Miami twice as bearish

So why did the title of this article include the words "Miami twice"? I suppose it does sound like the TV show Miami Vice (well, actually that was the main reason). I can't remember much about the show aside from the white suits, sunglasses and the 80s music, perhaps because, I was always much more a fan of the A-Team during that decade of shoulder pads and forgettable music. 

Before I visited Miami over the past week, I already had this vague image in my head of what to expect: the smell of oranges, the sight of the sea and the sound of Spanish, all somehow coalesced into a single snapshot, with the backdrop of whitewashed Art Deco buildings straddling the image. What I had not quite anticipated, was the serenity of the sunrise casting its shifting gaze over the beach. If you ever do go to Miami, I strongly recommend waking up earlier than you might ordinarily do to witness this.

Much of my time, however, was spent inside at the TradeTech USA FX conference, rather than watching the waves roll on beneath the sun. Whilst the sun was shining outside, the mood inside the conference was perhaps less than shining. A bearish mood pervaded most of the conversations during the conference. This was perhaps not unique to conference. In general, within the market, there seems to be a general perception that we've reached a stage where central banks are out of rope, epitomised by the move negative rates, the latest stage of easing. The recent market reaction following the BoJ's move to negative rates seems to tally with this. One interesting point raised by Steven Englander from Citi, during his conference presentation, was that potentially the markets have underestimated the creativity of central banks in coming up with solutions. 

To some extent, I have to agree with Steven's point, particularly when we consider how central banks have reacted following the financial crisis. They have been somewhat more creative than they were during previous crises, notably following the Great Depression. At present, it has become quite fashionable to be outright bearish. The market can often be "right" and it's a reason why trend following is a profitable strategy and why long only strategies have historically been profitable, albeit with some volatility. However, once the cacophony of market bearishness becomes overwhelming, the risks have evolved from being a black swan style event to merely a grey swan type of event and potentially the market will have overpriced the event. If everyone is expecting a disaster, then arguably market positioning will be skewed that way and if anything any "good" news can result in a nasty squeeze the other way. Insurance is most valuable when the market does not really agree about an event, whether it is in the nature of that event or the timing.

One example of this can be seen in Brexit. We of course do not know with certainty the outcome of the event. What we do know, is the timing of the referendum. Hence, knowing the timing means, we can hedge this risk. The likely risk premium which will seep into the market is likely to increase over time, as investors seek to protect themselves from an adverse outcome. Given it is risk that we can hedge, the temptation is for the market to end up overpaying for protection or having an extended exposure in the cash markets. Hence, even if there is a bad result, the risk premium will be so high that it is unlikely to be the case that a hedge would work. It's like buying a Ferrari and having such expensive insurance, that it ends up being the case that the cost of insurance makes up a large proportion of the cost of the car.

Planning for the expected, is perhaps not as important as planning for the unexpected when it comes to hedges. As Hannibal from the A-Team might say "I love it when a plan comes together".

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