12 Jul THE LEVERAGE IN THE RISK PARITY TRADES AND THE RELATIONSHIP TO THE BOND MARKET
Most would argue the current advance is predicated upon a dramatic change in monetary policy. The bond market has fully discounted a 34% drop in the overnight rate in four months, one of the sharpest declines in monetary history, a decline that is priced in equities. The issue at hand however, according to the FRB, the economy is still solid but uncertainties are rising.
Yesterday Bloomberg penned a story about how fast money quants have scaled record heights riding this bond rally using leverage and derivatives to take positions and amplify returns.
Partially because of the above, risk based parity funds are off to their best start since at least 2004 ramping up exposure to government debt while at the same time leveraging up. Bloomberg writes their leverage ratio is now about 190% from about 50% in January.
To write the obvious, these risk parity funds are now extremely vulnerable if there is a radical change in monetary policy assumptions or a selloff in the Treasury market.
It can be argued the credit bubble in investment grade rated debt is at manic proportions…$13.5 trillion and quickly growing.
Typically debt trades upon future inflationary expectations, expectations today are virtually non existent. But is this the correct view?
June’s core CPI was the greatest increase since January 2018, validating the FRB view that the lack of inflation is transitionary. The 0.3% increase was sufficient to push the year on year change to 2.1% from 2.0%. A major component of this increase was shelter costs, more specifically owners’ equivalent rent or what someone thinks they could rent their home for if it was indeed rental.
OER comprises about 32% of most inflationary indices. It is believed that OER will continual to make a “substantial contribution” to an expected acceleration in consumer prices from now to year end.
What happens if inflationary expectations start to become unanchored?
Many times I have commented about market imbalances, the result of technology based trading programs that has greatly skewed valuations. These models emphasize cost and speed of execution over liquidity and capitalization.
Little attention is focused to potential issues when prices are rising. In times of stress I am certain these technology based platforms will disappear thus creating an even more illiquid market. Unfortunately it only at this juncture attention will then be focused on a problem that I think is so obvious.
Hopefully these concerns do not rise to fruition.
Commenting about yesterday’s market action, equities again rose because of a dovish monetary policy view. Treasuries sold off on the stronger than expected CPI.
Late in the day both the Richmond and the Atlanta Fed President stated that he is skeptical about the need to reduce interest rates later this month because the job market is performing well and some measures of inflation are near the Fed’s 2% target.
Last night the foreign markets were up. London was up 0.18%, Paris up 0.44% and Frankfurt down 0.01%. China was up 0.44%, Japan up 0.20% and Hang Sang up 0.14%.
The Dow should open nominally higher on cautious optimism on prospects for easier monetary policy. The 10-year is up 1/32 to yield 2.14%.