Tag: Banking

Are Global Markets Facing a New Period of Volatility?

Written by IntaCapital Swiss on . Posted in News & Reports. Leave a Comment

On Monday 5th August 2024 trading rooms in financial centres across the world faced one of the most volatile and chaotic days in recent history. In the United States by the close of business on Monday The MSCI (Morgan Stanley Capital International) All Country World Index (ACWI) was showing 90% of stocks had fallen, in what has been termed as an indiscriminate global sell-off. In Tokyo the Nikkei was down 12%, in Seoul the Kospi was down by 9% and at the opening bell in New York the Nasdaq plunged 6% in seconds. However by the Thursday evening of that week the turmoil in the markets had been forgotten as the S&P and ACWI were both down by only 1%.

But what brought about this huge summer sell-off? Many financial experts suggest that financial markets had convinced themselves that a soft land for the US economy was a given especially after what was perceived as a successful fight against inflation, with interest rates being kept high by the Federal Reserve. However, the moves in the markets were completely off the scale in relation to what actually triggered the sell-off. Analysts suggest the touchpaper was lit when two economic updates were published in the first two days of August 2024, plus a further announcement by the Bank of Japan (BOJ) that they were raising interest rates.

The first set of data was a survey of manufacturing, which was closely followed by official data released regarding the state of the US labour market. When taken together analysts suggested that instead of a soft landing, the US economy was indeed heading for a recession, and that unlike the Bank of England and the European Central Bank (ECB), the Federal Reserve was moving too slowly on interest rate cuts. The data released on new jobs, which was by no means the worst of the year, fell short of expectations of being only 114,000 as opposed to the expected figure of 175,000.

The start of the sell-off began in the Asian markets on Monday 5th August, as a stronger yen and rising interest rates in Japan combined with the bad economic data coming out of the United States. A vast number of market players and investors have been tied up in the “Yen Carry-Trade”*, where advantage has been taken of low interest rates in Japan allowing investors to borrow cheaply in Yen and invest in overseas assets especially in large US tech stocks and Mexican bonds. A number of traders felt the Yen carry trade was the “epicentre” of the markets and the unwinding of these trade caused the shakeout that followed. 

*Yen Carry Trade – For many years cheap money has been in Japan where interest rates have held at near zero. Any investor, bank, hedge fund etc can, for a small fee, borrow Japanese Yen and buy things like US tech stocks, government bonds or the Mexican Peso which have in recent years offered solid returns. The theory to this trade is that as long as the US Dollar remains low against the Yen investors can pay back the Yen and still walk away with a good profit. 

The sell-off also hit the Tokyo Stock Exchange which recorded its sharpest fall in 40 years, whilst the VIX** also known as the “Fear Gauge” hit a high of 65 (only surpassed a few times this century having enjoyed a lifetime average of circa 19.5), implying the markets expect a swing of 4% a day over the next month in the S&P 500. Analysts announced that when trading hit its peak it was very reminiscent of the 2007 – 2009 Global Financial Crisis, but without systemic risk fears. A well-known Japanese equity strategist suggested “The breath and the depth of the sell-off appeared to be driven a lot more by extremely concentrated positioning coming up against very tight risk limits”. 

**The VIX – is a ticker symbol and the in-house or popular name for the Chicago Board Options Exchange’s (CBOE) Volatility Index. This is a popular measure of the stock market’s expectation of volatility based on S&P 500 index options.

In the last four years Yen carry trades have been very popular as Japan has been essentially offering free money keeping interest rates at almost zero to encourage economic growth whilst the United States, the United Kingdom and Europe were raising interest rates to fight inflation. For many, borrowing at next to nothing in Japan and investing in a US Treasury Bond paying 5% or Mexican Bonds paying 10% seemed like a no brainer. However, once the market fundamentals of this carry trade started moving towards negative territory the global unwinding of these trades was an inevitability.

The market makers were always in evidence throughout the sell-off, suggesting that the structure of the markets were still in place. However, experts said that the biggest moves on the VIX were driven by a tsunami of investors all moving in the same direction. As one senior executive put it “there was no yin and yang of different views”, it was just one way traffic. However, the rebound on the following Thursday just highlighted the lack of fundamental clarity where, as one expert put it “The market is so fascinated by what is the latest data point that the ties between day-to-day stock price moves and fundamentals are more disconnected than ever before”. 

There have, however, been undercurrents in the background indicating a shift in current trends, and with unnerving global politics from the United States to the Middle East plus continued rumblings from China over Taiwan, volatility in the markets is ever present. Add to this US growth trending downwards and market/investor concern over stretched valuations in the US tech market, taken together with other factors including the fourth consecutive move south in the S&P and the VIX trending higher, a negative move in the markets could have been anticipated. So, whilst the fundamentals were in place to be interpreted by market experts, it was the data points and the unwinding of the Yen carry trades that kicked off the volatility swings.

Looking back from today (Friday 16th August) it is as if the volatility and single day crash never happened, however a number of experts suggest that markets could remain volatile until the Federal Reserve interest rate decision in September. Many renown commentators have said what happens in the United States does not stay in the United States, especially as the country has been a major driver of global economic growth, so if the United States does go into recession the world as a whole would suffer. Analysts also suggest that there are further Yen carry trades to unwind which will impart volatility into the markets. In the short-term, therefore, it would appear volatility is on the menu especially with an uncertain presidential election in November. Long term volatility is difficult to predict, but the markets will now be aware that when there is consensus thinking e.g. a soft landing for the US economy and all is rosy in the garden, markets can quickly turn on their heads and bite you very badly.

Has the Federal Reserve Left it Too late?

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On the 6th of June 2024 The European Central Bank (ECB) cut their interest rates by 0.25%, the Bank of England followed suit on the 1st of August 2024 lowering their interest rates by exactly the same percentage points. However, the US Federal Reserve’s Federal Open Market Committee (FOMC) on the 31st of July announced they were once again holding interest rates steady at 5.25% – 5.50% where they have now sat since July 2023. The last time the Federal Reserve cut interest rates was in March 2020, but all eyes are now on the FOMC meeting in September where financial markets and experts are expecting the Federal Reserve to announce a rate cut.

The mood coming out of the Federal Reserve suggests a cooling economy with data showing rising unemployment and moderating job gains. This suggests that the Federal Reserve may well indeed cut rates at their September meeting, but a weakening economy in some cases can spiral into a recession by feeding off itself. So, has the Federal Reserve left it too late to cut interest rates? Economists and financial experts alike remind us that the United States avoided a predicted recession in 2023, which may have resulted in favourable predictions that the US economy would enjoy a soft landing in 2024. 

However, the Federal Reserve may have misinterpreted data in a favourable manner due to Q2 enjoying unexpected increased growth figures of 2.8%, which was taken as evidence that the US economy was indeed in good shape. Some analysts have looked beyond this figure and suggest the economic growth has been propped up not only by government spending (which has been backed up by a sizeable deficit) but also by excessive hiring in the public sector. Warning signals such as the ISM Manufacturing New Orders Index* (a bell weather signal for past recessions) is showing signs of decline, in the week ending July 2024 jobless claims rose to an eleven month high and plethora of companies who are consumer focused recently recorded earnings figures misses. 

*ISM Manufacturing New Orders Index – This index, which is sometimes referred to as the “Purchasing Managers’ Index”, is considered a key indicator of the current state of the US Economy. It indicates the level of demand for products by measuring the amount of ordering activity at the nation’s factories. 

Other warning signals come from the New York Federal Reserve who are suggesting that there is a better than even chance of a recession appearing at some stage in Q3 and Q4. Such predictions are based on “the curve over time of bond yields”* though this has been an unreliable indicator in the past. Experts at a major New York investment bank suggest that the mean or median optimum interest rate (based on a number of monetary policy rules) should be 4%. Yet the Federal Reserve chose not to cut interest rates despite inflation in June coming close (within 0.5%) to their benchmark target of 2%.

*The curve over time of bond yields – If the yield curve is flattening , it raises fears of high inflation and recession. In the event of yield curve inversion this “EVENT” is viewed as the likelihood of the US economy slipping into recession. An inverted yield curve occurs when short-term yields on US Treasuries exceed long-term yields on US Treasuries. This occurred on June 14th, 2024, when the yield for a 10-year treasury was 4.2% and the yield for a 2-year treasury was 4.67%.

Experts suggest that an economy does not slow down in an undeviating manner and, unless checked, an economy can lose economic momentum and spiral out of control into recession. That means that any pricing by the financial markets for a soft landing can quickly go out the window. There are enough warnings out there for the Federal Reserve to take their foot off the brake on interest rate cuts, but will they lament not having cut interest rates in July when the FOMC meets in September.

Bank of England Cuts Interest Rates: Aug 2024

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On the 1st of August 2024 the Bank of England (BOE) cut interest rates by 25 basis points to 5% making this cut the first of its kind since March 2020. The BOE has held interest rates steady at 5.25% since August 2023 in its on-going battle against inflation. The vote to cut interest rates was a knife-edge decision, with members of the Monetary Policy Committee (MPC) voting five to four in favour of cutting interest rates. It was the governor himself who cast the deciding vote whilst the chief economist of the BOE Mr Huw Pill voted against a rate cut. Financial markets had expected an interest rate cut because, for the second month in succession, inflation held steady at the BOE’s target of 2%. 

The Governor of the BOE Andrew Bailey said that inflationary pressures had eased to the extent to allow the Bank to finally cut interest rates, but he went on to warn the markets and general public that they should not expect large rate cuts in the forthcoming months. The Governor went on to say, “Ensuring low and stable inflation is the best thing we can do to support economic growth and prosperity of the country”. This cut will be a boost for the new Labour Government as they attempt to revive a stagnating economy and improve living standards. 

Whilst inflation fell back to 2% in May 2024 the BOE is still very concerned that prices still remain high and, in fact, are significantly higher than three years ago and sadly are still rising. The BOE remains worried that the service sector still has problems with stubborn price increases and resilience in wage growth. As for the future, the MPC advises that over the upcoming months inflation will probably rise to 2.75%, overshooting the benchmark set by the BOE of 2%. However, the BOE appears confident and have forecasted that inflation in 2026 will fall to 1.7% with a further drop of 0.2% culminating in an inflation figure of 1.5% in 2027. 

Analysts have noted that the MPC has adopted a change in guidance, the key change being the wording on the “ importance of data release on wages and growth and service prices” have been dropped, but they did go on to say that they are closely monitoring the risks of inflation persistence. The recent announcement by the government of a public sector pay increase will, according to Governor Bailey, have little effect on inflation and the impact of other changes in policy would depend on how they were funded. These uncertainties combined with the hawkish stance by the MPC have left analysts confused, saying that current BOE policy is highly ambiguous, and they do not appear to be in a rush to cut rates again anytime soon.

 European Central Bank Finally Cuts Interest Rates

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On June 6th 2024 the ECB (European Central Bank) announced a cut in interest rates of 25 basis points to the deposit rate lowering it from 4.00% to 3.75% as headline inflation is now just above its 2% target having fallen from 10% in 2022. Inflation has largely come down due to lower fuel costs and supply chains, which have now become normalised after a few post Covid-19 twists and turns. 

However, the ECB advised that inflation is not yet beaten as the service sector remains sticky and as a result the ECB announced that “despite the progress over recent quarters, domestic price pressures remain strong as wage growth is elevated, and inflation is likely to stay above target well into next year.” The decision to lower interest rates was nearly unanimous with the only negative vote coming from Robert Holzman, Governor of the Central Bank of Austria.

The President of the ECB Christine Lagarde hedged her bets when answering questions regarding future rate cuts. She is quoted as saying “ Are we moving into a dialling back phase? I would not volunteer that. Is the dialling back process underway? There’s a strong likelihood”. A number of experts have described her message as somewhat confusing, especially as she added “We are not pre-committing to a particular rate path”. Experts and analysts alike suggest that another rate cut in July is now unlikely, with financial markets now focusing on September 2024. 

Last month the President Lagarde declared inflation under control, however with the lack of a clear path on rate cuts being offered by the ECB the string of recent data has pointed the finger at enduring price pressures. This alone would suggest that the ECB is going to be, as with other central banks, data driven prompting cautions when talking about future interest rate cuts. Together with a quarterly outlook published by the ECB forecasts for inflation will average 2.2% for 2025 up from an earlier forecast of 2%.

Elsewhere the Bank of Canada reduced its benchmark interest rate but both the Federal Reserve and the Bank of England are fighting tougher price pressures, and are only expected to follow suit in the coming months. Financial markets are waiting for some clear signs from both the Bank of England and the Federal Reserve as to when they expect to cut rates.

Bank of England Interest Rates. Will They or Won’t They?

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This month on June 20th the Bank of England’s MPC (Monetary Policy Committee) will meet and decide whether or not to keep interest rates on hold. At the last meeting of the MPC in May, interest rates were held at 5.25% for the sixth consecutive month and are still at their highest level since the Global Financial Crisis 2007 – 2009. The Bank of England’s target figure for inflation is 2% and in April it dipped to 2.3% which is a significant difference to March’s figure of 3.2%. 

However, experts in the financial markets had expected CPI (Consumer Price Index a common measure for headline inflation) for April to come in at 2.1%. However an important element in core inflation (does not include figures from food and energy sectors) came in at 5.9% in April down only 0.1% from March. All the above figures are supplied by the ONS (Office of National Statistics).

At the May meeting of the MPC Governor Andrew Bailey indicated that June may see a cut in interest rates though it is not a “fait accompli”, whilst also advising that like other central banks any cut in interest rates will be data driven. In mid-May financial markets suggested that an interest rate cut in June was circa 60% as measured by the overnight index swaps*, but since the release of the April inflation figures in late May that suggestion of an interest rate cut has subsided mainly in part due to sticky service inflation figures.

*Overnight Index Swaps – This is a financial bet on the direction of short-term interest rates and is a type of interest rate swap. In this case, it is typically a fixed for floating swap, where one party pays a fixed rate and receives the floating rate (linked to an overnight index) while the other party does the opposite. The overnight index for sterling is known as Sonia (replaced sterling Libor) and stands for Sterling Overnight Index Average.So will the Bank of England cut interest rates on June 20th? A number of experts suggest that an interest rate cut may not happen as the services sector inflation remains a problem and came in a lot hotter than market analysts predicted. Many experts feel that services inflation remains a critical part of the Bank of England’s thinking regarding inflation and interest rate cuts, and therefore the MPC may well decide to once again hold rates on June 20th.

Bad Debts and Chinese Banks 

Written by Barclay Butler on . Posted in Blog Article, News & Reports. Leave a Comment

Chinese banks have for years been reluctant to disclose any information on poorly performing loans or outright bad debts. They go to extraordinary lengths to hide these problems usually teaming up with an AMC (Asset Management Company)* where a transaction takes place that removes these loans from their books. So it came as a surprise when the Bank of Jiujiang on the 19th of March 2024 announced that profits for the previous year will probably fall by Circa 30% due to loans performing poorly.

*AMC’s – Chinese Asset Management Companies came into existence in 1998 and were established by the Ministry of Finance with the purpose of professionally managing third-party assets and was considered at that time to be a major landmark in the development of China’s financial system. It marked the transition from an unregulated environment to one where these specialist companies would operate with a defined set of financial parameters, regulations, and standards. 

The deal with AMC’s to hide these bad debts or poorly performing loans is as follows. First, the bank lends to the AMC who in return purchases the toxic loan(s) from the bank. Within the contract between the two parties it stipulates that the AMC will avoid any and all credit risks in regard to the toxic loans they are purchasing. Furthermore, the contract is also riddled with confidentiality clauses that keep either party from disclosing the arrangement, indeed sometimes even to courts. The result is that when the bank comes to declare their profits for the year to their investors they can produce a relatively clean balance sheet. 

For a long time the financial regulators were hoodwinked into believing that many of the banks were actually solving their bad debt problem, when in fact things were just getting worse and a number of experts suggest for literally hundreds of banks across China these toxic loans now represent a ticking time bomb. However, NAFR (The National Administration of Financial Regulation established 10th March 2023) the new financial regulatory body has caught on to these subterfuges and have been handing out fines left right and centre some in the region of Yuan200 Million (USD30 Million). Indeed, NAFR, with new heightened enforcement capabilities, are taking debt concealment much more seriously. 

Sadly for the banking institutions many AMC’s have themselves become distressed and are now reluctant to take more bad debt on board. Some decades ago China actually created four centrally controlled AMC’s to take on bad debt and are now currently struggling with one needing a bail out in 2021 to the tune of USD6.6 Billion. This is becoming a runaway freight train of bad debt, and with Bank of Jiujiang’s bad loan book increasing 700% between 2015 and the end of 2023, the whole banking system may soon become imperilled. 

The US Federal Reserve Releases New Scenario Stress Tests for Banks 

Written by Barclay Butler on . Posted in News & Reports. Leave a Comment

On Thursday 15th March 2024 the Federal Reserve issued new annual scenarios for stress tests for banks which will check their health under extreme economic shocks. These hypothetical shocks will include a collapse of real estate prices (40% drop in commercial real estate prices), and a jobless figure of 10% and will cover 32 banks including some with as little assets as USD100 Billion. Furthermore, the largest and most complex banks will be tested under a scenario where five hedge funds collapse at the same time. These stress scenarios represent the first tests since the collapse of Signature Banks and Silicon Valley in March 2023, which also led to the collapse of Credit Suisse Ag sparking concerns regarding the banking system as a whole.

Interestingly, the Federal Reserve has advised that these hypothetical scenarios will not affect or impact any of the tested banks capital adequacy requirements, pointing out that all results will not be issued until June 2024. These tests were first put in place post 2007 – 2009 Global Financial Crisis to ensure that banks in the United States could withstand further economic shocks and would allow banks to continue to lend to businesses and households despite any on-going shocks. These tests were a result of the Dodd-Frank Act (full name The Dodd-Frank Wall Street Reform and Consumer Protection Act),  that was enacted into law on the 21st of July 2010.

These tests are also very timely as there are growing worries in the financial markets regarding the exposure to commercial real estate (CRE), by a number of lenders, indeed, in January 2024 New York Community Bank sparked a drop in their share price having reported losses on bad CRE loans. The CRE sector (data released show small banks account for nearly 75% of outstanding loans in the CRE sector), has been facing a double whammy on the financial front with falling office occupation (due to widespread adoption of remote work) and high interest rates due to the Federal Reserve’s quantitative tightening measures. Interestingly, the 23 banks that were tested last year passed the tests with flying colours showing under the stress test scenarios they would lose a combined USD541 Billion but would still have double the amount of capital required.

In November, the United States will have their Presidential election most likely between Joe Biden (Democratic incumbent), and ex-President Donald Trump (Republican candidate). If Donald Trump is the victor, financial markets should be reminded that under his reign he signed into law a bill that amazingly reduced scrutiny over banks with assets under USD250 Billion, thus removing the requirement for many regional banks to submit stress testing plus reducing the amount of cash on their balance sheet usually required to protect against financial emergencies. If indeed he tries to do this again, we can only hope that insiders and financial authorities can prevail against this sort of action, otherwise we may have another financial disaster on our hands.

What is Bank Liquidity and Why is it Important?

Written by Barclay Butler on . Posted in Blog Article, News & Reports. Leave a Comment

The global financial crisis of 2007 – 2009 is a classic example of what happens when banks do not have enough cash to pay their debts, e.g., all those items on the liability side of their balance sheets. The reasons for the named financial crisis have been written about and discussed and dissected many times, which is why banks and other financial institutions have to adhere to very strict rules implement by their own authorities, on the back of the Basel iii Agreement*.

*The Basel iii Agreement was implemented in 2009 after the global financial meltdown, this agreement was produced by the Bank for International Settlements in conjunction with 28 central banks from across the globe. This agreement was designed to promote stability in the international banking sector and is a set of reforms to mitigate risk that require banks to keep certain levels of liquidity and maintain certain leverage ratios.

Simply put, banks are now required to maintain adequate cash or assets that can be easily turned into cash to meet the demands of depositors and financial market counterparty transactions in the event of an economic shock as seen in the global financial crisis and in events in March 2023. If liquidity rules are revoked in any way the results can be catastrophic as in the failures of Silicon Valley Bank and Signature Bank in March 2023, which also resulted in a run on other banks.

These failures were put down to President Donald Trump signing into law a bill that reduced scrutiny on banks with assets under USD250 Billion. This was down to the naive thought that with the extra liquidity now available to certain banks, they would be able to invest the funds profitably. What became clear, however, is that these financial rules make a huge difference, and are truly there to stop banks failing. 

Sadly, it appears that despite financial disasters, lessons are never learned and the next financial crisis could be just around the corner. If this is the case, it is hoped that throughout the major financial centres in the world, the banks have got their houses in order. Indeed, last year the vice president of the European Central Bank announced that banks in Europe had robust liquidity and high capital ratios and depositors would be safe in times of economic stress. Furthermore, recent announcements from the Federal Reserve in the United States advise they will stress test thirty two large lenders in scenarios under severe economic shock.

Today it appears that financial authorities and regulators have put in place (or are putting in place) sufficient regulations and stress tests that will satisfy the Basel iii agreement. However, extreme vigilance must be constant by authorities and political masters should be advised to keep well away from the rules and regulations of banking systems. Financial shocks always come as a surprise, so it is always important to make sure that the regulations implemented to protect society are followed to a letter, and not just undone the moment someone forgets about the last crisis.

What is Basis Trading and How Does it Affect the Treasury Bond Market?

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Basis trading is a financial trading strategy regarding the purchase of a particular financial instrument or security (in this case Treasury Bonds) or commodity, and the sale of its related derivative. In this example, it is the purchase of a Treasury Bond and the sale of its related futures contract. In the treasury market, the trade is centred on the price differential between treasury bonds and their associated futures contracts.

From time to time, due to heavy purchasing of Treasury bond futures by insurance companies, institutional investors and pension funds*, the bond futures price rises above the price of the underlying bond. Once this price differential is in place hedge funds take advantage of this price differential and will buy Treasury bonds and at the same time sell corresponding Treasury futures. The upshot of this trade is that by selling the higher priced bonds in one market and buying the cheaper priced bonds in another market, the hedge funds can profit from the price differential. 

*Purchasing Treasury Bond Futures – Asset managers instead of buying actual Treasury bonds quite often prefer to buy futures because there is less upfront cash to pay. 

However, the profits from these trades are very small, and therefore heavy borrowing is required in order to make them more lucrative. Sometimes when there are unexpected episodes or events, this can quite often lead to market volatility leading to potential tragic consequences for the trade leaving the trader no option but to straight away unload all their holdings. This form of arbitrage*, as mentioned previously, requires heavy borrowing, and hedge funds usually borrow from the Repo Market**. It is normal for hedge funds to offer their Treasury bonds as collateral, as the normal practice is to roll-over these loans on a daily basis. Experts advise that these trades can be quite risky due to the amount of leverage involved (on average USD50 for every USD1 invested so 50 times leverage), plus a big reliance on short-term borrowings. 

*Arbitrage – the simultaneous buying and selling of currencies, commodities or securities in different markets or in derivative forms in order to take advantage of the differing prices of the same asset.

**Repo (Repurchase Agreement) Market – In this market money market funds, banks and others lend short-term capital against government securities, in this case US Treasury Bonds. Basically, in this transaction a borrower temporarily lends a security to a lender for cash with an agreement to buy it back in the future at a predetermined price. Ownership of the security does not change hands in a repo transaction.

When the Treasuries market experiences volatility, it can increase the cost of the trade thereby negating profitability, so hedge funds must very quickly unwind their trades in order to repay their loans thereby increasing volatility in an already volatile market.  Such fluctuations can see liquidity drying up and a decrease in the availability of buyers. In such instances* the Treasuries market can literally seize up, and with Treasury bonds being so fundamental to the credit market (and they are risk-free), the US Federal Reserve has had to intervene when the normal functioning of the market has become impaired. 

*Onset of the CoronaVirus – Back in 2020 when the Covid-19 appeared the huge volatility in the markets prompted margin calls in Treasury bond futures, amplifying funding problems in the repo market. Simultaneously, Treasury bond holdings were being dumped by foreign central banks in order to prop their own currencies with US Dollars. This prompted cash bonds to underperform their futures counterparts which is the opposite of the conditions needed for the basis trade to make a profit. It was never fully understood how much basis trading contributed to the turmoil in the market, but the rapid unwinding of positions by hedge funds certainly increased volatility. The upshot was the Federal Reserve promised to buy trillions of dollars of Treasury Bonds to keep markets running smoothly whilst providing the repo market with emergency funding. 

Basis trading subsided after the 2020 debacle but returned in early 2023 due the Federal Reserve monetary tightening policies by raising interest rates a record eleven times in eighteen months, which pushed up yields on 10 year Treasury bonds to circa 5%. On the demand side, this yield (highest since 2007) once again attracted large institutional buyers to buy futures, and on the supply side the Federal Reserve has increased sales of bonds to fund the US Government deficits, which has put downward price pressure on cash bonds. Therefore there is now a sufficient gap between the price of cash bonds and futures to have basis traders up and running again.

Financial watchdogs and authorities are unhappy over these trades, specifically because they are highly leveraged, and the fact that they are direct from one party to another. This means regulation is difficult, plus hedge funds themselves have much less regulation than banks. To this end, the Bank for International Settlements (BIS), the Bank of England and the Federal Reserve have called for closer monitoring of basis trades. Indeed the US Securities and Exchange Commission (SEC) finalised a rule in May of this year (starting June 2024)requiring all private funds to report sudden large losses, margin increases and any other significant changes.

Due to Government Crackdown, Chinese Quant Funds Suffer

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 For many international investors who are eyeing the Chinese equity markets with suspicion, the recent and sudden trading restrictions is yet another reason to avoid the markets. Indeed, until February 2024, China has endured a record outflow from the equity market, and due to never before seen crackdowns on the property and tech sectors, foreign direct investment is at a thirty year low. Furthermore, as a result of the Chinese government’s efforts to halt a USD$ Trillion sell-off in stocks the Quant industry*, (once a booming and integral part of the equity market) it has suffered losses and is yet another casualty of government policy.

*Quant (Quantitative) Fund – This is a fund that identifies with automated algorithms and advanced quantitative models together with statistical and mathematical techniques to make investment decisions and execute trades. Unlike other funds (e.g., hedge funds) a Quant fund has no human judgement or intellect in investment decisions, and experts argue that the computer based models mitigate losses and risks related to human fund management. 

Market analysts advise that the new restrictions will require Quant funds to be scrutinised and regulators will demand that any new entrants will have to report trading strategies before actually trading. Apart from sweeping regulations that are harming Quant funds, they have been caught off-guard by government intervention. Due to the five year low on the *CSI 300 index, they took very hard and forceful measures to stabilise the markets, with Quant funds firmly in their sights.

*The Shanghai Shenzhen CSI 300 Index is designed to replicate the performance of the top 300 stocks traded in the Shanghai and Shenzhen stock exchanges and is weighted for market capitalization. As such, it is seen as a blue-chip index for mainland Chinese stocks.

First of all, in early February 2024, the head securities regulator was dismissed and replaced by a veteran known as the “Butcher Broker” due to his previous record of hard crackdowns Experts suggest that Quants were targeted as the authorities were concerned that declines in equities were compounded by Quant funds making short bets and unloading large blocks of shares. Therefore some Quant funds were limited in their ability to undertake short trades, which, combined with shifts in the market, inhibited and stifled Quant funds. 

Analysts advise that a favourite trade for Quant funds is purchasing small cap stocks as they are susceptible to mispricing and the quants computer programmes exploits this opportunity to gain profitability, whilst hedging market exposure by shorting index futures. However, declines in small cap stocks made sure that quant funds reduce holdings and the huge selling triggered losses in the derivatives market known as snowballs*. This caused further panic in the market (known as a quant quake) and index futures were dumped by brokerages as well. 

*Snowballs – A Snowball product is a structured hybrid derivative which pays a bond-like coupon and consists of additional options on basic financial assets, which include underlying assets such as stocks or stock indexes. The word snowball derives from the fact that coupons can be rolled over and coupon pay-outs rely on the underlying asset trading within a certain range. 

Finally the volatility that was in the equity markets impacted those funds (e.g. hedge funds) who had invested in what is known as market-neutral products* and in many cases had leveraged themselves up to 300%, thus forcing them to unwind their positions creating even more havoc in the market which was already going south. This prompted the authorities to prop up exchange traded funds via government-led funds known as the national team, which resulted in a boost for large caps stocks but ignoring the small caps. Data released showed some of the top Quant funds lagging behind the CSI 500 Index (a well-known indicator of the performance of Chinese mid and small cap companies), by circa 12 points for 2 week’s ending 8th February 2024.

*Market Neutral Products – These funds/investments are designed to target returns that are independent of market directions. This is achieved with equal long and short positions in any industry and by investing in equities where the long positions are expected to outperform their peers and the short equities are expected to underperform. Any losses in the short position are offset by profits in the long position.

Following the crackdown on quants the main equity index has risen in nine straight sessions including every day from 19th -23rd February 2024, the longest run of uninterrupted gains in six years. So for now, the strong arm tactics of the authorities are working to stop the downward spiral of equities, however experts wonder if Quant funds will continue operating where there are such arbitrary market interventions. The question is this: will investors be convinced this a one off intervention? Or will the image the authorities have tried to create over the last thirty years that China is committed to a professional and open market be soured?

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