When Bill Gross speaks, the markets better listen. At Business Of Finance, we reserve a great reverence for Mr Gross not only for his adept ability to foretell mega trends in the financial markets, but also because the man has a rare talent in piecing everything together to form investment thesis that have proven to work well.
Frequent readers should know that the bond king correctly called for the collapse in the German bund market back in April, a sell off that many of finance greatest were caught off guard. Although he was almost bang on with his call, he subsequently admitted his execution of his thesis wasn't as good as the call itself.
We wrote a note explaining the technicalities behind what was the most vicious crash in the history of the German government bond market. As a pretext, 10-year bund yields rocketed from just over 0.02% to slightly above 1% in 2 months, a 100bp move for something that yield almost nothing. Sublime!
More importantly, the crash in bunds and other European bond markets, suggests that the quantitative anomalies and systemic risks which had previously been manifested by numerous micro crashes in bond prices, were mega real.
As an example, think about the level of financial innovation and architecture that exists today. Gone are the "weapons of mass destruction", also known as derivatives.
Retail investors and traders now have access to very complex financial instruments such as bond fund and volatility ETFs, and more recently funds that are synthesized using cross currency total return swaps on extremely illiquid markets such as a ferrous commodity contract that trades on a futures exchange in China.
In such cases, capital flows into these retail funds make up a bulk of the liquidity that the underlying trades on. Another recent example happened just this week where the U.S. ETF, NYSE: GREK (a Greek equity ETF) continues to trade when the Athens Stock Exchange was shut for the entire week. The ETF which feeds into the underlying was actually more liquid than the underlying securities!
Do retail investors and traders really know what they have involved themselves with? We hope so, but logic tells us otherwise.
Bill Gross' latest investment outlook titled "It Never Rains In California" delves into the reasons why the bond king believe a fat tail may be in the making, and why investors and traders should be prepared for it by having enough liquidity when the boat tips.
It Never Rains In California
Mutual funds, hedge funds, and ETFs, are part of the “shadow banking system” where these modern “banks” are not required to maintain reserves or even emergency levels of cash. Since they in effect now are the market, a rush for liquidity on the part of the investing public, whether they be individuals in 401Ks or institutional pension funds and insurance companies, would find the “market” selling to itself with the Federal Reserve severely limited in its ability to provide assistance.
While Dodd Frank legislation has made actual banks less risky, their risks have really just been transferred to somewhere else in the system. With trading turnover having declined by 35% in the investment grade bond market as shown in Exhibit 1, and 55% in the High Yield market since 2005, financial regulators have ample cause to wonder if the phrase “run on the bank” could apply to modern day investment structures that are lightly regulated and less liquid than traditional banks. Thus, current discussions involving “SIFI” designation – “Strategically Important Financial Institutions” are being hotly contested by those that may be just that. Not “too big to fail” but “too important to neglect” could be the market’s future mantra.
Aside from the obvious drop in trading volumes shown above, the obvious risk – perhaps better labeled the “liquidity illusion” – is that all investors cannot fit through a narrow exit at the same time. But shadow banking structures – unlike cash securities – require counterparty relationships that require more and more margin if prices should decline. That is why PIMCO’s safe haven claim of their use of derivatives is so counterintuitive. While private equity and hedge funds have built-in “gates” to prevent an overnight exit, mutual funds and ETFs do not. That an ETF can satisfy redemption with underlying bonds or shares, only raises the nightmare possibility of a disillusioned and uninformed public throwing in the towel once again after they receive thousands of individual odd lot pieces under such circumstances. But even in milder “left tail scenarios” it is price that makes the difference to mutual fund and ETF holders alike, and when liquidity is scarce, prices usually go downnot up, given a Minsky moment. Long used to the inevitability of capital gains, investors and markets have not been tested during a stretch of time when prices go down and policymakers’ hands are tied to perform their historical function of buyer of last resort. It’s then that liquidity will be tested.
And what might precipitate such a “run on the shadow banks”?
- A central bank mistake leading to lower bond prices and a stronger dollar.
- Greece, and if so, the inevitable aftermath of default/restructuring leading to additional concerns for Eurozone peripherals.
- China - “a riddle wrapped in a mystery, inside an enigma”. It is the “mystery meat” of economic sandwiches - you never know what’s in there. Credit has expanded more rapidly in recent years than any major economy in history, a sure warning sign.
- Emerging market crisis - dollar denominated debt/overinvestment/commodity orientation - take your pick of potential culprits.
- Geopolitical risks - too numerous to mention and too sensitive to print.
- A butterfly’s wing - chaos theory suggests that a small change in “non-linear systems” could result in large changes elsewhere. Call this kooky, but in a levered financial system, small changes can upset the status quo. Keep that butterfly net handy.
Should that moment occur, a cold rather than a hot shower may be an investor’s reward and the view will be something less that “gorgeous”. So what to do? Hold an appropriate amount of cash so that panic selling for you is off the table.