Taper, Rates, Bond Markets and Consequences

Blain’s Morning Porridge November 4^th 2021 – Taper, Rates, Bond Markets and Consequences

“You can choose your sin, but you cannot chose the consequences… ”

This morning: The Fed finally begun its cautious taper and the market did not immediately self-destruct… but the consequences of 14 years of central bank experimentation, regulatory overkill and the “processification’ of markets will have consequences… they may be bleak…

The big news this morning is Fed Taper. Tomorrow it will be the Bank of England hiking rates. Everything in markets is about consequences…. In bonds there is truth. Unintended and unexpected consequences and bond markets seldom sit well together. When bond markets sneeze… equity markets can end up on ventilators, dragging confidence down in their wake…

I appreciate the above statement might sound a bit Zen and the art of Bond Yields… but let me continue with the theme. Try this: meditate on markets. Separate out the background noise and madness of COP26, the Metaverse (or whatever tomorrow’s market fad is), politics, stock barkers, and charts, and listen carefully for the sound of single unstable stones and pebbles starting to dislodge from the towering edifice of the mighty bond market that hangs over us all…

Scary? Eh? I am angsty. It feels we’re missing something – or something is coming and we don’t know what it is….

Today dawns just like a beautiful bright blue morning on the ski-slopes; when you waken to the promise of a wonderful day on the slopes…. and then the mood is rudely shaken by the booms as the ski patrol fires mortar shells into the snowpack to dislodge the likely avalanches. What if they’ve missed the big one?

The bottom line is the market feels vulnerable to an avalanche as tapers ravel. Let me try to explain. For the last however many years – broadly since 2008 – markets have thrived on:

• The belief in implicit ongoing Central Bank support for markets to avoid a confidence collapse, “too-big-to-fail” systemic bailouts, and governments equating stock market rises with their own success.
• Successive waves of QE money printing have simply inflated the price of all financial assets. The “wave of money” market bulls believe has strengthened the market base, cushioning losses on the basis that when markets do slide, and because there is so much “buy the dip” money available they will swiftly recover from any shock.

But, less visible has been a massive change in the underlying structure of markets:

• The death of market making and risk taking by banks.
• The transfer of risk from large banks with their genetic credit DNA into a very much more diverse asset management and retail investors taking direct risk. (Regulators think they have changed risk appetites – all they have done is shunt it under another carpet.)
• The lack of experience across trading floors and dealing rooms at banks, investors, and brokers of market instability – anyone under 40 in finance has never seen real market mayhem.
• A changing financial mindset – from risk trading to risk avoidance, caused by regulation, compliance and a process driven approach to any aspect of finance the regulators think they can control.
• The gamification of investment into fantasy – even as fewer and fewer small stocks are covered by any real research..

I could go on and wax lyrical about how much better the world was when I was a lad, but the bottom line is you can’t train the market for the unexpected by making them do three or four modules on ESG investment or KYC multiple choices. Markets need to understand risk and thrive on it – not be “protected” and mollycoddled from it…

There are a small number of finance professionals across the market who get it, and will no doubt profit massively by praying on regulatory stupidity when the crunch comes. Many will bet that central banks will continue to distort markets to avoid meltdown. I am tempted to go with that myself.

But, I have a gut feeling the way we’ve manipulated the markets through QE bond purchases -effectively making central banks the buyers of last resort and making bonds prices a function of artificially low interest rates rather than the risk of not being paid back interest and principal – is about to bite us… hard.

Problem is.. I’ve been predicting a market meltdown ever since the last one…  And that is why I am listening very carefully to the rocks… There were a number of stories that set me thinking this morning:

The first is in terms of debating the number of angels it is possible to cram on to the head of the proverbial pin – will predicting inflation ultimately prove as meaningless? In the list of unlikely things a central banker will ever say, will FedHead Jay Powell continue his verbal inflation progression by saying: “inflation remains elevated, largely reflecting factors that were expected to be transitory”? In September he promised us inflation was transitory. Y’day he said it was expected to be transitory.

No matter.. the Fed announced a $15 bln taper (bonds and mortgages) and the world did not stop. The market did not immediately crash, trumble and burn. There was no immediate tantrum. Powell said he can afford to be “patient” on inflation.. and if the Fed is not concerned by the prospect of higher rates, then the great big towering edifice of the bond market can stand unbroken a while longer…. Really? How long for? Consequences…

The second story is the news some UK banks pulled fixed rate mortgages offers ahead of the Bank of England’s rate decision. When interest rates do rise, then the effects are simple to predict: variable rate mortgage holders will get stuffed by rising mortgage payments, as higher costs put off home-buying decisions, and the home market slows – causing a succession of ripple effects on confidence and the markets. Consequences….

A third story is how every single major newspaper has run something on the Dow Jones surpassing 36,000 last week, on the basis it was predicted back in the 90s in a book called “The New Strategy for Profiting From the Coming Rise in The Stock Market.” The book, incidentally, was totally wrong… the reasons stock markets are where they are today are nothing to do with the reasons the authors expected. Yet, every single newpaper article says something like equities being a market where patience is a virtue, and that in the long-term equities will outperform….

AAAARRRGGGGG…. At this point, assume I just screamed…

The reasons stock markets are so elevated are largely down to the consequences of factors such as QE, cheap money, walls of money, which in turn have fuelled a whole series of secondary consequences and investment behaviours that make zero sense in a real world; such as the belief unprofitable companies are worth more than profitable ones, and inspire the credulous to believe they can get rich quick from snake oil schemes like meme stocks and crypto.

It’s a madness of crowd, driven largely by the consequences of earlier actions.. The trick is going to be recognising what is real and what is not. Good place to start is be cynical. Ask the difficult to answer questions..

Five things to read today:

Torygraph – Royal Marines force US Troops to surrender just days into training exercise

FT – Zillow was not smarter than the housing market

Classic Rock – Springsteen Looks to Sell Catalog For Up To $415 Million

BBerg – The Electric Vehicle Supply Chain Has a Dirty Secret

WSJ – Credit Suisse Revamps Business in Post-Archegos Overhaul

Out of time, and back to the day job..

Bill Blain

Strategist & Head of Alternatives: Shard Capital