Tuesday, April 10, 2012

Loss of Conviction in Action

We closed the last post ("US Treasuries: A Great Hedge or the Biggest Bubble of All Time?") with the following observation:"
But how long can UST temp fate? The short answer is that until something we call 'loss of conviction' sets in, the UST will not be in crisis."

There is nothing like a real world example to illustrate a concept. Spanish bonds provide a great laboratory today. Yields on Spanish debt are fast approaching 6% and the new round of the crisis appears to be on. What does this have do with our previous discussion? Simply put, we are seeing investors losing conviction in Spanish debt. By itself, loss of conviction amounts to nothing more than changing opinion in the constant fluctuation of financial markets. Investors can start losing conviction in an asset class that has no fundamental problems. If this loss of conviction is severe enough, it can actually bring about deterioration in the fundamental picture it is supposed to reflect (something George Soros famously called Reflexivity).
However, as a pure case, tail wagging the dog is rare. During most volatility jumps, strong fundamentals will prevail over a fickle sentiment, so loss of conviction by itself should not lead to a higher risk forecast. The really dangerous situation is when a market or an asset class is already vulnerable to the sentiment change. What do we mean by vulnerable? We mean here exactly what we discussed in the previous post, the persistent and significant risk mispricing that creates fundamental vulnerabilities which will be exposed under stress. This concept is not invented by us, if one reads carefully the work of Joseph Schumpeter or even moreso Hyman Minsky, as well as "Endogenous Risk" by Jon Danielsson and Hyung Shin, it is possible to see the same concept from different angles. Market gets to a stage when it is overextended after massive risk mispricing and in this situation volatility jumps should not be treated as transient. To put it another way, a 'soft landing' is hardly possible when certain conditions met and one should observe turbulence as the sign of an impending crash. In other cases, turbulence could be disregarded.
Let's look at Spanish debt. From the screenshot below we see a few factor categories for the sovereign debt and currencies.
The one called Sovereign Yield Trends represents Loss of Conviction. The rest, like short-term capital flows etc. represent risk mispricing. Note that Spanish Bond has the first and last column in yellow (above median, but below the upper quartile). But it is not the only one in that company, other sovereign debt asset classes show risk mispricing of an equal or greater magnitude. The difference is that investors are not right now losing faith in Italian or Austrian bonds the way they are in the Spanish bonds. However, the vulnerability is there. And due to strong correlations between them, we conclude that the riskiness of those bonds are grossly underestimated.
What about the Treasuries, the starting point of our discussion? Note that Loss of Conviction is sitting exactly at 50, the median. Not a significant loss of conviction to be sure. That is why our models have not forecast high risk for Treasuries yet, because the Loss of Conviction has not set in. Once it does, we will be sure that we are in a "twilight stage of the bubble" to use a Soros quote one more time in this entry. Guess he knows a thing or two about bubbles. 'Til next time.

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