Along with the unusual conjunction of Mars, Earth and the Sun on Tuesday, I noticed an even more unusual alignment of highly informed US investors and highly informed members of the leftwing intelligentsia. They were agreeing on a common object of loathing: the Federal Reserve and the ways in which its quantitative easing supported a small oligarchy. The Mars-Earth-Sun conjunction happens every 778 days, but to hear near-perfect unanimity of opposition to the pre-eminent establishment institution? I have never heard it before, or even seen it through a telescope.
The investors were at Jim Grant’s conference at the Plaza, the semi-annual gathering of informed financial sceptics and the value tribe. Unlike the rest of us, who just moan about the Fed governors’ mispricing of risk, Jim is writing a book on the last time their predecessors did it right: the recession of 1920-21. Interest rates were raised, Wall Street and the banks were not supported with arcane schemes, and there was a sharp recovery in about 18 months.
That evening, the leftwing intelligentsia were down at the Strand bookstore in lower Manhattan to hear Nomi Prins, the ex-Goldman managing director and writer, talk about the multi-decade unholy alliance between bankers and the US presidency. It was a calm, authoritative elucidation of verifiable history.
Even the Fed seems to disdain the Fed. The resignation of Jeremy Stein from the Fed board of governors the previous week was taken as a planetary omen by the credit tribe. His February 7 2013 “remarks” on credit-market overheating have since been passed from hand to hand like an electronically dog-eared samizdat.
It reminds me of the consensus in France just before the 1789 revolution about the evils of the sale of offices conferring patents of nobility. From the left to the right, “everyone” from the ancient nobility to Parisian egalitarians agreed that venal ennoblement was wrong. When venality was finally abolished by the Assembly on August 5, though, no one was prepared for I guess what we would call the systemic risk. Without a clear alternative path to respectability, for years the only way to the top was through desperate adventurism.
Since we can see the popular consensus behind the coming illiquidity events, I do not quite see why more professional fixed income investors do not compete with each other by promising investors less frequent access to their assets. The fixed income universe is far larger than in 2008 and dealers who will buy when the world is selling, have fewer people, less and less capital, though more lawyers. The extra income to be earned by buying illiquid instruments has been quite persistent, and, when the cash is wanted, it will not be there anyway.
The problem seems to be that while you can measure returns any which way to however many decimal places you want, you cannot reliably measure prospective liquidity. If we cannot measure something, we will not have the illusion of control.
The Fed has been expressing muted concern about the declining levels of corporate bond liquidity. As a New York Fed report from last autumn put it, “Once the [Volcker] rule [trying to prevent banks from proprietary trading] is implemented, market makers’ capacity to provide liquidity will be reduced. Given that market-making is a profitable business, other institutional investors, who are typically arbitrageurs, will potentially fill the void. We doubt whether this is a desirable outcome, because our evidence points out that the unwinding of arbitrage positions by these institutional investors can be detrimental to the cash market, and thus to the funding costs of corporations.”
God forbid. But notice the “given” that market making is a profitable business. Kind of like the “given” daily liquidity for fixed income mutual funds. I have been wondering why, if it is so profitable, new, non-bank arbitrageurs have not been setting up shop to replace the teams and capital the banks are not committing.
My friend Jeff Peskind, founder of Phoenix Investment Adviser, a $1.15bn stressed bond fund, says the few new entrants to high-yield bond market making are not doing all that well. “The perverse thing is that you would think there was a big need for the dealers to provide liquidity, but the trading volumes are lower. Also the trading volumes have been funnelled even more into the big names.”
Martin Fridson, the high-yield bond industry analyst, says he doubts the contention of the banks and the Fed that the primary dealers have or will cut back on liquidity provision in response to the Volcker rule. “Their reduction in capital commitments came before the rule was embedded in the Dodd-Frank law.”
Yet investment managers are, effectively, only giving investors a narrow range of liquidity choices. You can have daily liquidity, or, if you like, quarterly or annual liquidity. Portfolio managers blame the Fed for all the over-arbitraging in the world, but there is a fair amount of excess return to be picked up in between those windows.
Perhaps if investment managers and Fed officials have their own “August 5 1789” moment, we might see a bit more creativity and value-adding work. Remind me to chart the next planetary alignment.