“Liquidity is confidence” according to Fed Governor Kevin M. Warsh and right now it feels like confidence and liquidity in financial markets is starting to ebb. Why you ask ?
Well first the evidence. Volatility has returned. As I write, volatility as measured by the Vix Index is currently at levels approaching those witnessed back in late February and early March. The world’s major equity indices are set to end the month of June in negative territory, barring a strong bounce later this week. Ten year bond yields in the UK, Europe and US have fallen back this week though they are still significantly higher than those experienced at the end of May. Further testament to the current lack of demand for risk is the cost of buying ‘protection’ through the iTraxx credit default swap indices (see here). Prices have increased by around 15-20% since the start of the month.
Last week Bear Stearns hit the headlines with the near collapse of their High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit Strategies Enhanced Leveraged Fund (try saying that after a few drinks). Essentially the funds had made leveraged bets on US sub-prime borrowers- (see here) mortgages given to individuals in the US with less than exemplary credit scores. Rising delinquencies amongst sub-prime borrowers have, unsurprisingly, resulted in a re-pricing of those securities backed by sub-prime mortgages. In some instances the re-pricing has been nothing short of extreme. A number of market participants, Bear Stearns being the highest profile example, (though Cheyne Capital, UBS and other investors are also alleged to have racked up significant losses) have struggled in the aftermath. Under pressure to meet margin calls and repay investors Bear Stearns and the like were forced to liquidate somewhat opaque and illiquid securities with, arguably, wider consequences for financial markets (both Richard & David have commented recently on this). The velocity with which confidence and liquidity can be withdrawn has become all to apparent.
It’s also worth mentioning that a few of us met yesterday with a senior strategist at RBS. He thinks we have a global inflationary problem on our hands (partly a result of the growth in the BRICs – Brazil, Russia, India & China). As a result he sees a Fed unable to cut rates in the face of continued US housing woes, higher bonds yields and increased volatility; all of which don’t bode well for leveraged investors and if he’s right will have significant implications for investor’s confidence. Richard gave this some attention recently (see here).
It is exactly these intertwined issues of potentially higher bond yields, further distress in the US housing market and record leverage amongst investors that has the financial markets spooked. Both Richard and I remain cautious on credit as we look for higher interest rates in the UK and Europe and have positioned our funds accordingly.