From Switzerland With Love: Some Hard Truths About Central Banks And Risk

Jan 23 2015 | 8:54am ET

Hard Truth #3: Market liquidity is not a continuum. Market shocks, whether policy related or the result of idiosyncratic exogenous factors, traditionally expose the fact that financial asset pricing is not a continuum but carries with it jump or gap risk. It has been argued for some time now that the impact of financial market regulation will be to significantly decrease market liquidity in times of stress, as financial intermediaries will not have the wherewithal to act as principals to warehouse risk. While the Swiss example was a particularly dramatic one, centering as it did on discrete price support that suddenly vanished, investors in other asset classes should take note: the early signs are that market liquidity in stressed environments is very bad indeed.

Hard Truth # 4:  Policy tightening has historically exposed weak hands. Beyond the issues raised above, the historical record tells us that policy tightening means deleveraging and that involves investment losses where valuations and positioning have become stretched. The past three Fed tightening cycles are a case in point. In 1994, Fed rate hikes generated a bond market rout, large derivative losses at a number of corporations, a currency crisis in emerging markets such as Mexico, and the high profile bankruptcy of Orange County, California. The Fed’s 1999 tightening campaign popped the dot-com equity and infrastructure bubbles and led to steep losses in corporate credit.

The Fed’s most recent tightening cycle in 2004-06, meanwhile, was as benign as could be. Its start was well-telegraphed via a shift in language from “considerable period” to “patient” to “measured” rate hikes, which then came as a series of easily-predictable 25 basis point upward steps. The ultimate impact, of course, was the emergence and deflation of a US housing bubble, which took down a range of structured credit with it, kicking off the financial crisis.

Both the Swiss example and the weight of history suggest that investors disregard the risks associated with policy shifts at their peril. Perhaps this time will in fact be different. However, with bond yields (both government and corporate) hovering near record lows amidst a multi-year run of low volatility, the odds do not appear to be particularly favorable. That is all the more true when one considers that that no one under the age of 30 has ever seen the Fed tighten policy while working as a financial market professional, and few much under the age of 35 have done so from a position of significant responsibility. With the continued appreciation in the US Dollar the backdrop is even more concerning in Emerging Markets as many risk takers cut their teeth only during the BRIC up-cycle and have never experienced a series of country defaults.

Buyers of securities and sellers of volatility have enjoyed exceptionally benign conditions for several years now.  In some quarters, policies are in place that may extend that run for another few quarters.   Elsewhere, however, it appears that the environment may be becoming less favorable for the strategies that have worked so well since 2010. The SNB shift may prove to be just the first example of this.  The hard truth is that investors and risk managers should be prepared for more.

Neil Azous is the Founder and Managing Member of Rareview Macro, an advisory firm to some of the world’s most influential investors and the publisher of the daily newsletter Sight Beyond Sight. Previous contributions to FINaternatives include The Cult of Loss Aversion: A Call to Rethink Risk in Global Macro Investing and Q&A: Neil Azous Talks Global Macro Investing.

Neil has close on two decades of experience across the financial markets, and is recognized as a thought leader in global macro investing. Prior to founding Rareview Macro, Neil was a Managing Director at Navigate Advisors where he specialized in constructing portfolios and advising on risk. On Wall Street, his career included roles at UBS Investment Bank and Donaldson Lufkin & Jenrette, where his responsibilities comprised of trading derivatives, hedging solutions, asset allocation and fundamental securities analysis. He began his career at Goldman Sachs in Fixed Income.

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