Alberto Gallo of Algebris Investments steps up to take his shot at the $64,000 (more like trillion) question in a report published this week “The Central Bank Bubble: How Will It Burst?”
Gallo manages the Algebris Macro Credit Fund described as “an unconstrained strategy investing across global bond and credit markets, and with lead responsibility for Macro Strategies” on the company’s website.
Gallo sets the scene as follows.
Most investors are still playing the game, and in the same direction. We estimate there are currently around $11tn in negative-yielding bonds and over $2tn in strategies that explicitly or implicitly depend on stable volatility and asset correlations. If low interest rates and QE have been the lever pushing up prices of dividend and coupon-paying assets, central banks are the fulcrum.
This fulcrum is slowly shifting: the ECB has just announced a reduction in its bond purchase programme, the Bank of England is likely to hike this month – even in the face of economic weakness –the Fed will likely hike rates again in December, and the PBoC has recently warned of asset overvaluation.
One of our favourite parts of the report is “The Magic Money Tree” infographic which explains how QE has benefited a plethora of investment strategies and created the current bubble to end all bubbles.
Now Gallo is obviously savvy because he doesn’t nail his colours to the mast on one factor which will prick the central bank bubble. Instead he offers four scenarios. The first threat is a rise in inflation, which he summarises as follows.
1. Inflation: after nine years of low-flation, the probability of a sudden rise in inflation is increasing, as job markets get tighter, globalisation leaves way to protectionist policies and liquidity reaches job-creating small and medium businesses as banks re-start lending.
Wage inflation aside, Gallo believes China could continue to export inflation based on a more resilient than expected Chinese economy. Gallo believes that China may have sufficient policy options to smoothly deflate its credit bubble. While we might disagree, it is a possibility.
The second threat to the central bank bubble is…central bankers.
2. Central bankers themselves: central banks appear to have shifted their tone to worry increasingly about financial stability. There are good reasons to do so. We are many years into a global synchronous expansion, and there will be little monetary policy ammunition to fight a new slowdown, with interest rates near record lows and $20tn in global central bank balance sheets. In some countries, like Japan and Switzerland, central banks have grown their balance sheets to sizes similar to their respective economies. The good news is some central banks are trying to curb stimulus before their mandate ends. The Federal Reserve is poised to raise rates again in December, the Bank of England will likely hike, the ECB has announced a reduction in purchases and the Bank of Canada has hiked too. The bad news is that markets have so far largely ignored this reduction in stimulus.
It makes sense…central banks created the bubble via QE and ZIRP/NIRP, so reversing that strategy might prick their own bubble.
The third threat is another merry band of miscreants.
3. Politicians: central bank QE has not only lowered yields and boosted asset prices. It has also artificially suppressed volatility. Yet volatility may come back as the consequences of rising inequality in the distribution of wealth, opportunity and natural resources across the world. The last decade has been great for billionaires, not so good for Main Street. Inequality of wealth and opportunity in developed economies has fuelled anti-establishment protest votes like the ones for Brexit or President Trump. Other populist parties are on the rise in Continental Europe and Scandinavia. In turn, domestic populism and nationalism in developed countries can increase commercial conflict and protectionism - see for instance the potential withdrawal from NAFTA, or the EU-UK tariff threat - as well as exacerbate militarism and geopolitical conflict. Populism has historically fuelled government spending and fiscal stimulus, higher taxes and aggressive redistribution policies, which could all re-price overvalued assets and/or target assets used as a store of value.
We have nothing to add.
4. The market: rising growth, low inflation and low interest rates have proven a boon to global markets. There are now $20tn in central bank assets globally, and around 10% of global sovereign debt is yielding negative. Investors have been buying equities for yield and bonds for capital gains, and have been selling volatility explicitly or positioned in strategies that are implicitly short volatility. These assume a stable volatility and correlation among the price of assets. For example, risk-parity strategies assume a negative correlation between risky assets, like stocks, and "risk-free assets", like U.S. treasuries. But what happens if both decline together, and short volatility investors become forced to unwind their portfolios?
Exactly, this is what we’re waiting for, but what is the catalyst? Nobody knows.
If we were forced to guess what will prick the bubble, we would probably place more emphasis on China than the Algebris report does. However, putting aside what causes it, we share Gallo’s view on some of the key mechanics which will be “in play” when a crisis unfolds.
What will the next crisis look like?
The over $2tn in explicit and implicit short-volatility strategies could be the spark, similar to sub-prime for credit markets in 2008, which was $1.4tn. However, a future crisis would be very different from 2008. Growth in passive investing vehicles and in the mismatch between assets they buy and liabilities they issue, lack of risk-free assets and growing collateral chains, diminishing trading liquidity due to higher capital requirements for dealers point to more fragility in financial markets.
It's perfectly set up, if we only knew when.
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Full report below...