A “liquidity regime” – the condition we now have as the Fed and other central banks douse markets with liquidity to manipulate asset prices higher – is “far more dangerous for investors” than when markets are left to their own devices. Under the current liquidity regime, asset prices are determined by central bank policies and move together. And there is “no possibility to diversify portfolios or hedge.”
That’s how a very inconvenient analysis by Natixis, the investment bank of France’s second largest megabank, Groupe BPCE, pulls the rug out from under the self-satisfied complacent markets of today.
Six years after the Fed and other central banks have imposed zero-interest-rate policies and waves of QE on their respective lands for the sole benefit of investors, investors now get what they really don’t like: undiversifiable risk – hence, real danger!
Since the Financial Crisis, monetary policies have been designed to create a tsunami of liquidity that would purposefully inflate all asset prices. Ben Bernanke called it the “wealth effect” in 2010. “Strong and creative measures” – QE and ZIRP – would lead to higher stock prices, which would boost wealth, spur spending, and crank up the economy. The latter, of course, is precisely what did not happen.
The strategy was supposed to make investors very, very rich. The more money investors had in the markets, the richer they’d get. Our favorite uncle Warren Buffett, whose financial and insurance empire got bailed out by the Fed during the Financial Crisis, came out on top. The prices of stocks, bonds, homes, classic cars, farmland, art… they all soared together, on cue, and as planned, under the Fed’s “liquidity regime.”
Natixis explains in the report:
A “liquidity regime” corresponds to periods when it is monetary policies and expected future monetary policies that determine financial asset price trends.
When there are expectations of a very expansionary monetary policy and massive creation of liquidity by the central bank, the prices of all financial assets rise, and the opposite holds in a liquidity regime when there are expectations of a more restrictive monetary policy.
Under a liquidity regime, assets that are touted as “risk-free,” such as 10-year Treasuries, move in tandem with higher-risk assets such as high-grade corporate bonds, junk bonds, or stocks. They all move together in the same direction: their prices rise when there is an expected or actual expansionary monetary policy; and their prices decline when there is an expected or actual restrictive monetary policy.
But when markets are left to their own devices, they operate under what Natixis calls the “risk-aversion regime.” Changes in risk aversion drive asset prices. The animal spirits either go in search of risk or flee from it in their unruly and unpredictable manner, and each time they do, the prices of assets in different risk categories move in opposite directions.
Investors fleeing risk will head into “risk-free” assets, such as Treasuries, and drive up their prices, while the risk assets they’re fleeing, such as junk bonds or stocks, decline. When investors change their mind and seek risk once again, the process reverses. This “provides diversified portfolios with a natural hedge,” the report explains.
It’s the most fundamental and the most important portfolio diversification strategy. But it doesn’t work under a “liquidity regime.”
The problem for investors under a liquidity regime is that their “diversified” portfolios are in fact not diversified. Sure, the risk posed by an individual company can be diversified by having stocks and bonds from a variety of companies in the portfolio. But market risk cannot be diversified. Having stocks and bonds in the portfolio merely gives the appearance of diversification.
But it’s an illusion: “There is no possibility for diversification or hedging in a ‘liquidity regime,’ since prices of all financial assets move in tandem.” And the inconvenient conclusion:
In reality, investors do not like a liquidity regime.
In a period of abundant liquidity…, the prices of all financial assets rise. One could believe that investors would like such a situation, but that is not the case. Investors know that if there is a turnaround in monetary policy expectations, all asset prices will fall. Accordingly, they cannot diversify their portfolios or hedge against the expected downturn in liquidity.
This issue apparently never occurred to any of the geniuses at the Fed, neither at the time these policies were hatched out in secret, nor as they’ve been pushed forward relentlessly. It boils down to this: The exit will destroy some of the capital that the “wealth effect” so laboriously created out of nothing. A diversified portfolio of financial assets won’t protect against it. Some hard assets might, and cash will, but real estate, art, classic cars, etc. won’t because they too are a function of the liquidity regime. It’s only a question of whose capital will be destroyed, and when.
One of the largest junk-debt deals ever takes shape in this environment where investors think there are no risks, even as the largest junk-debt deal ever is now in bankruptcy. Read… Junk-Debt Apocalypse Later
Would you like to be notified via email when WOLF STREET publishes a new article? Sign up here.