The Fault in Our Superstars
There is a great book by Roger Lowenstein called, "When Genius Failed: The Rise and Fall of Long Term Capital Management." Most millennials will not remember this one. It chronicles the meteoric rise and subsequent, equally spectacular collapse of the late hedge fund, Long Term Capital Management ("LTCM").
LTCM's untimely demise was in equal measure ironic, given its moniker, and unprecedented in scope, as at the time it posed such a severe risk to the entire financial system that the Federal Reserve was forced to step in and coordinate the fire sale of its assets to a consortium of the fund's creditors (of which, in another ironic twist of Karmic fate, Bear Stearns and Lehman Brothers were the lone holdouts).
LTCM was, at its point of inception, considered to be unquestionably the most elite hedge fund in human history, replete with star-studded Nobel laureates Robert Merton and Myron Scholes (the rockstar academics who invented the Black-Scholes option pricing model), former Federal Reserve Vice Chairman David Mullins, and John Merriwether, former Vice Chair and head of bond trading at Salomon Brothers.
This brain trust of celebrity financiers was considered to be the smartest money anywhere, and it used star power to hold LTCM's bankers in thrall, securing huge, opaque lines of credit at very favorable terms such that it was able to load up on massive amounts of leverage without triggering any alarm bells.
Merriwether and his merry men pushed the envelope of mathematical finance to its absolute limit. Their primary specialty was fixed income arbitrage, which usually involves the simultaneous buying and selling of different bond pairs until the prices of the two assets converge into a mathematically harmonious set of data points, at which point a profit is realized.
In theory, these types of trades are low-risk, low-return. Ergo, large amounts of leverage were required in order for the fund to generate excess returns, and LTCM therefore depended heavily on the credit lines extended by its bankers.
Things began to go south for LTCM as it became a victim of its own success; it was trading in such large volumes with its own capital base that it ran out of paper to buy and sell, while others also emulated the fund's arbitrage model, tightening spreads. Due to this proliferation of arbitrage trading, LTCM was forced to find other trading strategies in increasingly risky assets.
It diversified into equities (risk arbitrage) and emerging market sovereign debt and began to take on unhedged positions that were not market neutral. It arbitraged in highly illiquid over-the-counter option contracts on volatility and effectively became the "Central Bank of Volatility" due to the sheer volume of contracts it had written.
In the end, the bet that sank the fund was simply a bad bet on Russian sovereign debt that blew up when Russia defaulted in August of 1998. In the aftermath of the ensuing flight to quality, the fund was essentially obliterated in a giant short squeeze brought on due to the illiquidity of many of its positions.
The Value of $1,000 invested in LTCM (1994 - 1998)
Those who fail to learn from history…
There are some disconcerting parallels between the world of arbitrage trading in 1998 and the world of central banking circa 2016. LTCM's partners, in pursuing their quantitative trading models to the point of exhaustion, effectively failed to comprehend that the financial markets themselves were not akin to an experiment in a physics lab, but a social construct created by very fallible human beings.
Unlike a mathematical model, human beings can [unwisely] default on their sovereign debt payments (even when they have a printing press), pile into the same trades like so many lemmings until all the oxygen is sucked out of the room, take advantage of each other in zero-sum games, defraud each other, and otherwise fail to behave as predicted.
They failed to appreciate this distinction, because they were evidently blinded by their faith in their own models and convinced that their past performance would translate into future results.
Today, policymakers are essentially looking backwards and applying models that were developed in a prior century to developed, post-industrial economies with high ratios of public debt to GDP, gridlocked legislatures, and aging populations with different consumption and saving habits.
Between a Rock and a Hard Place
There is a quasi-iconic picture of Bank of Japan Governor Haruhiko Kuroda taken at last month's Jackson Hole economic symposium that has been circulating in the news media lately. If you scrutinize it carefully enough, you might imagine that he had been jet lagged and suffering from a dyspeptic ulcer, but was nevertheless dutifully putting on a brave face for the world.
A man in his position should have a dyspeptic ulcer, because being in his position would be very stressful for anyone who is not either psychopathic or otherwise devoid of empathy.
A poor man badly in need of a free lunch
The BOJ is the pioneering trailblazer for the world's central banks in that it has, since the early aughts, used Japan as a testbed in a heretofore open-ended monetary policy experiment known as quantitative easing. It has pursued these policies because it wants to create price inflation at a modest 2% per annum.
However, these policies have, thus far, failed to succeed; instead of higher consumer prices, the excess liquidity created by the central banks merely results in ultra-low yields and elevated prices for financial assets.
The fact that these policies have failed to cause an impact on inflation is not surprising, if you imagine that quantitative easing policies as a reward for the "haves" of the world who are pleased to see the value of their portfolio assets rise in value.
The "haves," however, are a population group largely comprised of baby boomers who are nearing their golden years and are not, presumably, inclined to run out to spend their newfound wealth on sports cars and ACME Consumption Widgets.
Here in the United States, for example, despite very low rates as far as the eye can see (or at least as far as the markets are pricing in), we do not see any moderation in the long-running, disinflationary trend in the rate of circulation of the underlying money stock:
The Road Less Taken
In a recent interview, former Treasury Secretary Hank Paulson recently remarked that we are in "uncharted economic territory." This quip almost seems cliché by now, but that doesn't mean that it is inaccurate. The world's central bankers, following their models and mandates, have collectively done their jobs to attempt to provide stimulus to their respective economies.
However, they have now effectively painted themselves into a corner, and their negative and zero interest rate policies are slowly destroying the very essence of the creative destruction that powers capitalism itself.
Stuck in neutral
Quantitative easing has limits and unintended consequences. The Policy Board of the Bank of Japan will convene tomorrow to debate them. They will discuss whether they may be able to lower short-term interest rates still further into negative territory without putting additional profit pressure on the banking system.
They will discuss if there were any other asset classes they might be able to buy with the money they create with the printing presses, now that they already own most of the entire market for certain JGB issues.
They will discuss whether they might be able to either talk down or divest themselves of the long end of the bond market without creating the impression that they were making the cost of money more expensive (which seems contradictory, considering that higher yields explicitly do translate into a higher cost of money).
However, any additional stimulus measures will be increasingly ineffective, as they will only marginally increase the money supply and therefore will not translate to higher inflation, in and of themselves. It is worth mentioning here that "helicopter money" is not an option because it has been explicitly ruled out by the BOJ, is illegal at present, and would absolutely entail the risk of a collapse in the JGB market.
The descent into insanity?
Ultra-easy monetary policies have distorted the fabric of capitalism itself. Anecdotal examples abound:
Sanofi, S.A. and Henkel, A.G., following in the footsteps of the negative yielding debt issuances by sovereign and state-sponsored entities, are now evidently being paid to borrow. Wouldn't it be nice to be paid to borrow? If I were paid to borrow, I would borrow as much money as I possibly could! This is a clear warning sign that the credit markets are mispricing risk.
There are other examples of moral hazard being created by negative and zero interest rate policies:
Many bulge bracket investment banks have realized that they can package and sell corporate debt directly to the 2,000 lb. gorilla in the room. Wouldn't it be nice if your customer had his very own printing press with which to create money to buy your products?
The BOJ, having effectively run out of bonds to buy, started buying equities in early 2016. Wouldn't it be nice to be a CEO today? You could mismanage your company into the ground, yet your stock options would still be in the money!
Why anyone would want to invest in the Nikkei, wherein one never knows exactly when the central bank will jump in and start buying and selling, is mystifying, but evidently this has not dissuaded market participants from front-running the ECB in anticipation of their intervention in the market for European corporates. Indeed, this "greater fool" effect is another explanation for negative yields.
Then there are the European commercial banks. From one side of its mouth, the ECB has mandated certain Italian lenders to raise capital to increase reserves. From the other side of its mouth, the ECB is taxing those very same reserves with NIRP!
Italy now has a banking system inundated with non-performing loans at 25% of GDP, and the ECB is actively engaged in creating an incentive for bankers to lend to increasingly less creditworthy borrowers in order to avoid a tax on their reserves.
If you are convinced that the BOJ is truly all but out of ammunition and will therefore be unable to keep expanding the Japanese monetary base, you should obviously buy the Yen (NYSEARCA:FXY). Japan runs a continual current account surplus with the United State and is also likely to benefit from any flight to quality from emerging markets during times of stress to the financial system.
If we see unexpected hawkishness from the Fed or noises from the Japanese Ministry of Finance regarding currency intervention, however, this trade could unwind, so tread cautiously.
Owing to the risks that have been created over a decade or more of experimental, beggar-thy-neighbor monetary policies, it would seem prudent to keep a large chunk of your holdings in cash, hold gold (NYSEARCA:GLD), overweight US equities in general, underweight emerging markets, underweight telecoms and utilities, and shorten up bond duration (although note that long bonds are a good deflation hedge if you think the risk lies there).
For some capital preservation, we recommend buying US equities with rock-solid balance sheets and putting short hedges in place on the rest of the equity market. The bet here is that the big chip stacks at the poker table will outperform the overleveraged competition in the event of a downturn.
Disclosure: I am/we are long FXY, GLD.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Disclaimer: This article provides the opinions of the author alone, has been written for informational purposes only, and does not constitute investment advice. References to specific securities are for illustrative purposes only and are not intended and should not be interpreted as recommendations to buy or sell such securities. Forward looking statements contained herein are highly speculative in nature and do not constitute actionable trading advice. Please consult a professional advisor and perform your own research before making any investment decisions.