Quantitative easing (QE) saved us from the 2008 crash and kick-started a recovery, but also encouraged a build-up of one-sided risk in the financial system. Are markets and the economy ready for the fallout?
The sudden rise in volatility last February shows that, despite strong growth, financial markets remain vulnerable. Since 2008, we have experienced seven flash crashes followed by sudden recoveries. Volatility has become binary with markets swinging between periods of shock and calm. While the VIX index, which measures the stock market’s expectation of volatility, has traded at a median of 16 since QE, against 18 before, the spikes in volatility have become twice as frequent. This is equivalent to exchanging stable, drizzly rain in the City of London for sunny weather but with more hurricanes.
As central bankers attempt to normalize policy, the risk is a collapse of carry trades in financial markets, where an investor borrows at a low interest rate to invest in something promising a high return, with a negative spillover into the economy.
Central banks have bought $21 trillion in government debt globally since 2008, pushing investors to search for yields in riskier markets. The result is a pyramid of trades dependent on stable interest rates: $12 trillion of government debt yields less than 1% and the yield from $11 trillion of corporate debt is nearing a record low. As cash-flows and growth rates are discounted at near-zero rates, $8 trillion of high dividend and growth stocks trade at record high valuations. At the top of the pyramid are strategies betting on stable volatility and asset correlations, which total up to $2 trillion, according to our estimates.
While carry trades have flourished, the architecture of financial markets has become increasingly fragile. In 1976, the economist Hyman Minsky wrote that a crisis can develop when financial structures amplify rather than dampen an initial shock. Today, we can identify a number of negative feedback loops in strategies which use leverage, buy illiquid assets or own a large percentage of their asset class. A bank-loan, exchange-traded fund (ETF) issues listed shares but takes between 30 and 60 days to settle a loan sale in the secondary market. There is also a systemic impact. ETFs own 3.9% of US high-yield bonds – more than the inventory of all broker-dealers put together. Passive strategies and quantitative trading together represent 60% of equity assets, according to JP Morgan research. With tighter banking regulation limiting the room for trading desks to absorb risk, markets can be caught in violent crosswinds when passive strategies unravel.
In the February sell-off, junk bond ETFs lost around 13% of their shares outstanding. Like instantaneous redemptions, these force the ETFs to sell bonds in the secondary market to redeem shares, expediting a sell-off. Because investors know this, they may be encouraged to sell, as the Bank for International Settlements wrote in a report last Sunday:
“[T]he unique structures of ETFs might allow, or even encourage, less stable investment behaviour by owners of these products”. Short volatility strategies act similarly: by selling volatility and put options in good times, they buy the dip, keeping stocks and credit within a narrow range. Lower volatility, in turn, generates profit for such trades and encourages more investors to pile into the same strategies. In a sell-off, however, the mechanism works the other way around and exacerbates the sell-off.
The result is increased fragility: if a flash crash can cripple markets during a global expansion, what will happen in a recession? And can financial market fragility translate into economic volatility?
While the Federal Reserve is normalizing policy rates, the European Central Bank and Bank of Japan remain the fulcrum for central bank balance sheets making up half of global QE assets. This means it will be more difficult for them to exit without shocks. In turn, financial shocks can hurt growth, potentially through three contagion channels.
Firstly, if QE worked through a wealth effect on asset prices and consumption, falling markets could reverse it. In the US, the top 10% of income earners account for a quarter of national consumer spending, according to the Bureau of Labor Statistics. This is also the group of people who saw their net wealth grow 24% from 2010-2016, thanks to rising asset prices, while the bottom 40% of earners experienced a decline in net wealth in the same period. In other words, income and wealth distribution has become increasingly polarized, which makes domestic consumption vulnerable to a financial market slump.
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Secondly, easy monetary policy has reduced funding costs for corporates but has also kept “zombie companies” alive, instead of having them restructured. This weak tail of corporates are susceptible to a sharp rise in bond yields: default risks would increase materially if the five-year Treasury yield is near 3% and high-yield spreads are above 500bp, according to UBS research.
Thirdly, tighter and more volatile financial conditions tend to discourage investments and dampen sales, which, in turn, hurts growth. As research by the St Louis Fed suggests, corporate investment in 1990-2015 on average dropped by more than 10% when financial conditions were bad, while sales growth also stagnated. The deterioration in investment and sales is especially pronounced for companies with high dependence on external financing.
Since the crisis, regulators have focused on bank capital to prevent a reoccurrence, while macro-prudential measures have overlooked market risks.
To build an anti-fragile market, regulators should encourage diversity and long-term incentives among investors, preventing negative feedback loops and promoting instruments that act as circuit-breakers in a crisis, such as convertible bank capital for banks and growth-linked debt for sovereigns. Without these measures, the risk of tail-events will remain high, and the likelihood of a full-policy normalization is low. Investors should prepare for hurricanes while the sun is still out.