A Tale of Two Systems
September 16, 2022
Central to Market Thinking is the notion that there are Three Tribes at work in markets – the short term leveraged traders, the medium term asset allocators and risk managers and the long term investors. Sometimes they all move in harmony, making for powerful momentum markets, but more often they move in some form of discord. Understanding which of the tribes is driving markets at any time is thus central to Market Thinking.
At the moment, there is a conflict between the short term leveraged traders who are actively trying to push markets lower and the asset allocators and leveraged long term investors who are struggling to deliver positive returns. One ‘system’ is actively looking to generate returns from a Bear market, while the other is looking for it to end. The question is whether it can end without Capitulation.
As Dickens said, in a Tale of Two cities, it was the best of times, it was the worst of times. Interesting then, but perhaps not surprising, that the performance and the ‘views’ of the current winners, notably the CTA traders, are attracting a lot more attention in market commentaries. We were particularly interested for example to see a very detailed and thoughtful note from a major investment bank this week that demonstrated its model ‘predicting’ the current positions of CTA traders, not least their negative bets on Equities, Bonds, Credits and metals versus their positive bets on the $ and energy. All positions we are aware of from our own models, but publishing this type of research suggests, to us at least, that the IBs are now looking to get themselves into the game. Of course a similar thing happened previously with Hedge Funds and IB proprietary trading desks, with both sides trying to ‘front run’ the other and get the long term investors in at the end to close out the position at a profit.
CTAs are highly profitable for IBs from a flow point of view, but clearly they also want a piece of the action and, perhaps we are being cynical, but telling the wider market what CTAs are doing, while emphasising that investors should do the same (as opposed to be contrarian) looks very similar to the narrative management game played regularly in the noise markets of FX and commodities. The response last week to the ‘bad’ CPI number – a sharp sell off in equities and a rally in the $ – was thus simply the CTAs (and their ‘trackers’) applying ‘more of the same’, accompanied by an ever expanding choir of bearish ‘analysts’. In our view a lot of this was aimed at trying to get the asset allocators to roll, or buy more, put protection in and around the September options expiry, thus setting the directional tone for q4.
Chart 1: It was the Best of Times ; CTA Traders having their best run in years
The first chart, as well as the above discussed likely allocation of more capital to these strategies, tells us that the narrative is currently being dominated by the short term leveraged traders on the bear side. The second chart meanwhile is an illustration of the pain on the other side of the trade – this shows the quarterly performance of the Bloomberg 60:40 Index; just as CTAs are having their ‘spring of hope’, so 60:40 funds are having their ‘winter of despair’.
Chart 2: It was the Worst of Times: 60:40 Funds having their worst time since the Financial Crisis
This isn’t just about the long term investor in the 60;40 funds which have historically dominated pension funds allocations. Perhaps even more important are the more medium term quant funds and minimum volatility target date funds or rainy day funds that incorporate a degree of leverage in the strategy. A traditional 60:40 structure can have perhaps 50% leverage added, making it essentially 90:60, but if the risk, or volatility jumps – and crucially the volatility of the bond element has jumped above the equity element this year – then the fund has to deleverage and in doing so sells down both bonds and equities. Going short and then trying to get the bigger player to sell back to you lower down is the central strategy here.
Interesting that one of the biggest players in this space, Ray Dalio of Bridgewater, is talking very bearishly at the moment commenting on a linked in post that if short rates went to 4.5%, equities could fall another 20%. He doesn’t mention what would happen to bonds, but the mechanics of the leveraged min vol funds obviously means they wouldn’t do well either. We would add something else to that scenario, particularly as Dalio famously said ‘cash is trash’ earlier this year in the context of higher inflation. In the context of markets however and a money management requirement to make some positive return, however modest, short-dated bonds/cash at 3.5%, or certainly at 4.5% looks very attractive. Managers are paid on nominal returns, not inflation adjusted ones.
This change in cash returns is also going to be particularly important for a lot of leveraged and illiquid structures as, to further quote Dickens, the age of wisdom starts to replace the age of foolishness (and SPACs). To get back to basics; Interest is a cost of doing business for borrowers and an opportunity cost for savers. Five years ago, a US two year bond yielded 1.2%, meaning that, all else being equal, tying up money for 7 years as required in a typical illiquid strategy had an opportunity cost of ‘only’ 8.7%. Plus of course, the cost to the product provider of the (almost inevitable) leverage applied was equally low. At the time European bond yields were actually negative 1% making the calculation even more ‘attractive’. Today, with 2 year bonds at 3.75% that is now 29.4% and at Ray Dalio’s 4.5% would be a 36% opportunity cost. Some of the strategies that ‘were all going direct to heaven’ are ‘all going (to go) direct the other way’.
For those that want to see the full quote from Dickens we have been referencing…