Are Markets Under Anaesthetics?

A few months ago I went under full anaesthetic for an operation. Although I was dreading the experience, I woke from it feeling surprisingly pleasant – free from pain and even euphoric.

When Central Banks embarked on their QE operations it was an extreme measure and it was meant to be temporary. In the way anaesthesia helped me, it was meant, briefly, to ease the passing of pain and ultimately aid a recovery.

But the anaesthesia is lingering longer than expected. With the Fed cutting rates and the ECB signaling renewed easing, we have begun to experience the longest period of abnormally low-interest rates in modern history. As someone who has traded core and EM rates with a double-digits handle in the past, this really seems out of line, especially when one looks at real yields. It is very hard to explain and justify to a long term investor the buying and holding of Bunds at negative yields, for example.

No one knows for sure what the actual impact of a prolonged QE experiment will be. But the gut feeling is that the longer it lasts the more damage it will produce – a chronic use of painkillers is addictive, and has serious side effects.

One clear consequence is the compression of yields and risk premiums, as well as volatility. This, in turn, is pushing investors to hold assets that seem expensive – the fear of missing out is just too strong. But the benchmarks have to be tracked and assets under management (AUM) continue to grow courtesy of CBs buying. So everybody has to continue dancing while the music plays.

We are in a world where prices move little until there is a decent reason for a repricing – which then occurs rapidly as it did towards the back end of last year.

So Where Does This Leave Investors?

1. Don’t feel too clever having made money this year. CBs have basically propped up all asset classes in a rare synchronized rally for bonds equities and Gold/Oil.

2. Be wary of the exit door. It has become smaller as consensus views translate into much bigger positions than real liquidity can absorb and as asset managers chase their benchmark.

3. The number of banks willing to absorb and warehouse risk has shrunk since the 2008 crisis because only the top players find it profitable to support the market.

4. A number of markets can remain one-sided for a while with screen marks artificially representing mid-market (trading volumes can be a good indicator).

5. Valuations make sense only in association with a range of tools assessing technical market positioning and flows in order to assess the real state of the market.

No one knows how the patient will feel when QE anaesthetic is ultimately reversed, and in the meantime, one has to remain cautiously invested and continuously monitor market conditions. But the increasing occurrence of flash crashes in recent years is a stark reminder of what will happen when CBs decide to call time on their policy of buyers of last resort.

Salomon Sebbag has been managing trading books for more than 26 years at JPMorgan. His areas of interest are Emerging Markets, Interest Rates Derivatives, FX crises and Liquidity.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)