Macaskill on markets: Trading the Great Moderation

Jon Macaskill
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Summer is upon us and with it the lull of the Second Great Moderation. The First Great Moderation, in the half decade to 2008, was a disappointment, given that it ended with the worst market crisis since the crash of 1929 and a global recession.

But it will clearly be different this time, as the world's central bankers devote themselves to ensuring that any signs of market stress are addressed with soothing commitments to low rates. Gone are the days when key central bankers were either wild-eyed free market acolytes of Ayn Rand (Greenspan, Alan) or owlish old buffers blinking in the sun (King, Mervyn).

Today's technocrats of market stability are an altogether more impressive breed. Even when the debonair new governor of the Bank of England ("the name's Carney, Mark Carney") shoots the sleeves of his immaculately tailored dinner jacket and warns that rates may rise rather earlier than expected, the assembled luminaries of the City of London take comfort from the knowledge that here is a man who knows what is required.

And if Carney has an equal in emollience, it is Mario Draghi of the European Central Bank, with his pledge that he will do whatever it takes to ensure stability. What exactly this might be is never explained, but everyone understands that it will be enough.

This masterful central bankery has had an understandable effect on market measures of volatility, which in turn is creating a dearth of trading opportunities. The Vix measure of S&P stock index volatility, once known as the fear gauge, had subsided almost to 10 by late June and was threatening to touch lows not even plumbed just before the credit crisis.

Across the rates, credit and foreign-exchange markets, other measures of volatility were also reaching or flirting with historical lows. Traders looked back at relatively recent periods that certainly felt volatile, if not downright alarming, such as the euro crisis of 2011/12, and realized that they had been wrong.

While pundits were warning of an imminent break-up of the euro and a retreat to caves for the effete inhabitants of the eurozone, the euro/US dollar exchange rate remained locked in an almost bizarrely narrow range of between 1.31 and 1.34 dollars to the euro, in what now seems like a harbinger of the Zen-like market conditions that are prevailing in 2014.

Pity the former swashbucklers of trading, the bank prop traders and 
hedge fund tyros who once rode waves of volatility to outsized profits, zigging 
when others zagged and bishing when weaker spirits could only bosh

Market commentators are coping with the change to a world of very little change. Pimco has adapted its description of the slow growth period expected after the 2008 crash (the new normal) to coin the phrase the 'new neutral'. 

This streamlined upgrade of an old catchphrase has been joined by the term 'patient capital', to describe the steady hands at certain investment firms who supposedly stand ready to correct any market lurches that might accompany an upward spike in interest rates and accompanying flight by panicking retail bond investors.

This iron willed source of buying in a potential crisis might be needed, given that bankers are now forbidden to reverse imbalances with proprietary trading, or indeed to hold significant debt inventories.

What exactly these patient capitalists do all day as the Second Great Moderation stretches on is a mystery, but it is a great comfort to know that they are waiting in the wings.

Analysts are also using cross asset valuations to demonstrate that what might seem like signs of absurd complacency in some sectors are in fact buying opportunities that have simply not been well understood. Stock analysts at Citi admitted in their half-yearly review of the European equity markets that many stocks did not look cheap, given that there has been a prolonged price rise.

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Macaskill on markets

But the analysts also highlighted the inexorable rally in the credit markets, where diminished secondary liquidity and a borrower default rate close to zero has encouraged steady buying from fixed income investors with few options in a zero rate world.

Most credit versus equity models show that the credit markets are over-valued, which apparently can only be viewed as a sign to buy stocks, as no-one is expecting an end to the tightening in credit spreads and appetite for new bonds seen so far this year.

Life in this best of all possible investing worlds is clearly sweet for steady-as-you-go holders of assets. But pity the former swashbucklers of trading, the bank prop traders and hedge fund tyros who once rode waves of volatility to outsized profits, zigging when others zagged and bishing when weaker spirits could only bosh.

Some of them may even be wondering whether their former success was due to the privileged information flow and access to under-priced capital that allowed them to make substantial bets in trending markets, rather than innate ability.

They should not be discouraged! For there are still trading opportunities available for the bold, and Euromoney is happy to share some tips for trading your way through this unfortunate period of calm in the markets:

1. Summon the spirit of Paul the Octopus and bet on the likely total size of coming regulatory fines at individual banks.

Pulpo Paul, the legendary Spanish Octopus with an apparent ability to pick World Cup winning teams, has passed away, but his spirit lives on in the new sport of “Guess the Size of the Fine” for sundry market abuses by banks.

Bid-offer spreads in this market are very healthy, as can be seen from the range of bets on a possible payout by BNP Paribas for breaches of US sanctions on countries including Sudan. BNPP itself, which might have been expected to have an inside track on the likely fine, appears to have believed it was on the hook for around $1 billion until just a few weeks before regulatory sabre-rattling pushed the number up to $9 billion.

Analysts admit that they do not have much insight into the likely total sizes of fines for individual banks, but that has not stopped them from having a crack at it and even venturing some very cautious observations about the implications of possible amounts.

Credit Suisse recently raised its estimate of the likely total payouts to come from European banks to $66 billion, for example, and pointed out that its guesstimate of €3.3 billion of coming fines for Deutsche Bank would eat up 41% of the €8 billion-plus raised in its recent equity offering.

It is easy to envisage Deutsche paying out far more than €3.3 billion, given its dominant position in many of the markets under regulatory scrutiny, but being relieved of over 40% of your new capital before you have even had a chance to mount an assault to recover lost fixed income market share around the world would certainly be galling enough.

2. Try to cultivate sources among regulators responsible for determining the size of the fines for individual banks.

It might seem like fines are assessed using a random number generator, given the wild divergence in amounts levied on different banks. But there is some method in this apparent regulatory madness – the trick is finding out exactly how it works nominally, then applying game theory and knowledge of the practical constraints on collecting fines to guess the eventual total.

US regulators recently displayed a rare example of sensitivity to accusations that they were rampaging round the financial schoolyard extorting money from any kids who looked like they might give it up easily, for example.

In an apparent move to address these concerns, regulators provided off-the-record guidance about the approaching fine for BNPP with some numbers designed to demonstrate that the bank was in fact getting off lightly, rather than being used for political purposes by zealous prosecutors.

This background guidance purported to show that BNPP was getting an easy ride because its fine as a proportion of $30 billion of suspect transactions worked out at a penalty of a little under 30 cents per dollar of sanctions-avoiding trades. Standard Chartered, by contrast, paid $1 of fines per dollar of suspect trades with its $667 million fine in 2012 and hapless old Royal Bank of Scotland disgorged over $3 per dollar of dodgy trades in its own $100 million settlement last year.

The same regulatory guidance also pointed out that under existing law BNPP could have been fined twice the volume of illicit transactions.

If this was designed to show that regulators have a systematic approach that they are applying consistently then it failed miserably. Why single out RBS, where senior managers can plausibly argue that they have no idea what is going on in far-flung parts of the bank? And why not take BNPP for the full $60 billion?

The answer of course is that BNPP could not pay a $60 billion fine without a capital increase that would probably need French state backing, while RBS has become so inured to paying fines and allocating costs for closing business lines that a $100 million payment seems like a rounding error.

A trader looking to prosper from a view on likely fine totals for individual banks would accordingly be well advised to look for insight into the process from knowledgeable sources. Of course inside information has to be treated carefully in a world of communications monitoring and there is a current lack of instruments for directly trading a view on fines.

Old hands in markets such as credit default swap dealing know that it is very difficult to make a charge of insider trading stick when it is expressed in an instrument that is affected on a secondary or tertiary basis by the inside knowledge, however, so this should not be an insurmountable problem.

3. Take your position in an instrument such as a dividend swap for the bank being fined.

The newly muscular approach to levying of fines by regulators is coming just as investors had begun to expect a return to something like pre-crisis dividend payment policies by banks (the old normal TM). There have been plenty of missteps on the path to a resumption in steady dividend payouts, such as rejected capital plans for Bank of America and Citi and near misses for Goldman Sachs and JPMorgan.

But even in Europe, with so many capital-strapped banks, analysts have recently predicted a rise towards dividend payout ratios of around 40% – lower than the 50% that was standard before the 2008 crisis, but well above the 25% or so of the years since then.

That assumption is now threatened by the Torquemada-style approach to fines for banks and the realisation by regulators that as long as they apply some caution they can milk big firms for many billions of dollars and euros.

This in turn should create opportunities for traders with any insight into total fines to prosper from dividend swap and futures volatility. Some banks, such as Credit Suisse, may try to apply their insouciant approach to fines (nothing to see here, everybody move on) to dividend policies. Others, such as BNPP, will surely have to cut back on payouts to investors.

Plus, if regulators overplay their hands and push a big bank so far with fines that investors lose confidence in the firm, then there could easily be a knock-on effect on overall market sentiment and a return of genuine cross-asset volatility.

And that would let a few lucky traders get back into the game as it should be played.