Market Insights

The Revolution Begins Part 2

Dusted ourselves down and carrying on, are we? BlondeMoney has taken your temperature and this is why you’re saying that the inverse-Vol product blow-up of Monday night doesn’t really matter:

  • It was an esoteric product with hardly any AUM
  • Caveat emptor, if you buy something and don’t read the prospectus, more fool you
  • We all knew this stuff was dodgy, so it’s no surprise
  • No-one has found any significant bodies
  • Market was too one-sided, this cleared out positioning and gives great levels to get back in
  • VIX at these levels is more normal anyway

First stage of grief, as we know, is Denial. It’s an odd kind of grief though: most discretionary investors were sick of the low vol / higher stocks feedback loop. You’d have thought many people would have embraced this mini earthquake. The reason they haven’t is that there’s no apparent fundamental reason for it to have occurred. Embracing the XIV blow-up would only be possible if it fed into the narrative: which appears to be, yields going up due to a late-cycle tax cut plus several Fed rate hikes, equals another ‘taper tantrum’. But it’s not really a tantrum, is it? Emerging markets, currencies, credit spreads, well they’ve barely budged. Also, as Toby Nangle pointed out, stocks came roaring back on Tuesday, in tandem with higher interest rates:

So discretionary traders must either admit that something else is going on, or consign the entire event to the folder marked “flash crashes” which to be fair had a heck of a lot of entries in 2015-16, but has largely avoided them for almost 18 months.

That would be a mistake.

There is an overarching narrative in play here. It’s just not macroeconomic. Nor can it just be written off as “retail gets involved in stuff they don’t fully understand, Part 724”.

It is in fact systemic.

The issues that took down the XIV are replicated throughout the exchange traded product (ETP) world. These products have to track an underlying. To do so, there are authorised participants who are expected to arbitrage away any difference between the ETF and the intrinsic value of its underlying. If the ETF traded under its intrinsic value, the arbitrage would suggest buying the ETF and then selling the underlying to make a risk-free profit (and vice versa).

There are so many issues with this, BlondeMoney is currently writing a larger report about it. For now, just mull this little list of problems that could affect the arbitrage process:

  • It becomes impossible to buy/sell the underlying
  • Other markets get used as a proxy hedge
  • The intrinsic value falls/rises faster than it can be hedged away
  • Algos drive the hedging and speed up the moves
  • Market makers disappear
  • Issuers are incentivised to move the market against the owners of their product
  • Issuers play pass the parcel with the risk and it ends up with someone who can’t handle it

This final point is now relevant for the XIV. Credit Suisse announced no loss from the entire debacle. Their spokesperson said: ‘We are the issuer of the ETN and, having issued it, we hedge the risk. We hedge XIV by trading VIX futures. … The positions constitute part of a portfolio.

Undoubtedly it was CS covering themselves by trading in VIX Futures right at the close; having bought when the VIX was around $25 it’s no surprise they looked happy when it was up at $50 the following day. ProShares were even smarter with their SVXY: they had to strike a NAV of a theoretical $4.22 on the close, but the next day it opened at $11.42.The NAV would have reflected the actual asset holdings of the fund, which suggests they also made a profit on their VIX futures hedging. VIX futures trade almost 24 hours; the VIX does not (well, it’s not even tradeable but that’s a whole other story).

The XIV has an extra twist. It is an exchange-traded note: as a “note” the credit risk lies with CS and they promise to deliver the return of a specific index via an over-the-counter derivative. They can hedge themselves by getting another counterparty to promise to deliver the same return to them, by writing another OTC derivative back to CS. Thing is, this other institution may not have finished hedging the mess that wound up at their door.

So, we don’t know where the bodies are yet, because the XIV hasn’t actually agreed on a closing price. In the acceleration event press release, Credit Suisse only said:

The date of the delivery of the irrevocable call notice, which is expected to be February 15, 2018, will constitute the accelerated valuation date, subject to postponement due to certain events’.

Note that it’s “expected to be February 15th” – is this so that other participants can get out of their risk? Is it “subject to postponement” if those events drive the price even lower? Is this just CS buying time for the market to digest more XIV hedging?

If so, then trapped counterparties will need to keep on buying VIX futures, and if they can’t do that, they’ll sell S&P 500 instead.

Alongside all of this, the liquidity in all of these markets is much reduced. Yes, the closure of XIV will take out some of the exponential convexity from the market. But there’s still the VXX out there, which is the fourth most traded ETF in the world with $1.5bn in AUM. This is a straightforward play on the VIX: meaning that if the VIX keeps going up, the VXX will need to keep buying VIX futures. And into a market that is now significantly smaller than it was.

Take a look at liquidity in the S&P500 futures market on Tuesday, courtesy of Nanex LLC:

The S&P500 futures market is NOT an esoteric market. It’s large and widely used. But it became so illiquid on Tuesday that one trader (@AMKcm) commented that you could buy an options structure such that you’d receive a premium and only lose money if the market dropped more than 25% in 4 days. In other words, liquid markets became disrupted.

Oh and did we mention about how the VIX itself is used for risk management of entire portfolios? After the financial crisis, long-term money managers felt that an early warning sign would be required so that they could shift their allocations ahead of time. The VIX would be an ideal input to a risk overlay, would it not? No point ramping up the equity exposure if the Fear Gauge is creeping higher, right?

Now, this is long term money. It doesn’t react within 24 hours. It takes smoothed monthly averages of prices before signals shift. And of course it takes readings of other risk sensitive indicators like credit spreads.

But if the price of the VIX remains elevated as the XIV closure takes time to come into effect, this will feed into long term investments. Then they will take risk off the table. In other words, sell everything that has gone up and get some cash back. Stocks and bonds have, until recently, been rallying. Both are now at risk.

And then we get into a feedback loop of our own. Wouldn’t it just be like us to have assets all completely correlated to one another right at the moment this is all happening? So that when one asset falls, all the others do as well? Well let’s have a look at where cross-asset correlation is right now, courtesy of Deutsche Bank:

Yes that’s right folks. Correlation is almost 1. Note that they are correct to point out this correlation is driven by “very strong momentum across asset classes”. Momentum, that’s the key.

There is not some great big macro narrative here. It’s just normal herding behaviour.

There are almost 5,000 exchange traded funds out there, containing ~4.5 trillion USD of assets. That increased by 1 trillion dollars last year; the year before it increased by $500bn. Growth is exponential. It needs a home. It goes to the place that most recently made money. Momentum is everything.

The problem with momentum is that a market becomes completely one-sided. That’s what happened on Monday. We simply ran out of any more equity buyers and the VIX hit a point where the ETPs linked to it had to, quite literally, knock themselves out.

The activity this week is not just about some small esoteric fund. It’s a reminder that the whole world now has the short volatility trade on; and that the products the world is using for this trade are one big negative feedback loop.

Macro will be irrelevant. All you need to know is how a market works. If momentum runs out, the trade is over. Panic sets in. Everyone heads for the exit at once, screaming “Fire”!

It’s Wile E. Coyote running out of road.

This week’s events have set the road runner on his trail. Either momentum will naturally shift, as it did this week, or an external event will make us realise the cliff edge has been whipped out from under us. Oh, now where else have we heard about a cliff edge… Brexit, anyone?

The Revolution Has Begun.

The Revolution Begins

As you awaken, strange events have taken place into the dark of the New York Close last night. You may have some questions.

Was it a flash crash? Well, it moved quickly but it wasn’t blink and you missed it. The VIX hit 38.8, more than double where it was trading on Friday, but it was a steady run higher for the last couple of hours of the trading day.

Stock markets followed suit, suffering their worst losses for several years.

So it was just a healthy correction then? That’s fine, we’ve all been waiting for that, the cash on the sidelines will be put to work into the close… Except that it wasn’t. The Dow was down 3% with half an hour left to trade; the mythical plunge protection team were nowhere to be seen with it finally closing down 4.6%.

So has something really bad happened? Well, we certainly got good jobs data out of the US on Friday, with wages growing at their fastest pace in 9 years.  So, the economy is doing well. Sure, that meant that interest rates have been rising, with the market finally, after all these years of those pesky Fed dots, now pricing in the 3 raises that the Fed suggested should take place this year.

This doesn’t sound bad, that sounds good? Yes, it is, and hence explained why stocks were hitting record highs as market interest rates hit multi-year highs.

So what happened?

Don’t look too hard for the narrative. The market just got too one-sided. More specifically, the volatility market had become a one-way bet. The signs were all there: the WSJ article, ‘As Stocks Reach New Highs, Investors Abandon Hedges’; the BAML surveyinvestors long, unprotected & say equity bull runs to ‘19’; and the biggest equity inflows in history:

Yes, this was an accident waiting to happen. But the big thing to focus on here is what happened to the VIX and all products linked to the price of the VIX.

If you, like BlondeMoney, switched on your computer screen last night and heard the VIX was trading at 35, where would you have expected currencies and interest rates to be trading? Well the last time the VIX spiked to those levels was 25th August 2015: the same day that the New Zealand Dollar suffered its biggest drop in 30 years. Not much of that to see (at least not at the time of writing). What’s the difference between now and then? More central bank money sloshing around, and more passive money sloshing around. More belief that because things have been calm and asset prices have been rising for so long, they will continue to do so.

A 100%+ rise in the VIX on nothing should put an end to that.

August 2015 provided us with a warning. This is what happened to the VIX then:

Prices for the CBOE Volatility Index, the market’s favored barometer of volatility, did not update for the first half hour of the trading, a result of market volatility that also led to erratic quotes in S&P 500 options, Suzanne Cosgrove, a spokeswoman for the CBOE said.’

Traders who wanted to buy and sell SPX options were held back because a lack of liquidity caused problems in their pricing. Many were at zero or had bid/ask spreads so wide that they were unusable for trading. As a result, SPX options barely traded.

“Basically, the computer market makers that sit behind it all were flashing ‘I don’t want to trade’ signs,” said Jim Strugger, a derivatives strategist at MKM Partners.

The lack of liquidity was not restricted to SPX options, but was broad based, with even normally very liquid sector Exchange Traded Funds (ETFs) hardly trading in the first hour or so, strategists said.’

Oh and this is where we come to the very big problem that we have now. What have been the biggest beneficiaries of all the passive money of the past few years? ETFs into Short Volatility strategies you say? The two biggest are known as XIV (inverse VIX) and SVXY and good lord yes they did indeed see some lovely big inflows at the start of this year:

Why should I care? These guys knew what they were getting into… you win some, you lose some.

Caveat emptor indeed my friend. But that’s a bit like saying people should have known what a CDO squared was. They should, but the unwind in the price of securitised products was instrumental in causing the financial crisis in 2008.

Here is the SVXY in a chart:

As it trades inversely to the VIX, it’s no surprise to see the price has fallen. But look more closely at the x axis. These products trade outside of the hours that the VIX trades.  The SVXY lost 32% during the usual trading day but then slipped another 81%. It was trading at $114 on Friday. At the time of writing it is trading at $14.

This has sent people scrambling to check out the prospectus of the fund they have invested in. It can’t deviate so far from its intrinsic value, can it?

Here’s the prospectus for the XIV, and it turns out that funnily enough it makes a provision for these deviations. It describes an “acceleration event”. This is legal terminology for “we are redeeming this note now because some serious stuff has gone down”. In other words, your note is worth nothing now, because the following occurred:

Right now, it looks likely that these exchange-traded products based on the VIX have gone through a fall of 80%, hitting the 20% level to trigger this provision.

So you’re saying that a product that was supposed to track an index just went to almost zero?


And these aren’t just some random esoteric products. 6-8million is their average daily volume. As of last night, the volume traded yesterday was over 40 million. The SVXY is the 47th most traded ETF in the world, ranking above the Vanguard FTSE Europe ETF or the SPDR DJIA ETF.

Anyone holding an ETF right now should check what it is they actually own. Volatility ETFs are the canary in the coalmine. The VXX is the fourth most popular ETF, and put simply, it gives exposure to S&P500 volatility. It has been popular as a tail hedge, a way of owning some of the “Fear” that the VIX index is supposed to represent. But a cursory look at the VXX prospectus reveals the following:

‘The VIX index tends to spike when anxiety increases, and as such often moves in the opposite direction of stocks. However, it’s important to note that VXX does not represent a spot investment in the VIX, but rather is linked to an index comprised of VIX futures. As such, the performance of this product will often vary significantly from a hypothetical investment in the VIX (which isn’t possible to establish). ‘

So it tracks something hypothetical, and it may not even track it that well?


Oh and one more thing:

‘One structural note: as an ETN, VXX avoids tracking error but may expose investors to credit risk’

The XIV is an ETN, provided by Credit Suisse. This means it contains credit risk with respect to the bank providing the note. No wonder CS shares are down 5% in after-hours trading. Oh, and the small matter of CS owning 39% of the XIV shares outstanding too.

Blondemoney doesn’t like hyperbole but our opening note for 2018 was entitled “Revolution”. We warned then:

This is the year the Revolution gathers pace. The voters have chosen new leaders, new policies. Financial markets are so far ignoring that, pumped up on cheap money and low vol. But the free money taps are being switched off. The passive trend followers won’t continue once volatility infects the system. So far, it’s holding firm. Political risk can’t be priced, so it’s being ignored. But the foundation of the Buy The Dip machine is being whittled down. First the central banks moved away. Next the passive money will find it’s going into a home that’s unsupported by new governmental policies. And finally it will give way when we shift to a new volatility regime.

What to watch:

  • Any pause or reversal in passive money inflows

  • Any disconnect in pricing in any liquid market, even if it’s only for a few seconds

  • Problems reported in administrating ETFs and other passive vehicles

So what do I do now?

It may take some time for the penny to drop, but the tremor in the VIX-linked products has broken the permanent liquidity illusion. Now, there will be a reassessment, slowly, of ETF/ETN investments. Denial at first, refusal to accept what has been seen. But eventually the realisation: They may not protect against all risks, nor perform as expected in all scenarios. The tinder is gathered; the central bank fire extinguishers are absent and ineffectual. The spark now will be the unexpected. Or rather, the unpriced. Political risk remains the prime suspect. Own something liquid and politically safe, like Japanese Yen. The euphoria will be hard to shift; there will be talk of reduced Fed rate hikes, or delayed ECB taper. But what can they possibly do when it turns out the market owns a bunch of investments that aren’t as liquid as they look?


Well hasn’t this new year just started with an overflow of euphoria? The best start to the year for Global Stock Markets since 2006!

As this chart shows, it was only two years ago that we were lamenting the absolute worst start to the year for stock markets ever. So we’ve gone from worst ever to one of the best ever, in just two short years. Perhaps that’s why it is hard for discretionary investors to shift the sinking feeling from the pit of their stomachs. The question is whether 2016 was the aberration, and bring on the euphoria… or is 2018 just too darn optimistic?

The answer is potentially both. In 2016 there wasn’t any strong fundamental reason to panic but a wobble in China set off a firestorm that engulfed Deutsche Bank CoCos and Oil. Now, in 2018, the global economy is looking a lot stronger but the perma QE central bank taps are being turned off just as politics becomes much more uncertain.

The reason for the over-reaction on both sides? The new nature of volatility. Rather than being linear, it’s a step function. Either we languish in the doldrums of zero vol, or we step up into a giddying spiral of ever-more panic.

We first flagged up in the summer of 2014 “How Volatility Eats Itself“. Central banks were worried. The NY Fed produced a blog post “What can we learn from prior periods of low volatility?” in which they compared the drivers of low vol at that time to those of 2007:

As we noted at the time: ‘This says: Volatility is low because Treasury yields are low and not moving around very much. It’s very different to Lehman, when household confidence was in disarray, credit spreads were high and random news was flying around.’

The authors concluded:

During times of relative market calm, like today, it could be that low financial market volatility is pushing these fundamental drivers lower, rather than the other way around.’

Yes, you got it, this means: stuff not moving around much makes things not move around much. Low vol begat low vol. But then we had a whole host of flash crashes, culminating in the Brexit induced fall in GBP. That crazy start to 2016 was a blow up whose time had come.

So what has happened between then and now which means we have returned to the low vol world? 

The Fed have hiked 5 times, wasn’t that supposed to derail things? Well no, because the ECB took up the QE baton. As the ECB’s Coeure helpfully explained last summer, their asset purchase programme plus a negative deposit rate ended up as turbo-charged global QE. It depreciated the Eurozone’s currency, flooding the world with liquidity, which then found its way into other global bond markets, once again flooding the world with liquidity. Although this process began in 2014-15, it only really started to ramp up in 2016 onwards – see how the blue line runs significantly higher as we cross into 2016:

…and more importantly, it stays in high territory throughout 2016 and 2017. Meanwhile the next leg of the turbo charged QE was kicking into gear: the rise of passive money investments. Look at how money moved from active into passive funds in the first half of each year, and how this picked up speed from 2016:

And so we dropped quickly back into low volatility territory. So, 2016 is the lesson for what will happen when the next blow up comes. But 2018 can get more euphoric before that happens. At some stage, the passive money machine will realise the central bank money machine is stopping. Overnight, the Bank of Japan cut its purchases of >10y bonds by ¥10bn. The ECB is following suit, albeit slowly. If we go back to Coeure’s chart, we can see that it was a year after the APP began when the portfolio shifts really started to motor; and a year after that when the passive money inflows accelerated. So, it’s going to take some time before the market’s accelerator pedal realises the car is out of fuel.

Blondemoney believes political risk will lead to liquidity events, much as we saw in the flash crashes of 2015-16, and that Brexit, with its ticking clock deadline, provides the spark. We won’t escape this year without a wobble of some kind, with the realisation that developed markets have gone the full emerging market.

Until then, it’s like Loreen said:

Forever, ’till the end of time 
From now on, only you and I 
We’re going up, up, up, up, up, up, up…



Elections a-go-go

At the start of the year, the European elections were the big event risk ahead. Fast forward nine months and this weekend’s German election is met with barely a shrug, thanks to the victory of an oedipal ingenue into the Elysee Palace. The threat of Marine Le Pen has receded so much that one of her closest aides has just quit the National Front, and with it, one of the key architects of their Frexit policy. The Eurosceptic knaves have been vanquished. Even a country that has voted to leave, will today see its Prime Minister lay out a policy for its exit that means it won’t exit for 2 years after it’s technically exited. Geddit?

Blondemoney forgives you for EU-fatigue. At some stage, the Brexit shambles negotiations will produce an almighty bout of excitement, but for now it’s just so earth-shatteringly nuanced as to be eminently forgettable. Hand us an instant-result FOMC meeting any day.

At least politics this weekend should provide a binary outcome.

First up it’s the German election. Although no-one really much seems to care about that, with Merkel consistently riding high in the polls, rarely troubled by the opposition’s Martin Schulz. The bookies have her party emerging as the largest at an eye-wateringly certain 1/100. Even as the largest party she likely has to enter a coalition, however, with the following potential scenarios that could emerge:

Given the market is totes not both’d, we might not get much of a reaction to any of those scenarios, but things to watch out for would be:

  • FDP joining a coalition – as they are the most “anti-Euro” of the larger parties
  • AfD gaining any kind of representation – or indeed, if they don’t, despite polling almost twice what they were in the last election, thus suggesting the anti-establishment vote is dying off

Next up it’s the New Zealand election. This had looked to be hanging in the balance with polls showing the charismatic new young (female) leader of the Labour Party driving them into the lead in the polls ahead of the incumbent National party. “Jacindamania” is now ebbing away, however, with the most recent polls giving National a clear lead of 7-10 pts. Again the market doesn’t seem too worried, probably because the New Zealand Dollar is most often used as just a proxy “risk on / yield hunting” currency. But there are potential pitfalls ahead. The Labour Party want to change how the RBNZ works, and introduce a Fed-style dual mandate; while coalition partners could include the anti-immigration party the NZF. Admittedly, the NZF have already been in government, and a new mandate for the RBNZ might not change much in practice.

Either way, we will have a sense of the result by 8am BST Saturday morning when the exit polls come out…
And for Germany, by 6pm BST Sunday evening.

(Although for both, coalition forming could mean the final government isn’t in place for a few weeks yet).

You might wonder why everyone is so relaxed, given how unreliable polls have become recently. Blondemoney would argue that polling accuracy is proportional to the proportionality of the voting system. In other words, if it’s a proportional representation system, then it’s easier for the polls to capture. The more it’s “first past the post”, or an electoral college, then it’s much harder to predict.

Both the German and NZ elections use a fairly proportional system – a mixture of PR and FPTP. For the election geeks amongst you, both countries actually use the relatively unusual ‘Webster/Sainte-Lague‘ method for determining seats from vote share. (And if that’s not your weekend reading sorted, I don’t know what is). So the polls should be decent at predicting the result. (Famous last words??)

Either way, from this point on, Merkel in charge of Germany means she can get on with taking the EU forward. That may be marginally Euro positive. For New Zealand, its currency can get on with being the favourite of those who like to trade EM without being able to invest in EM!



Will the Fed end the Truman Show?

We have talked before about how the market is sailing with unsurpassed ease towards the inevitable brick wall at the end of the Truman Show. At some stage, we will wake up from the low volatility, lowflation, low rates environment. The tricky part, as ever, is picking the tipping point. So let’s just consider these charts:

1. The last real bout of volatility came at the start of last year, when China was blamed for market turmoil that ended up with a rout about CoCos. Since then, global equities have had a very lovely time thanks, up 40% in almost a straight line (h/t @HayekandKeynes):

2. And as we know volatility has concomitantly collapsed. Here’s another take on that with a look at the 1 month volatility on the Russell 2000, which is in single digits for the first time (h/t @DriehausCapital):

And just a reminder of how mad this is, historically speaking, with @charliebilello flagging up that the last 5 days have been ‘the most peaceful in the history’ of the S&P:

I flagged up before to keep an eye on the AUD, and if it can stay above 0.8000 then that’s a good indicator of euphoria continuing to trend. It’s managing it, but Blondemoney is now concerned about that perennial canary in the coalmine, the South African Rand. That’s fallen almost 5% against the US Dollar in the past two weeks. Now, some of that really is because of issues specific to South Africa (with President Zuma still under a corruption cloud). But we know that when there’s a mad dash for yield, those pesky political issues are pushed aside. The euphoria cannot be all pervasive if the Rand is weakening.

So, it’s over to the Fed. Tonight they have the platform to provide quite a signal of their intentions. It’s Janet’s penultimate FOMC meeting to include a press conference. If her term isn’t renewed, that means it’s her second-to-last chance to make her legacy stick. She was handed the poisoned chalice of removing policy accommodation into a weak and uncertain economy, and she will want to make sure she is considered to have gotten the job done. Equally, she wouldn’t want to leave a trail that could implicate her in whatever the next crisis may be. So, she needs to stick to her guns. They’ve hiked, but not in such a way as to destabilise the markets. Have they done enough to prevent another financial bubble emerging? Or have they done too much, and squeezed out inflation before it got any momentum?

That’s the line she has to walk tonight. USD/JPY overnight straddles are priced around 95 pips, suggesting a big figure move could be on the cards. But with most markets comfortable with no volatility at all, yet a divergence occurring between the high yielders, there is the possibility for a much bigger move. Look out for a higher USD from here.