There are a couple of undercurrents going on in the world and I think they’re worth commenting on. The first is the now widely accepted belief in a world of one asset. I can’t recall speaking to a person for weeks who doesn’t share the view that financial assets are basically now much of a muchness. After all, if central banks can simply buy assets with newly created money every time the market might sell off, why worry about whether a given asset is actually preserving your purchasing power by providing cash flows in the future? Everything is fungible. You needn’t worry about new assets being created too quickly to dilute the value because the same central bankers buying the assets are strangling the investment process at source – ie – preventing banks from making “imprudent” loans. So we have a world where 12m $ Libor is about 1.5%, and the yield on the 10y Treasury bond is 1.5%. Happy days.
Secondly, it’s an article of faith that money is sloshing around the world chasing yield. But for all that’s made of the “mad rush” into EM, with flows into EM bond funds being apparently quite high, I read elsewhere (via the good offices of HSBC, for those of you with access to their research the piece is called GEMs Equity Strategy from the 23 of August) that flows into EM equities are quite light given the risk environment. But if you look at basis markets the world over, ie, markets for funding, it’s quite apparent there’s not an abundance of funds cruising the world looking for a home – in fact there is an acute shortage. Granted some of this may abate when reforms to US money market funds that are due on the 14th of October pass, freeing up some $ reserves currently sat pat waiting to meet possible redemptions, but there seems to be a wider problem of $ availability in global funding markets. Cross currency basis curves are stretched, but pancake flat- so you have the perverse situation of there being apparently a big $ shortage now, but no risk premium priced for that getting worse.
The synthesis of these two observations is that everyone believes that there’s no risk but equally there’s no liquidity either. I don’t really know what to do with this idea. At the moment I’m advising clients to buy carry, sell gamma, and use some of the proceeds to stock up on options that will pay big if rates go up a lot. If there’s no liquidity, but everyone believes that cash today is the same as cash tomorrow and always will be, something has to snap.