Fed Day, Junk Bonds and Unicorns
What time is Fed Day?
The essence of finance is time travel. Saving is about moving resources from the present into the future; financing is about moving resources from the future back into the present. Stock prices reflect cash flows into an infinite future; a long-term interest rate contains within it predictions about a whole series of future short-term interest rates. Markets are constantly predicting future actions, and as those actions move closer in time, the predictions become more solid and precise. More than that, though: Because the markets don't just predict the future, but guide decisions and allocate resources in the present based on those predictions, the prediction is often more important than the outcome, so that some radical philosophers believe that the event itself is no more real than the market that predicts it. In a sense -- in a real, economically meaningful sense -- the Fed has already raised rates, because we have talked about it so much. In a sense, the Fed decision takes place within us, each day. In another, more accurate sense, though, "the Federal Open Market Committee releases its policy statement at 2 p.m. Wednesday," and will likely announce that it is raising short-term interest rates above zero for the first time in seven years. Get excited.
Here is Bloomberg's preview, which suggests that if nothing else the era of easy money has led to a certain inflation in metaphors:
"Liftoff is essentially baked into the cake,” said Gennadiy Goldberg, U.S. strategist at TD Securities in New York. "But if the Fed capitulates on the four hikes, that would be seen as a dovish hike.”
At the Wall Street Journal, Jon Hilsenrath wrote an elegy for the end of an era. Matt O'Brien asks if that era might be coming back pretty soon. Money market funds are stoked. Online lenders are not. And what about your mortgage?
Worries about bond market liquidity are sort of fractal, repeating at different scales. There are micro-worries like how much it will cost to sell a bond, and medium-size worries like how much support dealers can provide to markets or how well equipped mutual funds are to handle redemptions. But it seems to me that the fully zoomed-out worry is: Can bond markets handle reversals? Has something changed in the structure of the market, or in the composition or behavior of investors, so that now if people want to sell bonds, there will be no one to buy them, and a crash will spiral into disaster?
That's sort of an apocalyptic thing to think, but I suppose there was (and is?) a case that the withdrawal of bank market-making, or herding among investors, or the zero-interest-rate environment, or the rise of mutual funds offering daily liquidity to flighty retail investors, would not just increase volatility but fundamentally destroy the resiliency of bond markets.
But high yield did great yesterday! The big index ETFs, HYG and JNK, closed up about 1.6 and 1.2 percent, respectively, after a couple of terrible days. And "some big asset managers are looking at the recent corporate debt market turmoil as a buying opportunity":
Bill Gross, a bond fund manager at Janus, has also been swooping in. High-yield is “just loaded with bargains”, Mr Gross said in an interview with CNBC on Monday. “It’s like the pelicans in Newport Beach. They’re just diving down and picking out those fish.”
I suppose Gross has no redemptions left to worry about, but in any case someone is buying, and life is going on for high yield. Others are more nervous:
“Recent weakness in higher-quality junk names in parallel with mutual fund outflows and illiquidity is also disconcerting, because this may be a preview to investors of how the credit cycle ultimately ends,” says Matthew Mish, a strategist with UBS.
And Wilbur Ross worries about "a wall of maturities starting in 2018, building up through 2021 [and] 2022." But that's fine, a diversity of views is fine. The worry would be if everyone was positioned the same way on the way up, and then repositioned the opposite way on the way down; that doesn't quite seem to be happening.
Meanwhile, the past few days' weakness in junk bonds "isn't the making of another financial crisis," in part because banks are mostly untouched by it. Part of why they're untouched by it is that they're very careful about repo financing, especially at year-end, which might be both exacerbating the recent crash but also making it less systemic. And in other news, "Third Avenue Bled Managers, Billions of Assets Before Fund Shut."
I realize that my efficient-markets-fundamentalist leanings aren't, like, right, as an absolute matter of fact. Surely investing skill exists, and there are patterns to markets, and you can make intelligent decisions about how to allocate your capital. But here is an article about how a lot of hedge funds have had rough years and are raising money anyway, and I submit to you that the most fun way to read it is while imagining that investing is a pure coin-flipping contest:
Mark W. Yusko, chief investment officer of Morgan Creek Capital, said the decision to give new money to a manager who has subpar performance in a given year ultimately comes down to a matter of faith.
“What you have to decide as an investor is, Do you believe that the skill level of the managers has changed?” Mr. Yusko said. “If you don’t, then the portfolio theory of investing says that’s when you should be adding capital.”
If only there were a quantitative way to measure a manager's skill! Oh well.
People are worried about unicorns.
Slack is a company that makes a pretty good instant messaging system, but late capitalism being what it is, Slack is also an extremely self-aware financing operation. Slack goes about its business and people just fling money at it. So it takes the money. Its chief executive officer, Stewart Butterfield, is charmingly open about why he takes money from investors that he doesn't think he needs:
This is the best time to raise money ever. It might be the best time for any kind of business in any industry to raise money for all of history, like since the time of the ancient Egyptians. It’s certainly the best time for late-stage start-ups to raise money from venture capitalists since this dynamic has been around.
So now he has all that money. What to do with it? What else?
Slack Technologies, a Silicon Valley darling that's raised more than $300 million, wants to give some of that money back. The startup, which runs a popular corporate chat service, is forming an $80 million venture fund to invest in other startups.
Stewart Butterfield, chief executive officer of Slack, said his company is contributing more than half of the total fund. The rest will come from some of Slack's own backers. The fund will invest about $100,000 to $250,000 in smaller startups building applications that work with Slack's messaging service, Butterfield said.
On the one hand, if people are flinging money at you, and you have no other uses for the money, you might as well fling it at other companies and see if they can do something with it. (Consider my casual view that this dynamic explains why mature public companies give so much money back to investors, while investors give so much money to innovative unicorns.) On the other hand, if you think that today is the world-historical best time to raise money from venture capitalists, then you sort of implicitly think that today is a world-historical bad time to be a venture capitalist. (I know that's not strictly true -- maybe we just live in a golden age of innovation that will make everyone rich -- but "this is the best time to raise money ever" does imply something about valuations.) It seems like a waste to brazenly top-tick the venture capital market for free money, and then turn around and invest it in venture capital. In any case, a truly disruptive tech business model would be to just raise venture capital and invest it in other startups, without the distraction of actually having a product. Elsewhere, "Silicon Valley Unicorn Obituaries."
People are worried about bond market liquidity.
You can just take that as a given, these days -- see "Junk bonds," supra -- but as a bonus here is a good post on bond-fund liquidity from the pseudonymous Lady FOHF:
One of the interesting factors is that a mutual fund manager chose to suspend redemptions rather than take losses: setting a precedent for longer term restructuring and liquidation rather than taking the short, sharp, pain of price discovery. Suspending an unlevered fund means that the manager is under no pressure to immediately dispose of assets and can, in principle, wait for the market to start functioning normally again. This assumes that the marginal buyers for these assets are not also suspending redemptions and waiting for the same thing.
Judging by yesterday, I would say that so far they aren't, though a rally in junk bonds generally is not quite the same thing as a bid for the particular distressed-ish bonds that Third Avenue's Focused Credit Fund('s liquidating trust) holds.
People are worried about financial stability generally.
The Office of Financial Research released its Financial Stability Report yesterday, finding that "threats to U.S. financial stability remain moderate, in other words, in a medium range, but they edged higher within that range over the past year," which reads like a delightful bit of pseudo-precision. Bond market liquidity is definitely on the list, though in sort of a moderate-to-medium way:
Market liquidity appears to have been fragile in recent years, declining sharply during a number of market shocks even in the largest, most liquid markets. Such sharp declines in liquidity amplify market stress and could, in the event of a sufficiently large shock, threaten broader financial stability. Bond market participants sometimes attribute the deterioration of liquidity to changes in regulation — particularly increased capital requirements for banks — but closer analysis indicates a number of other factors have changed liquidity conditions since the financial crisis. Some factors are structural, such as the increase in automated trading, changes in market-maker risk appetite, and changes in the investor base. Other factors are cyclical, such as lower returns in a period of extraordinarily low interest rates and changes in the supply of collateral. There is wide recognition that many of these factors have shaped market liquidity. Their relative importance is widely debated but not easily measured.
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