The time has come to start using this platform properly and actually making good on my stated aim of informing folk about the goings on in financial markets from a socialist perspective. A variety of events in my work life have conspired to make things much more interesting of late, so I hope that this will be reflected here. The below is a quick summary of the year so far in Macro markets. Footnotes are provided for the benefit of any non market folks reading!
Talk to anyone who runs money at a macro fund, and they’ll tell you it’s been an impossible year to make money in rates markets. That’s because the last 6 months have been one of those rather special times when the ever smug hedge fund community has got it totally wrong, and the dumb money has got it right. Basically, at the start of the year, the market was all excited and getting hot under the collar about rate hikes from the Fed and the BOE. With forward guidance, we had a clear idea that we were going to get rate hikes when unemployment hit a certain level. The trade was to be short bonds (1) , and everyone got involved. Macro managers are making all kinds of excuses about why the returns have sucked this year, but the reality is that they all got the direction wrong. I saw them entering the positions, and I’ve seen them slowly traipsing out with their tails between their legs. Forward guidance evaporated, rate hikes have been pushed back into early next year, and graduallyr the fast money players have bought back their shorts. Meanwhile, real money, with a tonne of cash to invest and equities at all time highs had no choice but to keep buying bonds, and mighty fine they’ve done too!
However, the thing is, in spite of deteriorating data across the board, the market continues to price a decent amount of rate hikes in the front end of the US and UK curves (2). This means that interest rate curves are very flat. All the rises are priced in the front, but a relentless summer of bond buying has depressed rates across the back end. The trouble is though, we’ve now been at zero interest rates in the US and the UK for many years, and without central banks intervening to control credit conditions in the economy, commercial banks have got on with the job by themselves. Rates of credit creation in the UK and US are now around average levels, but they’re no longer at the high levels of a couple of years ago, such that I have every expecation that the data will continue to deteriorate. The worry is that having kept rates on hold for so long, central banks will simply never get the opportunity to raise them, because they’ve baked low rates into the economy. This is now a popular narrative in financial markets.
The thing is, it misses an important truth. It may just be that the natural rate of interest for the global economy has fallen, and we are witnessing a titanic struggle by institutions designed for 2% p.a growth to deal with 0%. And make no mistake, our instutions are built on this assumption. Pension funds assume real rates of return consistent with long term averages, but we are seeing these long term averages crumble. Lending money to the federal government of Germany commands a yield of just 1%, for a 10y Bond! 3 y bonds are barely positive. Finance takes a long time to catch up with changes to the mode of production, and it always swings too far each way. It took a long time for investors to believe in railways, but when they had it figured out they plowed in enough cash to build railyway lines to every tiny english hamlet and cause en enormous speculative bubble. The global financial system is massively dependant on positive real rates of return. The unwind of this could be the mother of all financial calamnities.
This is a first pass at a bunch of complex stuff, so expect more in each component. We live in exciting times my friends!
1. Bond yields are partly determined by the risk free interest rate. The central bank in a country sets this rate. Bond prices and yields move in opposite directions. If you’re holding a bond that yields 3% to maturity, and the central bank jacks up the interest rate to 4%, the market price of your bond falls to make the yield equal to 4% (plus term premium, plus credit spread – investopedia it!). Basically, when the CB is going to raise rates, don’t be caught holding fixed income!
2. This sounds like it’s complicated to work out, but it ain’t. If you want to know how many rate hikes are priced into a given period of time, just look at the inteest rate futures strip. For GBP it’s short sterling, for the US it’s Eurodollars, for the EUR it’s Euribors. So for example, between December of this year and december 2015, to find the number of hikes priced into GBP, we take the price of the Dec 14 Short sterling future (99.29) , and subtract the Dec 15 future (98.51) to see that .78% of hikes is priced in, ie about 3 x 25bp hikes.