Wednesday, August 24, 2011
- A Word On The 'Overnight' Market
In response to a frithguild request, I started writing a primer on the impact of political risk on counterparty and repo issues and overnight lending markets, but about a page and a half into it I realized that everything I had written was too pretentious to publish. I have that problem sometimes. But I've learned never to take 100 words to say what I could otherwise say in 10. Anyway, the last thing you need to spend your time on is me explaining how smart I am, so I trashed the whole primer. I’m sure you have better things to do.
Besides, you all know what political risk does. It gives some people a benefit who don’t deserve it, and penalizes everyone else. But what’s worse is that whatever effect it causes can go away in an instant. A CEO accidentally offends the wife of a political leader at a fundraiser and there goes his competitive advantage... POOF – like a puff of smoke. You can’t invest in anything so fleeting; not in any size anyway. And that's very much the situation in the developed world today.
The current economic winners are only winning because they’ve been chosen by a large government. Level the playing field and none of the big money center banks would still be in business. You could say that they’re being systematically mismanaged, but since the Fed is supporting them, it doesn’t matter. So if you want to get compensated for both the political risk and the counterparty risk of losers being treated as winners, when the government is manipulating long term rates, short term rates, the value of the currency, and the value of risk assets (equities and commodities), where do you go?
The answer is the overnight market – repos. You offer a lower value for bonds offered as collateral, and demand a higher yield from counterparties. The technical explanations for this are many, but unimportant. Call it a change in the return distribution, or greater tail risk, or whatever. What it means is, when a policy changes happens it will have a dramatic effect on the markets lowering the value of debt (which is artificially high) and raising the yield on loans (which are artificially low). The overnight market is simply pricing that in now. It’s a reflection of the gap between the objective reality of the financial markets and the ‘make believe’ reality of politics.
That’s it. That’s really all there is to know about the overnight risk issues. The banks are being systematically mismanaged as are the balance sheets of virtually every nation state in the developed world. And since you won’t be compensated for the extra risk in those markets directly, you’re getting the return where you can.
As I’ve said a number of times before, risk cannot be eliminated, only distilled. Right now, it’s being distilled to the last market where government is allowing freedom of motion. And when the ECB, the Fed and the other policy makers once again allow the markets to price in reality, my bet is the rest of the market will look more like Repos do now than the other way around.