Friday, November 23, 2007

The curious case of the vanishing bid

A late November tempest howled outside in the London night, and the gale rattled the room’s ancient windows, disturbing what had heretofore been a pleasant evening’s reading. Still, the chamber was warm and snug, and a comforting safe haven against the late autumn storm.

“You’re right, Watson,” said the voice of Mr. Sherlock Holmes, disturbing me from my reverie, “it’s a good thing we took out that price guarantee from British Energy.”

“My word, Holmes!” I exclaimed, leaping from my chair. “How the deuce did you know I was contemplating that very thing?”

“Tut, tut, Watson,” came the gently mocking reply from my friend. “Nothing could be easier. I observe that you’ve been perusing the markets section of the Financial Times, doubtless to check on the progress of that South African issue you purchased a few months back. I can see from here that you had turned to the commodity section, where you’ve no doubt read that energy prices are, yet again, threatening to breach all time highs.

“The requirement for adequate heating is painfully obvious on an evening such as this,” he added, glancing ruefully out the window, “as the ferocity of the storm outside cannot elude even your powers of observation. Indeed, I saw you stare outside this very window not five minutes ago, and the disgusted shake of your head told me that you were not pleased with what you saw. When you then glanced at the thermostat immediately thereafter, I surmised that you must be ruminating on the likely rise in heating bills over the next few months, and the serendipity of our having chosen to lock in what I’m sure you’ll agree is a competitive rate. I merely agreed with your rather excellent deduction.”

“Extraordinary, Holmes! When you describe it like that, it all seems so simple. And yet no one but you manages to see what, when you explain it afterwards, would appear to be the most obvious thing in the world.”

“Most of my observations are obvious, Watson, for those who are prepared to see rather than merely look. Unfortunately, many of my colleagues, such as the well-meaning but hopelessly bumbling Lestrade, are only prepared to look for those facts which appear to support their prior beliefs. I, on the other hand, keep an open mind and thus am able to see what others often miss."

It was a measure of the esteem in which I held my friend Sherlock Holmes that I didn’t raise an eyebrow at his description of the Chief Inspector of Scotland Yard as “hopelessly bumbling.”

“And what I see this evening,” he continued, “is a night best-suited to a comfortable chair, a good book, a pipe full of tobacco, and perhaps a passage or two of Mendelssohn upon the violin.”

As if to prove that even the ablest of sleuths can miss his mark on occasion, the bell at the door of 221B Baker Street rang vigorously just as Holmes reached for his violin, announcing the presence of a visitor who no doubt required the services of my illustrious friend.

“Ah, Watson,” remarked Holmes, shaking his head with a wry grin, “I was mistaken. For unless my powers of observation have departed me altogether, we shall have a more stimulating pursuit this evening, courtesy of this gentleman here, Mr....?”

Our visitor strode into the room through the door opened by Mrs. Hudson, but was taken aback to see us both looking at him expectantly. After gathering himself for a moment, he then resumed his forward progress and seized Holmes by the hand. “Charles Danforth Ogden, Mr. Holmes, Charles Danforth Ogden. It’s a pleasure to meet you, sir, but you must help me!”

Mr. Charles Danforth Ogden was a youngish man in his mid-thirties, dressed in crisply pressed chinos, a dark blue jumper over a collared white shirt, and dark blue raincoat, from which he shook the water unconsciously as he stood before us. Although his visage retained a certain boyish aspect, he nevertheless carried himself in the manner of a man who is accustomed to having his orders carried out by others.

“Well, Mr. Ogden, what can I do for you? Is there a problem with your fund that you wish me to help you with?”

“Yes, Mr. Holmes, yes, it’s all gone horribly wrong and I can’t figure out why!” our guest exclaimed, before gaping at Holmes. “But...but...how did you know I was a hedge fund manager?”

“Please, Mr. Ogden, you insult me. If I couldn’t spot a hedge fund manager (what with your business casual attire, Rolex, and expensive jacket) from a mile away, I wouldn’t be much of a detective, would I?”

“Ah ah, Mr. Holmes, I see you’re right. Very clever!” Charles Danforth Ogden then straightened up and assumed an air of authority. “Yes, well, I am the founding principal and Chief Investment Officer of the C/D/O Enhanced Multi-Strategy Fund, a diversified hedge fund that seeks to generate stable returns for our investors with moderate volatility and low drawdowns.”

“Yes, yes,” said Holmes, “I’m not a fund-of-funds manager so you can spare us the marketing spiel. Please proceed to describing your problem; the sooner tell us your story, the sooner we can be of service to you.”

Ogden glanced at me uneasily. “Perhaps it would be best if we got you and your friend to sign a non-disclosure agreement. If investors found out....”

“Now really, sir,” burst out Holmes, angrily. “Dr. Watson is my friend and colleague, and you can trust him as you trust me. And if you do not trust me to keep my lip buttoned, then I’ll wish you goodnight and ask you to leave, for I had rather planned to treat Watson to a spot of Mendelssohn.”

Ogden’s shoulders slumped at this rebuke. “I’m sorry, Mr. Holmes,” he said. “I’m just so worried about my fund that I’m not sleeping or thinking straight.” His body crashed into the chair that Holmes gestured him towards. “Here’s the story.

“Our fund has been running for a year and a half. For the first year or so things went swimmingly, with steady monthly returns and a nice growth in assets. Early in the summer, though, we ran into a bit of a bother, as some of our holdings appeared to decline in value; however, they don’t really trade so it was difficult to know exactly what sort of hit we were taking.

“In August things got quite bad, really, with credit imploding and funding rates blowing out. Some of the fund-of-funds investors that we picked up in May and June told us that if we didn’t make money in September, they’d pull their assets.

“Naturally, this was a stressful time for us, and we felt a bit adrift. However, one of my trusted brokers sent us a research piece that seemed to show the way to recouping our losses. Here, here it is.” Ogden’s hand dipped into his jacket pocket and emerged clutching a rumpled sheet of paper, which he handed to Holmes.

Looking over my friend’s shoulder, I read the following pearl of financial market wisdom:

To: charles@cdofunds.com

From: johnny.wideboy@bigi-bank.com

Date: August 31, 2007

Subject: How to make money in equities

Cheat sheet: reacting to data and market releases

1) weak data = Fed ease, stocks rally

2) consensus data = lower volatility, stocks rally

3) strong data = economy strengthening, stocks rally

4) bank loses $4bln = bad news out of the way, stocks rally

5) oil spikes = great for energy companies, stocks rally

6) oil drops = great for the consumer, stocks rally

7) dollar plunges = great for multinationals, stocks rally

8) dollar spikes = lowers inflation, stocks rally

9) inflation spikes = will inflate all assets, stocks rally

10) inflation drops = improves earnings quality, stocks rally

“We were a bit desperate for returns, and this research seemed more insightful than the usual rubbish coming out of investment banks. So in early September we went limit long the S&P, AUD/JPY, EEM, and the Hang Seng. By mid September it was working so well that we figured credit was going to tighten back in hard, so we bought some of the A-rated tranche of the latest ABX index. When the Fed cut 50 basis points on September 18, it was like we’d won the lottery. Stocks moved so far, so fast that by the end of the month we’d made a new high water mark for the fund and were mentally spending our performance fees.

“Sure, the credit trade wasn’t working so well, but we were making so much money in equities that it didn’t matter. We had Fed liquidity supporting the S&P and the carry trade, and de-coupling plus Chinese investment buoying EEM and the Hang Seng. It was bid, no-lid, and we were making money hand over fist.

“But by the time mid-October rolled around, things had cooled off. Our ABX position was sinking like a stone, most of our structured credit holdings had actually been downgraded, the yen quit going down, and then even some of our equity longs started to retreat. EEM and the Hang Seng were the only things keeping our P/L afloat.

“I tried getting ahold of Johnny Wideboy, the analyst who’d made us so much money with that research piece. But my contacts at BigI-Bank said that he’d been made redundant following a $12 billion subprime writedown.

“And now every bit of our portfolio is falling in value, even the emerging market equity position! Mr. Holmes, it’s doing my head in! Our fund-of-funds investors are once again ringing up and threatening to pull their assets unless we right the ship quickly. So I ask you, Mr. Holmes, to tell me: what happened to the bid? Why has it vanished, and when will it come back?”
Sherlock Holmes sat back in his chair and stared earnestly at our visitor. “I must tell you, Mr. Ogden, that this is not my area of expertise. Watson here spends more time reading the financial pages than I.” Charles Danforth Ogden looked crestfallen. “Nevertheless, I will look into the matter. I shall ring you at the number on your card when I have reached a satisfactory conclusion.”

Ogden sprang from his chair and shook Holmes warmly by the hand. “Oh thank you sir, thank you very much! I’m at my wits’ end, and if I don’t discover where the bid has gone to, my fund is finished for sure!” And with that, he turned on his heel and strode out the door, leaving Holmes stroking his chin thoughtfully. Sensing that my friend was entering one of those contemplative reveries that so often yielded fruits of progress, I returned to my pipe and my newspaper. Not a word was spoken in our Baker Street rooms for the rest of the evening.

Will Holmes get to the bottom of the mystery?

Why has the bid for risk assets vanished, and when will it come back?

To be continued.....

14 comments:

jdc said...

It's funny, actually - there's been a bit of an upward movement in the Elexon Best View prices moving average, but it's still way below anything we had 18-24 months ago.

I keep waiting for wholesale electricity prices to follow oil. Indeed I keep waiting for gas to follow oil, and it's not happening.

So as a consumer I'm happy, but I'd rather take the hit on my electricity bill to resolve the cognitive dissonance.

Macro Man said...

Yeah, the power price guarantee thing was not technically accurate, but I needed a "Holmes amazes Watson with his powers of deduction" device, and that was the first thing I came up with. Natgas is the real driver of heating bills, and for the time being pries here are relatively well contained.

Robert R said...

Bernanke and his ilk at the Fed and private-sector economists (almost all of whom are former Fed economists) went to great lengths over the past year to claim that the inverted UST yield curve was *not* an indicator of recession.

Despite the fact that the yield curve inverted before each of the six recessions since 1969 -- and that it *never* gave a false signal -- Bernanke, that academic genius, claimed that "this time is different." There was a "savings glut" causing the inverted yield curve and, somehow, this meant that it was not really giving a signal of recession.

So the Fed kept rates on hold even though the UST yield curve (3-month to 10-year) was inverted from August 2006 through May 2007. Previously, a recession would start about 12 months after the first month of inversion, which meant that a recession could start sometime around Q3 or Q4 of 2007.

The Fed knew very well about the ability of the curve to predict recessions, but they chose intentionally to ignore it. No, actually, it was worse than that. They chose to actively argue against the curve.

So, here we are in 2007:Q4. By keeping the curve inverted from Aug 06 - May 07, the Fed kept monetary policy much too restrictive. They did the same thing in 2000 and caused a recession in 2001.

When will the bid return? Well, that depends on how quickly and forcibly the Fed cuts rates. If they cut rates enough to get the curve (3mths-10yrs) upward sloping by, say, 250 bps, then the bid will *start* to re-emerge, but probably not until then. So, I would say that the bid will not return for about one full year. Maybe next Thanksgiving will be a better one for the bulls.

As for the Fed, they once again made a huge error in policy that caused systemic destruction of value in the financial markets and, soon, in the overall economy. The lazy journalists that we have will no doubt miss this story. They will not blame the Fed, but will point the finger at mortgage lenders.

So, Holmes, perhaps you can put that in your pipe when ruminating about your client's request to find the "vanishing bid."

Macro Man said...

If an inverted yield curve is a failsafe predictor of recession, why doesn't it work in any other economy?

Anonymous said...

beucase the regularoty, tax level, currency status worldwide, level of trade, banking system, credit growth level is different

Gooner said...

If the Fed had actually acted by cutting rates, due to the curve inversion, and hence managed to avoid this up and coming recession. What then ??

1: The curve inversion would have failed in giving a recessionary signal. (Though presumably since the Fed cuts may have been expected, the curve would not have been inverted...Go figure!)
2: Borrowers would have continued their borrowing binge.
3: Risky assets valuations and dubious lending practices would have increased even further.
4: Asset valuations would be even more inflated, the bubbles even bigger.
5: The USD would be even weaker.
6: Consequently inflation will probably have been that much greater.

All this ultimately leading to a series of greater rate hikes. - Consequently leading to another and probably deeper curve inversion, and a deeper recession . -- Hmmmmmmm, kind of back to stage 1.

"Cassandra" said...

MM - The market non-sequitir that nags me is why, when, risk assets find their bid, and AFTER bonds have rallied nicely nicely, AND the SPOOZ have taken back nearly 2%, the bond hasn't done a shitter. Have bond traders been so whipped that they;ve stopped even trying to short it? If said: golds flying, stocks are flying, risk assets are flying, what do thing bonds are doing? Most (in my day) would have said "their coming under pressure". Are these markets so disconnected, now that the marginal holders are mostly central banks & SWFs?? Just curious...

James said...

Speaking from the floor of the CBOT. No one has ever seen the bond market ever act like this before. My father was in the five year futures pit the first day it opened. The market has simply lost its its sensitivity to inflation. I think the world is going to have a nasty hyperinflationary scare before the globe has to get real about monetary dillution.

OldVet said...

Low yields on Dollar bonds? If the buying volumes are normal for bonds, and yields continue low, then buyers must indeed be CB's. Who else could afford to ignore inflationary prospects? Is this a quiet coordinated intervention? Somehow I think the FX markets will overwhelm CB interventions, if so.

Anantha said...

the answer perhaps lies in the email that Charles received from this "laid-off" sales guy. Every one had already bought and now, there is no bid. A great post.

Anonymous said...

Very nice and enterntaining story about Sherlock Holmes! Bravo MM! -FR

Cheesehedgie said...

Bravo! Brilliant, macro man, an absolutely wonderful post. I have been chuckling at it for the past 15 minutes.

Who is Moriarity in this tale? Who killed the bid?

And why shouldn't we appoint Brett Favre as Fed Chairman, as he is one gentleman who always seems to get things right?

Macro Man said...

Cheesehedgie...I think we've already had Mr. Favre as Fed chair in Alan Greenspan: old for his position, a real gunslinger who often makes very good plays but sometimes does things that make you go "WTF!?!" It pains me to say it, but perhaps Tom Brady would be a better choice.

In any event, tune in tomorrow for the conclusion to the adventure...

Peter said...

haha.. nice post

reminds me of a story in 2004 or 05, cant remember
the phone was ringing on the sales desk, and one of the older sales guys - half jokingly - yelled at a junior guy: "dont pick it up, they want bids! and we dont do bids now"

anyway... it will take a while for the bid to return.
and i think the bid for some of the EM currencies is starting to vanish as well... look at RON. seems like Current Accounts are beginning to matter. the first step towards a more rational environment for markets. Goldman had a brief piece on this as well last week, titled Current Accounts matter again or something like that