1. Art and Diseño

Viewpoint
February 2015
Your Global Investment Authority
New Neutrals, Fat Tails and
Distorted Markets
This article originally appeared on institutionalinvestor.com
on 27 January 2015.
Vineer Bhansali, Ph.D.
Managing Director
Portfolio Manager
Dr. Bhansali is a managing director and
portfolio manager in the Newport Beach
office. He currently oversees PIMCO's
quantitative investment portfolios. From
2000, he also headed PIMCO's firmwide
analytics department. Prior to joining
PIMCO in 2000, he was a proprietary trader
in the fixed income trading group at Credit
Suisse First Boston and in the fixed income
arbitrage group at Salomon Brothers in New
York. Previously, he was head of the exotic
and hybrid options trading desk at Citibank
in New York. He is the author of numerous
scientific and financial papers and of the
books "Bond Portfolio Investing and Risk
Management," "Pricing and Managing
Exotic and Hybrid Options," "Fixed Income
Finance: A Quantitative Approach" and the
most recent book, "Tail Risk Hedging." He
also holds the ATP (Airline Transport Pilot)
certificate, the highest civil aviation license
in the U.S. He has 24 years of investment
experience and holds a Ph.D. in theoretical
particle physics from Harvard University. He
has a master's degree in physics and an
undergraduate degree from the California
Institute of Technology.
PIMCO identified a secular investment theme a few years ago,
and the logical progression of events is playing out close to
the script. Circa 2007 we identified “stable disequilibrium,”
which preceded the financial crisis of 2008. The New Normal
of subdued growth and central bank action followed
naturally from this. And finally, the New Normal morphed
into The New Neutral, which is characterized by lower-thanhistorical growth rates and, consequently, lower-than-normal
policy rates. The next logical step is a natural market ecology
that consists of large market movements from improperly
positioned participants and even more radical policy
responses.
Policy responses emanating from the willingness and the ability of central
bankers to try to support their local markets and hopefully their real economies
can best be characterized as a culture of “credible irresponsibility” (which we
discussed in a forum a few years ago and which follows a period of precommitment to accommodative policy). Credible because they can do it – they
have the ability, at least in the short term, to follow up on their promises to
deliver even more massive doses of stimulus (witness the well-anticipated
quantitative easing announcement by the European Central Bank), and
subsequent off-cycle responses from other central banks (Singapore and
Denmark to name two more). Irresponsible because in a game of stare down (or
“chicken”), the unpredictable actor, who appears to be acting irresponsibly in
the short term, has the better chance of being the winner.
From the perspective of market participants, credible
irresponsibility was best illustrated by the decision of the
Swiss National Bank (SNB) to suddenly, and without
warning, drop the floor they had put in place for the Swiss
franc versus the euro. The SNB on January 15th despite
previous guidance to the contrary, and facing increasing
upward pressure on the franc did a shock 180° and
dropped the 1.20 franc-per-euro cap on their currency.
This led to widespread market disruption as foreign
exchange risk became unhedgeable, dealers got hit with
forward, option and volatility spikes, and risk-reversals
exploded as demand for Swiss franc call overwhelmed
available supply.
The following night massive FX forward positions were
unwound with anecdotes indicating that overnight implied
rates plummeted to -9%, and the risk continued to
percolate out sending 10-year yields well into negative
territory: a cycle of dislocation courtesy of central bank
policy.
FIGURE 1: SWISS FRANC SOARS VERSUS EURO AFTER SNB
LETS IT FLOAT
1.05
FIGURE 2: SWISS 10-YEAR RATES FALL INTO NEGATIVE
TERRITORY
0.95
0.9
Percent
23-Jan-15
21-Jan-15
19-Jan-15
17-Jan-15
15-Jan-15
13-Jan-15
9-Jan-15
11-Jan-15
0.2
7-Jan-15
0.7
5-Jan-15
0.3
3-Jan-15
0.75
1-Jan-15
0.4
30-Dec-14
0.8
28-Dec-14
0.5
26-Dec-14
0.85
24-Dec-14
Euros per franc
1
As mentioned, the greatest distortions are evident in the
interest rate markets. Swiss yields (both government bonds
and swaps) are negative out to 10 years. In other words,
you have to pay money to lend them money. There is a
rational (relatively speaking) explanation for this: Swiss
short rates are negative – Swiss target rates are -0.75%
and one month deposit rates quoted at -1.625% on
Monday traded at -3% just a week ago. (One would
naturally trace the highly volatile movement in the deposit
rate to the unwind of currency forward positions that were
not prepared for such a surprise, though evidence of this
smoking gun will probably only emerge in the weeks and
months to follow.) Since long-term rates are nothing but
an average of short-term rates in the future, if we assume
negative short-term rates out into the future, the negative
longer-term yield follows arithmetically. Collateral damage
is being felt by modelers of interest rate derivatives, where
much of the accumulated knowledge over multiple
decades was designed to preclude negative nominal
interest rates, which are simply the norm in many
developed European nations. This has resulted in many
derivatives markets freezing up (for instance, in the Swiss
swaptions markets liquidity has essentially evaporated).
0.1
0
-0.1
-0.2
23-Jan-15
21-Jan-15
19-Jan-15
17-Jan-15
15-Jan-15
13-Jan-15
11-Jan-15
9-Jan-15
7-Jan-15
5-Jan-15
3-Jan-15
1-Jan-15
30-Dec-14
28-Dec-14
26-Dec-14
The massive currency swings that this created resulted in
irrecoverable damage to many large and small investors,
but consistent with our theme this was nothing but a
continuation of the natural evolution of the interaction of
policy and markets that will result in fatter tail events and
market distortions.
-0.3
24-Dec-14
Source: Bloomberg as of 23 January 2015
Source: Bloomberg as of 23 January 2015
Relatively speaking there is nothing wrong with negative
rates, and in many cases they might even be required to
FEBRUARY 2015 | VIEWPOINT
2
extract an exorbitant price for insurance so that taking risk
becomes the only choice. But we should step back and
reflect on whether as investors we should be willing to pay
for the privilege of lending (in absolute terms) for the next
ten years to an economy that depends on banking and
exports (both of which suffer under perpetual negative
rates) and that willfully allowed a 30% strengthening of its
currency against its trading partners after promising the
opposite. Whatever the answer to the question, one
cannot ignore that this type of market distortion is a
natural aftermath of fluid policy action and opens the door
to unforeseen risks and fat tails.
While it might not be easy to protect against unforeseen
events (please see PIMCO’s October 2014 Viewpoint,
“Can Anything Go Wrong for the Markets?”), one can
easily see that the logical aftermath of The New Neutral is
an environment of unpredictability, market distortions and
fat tails. The theme for portfolio construction that works in
such environments is one of opportunistic strategies
combined with tactical allocation and well-protected
exposure to risk assets. Hanging your hat on the “central
bank put” is becoming fraught with dangers like none of
us have seen – ever. Good luck.
FEBRUARY 2015 | VIEWPOINT
3
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