The chart below is fascinating to us, particularly in light of the fairly modest in magnitude, but quite speedy rise in UK yields. The chart shows the difference between futures prices for sterling 3 month LIBOR expiring in September 2022 and 3 years later, in September 2025. They price at 100 minus the interest rate, so a price of 99.5 equates to a 0.5% prevailing rate at expiry. Roughly speaking, individually the contracts can be interpreted as the markets best pricing for interest rates at those points in time, the spread between them gives a look at how the path is priced to get there.
A year ago, rates were priced to be at about zero in September 2022, and not much higher – maybe 1 hike – by September 2025. At a starting point of functionally zero rates – that’s a pretty poor prognosis for 5 years time. Earlier this year, the spread between contracts increased as the nearer maturity contract dropped a little in price – implying higher yields – while the longer maturity contract fell more in price. The spread widened to a high of 78bps in early summer. That’s the market roughly saying things are a bit better economically – over the next few years we will see about a hike per year.
The interesting part is not even the most recent drop in the September 2022 contract, as the market is pulling forward all those hikes into the next 1 year. Higher inflation and a better economy allowing the Bank of England to hike. So far so good, a bit aggressive maybe, but sure, probably some natural gas inflation in there. The interesting part to our eye is that the spread has collapsed. It is as if the market is saying ‘Sure you can hike now – but you’ll get to 1% and have to stop as the economy can’t withstand it, that’ll be it, maybe you’ll end up cutting again’. Now there are other things at play here in terms of pricing along the curves and longer rates being driven by other things – but as a fairly clean barometer its reasonable. The rubber is hitting the road on markets determining escape velocity. Will we get a self-sustaining recovery and a more normal economy that can sustain these yield levels and maybe higher as things take off? Or not? Its fascinating to watch play out…
“You can eat or you can sleep”. The biggest change I have witnessed over the course of the past 3+ decades is the change in investor preference, particularly hedge fund investors, away from positive skew to negative skew… from sleeping to eating. I sleep well. The quote came from a discussion my partner had with another manager who runs a fund that is often aggressively short volatility. He, like all of Wall Street and beyond, have monetized this preference for negative skew – regular returns most of the time, with the occasional blowup. They are eating well.
The preference for negative skew flies in the face of conventional finance theory and behavioral economics. After all, why would people buy lottery tickets? Smarter people than me have worked these ideas over, and it’s a bit of a mess. Let’s just think about 3 possible drivers (I am not bashful about stealing others good ideas). Some of these thoughts are motivated by a great blog post that can be found here: https://www.macroresilience.com/2010/01/13/do-investors-prefer-negative-skewness/
Falling Yields. Investors will give up positive skew in return for higher yields. In a low rate environment, one can get a higher yield by selling options. The last 25 years have seen persistently lower yields, and a wildly expanding options playground. Man wants a green suit, turn on the green light. Build product that yields well but has negative skew.
Moral Hazard – that thing officials used to worry about. No more. The central banks of the world, and, increasingly, the folks at the controls of fiscal policy, all but guarantee the financial downside. A hedge fund / family office that exploded earlier this year drew only fleeting notice from officialdom. Why? Because it was a garden variety bad trade, housed at one particular fund. There was nothing systemic about it … because it was a positive skew position. It was a classic one-off. Importantly, at the end of the day, they knew what he could lose. Systemic option selling has unlimited downside, and the players will not let that happen. Investors have grown to rely on this protection and have piled in – moral hazard.
Principal/Agent. No one likes to be told they have lost money. Agents know this. They also know that if they have company, it goes down easier with the principal. Join the crowd and count on number 2 above. Early in my career, we were trying to interest a large consultant in our fund. He listened politely, but at the end of the day he said that he was investing in a mortgage fund that made money every month. The meeting ended (as I recall we took him to dinner and a ballgame… I still regret it). That fund blew up a few months later in the first of the many mortgage meltdowns. He survived… in fact sold the consulting firm to a private equity shop. Eating well.
Contrary to these changes in preference, we have no intention of changing our stripes. We understand that our style is a more difficult hold than a steady earning, negative skew manager – that’s why there are very few of us left. But in a portfolio context, there is real value in a strategy that pushes against the prevailing wisdom. And we have demonstrated, over 3+ decades, that we can sleep well.