October and November have not been kind to hedge funds. No strategy has made money (excepting the weird guys that lose 5% a month for five plus years, only to make 20% once in a while), and frankly YTD most have been losers per the friendly guidance of BarCap. In short, risk markets have been undergoing a slow-motion credit crunch beginning earlier this year. The quick highlights of this include the VIX explosion due to massive vol selling, a rolling series of emerging market crises that is by no means complete, the implosion of the cryptocurrency bubble, leading to the current weakness in credit and equity selling.
This takes us to the proximate cause and culprit: Jerome Powell’s insistence on normalizing monetary policy. There are a number of legit motivating factors to this. There is a need to contain inflation expectations given a very tight labor market. The effectively negative (nominal and real) interest rates Powell inherited as a result of the financial crisis has created all kinds of perversity in financial markets. Seriously, how could anyone look at cryptocurrencies, the greatest bubble of all time, and not understand that something is deeply wrong with the operation of financial markets?
Perversity or not, be not blind to the downstream effects the rate hikes generate. Three of four Fed rates hikes at 25 basis points each step may not seem so disruptive on the surface, but they have injected a sanity in funding markets not seen in nearly a decade. The meltdown in virtually all hedge fund strategy performance is an indicator of system-wide deleveraging due to rising short term funding costs. This leads to the following corollary:
Corollary: risk appetite, especially of the wild-hare variety, is going to be dampened until rates fall again.
The reason is simple. Normalized funding markets mean a decent return on cash. That in turn means less incentive to move farther out on the risk spectrum.
Leading to the main proposition:
Proposition: Meaningful returns on cash make even multi-year low valuation less of a bargain than they would be given lower policy rates. Further, higher cash returns suppress risk appetite. The de-risking of portfolios continues until risk appetite and/or leverage increases commensurate to support valuations.
Based on the yield curve, the current tightening cycle looks like it is wrapping up. Let’s have a look.
The 1s30s spread as of November 19, stands at 66 basis points, and 2s10s is only 41 basis points. If current inflation and growth prints remain on current trend (plausible), then you don’t even have room for two 25 basis point hikes before the UST yield curve inverts. This is what happens when you tighten monetary policy when there is no inflation in sight. There’s only so much bubble-bursting activity possible before the economy gets upended in the process.
The yield curve more than anything shows the plight of Chairman Powell. 2019 is going to have both transitory and persistent inflation drivers; among the former energy prices, among the latter tariffs on imports and wage pressures. Further, I suspect he holds a conviction that something is deeply wrong with subsidizing some with negative interest rates despite multi-decade lows in unemployment to the detriment of savers.
He’s right, of course. There is something wrong with screwing savers out of returns and driving investors far out on the risk spectrum. But it appears that excising the financial perversity nurtured over the last decade will be harder than he thinks.