Markets Show They Aren't Prepared for the End of Stimulus
Quantitative easing saved us from the 2008 crash and jump-started a recovery. It also encouraged a build-up of one-sided risk in the financial system. Are markets and the economy ready for the exit?
The sudden rise in volatility in February and March showed that even with strong growth fundamentals, financial markets remain vulnerable. Since 2008, there have been seven flash crashes followed by sudden recoveries. Volatility has become binary, with markets swinging between periods of shock and calm. The VIX index traded at a median of 16 after the start of QE and at 18 before, but the spikes in volatility have become twice as frequent. It is the equivalent of swapping a stable drizzle rain with many days of scorching sun, at the price of occasional natural disasters.
As central bankers attempt to normalize policy, there is a risk that carry trades in financial markets will collapse, with a negative spillover to the real economy.
Central banks bought $21 trillion in government debt globally, pushing investors to search for yield in riskier markets. The result is a pyramid of trades dependent on stable interest rates: $12 trillion of government debt yields less than 1 percent and $11 trillion of corporate debt have yields near record lows. About $8 trillion of high-dividend and growth stocks trade at record high valuations, as cash-flows and growth rates are discounted at near-zero rates. At the top of the pyramid are strategies betting on stable volatility and asset correlations, which total up to $2 trillion, according to our estimates.
While carry trades flourished, the architecture of financial markets has become increasingly fragile. In 1976, Hyman Minsky wrote that a crisis can develop when financial structures amplify rather than dampen an initial shock. Today, there are a number of negative feedback loops across strategies that use leverage, buy illiquid assets or own a large percentage of their asset class. A bank-loan exchange-traded fund issues listed shares, but it takes between 30 and 60 days to settle a loan sale in the secondary market.
There is also a systemic impact. ETFs own 3.9 percent of U.S. high-yield bonds, more than the inventory of all broker-dealers put together. Together with quantitative funds, passive strategies represent 60 percent of traded volume in equities, according to JPMorgan research. With tighter banking regulation limiting room for trading desks to absorb risk, markets can be caught in violent crosswinds when such strategies unwind.
In the February sell-off, junk bond ETFs lost around 13 percent of their shares outstanding. Like instantaneous redemptions, these events force the ETFs to sell bonds in the secondary market to redeem shares, accelerating a sell-off. As the Bank for International Settlements warned in a report issued earlier this month, “The unique structures of ETFs might allow, or even encourage, less stable investment behavior by owners of these products.” Short volatility strategies act similarly. By selling volatility and put options in good times, they keep equities and credit spreads within a narrow range. Lower volatility, in turn, encourages more investors to pile into the same strategies. In a sell-off, however, the mechanism works the other way around.
The result is increased fragility: If a flash crash or an unwind of crowded trades can cripple markets during a global expansion, what will happen in a recession?
While the Federal Reserve is normalizing policy rates, the ECB and BOJ remain the fulcrum for central bank balance sheets, making up half of global QE assets. This means it will be more difficult for them to exit without shocks. In turn, financial shocks can hurt economic performance: If the QE worked through a wealth effect on asset prices and consumption, falling markets could reverse it. The top 10 percent of U.S. earners -- who benefited most from rising asset prices -- accounts for a quarter of national spending, according to the U.S. Bureau of Labor Statistics, while wage growth remains sluggish.
Since the crisis, regulators focused on raising bank capital to withstand another crisis. The next lightning, however, is likely to strike elsewhere. To ensure a sustainable exit from QE and build a policy buffer against future shocks, central bankers need to fix the fragilities they have implicitly encouraged with low rates and stable forward guidance.
Building a resilient market architecture means encouraging heterogeneity of strategies and long-term incentives among market participants, preventing negative feedback loops, and promoting instruments that act as circuit-breakers in a crisis. These include convertible bank capital for banks, which help recapitalizing institutions in a crisis, and growth-linked debt for sovereigns, where coupons go down in a slowdown, reducing the need for austerity.
Until we fix fragility in the financial system, the risk of tail-events will remain high, hurting both markets and the economy. As a result, the likelihood of a full policy normalization will stay low. This explains the recent increased demand for haven assets including long-term U.S. Treasuries, German Bunds, Japanese government debt and emerging-market local currency debt. Investors are preparing for hurricanes while the sun is still out.
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Max Berley at email@example.com