There's a storm coming

Brett Gillespie

Global Macro

In “The Second Machine Age”, Eric Brynjolfsson and Andrew McAfee from MIT, chronologise how quickly technology is changing the world, and posit what the world might look like in the future. "Most fear that technology will replace most jobs. But the analogue and prediction I found most interesting was that man and machine will do better than machine alone".

The alarm bell for machines replacing man was arguably first sounded in 1997, when Garry Kasparov, world chess master, was defeated by IBM’s Deep Blue computer. But subsequently Kasparov could beat Deep Blue, or indeed any follower, with the assistance of a computer and even the most rudimentary chess game.


I acknowledge that there is an awful lot of systematic work in my own process. There has to be in today’s world, where information is so plentiful and absorbed so quickly. And so daily our programs systematically review:

  1. Trend and momentum in markets
  2. Over 80 indicators of global risk
  3. Whether volatility is cheap or expensive across the globe, and the largest volatility “skews” to take advantage of.
  4. What factors are the key drivers of all currencies, via historical correlation and regression analysis
  5. Whether global economic data is beating or missing consensus forecasts, via our surprise indices
  6. Whether the global economy is mapping our forecasts via our nowcasting indices
  7. And how our financial condition indices are evolving

I could go on! But the point is we systematise a lot of our inputs to give us an instant read on how economies are tracking and are projected to track, value in markets, timing of execution from market signals, and the best way to express themes in option markets.

And then we use discretion.

Because that is where the creativity comes in.

There are so many macro events that can’t be modelled. Trump, any day of the week. Brexit. A left and right wing party joining in Italy. A central bank suddenly swinging hawkish or dovish. One needs to brainstorm, probability weight and identify catalysts. The systematic analysis takes the pulse of the globe and identifies the best way to structure the portfolio. But then we use discretion to tick the box, or indeed think outside the box.

And so one question is “Are we about to repeat 1994?” The largest annual negative return in bonds in modern time.

The short answer is possibly. But it is more complicated than 1994. For an analogue, I think one has to look to 1994, 1998, and 1968!

Let me explain.

I have talked about 1994 before. Let’s first understand what happened. The backdrop:

  1. The Fed funds rate was 3%, and had been there for about 18 months, following a 3 year decline from 9.75%. Rates were never going to rise, and the way to make money for the prior 3 years was simple. Long interest rates (buying bonds) anywhere. The higher the rate, the better. Sound familiar?
  2. When the Fed started hiking in 1994, carry/long rates was obliterated. Nowhere was the reversal more ferocious than European peripheral bonds – the carry of choice back then. It was nothing to do with fundamentals – the central bank there never hiked. Simply the bursting of a “carry” bubble.

After a tech bubble and a housing bubble, it astounds me that many don’t recognise we are in the midst of the next central bank engineered bubble, the global bond (carry) bubble.

So, when this bubble bursts, what will it look like? Well first, where is it? After 10 years of quantitative easing and zero to negative interest rates, where have investors gone to find yield? Well it has been out of money market funds and into bond funds to start.

Overwhelmingly the money has flowed into “investment grade” credit (IG) in the US. Corporate debt. But not “high yield”. Money has been flowing out of that sector since the energy crisis in 2015.

Nonetheless, for a true bubble to burst, we need two factors:

  1. A fundamental change
  2. A lack of liquidity

The two are not unrelated. As the fundamental picture reverses, liquidity dries up. But poor liquidity will dramatically exacerbate a minor fundamental tweak. Whereas good liquidity won’t prevent a bubble bursting when the fundamentals change.

So which bubbles are most vulnerable from a liquidity perspective? To answer that, we calculated how much money has gone into each sector relative to its size in 2009. This gives us an idea of how much money has been driven into these markets by QE/zero rates, and hence the potential for a reversal of those flows. The EM markets are very vulnerable…

How has so much money made its way into this space? ETFs, or exchange traded funds. A decade ago, it wasn’t very easy for an investor to own a collection of emerging market bonds. They would have to buy them in each country, and manage the FX risk. Wouldn’t it be great if someone could package this up and do that for you? With all investors in search of yield, enter the ETF. Voila! You want yield? Get the best in the world via our ETF! Boom!

But what happens if everyone wants to sell? Then the manager actually has to go into the market and sell 1,003 bonds. The liquid bonds turn over about 0.25% of their issue size each day. Heaven forbid if you wanted to sell 5% of an issue. HY ETFs argue they are only 14.2% of the retail market. But if everyone is selling their ETF, won’t the other holders be selling too?

The bottom line is the ETFs allow easy access to an illiquid market. This is fine until it isn’t. God forbid someone yells fire. Or Fed. Because as the Fed continues to hike, the reason for being in these EM ETFs is crumbling. Investors are eyeing the exit…

So how does it play out? A bubble bursting is notoriously difficult to predict.

But we have a catalyst – Fed hikes. The turn looks to be in, and the flows are starting. We think there is a very real risk a bursting is unfolding, and as such we are positioned for a bust in this sector

What would make us more certain? That is where 1968 comes in. That was the last time the Fed set zero real rates in the belief inflation would not emerge. Indeed, Powell recently touched on this at his Sintra speech, in an effort to dissuade commentators that this was a worthy analogue.

The bottom line is that the late 1960’s is the last time the Fed had policy this easy with the labour market so strong. And it’s fair to say the result was disastrous. Which is why 1994 does not serve as a perfect analogue. In 1994, Greenspan was determined not to repeat the mistake of 68. Hence he hiked interest rates aggressively, before and so inflation would not have a chance to emerge.

This won’t happen under a Powell Fed, with a symmetric inflation objective. At least not until it is too late. 

And 1998? In a hiking cycle, things break. I refer to 1998 (and 1997) because an offshore crisis averted the Fed rate hikes, and indeed prompted the Fed to reverse direction and cut 75 basis points. So could a crisis in EM now pause the Fed? Possibly.

So after so many possibilities, let me draw together the possibilities for you.

First and most simply, the Fed needs the US economy to slow down.

How strong is that need? If wages and inflation don’t accelerate, in the Fed’s current view, that need is fairly strong. But similar to 04-06, it still takes a lot to placate the determination of the Fed to return policy to a somewhat restrictive level – in their mind about 3.5%.

What if 68 is the right analogue? Put politely, the Fed would be in rather a pickle. They will have to hike rates aggressively and engineer a recession. Hence Powell’s optimistic counter.

But here’s the rub. Rate hikes from the Fed is not the only way to slow the US economy. A tightening in “financial conditions” will slow the economy. And this can occur via higher interest rates. Or higher rates for corporates. Or a higher USD. Or a fall in equity markets. Or some combination.

So if the wall, or EM market, falls down, the US Financial Conditions Indexes will tighten significantly via falling equities, rising corporate spreads and a strong USD. But not via Fed rate hikes. Indeed, like 98, the Fed might actually ease.

So how do we position for this?

We position for a tightening in the Financial Conditions Indexes. Sounds easy enough. Like herding cats…

Well in fact, if you want to herd cats, it’s best to do it one at a time. So we look at each component of the Financial Conditions Index.

  1. Fed hikes. The only direct tool available to the Fed if the Financial Conditions Index is not tightening. We are positioned for Fed hikes through 2019.
  2. Long bonds. Not directly controlled by the Fed, but influenced by the Fed and Fed expectations. A steepening of the yield curve, say due to higher inflation, would tighten the Financial Conditions Index. We have options for the curve to steepen.
  3. Corporate credit. Highly correlated to equities, but a liquidity break could see an outsized move. We are short IG credit in the US via options.
  4. Equities. Equities can fall for a number of reasons. The Fed, an EM crisis, an IG crisis, tariffs. We have the first 3 covered directly. From time to time we run downside on the US equity markets via options as well.

We think EM, both equities and bonds, is the next candidate for a “liquidity” break. So we own puts and put spreads on the ETFs that hold emerging market equities and bonds.

So that is it in a nutshell. Financial conditions in the US need to tighten. Quite possible an awful lot if wage and inflation lifts, which looks likely. But after a 10 year yield chase, it is quite likely something breaks and does the Fed’s job for it. And that will not be at all pleasant. Well at least not for the average investor. For us, we are looking forward to that once in a decade (or lifetime?) opportunity.

Do not be complacent.


About the Ellerston Global Macro Fund

The Ellerston Global Macro Fund is an absolute, unconstrained strategy investing in a number of fundamentally derived core themes, optimised via trade expression and portfolio construction across Fixed Income, Foreign Exchange, Equity & Commodities. It focuses on capital preservation while providing low to negative correlation to traditional asset classes. Find out more.

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Brett has worked in the financial services industry for over 28 years. Most recently he was Head of Global Macro at Ellerston Capital. Prior to that he spent over 10 years as Senior Portfolio Manager at Tudor Investment Corporation.


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