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What is the market telling us?

This question comes up frequently, especially when talking about the bond market.

People will ask what 'the market' is trying to tell us as if the market were an all-powerful singular entity, projecting its opinion out for the world to interpret.

There's often an implicit assumption that traders are transacting for the exact same reasons. Either they think the number goes up/down or they're executing an order for someone else who thinks the number goes up/down.

How realistic is this framework?

When people talk about the markets, there's usually a speculative angle to the commentary. To some extent this is probably accurate.

Over time, markets are the sum of decisions made by thousands upon thousands of minds and opinions trying to price a vision of the future.

  • Sometimes the vision is clear and markets will trend.
  • Other times there's more uncertainty and markets will chop.
  • Then there's 'the rest of the time' when markets do a bit of both

What about the participants that are forced to transact? For example:

G-SIB's (Global Systemically Important Banks)

Your 'too big to fail' banks had to be watched more carefully after the GFC.

A new regulatory framework was required ๐Ÿ‘‡

To reduce the probability of failure of G-SIBs, the Basel Committee on Banking Supervision (BCBS) increased the going-concern loss absorbency of G-SIBs through an assessment methodology and related higher loss absorbency (HLA) requirement.

In layman's terms, they need to hold higher reserves in case the shit hits the fan again.

And the more 'risk' they're holding at any time, the more reserves need to be set aside for losses. ๐Ÿ‘‡

As this is only measured once per year, banks game the system ahead of the reporting period (year-end) to ensure they maintain a lower score.

At the risk of oversimplifying, they sell riskier assets and buy zero/low-risk ones.

It's no secret. The Fed published a paper on this here ๐Ÿ‘‡

How Do U.S. Global Systemically Important Banks Lower Their Capital Surcharges?
The Federal Reserve Board of Governors in Washington DC.

The ECB even have a working paper titled:

"Behind the scenes of the beauty contest: window dressing and the G-SIB framework"

This is a good read on the subject too:

G-Sib regime: somethingโ€™s broken -
US banks are taking the Fed for a ride โ€“ itโ€™s time to address the issue

Fair to say that they're transacting for regulatory reasons rather than directional speculation...

Gamma Squeezes

Over in the options market, dealers are taking on risk every time they sell a call option. Dealers will always try to be directionally (delta) neutral. ย 

So, when demand for call options drastically outpaces demand for put options (as we've seen a few times over the past year) dealers have to actively hedge that directional exposure and buy the underlying stock, creating a self-fulfilling loop.

e.g. If someone buys Tesla calls, and the dealer can't write an identical amount of call and put options to hedge and achieve balance, they might be forced to buy shares in Tesla to hedge their risk .

There's another knock-on factor too: Index-trackers/ETFโ€™s have to buy the stock in order to accurately track the index price movements caused by this 'forced' buying.

GSIB, Gamma, ETF's: None of these transactions are 'directionally' motivated. They're the product of constraints and/or forced actions.

Pension funds also operate under constraints. They can't bet the entire fund on a Gamestop short squeeze. They need to invest (primarily) in high quality assets such as sovereign bonds.

Keep that ๐Ÿ‘† ย in mind when anyone says that bond yields are telling a story, Goldman Sachs point out other factors in play

โ€œThere are two possible explanationsโ€ for the new bond market conundrum, according to Goldman, โ€œa widely prevalent low terminal rate view, or that the price signal is distorted by supply/demand imbalance.โ€
The Wall Street giant said the imbalance between supply and demand is โ€œa more compellingโ€ explanation, adding that itโ€™s โ€œone that will take time, and some rate hikes to resolve, leaving the long end relatively sticky over the course of the year even as front end yields reprice materially higher.โ€
Foreign demand for U.S. Treasuries remains high as other sovereign yields are negative or near zero, a point raised by Fed chair Jerome Powell after last monthโ€™s central bank meeting.
In recent years, large institutional investors including pension funds and insurers have also been buyers of 30-year Treasuries when yields have risen above 2%, which is seen as reflecting expectations for a low terminal funds rate.

While it's a useful exercise to try and 'read the mind' of the market, (and useful stories are definitely being told by moves in different asets), understanding constraints and forced transactions is important too.

When things don't make sense from a narrative perspective, consider the constraints.

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