The text that follows may be the best summary of what has happened on Wall Street – both forensically and philosophical – over the past 7 years, explaining how central banks broke the “market”, and why traders, investors, regulators, policy makers, and everyone else suddenly has no idea either what is going on or what to do next. Not surprisingly, it comes from Deutsche Bank, which this week has been staring at the corpe of Lehman Brothers and wondering if it is next…
From DB’s Aleksandar Kocic
Asphyxiation — code orange?
We believe for the past few weeks we’ve been experiencing an accelerated reaction to a policy mix that caused a general shift in perception of risk from isolated idiosyncratic flare-ups to pseudo systemic. The mix is defined by seven years of unprecedented liquidity injection with low rates and record low volatility on one side, and bank regulation with diminished capacity of the market to extend liquidity on the other.
The first effect alone has three major consequences. Low rates had been making UST investments unattractive (expensive). So, investors sought yield elsewhere. This is where low volatility played the role. Portfolio managers adjust their position on the mean-variance frontier by matching their risk limits to a particular return. Extinguishing volatility pushes them towards riskier assets without a need to change their risk limits. This was ok as long as volatility remained low. Instead of investing in UST, duration players moved across the credit line into IG, HY, etc., which offered higher yield and superior carry. In these markets carry becomes the main theme and everyone who refuses to play that game is punished by high negative carry. This was stimulating for risk, and risk assets outperformed in low rates and low volatility environment. Correlations between risk assets and yields changed sign, but nobody complained because both stocks and bonds rallied.
Negative carry of any contrarian position was punitive which resulted in massive one-sided positioning. The problems began with the start of stimulus unwind as all of its underlying aspects began to reinforce each other and regulatory environment amplifies their effect.
There is a huge overweight in relatively illiquid assets. While positioning grew, regulation has significantly diminished dealers’ capacity to absorb those unwinds, which would have been difficult even without the regulatory restrictions. Volatility is on the rise and even those positions that used to look a safe are appearing increasingly risky forcing additional need for their unwind. So, with reduced of liquidity, investors have to get out of healthy, well-performing/non-problematic assets in order to cover MTM losses and possible costs of redemptions. The legacy of 2015 which was a difficult year with massive wave of redemptions only exacerbated the situations resulting in low tolerance for risk, while failure of large class of standard economic models and loss of forecasting power resulted in low confidence across the board.
The effects of policy unwind and liquidity dislocations are accelerated by the currency play in Asia. While alone this creates a problem, rate hikes and a strong USD makes it more difficult for the EM measures to be effective and creates another reinforcing loop. Problems in any market sector have a potential to create contagion.
The markets are not insulated from each other but are coupled in a “destructive” way, a mirror image of QE dynamics. Risks are becoming unpinpointable. Problems are global while politics remains inherently local allowing the existing trends to remain unchecked and self-reinforce. Any action causes further problems, which creates a quicksand effect — everyone is both a victim and an accomplice.
via Zero Hedge http://ift.tt/1TivU8b Tyler Durden