Hold on to your horses, the summer vacation is almost over
It is with considerable trepidation that I go into the last week of August. Beginning September, Americans get back from their summer vacation, and this includes Wall Street’s traders, investment managers, bankers, and everyone else with an interest in making money on the bourse.
It usually takes about a week to catch up on international market moves, and to monitor the progress of the underlings on the trading floor.
While the bosses were away on holiday, the junior traders had to man the office, operating within strict parametres as determined by the investment industry’s leading minds. On top of this, high frequency trading executed by computers is as vibrant as ever, giving us the lofty highs of the major financial markets in the USA.
Fortunately, not all Americans went on holiday. The small cohort of dedicated investment managers who stayed at home, have used the absence of the big guns to wrench some more small marginal returns from an industry that finds itself squeezed all the time for return on investment.
A report by one of these stay-at-home investors, alerted me to the fact that despite the pervasive incognisance, market fundamentals remain market fundamentals. The report is rather too technical too dwell upon here, but two main issues caught my attention.
First, if an investor now pays more for an asset than what it is reasonably worth, then, in his mind, he is banking on a sustained income stream for the foreseeable future, in this case, about three to five years. But, essentially, since he has paid too much upfront, that perceived future income stream, is a fallacy.
Second, there is a thing such as compressed risk premiums, which in ordinary English simply means investors are becoming reckless, or complacent, or simply daft. When investors pile into marginal assets like junk bonds, the typical reciprocal action is to demand a higher return. In other words, issuers of junk bonds, and every similar low-rated instrument, must pay a higher interest to compensate investors for the higher risk.
The difference between a “normal” rate and the higher interest rate is called a risk premium and according to my US analyst, it has all but disappeared.
Today, interest rates on junk bonds are more or less in line with interest rates in the money market, i.e. short term funding. And as we all know, interest rates in the money market is the only interest rate the Federal Reserve has a mandate to determine, and that it is basically zero.
Therefore, if money market interest rates are zero, and junk bonds now also trade at close to zero, the risk premium has become compressed, has become very small, insufficient to compensate the investor when a correction happens. And speaking from experience, they argue that compressed risk premiums can not go on forever.
In short, several leading American investment minds are warning that the system is as unstable as ever, potentially at least as unstable as in 2001 and in 2007.
So what will happen in the next two weeks? Once back in the office, investors will carefully weigh their portfolios for risk versus return. This may lead to some major adjustments in portfolio composition.
The signal to watch for is the movement in the capital market. Despite an economy that fails to reach take-off velocity five years after the financial crisis, investors and in particular investment banks, have since the interest rate scare of March this year, become tolerant of extreme gyrations in all asset classes. But the major US indices have just kept going upwards.
Every now and then, when some headline news has scared the market again, there is a noticeable move into US treasuries bringing long-term rates down from around 4% three years ago, to just over 2.4% this week. In Germany, the move is even more extreme. German Bunds yielding just over 2% two years ago, are down to just 0.9% this week.
Are these moves in the capital market indicative of large investors remaining cautious? I certainly think so, otherwise yields on US 10-year Treasuries would have been north of 4.5% and on German Bunds, around 2.5%.
But the market, or rather sentiment, is notoriously difficult to pinpoint. I will keep an eye on Treasury and Bund yields for the next two weeks. I believe the capital market will provide the first telltale signs when the major investors start to run for the gates. What effect it will have on us, is food for another day.