This week in bizarro world the European Central Bank went nuclear and turned the capital markets upside down. Thursday the central bank introduced a negative interest rate on deposits at the ECB, and on Friday yields and credit risk premiums on peripheral European bonds collapsed. Remember the European debt crisis? Well, as of Friday yields on 5-year Italian and Spanish traded through US 5-year yields. When adjusting for the spreads on the respective credit default swaps, the US 5-year trades 87bps cheap to Italy and 75bps cheap to Spain. Not too long ago these yields were over 500bps wider than treasuries.
On the flip side the Federal Reserve continues the QE exit process, and is not only poised to raise interest rates but will also be mopping up trillions in excess liquidity. This massively diverging monetary policy between the two central banks has historically brought an increase in systemic risk. In March 2011, when QE II was stoking inflation and the ECB was contemplating tightening, international research firm GaveKal issued an ominous report titled "Past Clashes in EU-US Monetary Policy" that chronicled four tumultuous incidents when monetary policy diverged.
1. In 1970, as the US sank into a mild recession, the Fed slashed interest rates from 9% to 3.5%. The Bundesbank, more worried about inflation, refused to ease substantially until nine months after the Fed and then started reversing its rate cuts in June 1971. Two months later, in August 1971, Nixon abandoned the gold standard and the Bretton Woods currency system collapsed.
2. On October 1, 1987, the Bundesbank unexpectedly orchestrated an increase of +50 basis points in market rates, thereby breaching the "Louvre agreement" to support the Dollar, at least in the eyes of the Reagan administration. A public attack on German monetary policy by James Baker, the US Treasury Secretary, was followed immediately by "Black Monday", the biggest-ever global stock market crash.
3. In 1991-92, while the Fed was pulling the US economy out of the 1990-91 recession, Buba again went on the war-path, following a row with the German government over the costs of re-unification. In July 1992, Buba raised its discount rate unexpectedly from 8% to 8.75%. Black Wednesday -- the collapse of Sterling, the Lira and SKR -- followed on September 16, 1992.
4. The latest such incident occurred in July, 2008, when the ECB raised its repo rate in response to the last oil shock, while the Fed was easing to relieve the banking crisis. Lehman went bankrupt two months later, although the causal connection was less obvious than in cases (1) to (3).
Fighting their single inflation mandate the ECB would go on to raise interest rates by 50bps to 1.50% in July 2011. In August the stock market crashed.
This time around is different in that it's the Fed that's tightening as the ECB is easing. Does this reduce the systemic risk that has accompanied past policy divergences? I don't know. I don't think anybody knows. But it would be naïve to think there would be no impact on capital flows and banking system liquidity. With implied volatility on all risk assets at record lows in the face of unprecedented monetary policy maneuvers, I suspect smart money investors will be looking to dial back risk exposure.
Where is the risk going to come from? Will it show up in currencies, stocks, bonds or commodities? Maybe nothing happens. Maybe the reaction is delayed. Will you be able to see it coming?
I tend to seek macro wisdom when I am uncertain as to the macro conditions and this is the most uncertain environment I can recall in my 20 years in the business. Anyone who tells you otherwise is either a liar or doesn't understand where risk comes from.
I pulled up an old interview Bloomberg's Erik Schatzker conducted with Bridgewater's Ray Dalio on September 15, 2011. The markets were in the midst of the most volatility since 2008, but Dalio was at ease. The emphasis is mine:
DALIO: No. I think that there is an intrinsic characteristic that determines the returns of asset classes. So a very simple example would be, if inflation was to come down by a certain amount, you multiply that times the duration of the bonds. And all things being equal, it will carry over to the bond returned. And so that there's a certain structure that exists in asset classes. There is no such thing as an intrinsic classic correlation.
So the relationship between bonds and stocks, for example, can either be positively correlated or negatively correlated, depending - and both of them makes sense, if you know what determines the pricing of that asset class.
So bonds are always logical in that way. Stocks are always logical. But if you come into a time, for example, when economic uncertainty and volatility is greater, then they'll be negatively correlated. If you're in a period of time where inflation uncertainty and volatility is greater, they will be positively correlated. Both of those things are logical, OK, if you know how they behave.
Therefore, it's that understanding, not a fixed notion that there should be a correlation. That fixed notion of the correlation doesn't exist. There's no such thing as correlation. There's only the logical behavior of each of those two markets that then will determine its relationship.
And so when I say uncorrelated asset classes, what I'm really doing is not using the classic measure of correlation like its stocks and bonds are 40 percent correlated when I'm, instead, really referring to is do you know how they behave?
And isn't it going to intrinsically behave alike or differently?
It sounds complicated but it's really very simple. Bridgewater won't tell you what it's buying, but on its website
there are very candid articles explaining the company's asset allocation philosophy and method of exposure.
In The All Weather Story
Bridgewater describes its balanced portfolio for any and all market environments. The key is identifying growth and inflation as the drivers of asset prices, and balancing exposure to both in rising and falling environments. As it says, the value of an investment is primarily determined by the volume of economic activity and its pricing (growth and inflation).
Bridgewater notes that market prices are subject to surprises in either or both of these factors. There are assets that perform when growth surprises to the upside, and conversely when it surprises to the downside. There are assets that perform when inflation surprises to the upside and conversely to the downside. There are basically four different environments and they want equal exposure to all four.
The firm diagrams a box describing these exposures. For growth rising it wants 25% exposure to equities, commodities, corporate credit and EM credit. For growth falling it wants 25% exposure to nominal bonds and inflation-linked bonds. For inflation rising it wants 25% exposure to inflation-linked bonds, commodities and EM credit. For inflation falling it wants 25% exposure to equities and nominal bonds.
As Dalio noted in his interview, asset prices aren't absolutely correlated it depends on how they behave under the growth environment and, more importantly, how inflation is impacting this growth. It's not about a preconceived notion of correlation. It's how assets correlate to changes in growth and inflation, or as he says, what determines the pricing
. Again, he says:
So the relationship between bonds and stocks, for example, can either be positively correlated or negatively correlated, depending -- and both would make sense, if you know what determines the pricing of that asset class.
The "All Weather" portfolio is one that owns uncorrelated return streams to surprises in growth and inflation. It attempts to mitigate systemic risk through leveraging diversification, while collecting the risk premiums offered by its various assets. It's simple yet brilliant.
We are coming up on a Fed meeting, and there will be a lot of focus on the Fed's projection for the level of interest rates. Don't believe the hype. Nowhere does Bridgewater mention where the Fed funds rate is in their asset allocation model. The only thing that matters is growth and inflation; you want a balanced exposure to both drivers of asset prices, and in both directions.
In the current environment the expectation for growth is high and inflation is low. It's truly a Goldilocks scenario. However with unprecedented central bank action, is this scenario sustainable? Inflation is low by historical standards, but so is growth. The slightest shock from such a low base can have a magnified impact on the economy. There is not much room for error.
The Fed has a very delicate task. Move too slowly and rising inflation risk could crush aggregate demand. Move too quickly and it risks creating a liquidity vacuum that sucks the fuel out of the financial system. Instead of assuming they walk the tightrope, I think this is a time investors should assume policy error risk is high and look for exposure to risk in both tails.