When the market ignores a black swan

Wednesday, September 25th, 2019

The attacks on Saudi oil refineries last weekend should have caused more significant oil, equity and bond market reactions than they did. The relatively muted oil price jump, to prices below the levels of a year ago, has now almost fully reversed as the Saudis apparently will rapidly restart production. The 1% rally in gold prices (3% below recent highs) suggests that the major market traders, mainly massive quant funds, were either relaxed with developments or already so long gold that they felt no need to increase their positions.

World equity markets also behaved with remarkable stability in the face of the significant risk of energy supply dislocation plus the heightened risk of inflation. Then again, with every major central bank targeting higher inflation, it seems that the surprise attack on Saudi Arabia may have been regarded by markets as positive news. The bond markets weakened slightly, as long term yields rose, but they were already correcting from overbought positions.

The VIX index barely reacted … basically, it said “meh”


Source: Bloomberg

It is important to understand that the quant funds that trade momentum have tremendous amounts of both funds and leverage to undertake their activities. The creation of vast amounts of speculative capital has been a consequence of unrelenting QE, with super low interest rates spurring the growth of these funds and encouraging leverage. However, their activities require scrutiny because sometimes they will directly or indirectly cause market price volatility.

Why did US interbank rates spike this week?

One such example may be the striking and isolated observation of extreme price volatility observed in US interbank money markets. This week, overnight interbank interest rates (or the repo rate) jumped unexpectedly to 10% as opposed to the targeted rate of 2.25%.


Source: FT

At this point, there are few credible explanations for this spike, which resulted in the US Federal Reserve pumping US$56 billion into the market (on Tuesday) to ease the pressure. One theory relates to the timing of corporate tax payments.            Tax day for companies in the US is September 15. Some companies prepare by pooling the cash they need and placing it in money market funds – vehicles that use the repo market to lend out cash for brief periods. On tax day, that cash is withdrawn from the market, reducing the supply of dollars, and potentially creating a sudden shortage.

Another theory is that the funding of the Trump administration’s USD $1 trillion deficit is flooding the market with short term treasuries and soaking up market liquidity. Thus, this week the system faltered trying to find interbank liquidity.

We don’t know if either was the cause – they both sound plausible, but we think it ignores a larger, structural issue: ultra-low rates mean that banks are reluctant to hold large reserves. Over the last 5 years or so, US banks have halved the size of the reserves they hold. Fewer cash reserves mean less money at the banks to cover short-term funding stresses. Upward pressure on overnight interest rates may be an indicator that bank reserves are too low.

This type of Fed action was last undertaken ten years ago in a much more difficult environment, during the height of the GFC. What stresses or strains in the banking system are present now, at a time when the consequences of QE and negative interest rates are hardly understood, and when interest rates have never been so low?

Maybe another explanation for the spike in the repo rate will emerge in coming weeks. We don’t know. Is it a coincidence that this occurred just as the attack in Saudi Arabia took place and the oil price spiked? Perhaps a giant hedge or stop loss was activated in the US cash market when oil prices suddenly lifted. Who knows? But it does indicate a degree of nervousness and anxiety in the money markets, which normally flow smoothly and without undue volatility.

The activities of massive trading houses, hedge funds, quant funds and investment banks expose financial markets to the risk of sudden meltdown or “flash crashes”. The Fed did what was required on this occasion, but it is a warning sign. 

The oil market is clearly in oversupply

The attacks, wherever they came from, targeted Saudi Arabia’s national oil company (Saudi Aramco) that was heading towards a massive stock exchange listing – potentially the largest ever, valuing the total company at between $1.5 – $2 trillion. The listing and partial sell down of equity was designed to raise money and so alleviate the pressing financial needs of the Saudi Kingdom that has struggled with lower oil prices, and as US shale oil production came on stream.

The attacks targeted the world’s largest crude processing facility (Abqaiq) as well as Saudi Arabia’s second largest oil field. The attacks (armed drones and/or missiles) resulted in a production suspension of about 5% of global supply. This is the biggest attack on Saudi Arabia’s oil infrastructure since Saddam Hussein fired Scud missiles into the Kingdom during the first Gulf War (1990).

The risk of wider conflict in the region, including a Saudi or US response, should have dramatically raised the risk premium in crude prices. Further, the oil price should have reflected the risk that further attacks occur in the region, resulting in disruptions to oil flowing out of the Strait of Hormuz. However, there is abundant potential supply around the world, and the muted price response suggests that there is probably a supply glut at a time when the slowing world economy is reducing demand.

It is interesting to note that an attempt to disrupt production would directly affect China (a perceived ally of Iran), which imports 10 million barrels of oil per day. A lift in oil prices has significant repercussions for China’s negotiation with the US in the current trade dispute and could make China more amenable to a negotiated settlement.

Source: US Energy Information Administration

The ramifications of this hostile act in the Middle East certainly pits the major world powers against each other. The covert activities of Russia, also an ally of Iran, would seem to be partly stimulated by their desire to disrupt oil supplies in order to raise prices. Whilst the US does not want higher oil prices (which would hurt US consumer spending, the mainstay of the US economy), it would help the Trump Administration put pressure on China. Meanwhile the Saudi Kingdom’s desire for cash is affected, while the rest of OPEC finally has a reason to lift supply to fill a shortfall and therefore generate much needed cashflow. 

The oil supply market presents as a complicated web, with the major suppliers (ex the US and Canada) having long histories of instability. All are driven by self-interest, usually managed by a desire to maintain oil prices through OPEC.  However, OPEC also needs a stable world order with stable demand met by stable supply. Any breakdown will have short term price consequences that would hasten the development of a range of alternatives for oil. Most oil producers recognise that climate change probably means that within a few decades, cleaner sources of energy will exist, and their dirty “black pools of treasure” will become worth far less.

The ECB does it again – the US followed and Japan is thinking

Amid concerns about a global slowdown and trade tensions, the European Central Bank (ECB) last week cut its rate target to minus 0.5% and reintroduced a program to buy eurozone debt (QE). This decision was a replay of previous decisions, seemingly revisited every year by the ECB as Europe rolls in and out of mild recession.

However, the ECB did acknowledge that lowering the rates that it will pay banks on their excess cash deposits was damaging bank profitability. Thus, they are also introducing some offset arrangements which protect the banks’ profits, but which will penalise household savers and investors generally.

The failure of these policies is apparent, but this has never stopped Mario Draghi from relentlessly pursuing them. He is thankfully retiring in November.

This ECB decision put increased pressure on the Fed, adding to the tweeting pressure from President Trump. The Fed at its meeting this week succumbed and cut its key policy rate by 0.25%. In doing so it sighted weakening world growth and trade pressures.

Meanwhile, the Bank of Japan’s policy board is leaning toward keeping policy steady at its own meeting this week because the domestic economy looks relatively solid and the markets are stable. The central bank also wants to see the impact of a sales tax increase, which will be introduced on 1 October. Previously increases in sales tax has brought forward consumption and given a short term spike to growth.

Japan is having to cope with a sharp fall in its exports as they fell for the ninth straight month in August amid the global slowdown and trade tensions. Exports from Japan have now fallen by 8.2% year on year, with exports to China, Japan’s biggest trading partner, down 12%, and those to South Korea, with whom Japan has been embroiled in an ugly trade dispute, fell 9%. One reason for weakness in export growth was a stronger yen, which makes Japanese goods more expensive for foreign buyers.

We have commented previously about the proliferation of negative interest rates across Europe and Japan caused and maintained by very loose monetary policy. More broadly across European government bond markets, the table below shows four countries now have negative yields on 100% of their bonds (Germany, Denmark, Netherlands, Finland). Even Spain and Portugal, which just a few years ago were at the centre of the Eurozone debt crisis, now have most of their bonds with negative yields.

The compression of yields affects both savers and investors alike. In particular the pressure on European pension funds to find positive yield to meet liabilities has become acute. Further, the risk to the viability of these pension funds in holding long dated bonds (long duration) has become extreme.

For example, recently the German Government became the first bond issuer ever to convince investors to buy 30 year bonds that pay zero interest. In fact, the bonds priced with a negative yield of -0.11%, meaning that lenders (i.e. bond investors) are paying the German Government to hold onto their money for the next 30 years.

To explain the (duration) risk of holding these bonds, it is a fact that just a 1% increase in bond yields, which is where yields were as recently as October last year, would result in a capital loss of 32%.

RBA minutes strengthen easing bias: “would ease … policy further if needed”


The recent RBA meeting (September) held the cash rate at a record low 1.00%. On Tuesday, the minutes of that meeting were released and took a material step in the dovish direction leading markets to become firm in the expectation of another 0.25% interest rate cut in either October or November.

The minutes largely repeated previous statements by the RBA, stating “it was reasonable to expect that an extended period of low interest rates would be required … to make sustained progress towards full employment & achieve more assured progress towards the inflation target”.

However, their easing bias was strengthened and seemingly became more urgent. Stating they “would assess developments in both the international & domestic economies, including labour market conditions, and would ease monetary policy further if needed”.

We surmise that any further cuts in interest rates in the US (following the European lead) would stimulate the RBA to follow suit.

The minutes also noted that the RBA had observed only moderate consumption benefits from the recent tax cuts to low income workers.  “The low and middle-income tax offset (LMITO) was expected to boost household income, and thus support consumption growth, in coming quarters … However, the Bank’s liaison with retailers suggested that this had yet to lift spending noticeably. Members noted that even if the LMITO was used to pay off debts, this would still bring forward the point at which households could increase their spending.”

More positively, the RBA noted “housing loan approvals to both owner-occupiers and investors had increased for the second consecutive month in July … and was consistent with the signs of stabilisation in the established housing market.”

Overall, it seems that the RBA remains hostage to international monetary policy and international events. The attack on Saudi oilfields may have been regarded in the past as a “black swan” event that could have disrupted world growth, either directly through inflation or a major middle east conflict.

However, on this occasion that was not the case. But is this caused by a widespread level of complacency resulting from years of low interest rates?

In our view, the short term dislocation in US monetary markets this week suggests that there is every reason not to be complacent with investment markets at present. Diversification and a focus on yield and growth a fair price remains our strategy at Clime.

Complacency … “everything is just fine!”

Source: Hedgeye

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