Bilal’s Macroscope: The Next Crisis Is Emerging From the Shadows?

We’re all trying to work out where the next crisis will come from. Will it be a bank failure, a credit crisis or a geo-political event? But what if it’s already started? Remember, in March, nickel markets went wild as a large investor was unable to deliver on a margin call. Then more recently, we have seen UK pension funds having to sell assets to be able to post liquid collateral on their derivative losses. Many investors have shrugged these off as one-off liquidity events rather than deeper solvency issues. But when heavily regulated pension funds need Bank of England support to avoid bankruptcy we have to take notice. The focal point of the next crisis, then, could be the low-quality collateral used to generate leverage during the ‘good’ times of low yields. When this collateral is called into question, the pyramid of leverage comes tumbling down and we have a crisis.

To support this thesis, we recently identified three factors that suggest financial institutions are having collateral problems. One is the heavy use of the Fed’s reverse repo facility. This essentially means that financial players are parking cash at the Fed in order to get safe Treasuries in return. Another is that Treasury repo fails have recently spiked. This means that one party in a repo transaction that pledged treasuries as collateral didn’t have the treasuries to deliver. Finally, non-US investors are piling into US Treasuries even though US bonds have sold off massively this year. All of this suggests a hunt for high-quality collateral in the market.

Who are the financial players most involved in this space? It’s shadow banks or non-bank financial intermediaries (NBFI). These are entities like pension funds, insurance companies, money market funds, hedge funds, private credit and private equity firms that provide ‘bank-type’ lending to the system. The growth of these shadow banks has far outpaced traditional banks since the global financial crisis of 2008. For instance, in 2008, banks had assets of $112 trillion globally while shadow banks (NBFIs) had assets of $103tn. Fast-forward to 2020, the most recent data, bank assets have grown 60% to $177tn, but shadow bank assets have grown by double that rate, to $226tn. Shadow banks now provide more financial intermediation than traditional banks. Shadow banks, then, are likely to be the epicentre of any crisis.

The upshot is that we cannot ignore signs of stress in collateral markets as these reveal fragility in shadow banks. It also suggests that even with equity markets down this year and wider credit spreads, we could still see more downside in risk markets.

Our Current Favourite Discretionary Trades

We continue to be bullish USD, bearish rates and bearish equities. More specifically, we like to be:

1. Long USD: short EUR/USD, long USD/INR, long USD/CNH
2. Short rates: short bunds, paid PLN, CZK, INR 1Y or 2Y rates
3. EM FX crosses: long THB/TWD and short ZAR/IDR

Having been bullish GBP a few weeks ago, I’m becoming more bearish on GBP and I’m considering a short GBP/CHF trade.

Do Our Models Agree with Us?

As usual, I like to cross-check our views against our models:

• Our momentum models are giving uniformly bullish USD signals, bearish equity signals and bearish rates signals. Over the past month, the rates models have worked especially well. Overall, the signals support our discretionary views.
• Our positioning data shows that hedge funds have increased their short US 2y bets, which we would agree with. Real money, on the hand, are long the US 2y and are trying to fade Fed hawkishness.
• I discussed the success of FX carry strategies last week, Our weekly carry update finds that CNH is now a favoured low-yielder to add to our baskets. This supports our bearish CNH view.
• Our flight data shows flights our of major China airports continue to plunge which is bearish signal for the economy. Our China Growth Tracker also finds weak growth momentum.
• Our rates PCA models find value in UK 2s10s and 10s30s steepeners.

Recent Questions from Clients

• Should we buy GBP on Truss departure?
• What are the implications of the China Congress?
• Is long Brazil a consensus view?
• Do low natural gas prices mean Europe has averted a winter crisis?
• Will MoF intervene on USD/JPY?
• When will BoJ YCC end?
• How will markets behave if there is a nuclear war?

What I’m Reading and Watching

• I was looking into whether there was one sentence that could distil all of science! Here’s what I found.
• I’m loving the Netflix show, The Watcher, about a family that moves to the suburbs only to be terrorised.
• I’ve started to listen to Lex Fridman’s 8hr (!) interview of techie Balaji Srinivasan. So far, so good. Balaji always has great insights.
• A client told me that my interview of Robert Carver was ‘one of the best episodes I have listened to’.
• I liked this article How Do the Books We Read Change Our Brains?
• Rock Climber Captures Terrifying POV Footage of Bear Attacking Him Yikes!

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

(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.)