as for quantitative aspect as for the surety to get back capital (and interest) whenever the needs (in a mature fiat-money regime the doubts about the repayment capacity are reserved only to the perifery of the system).

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XRay
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November 28, 2007 at 10:24 AM ×

Beautifully written, Sir!

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