Will Investors Play The Cooperative Game?

Following a 6 months period during which equity markets experienced seemingly one way movements – up and the US sovereign debt yield curve was calm, the latest turbulence principally in the bond market may just be a warning signal, certainly when coupled with the rising volatility seen during the last 5 weeks.

For now though, investors are remaining just vigilant as the latest tsunami warnings coming from Italy and Cyprus have proved false alarms. But, in a fast-paced world, that may quickly change and turn into the worst of the situation for “Helicopter” Ben Bernanke  – a sell-off in both bonds and equities – crushing self sustaining recovery hopes and providing an unwelcome memory from 1994 (see bloG below).

Although we’ve avoided a major sell-off in equities for now, it is undeniable that the US equity market is now pausing for breath. After experiencing a substantial from early Autumn last year which was catalysed by “Super” Mario Draghi’s comments re the commitment to keep the Euro safe, and then followed by Bernanke’s increased QE implementation, and now and by carefully chosen words and rhetoric games being played over the “tapering” of QE, the rally is showing signs of running out of steam. It is true that after any retreat, equities have quickly recovered during the last 12 months. However, here’s an interesting stat, for the first time during this period, the S&P 500 has not risen over the preceding 30 days. In fact it has now lost 1.3%. That could be a sign of waning momentum…

If we look at European markets, the situation is even worse. The FTSE, for example, is down 4.9% over the last 30 days and the German DAX down 1.6%. In Asia, the high-flying Nikkei has been pole-axed during the last 30 days and it is down 14.8% – something we flagged as a trade just days in advance of its break.

If the equity drop isn’t telling a story, then let’s look into the credit markets. Credit spreads have been widening just as they had previously in the year during the crisis felt in both Italy and Cyprus. This time, the reasoning behind the widening is different, as concerns about a “rates back-up” are back on the frontline, but one way or another, investors are long risk cash and short risk synthetic short. They’re using derivatives to hedge against the potential risk created by an unwinding of QE in the US.

No one wants to miss the current rally in equities or jump off the artificially inflated bond bull market, but at the same time there is a negative feeling growing and investors are increasingly looking to protect for that. That may actually act as a brake on any shakedown as the more severe one’s inevitably come about when nobody expects it. Certainly in looking at the equity Put:Call ratio in recent weeks, it is clear to me that investors are looking after the downside and in fact this must be seen as a positive sign.

In both the Italian and Cypriot situations, investors unwound their derivative hedges as bond prices fell whilst keeping their investments untouched and that’s probably what will happen now, but there are some particularities that differ in the current situation from the previous episode. Reported long risk positions have now risen to the highest since may 2011 (most likely as hedge funds continue to chase beta), the extent to which investors have used synthetic index hedges is now much higher, and although cash spreads barely moved during the previous crisis widenings, they have now widened significantly.

Will this time be different? Will investors unwind their risk hedges? Or, will they opt to unwind the long part of their portfolios? Investors face a prisoner’s dilemma. By acting before than others, they can avoid losses even though when others do react they will all be worse off or they can just wait for a cooperative solution with nobody doing nothing. It seems they are opting for the latter presently.

By trying to save themselves ahead of the crowd (being the first to unwind the long risky positions), investors will be better at a first step, but then the best move for others is to follow this action and also to unwind long positions. With everybody doing the same, spreads will substantially widen and everybody will be worse off.

Unfortunately, theory gives an answer for this dilemma as the Nobel Prize winner John Nash discussed in his work. The non-cooperative equilibrium is worse than what would result from a collaborative solution and so it will most likely hold as investors try to get the best for themselves. The game changer here is the Federal Reserve. If they come to the rescue again this week with more dovish and “anti taper” words, then spreads may tighten again, otherwise we may see continuing drops in equities and a quick & sharp incremental increase in bond yields.