Canada is not for sale

Summary

• Narrative update — Slower growth and the implications of a stronger US dollar.

• Fed rate cuts — The trade war feed back loop. 

• China being labeled a currency manipulator — Not exactly what you expected.

• The fragility of modern market structure — Market liquidity and volatility feedback loops.

• Propellor head special — Gamma hedging.
  

Market’s have been fairly volatile the past several weeks following the continued slowdown in the global economy and the US administrations decision to tear apart the Osaka trade truce. Since my last email things have gotten a lot worse for the global economy — death by a thousand cuts so to speak. The latest string of data confirms that the manufacturing recession is getting deeper and, in Europe, the German economy is one quarter away from a technical recession after the economy contracted in Q2. The German government announced that it may start spending money to help mitigate the slowdown which is a welcome change to the status quo. If there was ever a time for Germany to start borrowing money it would be now given that investors are paying for them to borrow. Meanwhile, Chinese data this week helped reinforce the somber tone in markets by indicating a larger and more broad-based slowdown than originally anticipated. The market reacted negatively to the news, marking a significant shift away from the “bad news being good news” dynamic to bad news beginning to cast serious doubt on policymakers ability to reflate the global economy. The slowdown in China helps highlight just how much of a challenge central banks face and, with bond yields continuing to fall, the market is preparing itself for a global synchronized slowdown. Major 10-year sovereign bond yields have declined well over 100 bps since the start of the year and the market value of debt that holds a negative yield has nearly reached US$ 17 trillion. The growth in negative-yielding debt has pushed investors into riskier assets or assets with a longer time horizon (duration). Remember that several high-yield bonds in Europe are trading with negative yields and, just last week, the Danish 30-year mortgage rate flipped negative. You read that right — In Denmark, someone will pay you to take out a 30-year mortgage. Of course, this has come as a result of the global game of interest rate limbo that central banks have been playing since the start of the year but there is more to it. As the economic backdrop becomes more uncertain, companies hold off on investing, creating an excess supply of savings which will naturally push interest rates lower. Amidst all of this, US economic data has been fairly resilient with little signs of the global slowdown making landfall stateside. The US 2s10s curve has inverted, likely following the recent push into duration. In the past, when this portion of the yield curve inverts, a recession has hit the US after 14-20 months. I won’t go into the reasons why this time may be different but know that this time may be different. The US’ outperformance relative to the rest of the world has put unwanted pressure on the US dollar to appreciate. In my previous email, I had mentioned that we were starting to see some funding pressures in the US dollar market and those pressures became more apparent over the last two weeks. The trigger was likely the US government lifting the debt ceiling which was followed by the Treasury's plan to borrow more than anticipated. The concern is that private sector banks have reached a limit on how many Treasuries they can (or are comfortable) holding and the market participants buying these new Treasuries will not be the "usual suspects". This is expected to take out even more US dollars from the global financial system. The “problem” is that the US dollar acts as a safe-haven currency and, given the latest developments on trade, has been bid due to the flight to safety dynamic. Remember that a stronger US dollar poses serious risks to emerging markets (EM) given that the majority EM countries and companies issue in US dollars (the USD market is generally deeper and more liquid) which can create solvency issues. Although not explicit, the Fed likely cut rates by 25 bps to help alleviate some of these pressures. The Fed is also aware that the US cannot weather the global slowdown forever and likely took out some "insurance" for when the US does slowdown. As such, the rate cut was coached as a "one and done" situation by referring to the cut as a "mid-cycle adjustment”. I had warned about this in my previous email, Insurance cuts, where I mentioned that the Fed would need to keep the dream of further rate cuts alive to avoid a selloff.  Although Powell failed to do so, the President did not disappoint and slapped another round of tariffs on Chinese goods less than 24 hours after the FOMC meeting. Which, in his way, kept the dream alive.  The latest escalation in tariffs shows how the President is using the trade war to engineer rate cuts when the Fed attempts to steer the market away from a full-blown easing cycle. The figure below shows this feedback loop. 

This puts the Fed in a particularly difficult position. If the Fed “bends the knee” to the President, Powell runs the risk of implicitly underwriting the trade war by providing markets with the “cushion” needed for the President to pursue these radical trade policies. The main idea is that the President has created rate cuts by being insane — Earlier this week there were rumors he wanted to buy Greenland (for the record Canada is not for sale) but he's also been actively commenting on the situation in Hong-Kong and has even sold jets to Taiwan. This emphasizes that predictable monetary policy gives way to irresponsible trade policy and more broadly geopolitical uncertainty. The chart below shows a proxy for monetary policy uncertainty plotted against broader economic policy uncertainty which has reached all-time highs. 

This is a classic case of stability breeding instability. In the US, the market is now pricing in another 3 rate cuts from the Fed by the end of the year. Remember that the cost of disappointing the market likely far outweighs the cost of a rate cut, especially if the global economy continues to deteriorate. Although this does seem like a case of the tail wagging the dog, if Powell does not deliver rate cuts then bond yields spike and markets selloff (tightening financial conditions) and making things on aggregate worse than they would have been had he just cut. The real question is -- At what point does the Fed start to worry about inflation? Remember that the latest CPI (Consumer Price Index) print came in well above expectations and the recent U-turn from the US gave the market the first sign that President Trump may be concerned about tariff-based inflation. For those who don't know, the US has decided to delay the implementation of tariffs on some consumer goods from September 1st to December 15th. This is particularly convenient because it happens to miss the holiday season. Goldman has done plenty of work on tariffs and concluded that the majority of the costs are being passed onto the US consumer. This puts us in a dangerous place because it hints towards stagflation, a period in which a countries output falls while the price of goods and services rises.

Contrary to what the US administration will have you believe, China has not been weakening its currency (CNY). Earlier last week the US named China a currency “manipulator” after the CNY broke through a key psychological level of 7 USD. The chart below from Goldman Sachs shows how China has been manipulating the currency higher to keep the US administration happy (the opposite of what the President has been claiming). So yes, they are manipulating their currency but not in the way you would think.

The dark blue line shows the fix that the PBOC sets and is used as a reference rate for trading on that day. The grey bars show the adjustment that the PBOC had introduced last year called a “counter-cyclical adjustment factor” which helps adjust the currency fix to fair value. The grey bars are, for the most part, negative showing that China has been supporting the CNY. Remember that this chart shows how many CNY 1 USD buys -- a lower number implies a stronger CNY. The recent funding pressure in US dollar markets have forced China to adjust the currency fix more deliberately and it looks like they simply just couldn't lean against the wind any further. When you take the above in conjunction with the faltering Chinese economy, it comes as no surprise the CNY would depreciate. With that said, make no mistake that the US tearing up the G20 agreement in broad daylight was one step too far for China but, there were other reasons for the currency to break through the 7 USD mark. These developments highlight that Beijing can sink wall street overnight depending on where they decide to set their currency.

The rest of this email gets a bit technical but serves to lay some foundation for discussing why modern market structure is more fragile than in the past. Market crashes aren’t a “new” phenomenon and it makes it difficult to tie any market crashes solely to these “systematic” investing strategies that I often bark on about. The reality is, these programmatic strategies make markets more efficient, but they set the stage for “flash crashes” to happen more often. An important "feature" of the new market structure is the feedback loop between market liquidity and volatility. The chart below shows the relationship between the market depth (how liquid the market is) and volatility (in this case it’s the 1-month implied volatility from options — the VIX Index). 

We can see that when liquidity is high, volatility remains low, and when liquidity is low, volatility is high. This shouldn’t come as a surprise, after all, as fewer people are willing to buy and sell it should be easier for prices to move (which is what volatility is). When volatility rises, markets become less liquid and systematic funds tend to deleverage their positions, often exacerbating the decline in markets. The funds that I am referring to in this case are momentum hedge funds (called CTA — Commodity Trading Advisors). These funds wait for a trend in the market and then follow the trend. Typically these funds have “negative gamma” exposure which means they buy when the stock goes up and sell when the stock goes down (that is what trend following is). This is similar to what can happen in options markets when dealers have to hedge their exposure (something I will get into below). The important thing to remember is that this liquidity and volatility feedback loop exists in part because of these negative gamma effects and, for the most part, this feedback loop results in very slippery markets like the ones we've seen over the past few weeks.

Dealer hedging dynamics — Gamma’s gravitational pull. In the past, I’ve talked about how many investors have been forced “down the quality ladder” in a search for yield. Another way for investors to get a yield is by simply selling options on things that are unlikely to happen and collect a premium. It’s equivalent to me charging someone to borrow my snowblower over the summer because I've never had to snow blow my driveway in the middle of august. In doing so I take my snowblower, which is just sitting in my garage, and end up making a little extra money on the side. Remember that in a world where central banks have essentially eliminated risk-free return, every little bit helps. Asset managers have had to get creative to meet their required rates of return. This marks a big shift from funds that used to be buyers of insurance now becoming sellers of insurance (think of options as a way to manage risk). As a result, dealers end up having to manage their risk a lot more and the direction in which they hedge can change depending on how the market moves. Picture this -- When an investor sells an option to a dealer, that dealer is then long gamma (a long position in a put or a call has a positive gamma). Where delta is how quickly the price of the option changes when the price of the underlying asset changes and gamma is the rate of change on the delta of the option. The hedging activity, in this case, is one in which the dealer would need to buy/sell the stock when the price falls/increases — Essentially, the hedging activity of the dealer is going in the opposite direction of the market. The opposite is true when an investor buys an option from a dealer. In this case, the dealer has negative gamma and when the stock increases, the dealer buys the stock and when the stock decreases, the dealer sells the stock. In this situation, the hedging activity of the dealer is going with the market and creates more volatile markets by exacerbating increases/decreases. The chart below comes from a WSJ article which does a great job of explaining this dynamic (I recommend everyone read this — link here).

The x-axis shows the estimated amount of dealer gamma in billions and the y-axis shows the one-day return of the S&P500. When gamma is positive, dealers are hedging against the market and are suppressing volatility. When gamma is negative, dealers are hedging in the same direction as the market, creating more volatile markets. This helps explain why markets can go through a period of calm where we see little volatility. These periods are typically referred to as "gamma traps" because when dealers have positive gamma their hedging needs tend to put a cap on how high/low markets can go. Current estimates of dealer gamma show that we are close to zero if not negative meaning that we should expect markets to remain fairly slippery. The chart below shows estimates for the combined gamma of the S&P500 index and the SPY ETF (which tracks the S&P500). 

The x-axis is the value of the S&P500 and the y-axis shows the amount of gamma at each level of the S&P500. The vertical line shows where the market closed on Friday. Although it looks fairly choppy, we can see that there is a clear flip to positive gamma at around 2950 meaning that around 2950 we can expect to see the market become far calmer. If all of the above went over your head that is ok. I wanted to introduce this kind of language in this email because these are important dynamics that impact markets. I will continue to flush these out in the coming weeks and provide better examples. Right now, just be aware that we are in a situation where markets will continue to be fairly volatile based on how much negative gamma is floating around in the market. I promise next weeks email won’t be this long winded.  Tiago Figueiredo