The End of Positive Convexity

Nick Ferres Vantage Point Articles

The decade since 2008 has been characterised by a regime that some observers such as Larry Summers have termed “secular stagnation” – the prevailing bias that low trend growth, low inflation and low interest rates are a permanent state. This belief was pervasive and self-reinforcing for policymakers’ and market participants. An additional and related feature of the regime was volatility aversion. In secular stagnation, investors had a clear preference for assets with perceived stability of cash flow and price. On the one hand investors preferred to hold equities with bond-like characteristics and credit. On the other hand, investors sought growth in what was perceived to be a low growth world in equity sectors like US technology. The Federal Reserve and other central banks reinforced the regime with their actions and promises: anchoring the policy rate and future short rate expectations at a low level with forward guidance and providing liquidity via balance sheet activities (quantitative easing).

In that regime, a range of carry trades worked extremely well. As we have noted in the past, there is an intimate link between liquidity, volatility and leverage. Put another way, when liquidity is plentiful, risk free rates and volatility are low, carry trades in credit or related assets perform extremely well. Another feature of the regime was the negative correlation between bond performance and equities. In the 2008 crisis, the most effective hedge for an equity portfolio was a long position in Treasuries. Risk parity was a systematic and levered version of this strategy. It had spectacular success while that correlation persisted. However, the risk – as we noted more than two years ago – was that the correlation might eventually break down. On a related point, correlations on risk assets have all trend towards one over the past two weeks which has also clearly contributed to a VAR (Value-at-Risk) shock.

More recently we suggested that a plausible trigger for a breakdown in the inverse correlation between bonds and equities might be when policymakers pivoted toward aggressive and sustained fiscal policy. As has become widely appreciated over the past week, the economic response to the coronavirus has become fiscal. The size of the fiscal measures are now a cumulative $1.5 trillion US dollars globally. That excludes the likely $1.2 trillion from the United States. Like everything in this episode, the escalation in fiscal spending has been rapid. Moreover, if the fiscal expansion is accompanied with quantitative easing, then policy has effectively pivoted to helicopter money (direct handouts) or outright monetisation.

Looking forward, if there is a sustained pivot to fiscal policy to maintain economic growth after the virus-driven sudden stop ends, it could contribute to a sharp V-shape move in both sovereign yields and a steepening of the yield curve. However, in the short term the impact of the extremely large lockdown (or shut down) of activity on growth has probably been greater than the offsetting policy measures from both the monetary and fiscal authorities. From our perch, that is what price is telling us in how it has responded to news. For example, a conservative back of the envelope estimate of the impact of the shutdown measures on US GDP suggests that it will likely be more than -10% (or deeper) over the next quarter. That would be larger than the worst quarterly contraction during 2008 and greater than the current planned policy stimulus. The estimate on the US is also likely to be consistent across the developed world. On the positive side and as we noted above, the policy support in the pipeline will set up a sharp recovery once the healthcare crisis peaks.

The final point to note for markets is that following the collapse in Treasury yields to a record lows in early March, the nominal yield no longer offered compensation for future inflation risk. Moreover, once sovereign bonds stopped providing positive returns during phases of falling equity markets, they ceased being effective as a diversifier for risk assets. Of course, some investors who relied on this strategy (risk parity) also had levered long positions in the Treasuries. That also contributed to forced selling during the recent VAR shock. In the medium term and looking beyond the current episode, a rise in sovereign bond yields for the right reason – a cyclical acceleration in growth – would be positive for risk assets. In the short term, the way price continues to respond to more policy news suggests that the impact of the sudden stop is more impactful. Ultimately, investors will likely require a peak in the healthcare crisis in the United States and Europe, before equities can recover in a sustainable manner. On the positive side, the episode has created some enormous valuation anomalies and opportunities (more on that to follow).