One of the Fed’s recurring arguments meant to explain why the financial system is more stable now than it was 10 years ago, and is therefore less prone to a Lehman or “Black monday”-type event, (which in turn is meant to justify the Fed’s blowing of a 31x Shiller PE bubble) is that there is generally less leverage in the system, and as a result a sudden, explosive leverage unwind is far less likely… or at least that’s what the Fed’s recently departed vice Chair, and top macroprudential regulator, Stanley Fischer has claimed.
But is Fischer right? Is systemic leverage truly lower? The answer is “of course not” as anyone who has observed the trends not only among vol trading products, where vega has never been higher, but also among corporate leverage, sovereign debt, and the record duration exposure can confirm. It’s just not where the Fed usually would look…
Which is why in the excerpt below, taken from the latest One River asset management weekend notes, CIO Eric Peters explains to US central bankers – and everyone else – not only why the Fed is yet again so precariously wrong, but also where all the record leverage is to be found this time around.
This Time, by Eric Peters
“People ask, ‘Where’s the leverage this time?’” said the investor. Last cycle it was housing, banks.
“People ask, ‘Where will we get a loss in value severe enough to sustain an asset price decline?’” he continued. Banks deleveraged, the economy is reasonably healthy.
“People say, ‘What’s good for the economy is good for the stock market,’” he said.
“People say, ‘I can see that there may be real market liquidity problems, but that’s a short-lived price shock, not a value shock,’” he explained.
“You see, people generally look for things they’ve seen before.”
“There’s less concentrated leverage in the economy than in 2008, but more leverage spread broadly across the economy this time,” said the same investor.
“The leverage is in risk parity strategies. There is greater duration and structural leverage.”
As volatility declines and Sharpe ratios rise, investors can expand leverage without the appearance of increasing risk.
“People move from senior-secured debt to unsecured. They buy 10yr Italian telecom debt instead of 5yr. This time, the rise in system-wide risk is not explicit leverage, it is implicit leverage.”
“Companies are leveraging themselves this cycle,” explained the same investor, marveling at the scale of bond issuance to fund stock buybacks.
“When people buy the stock of a company that is highly geared, they have more risk.” It is inescapable.
“It is not so much that a few sectors are insanely overvalued or explicitly overleveraged this time, it is that everything is overvalued and implicitly overleveraged,” he said.
“And what people struggle to see is that this time it will be a financial accident with economic consequences, not the other way around.”