Market Insights

Timeline Of A Crisis

Batten down the hatches. Can you feel the storm coming? Did you hear the warning from the Cap’n? Andrew Bailey, Chief Executive of the Financial Conduct Authority couldn’t be clearer in his speech last week:

‘our job is to be watchful to the build-up of risks and vulnerabilities in the system… The secondary market liquidity of ETF shares is dependent on market makers and authorised participants… We know relatively little… about the capacity and willingness of APs to execute their function in stressed conditions where they may be under pressure to tighten their own risk limits. The result could be unexpectedly large discounts for ETF investors selling their holdings relative to the estimated value of the underlying assets, and possibly a need to suspend fund dealings… this could have the potential to amplify shocks to market conditions which are already under stress. We have no easy way of sizing this risk, but we cannot ignore its potential given the rapid growth of ETFs.…the global financial system is more resilient than it was… [the issue] lies in what level of continuous market liquidity conditions investors expect, and thus the liquidity transformation they accept.’ 

Aye there’s the rub. Liquidity.

This isn’t just a warning for a few years from now. It’s already happening. Prices are moving around more than we might expect under “normal” conditions.

Look at Facebook.

The weekly fall in its share price in March ranked as the third biggest weekly loss ever. It floated in May 2012, and suffered some big weekly moves around that time. But since then, fairly calm. Until this year.

You might argue that Facebook was overdue a correction; that tech companies are wildly overvalued; that the Cambridge Analytica issue was a canary in the coalmine for a company – nay, industry – now facing much greater regulation.

True. But are those arguments enough to warrant a weekly decline in the share price that sits in the top 3? The volumes traded that week weren’t even in the top 10. And what’s that coming in at no.11 in our list? The week including the VIX blow up. Is that a fundamental reason to sell Facebook?

Facebook constitutes a large part of many passive investments. According to, Facebook is one of the Top 15 holdings of 106 different ETFs. Added up, their exposure to Facebook constitutes approx. $23bn. That constitutes 5% of its total market cap akin being a top 3 shareholder. (Click here to see our calcs).

Now, the holders of these ETFs might not move their positions all that much. But the market makers have to adjust their positions as the price moves. They are committed to tracking the underlying index. It’s like a shadow of the $23bn is just sitting there, having to trade each time Facebook’s share price moves.

If someone sells an ETF in the secondary market to one of the market-makers, then they have to lay off the risk as cheaply as possible. A computer is usually involved. It’s a simple algorithm. If Facebook is the biggest weight in the index, then cover that risk first.

The tracking mechanism of the ETF therefore creates a multiplicative effect. That’s why prices are moving more than we might otherwise expect, under “normal” circumstances. The amount of daily volume linked to passive investments is rising. As Credit Suisse noted, 40% of all trading volume now takes place in the first and last 30 minutes of the trading day, compared to 31.5% a decade ago.

With prices moving around more, liquidity is at a premium. That’s why we can get the 3rd worst weekly loss for Facebook taking place without the 3rd biggest weekly volume.

It’s only going to get worse. With fundamental investors confused, they sit on the sidelines. Delta hedgers are the only people who have to trade every day. With volatility levels rising, they trade in larger size on larger moves, in order to protect their position. Liquidity suffers further. It won’t take long before:

  • This impairs the ability for market makers to make money
  • They stop making prices
  • They’re kicked off the exchange
  • Liquidity in the ETF suffers
  • APs step in to create/redeem shares in the ETF itself, looking for an arbitrage profit
  • They ram all the orders into the close but liquidity is so bad from everyone trying to do the same trade at the same time that it’s executed at distressed pricing.
  • The arbitrage can’t be done. They step back from the market.
  • The ETF no longer functions as it should.
  • Investors are left holding an instrument that is entirely divorced from reality.

This process is now underway:

Step 1:  With more delta hedging taking place in larger size on larger moves, we will have prices move further than you might think for a number of days, then reverse track [Rusal dropped 50% the morning after sanctions were announced; rallied back 30% when they were thought to be eased two weeks later]
Step 2:  ETF issuers have to retire any products which struggle to track the underlying. [Barclays retired $1.2bn of ETNs on 12th April as they were no longer profitable, and reissued some with a new embedded call option]
Step 3:  Exchanges tighten up the rules on market-makers. [NYSE Arca issued new listing standards for ETPS in January]
Step 4:  Big winners will turn into the biggest losers as momentum reverses. Watch out for those much-mocked 200 day moving averages and other technical indicators that a market divorced from fundamentals relies upon
Step 5:  A squeeze on markets where the liquidity transformation is most out of whack. Credit markets, particularly high yield, should suffer.
Step 6:  Banks and brokers who can least manage the market-making and AP process to suffer losses.
Step 7:  ETF issuers to lose assets.

For now, in Step 1, fade the big moves. When we get to Step 4, the bigger breakouts will begin, and momentum will have turned.

At each stage, expect the narrative to change, isolating the issue. Credit ETFs were always a risk, they’ll say. Momentum stocks were overvalued, they’ll say. It’s Trump. Trade. Russia. Brexit. The Fed.

Yes, the fundamentals might understandably cause a re-pricing. But the mechanics of this market have created the perfect set up for it to turn into a crash.

Let Me Read You a Bedtime Story

‘Twas the morning of payrolls, a time to switch off the screens and settle into a comfy chair with a warm mug of tea. Your mind has been full of trade wars and technical laws; the noise of markets as deafening as it has been uncomfortably inexplicable. It’s not just in your mind. The year so far has been resoundingly loud, with the S&P500 experiencing as many days up or down 1% in the first quarter as it did two years ago. That was when the year kicked off with stock markets suffering a bloodbath on ‘China news‘.

You embrace the pause. The chance to breathe. You knew last year’s compression in volatility and overvaluation in many risky assets was unsustainable. You wanted to get back to some kind of normal. But this doesn’t feel normal, does it?

Beads of sweat appear on your brow. Your gut tightens. Ghostly images of the VIX on February 5th break into your mind. The dream return of volatility has turned into an inexplicable nightmare. The lion has awoken, it’s broken out of the cage, and you don’t know why or what it will do next.

Shhh, don’t worry… BlondeMoney is here to mop your brow, make your tea, and explain everything. Close your eyes, take a deep breath, and come with me into the world of…. ETFs.

You know what they are – they simply track the return of an index, and they’re tradeable at all times. No wonder 5 trillion dollars currently sits inside them. You’re impatient with this story already. You know this stuff. It’s mostly not leveraged and it mostly holds the underlying securities, so who cares, right? Stop troubling me with this…

I’m sorry Dave, I can’t do that. We need to dig deeper.

The genius of an ETF is its liquidity transformation. Want to track an index of something that barely trades, but with a product that’s always tradeable? Boom – here comes the ETF. It does this because of the arbitrage available to its market makers, known as Authorised Participants (APs). The story goes that they will always take the risk-free arbitrage opportunity if an ETF deviates too far from its intrinsic value (IV). If the ETF trades at a premium to its IV, the AP will sell the ETF and buy the underlying assets it tracks (or vice versa), then repeat until the arbitrage disappears. A natural balancing act.

You’re almost falling asleep now, this is so obvious… 

But what if the APs don’t do that at all? What if they’re massive prop desks, who use the liquidity from ETF trading to get them in and out of their chosen positions? What if they hedge their ETF positions in the most liquid and most correlated asset they can get their hands on, rather than the actual underlying? What if, in a remarkable twist, they hedge their ETF position by going out and shorting the specific ETF they’ve just been given?

Wait… what?

OK, let’s go back a step. Start with the simple stuff.

We can all understand that if a market-maker is paid for an S&P500 index tracker, they are now exposed to the performance of that index. We can understand it’s very unlikely that the cheapest and quickest hedge would be to go out and buy all 500 stocks in their index weighting. We can understand they would instead just turn to the S&P500 futures market. It’s massive, with average daily volume in the most liquid e-mini market over $140bn. But what if APs turn to this market for all ETFs, rather than just the specific ones tracking this index? Not to hedge all of their risk, but to hedge some of it. After all, most equity based indices have a high correlation to the S&P500.

Now let’s look at those numbers again. The biggest ETF out there is the SPY, and its average daily volume is $31bn alone. Not all of it needs to be directly hedged but that’s almost 20% of the entire S&P500 futures market daily volume, just for this one ETF.

That doesn’t sound too scary. Markets are full of big numbers. That’s global finance.  

No, the scary factor comes from what the APs actually do with all those other 5,000 ETFs out there. Blondemoney has been talking to them on your behalf, and with some difficulty. Did you know that the AP isn’t listed in the ETF prospectus? Did you know that they’re not always obliged to make a market? Do you know how many APs actually provide the markets in each ETF?


Don’t be embarrassed. This information isn’t clearly available. Isn’t that worrying?

Maybe. But the grand-daddy of ETFs, the man who founded Vanguard, Mr. Jack Bogle, he says this current volatility is nothing to do with them. He says Active guys hold similar stocks to the Passive guys. 

Ah yes, Jack gave a fascinating interview to CNBC on this yesterday. His most revealing comment was that ‘what we’ve seen in the market is lots of selling of Facebook shares, not lots of selling by ETFs‘. He’s right that it’s not as simple as “retail investor sells a FANG ETF, Facebook share price falls”. And he is right that the market is simply selling a lot of Facebook shares. But he is wrong not to associate the two points with one another.

If the ETF is sold, the AP has to adjust its inventory accordingly. And if Facebook is then part of the weighting of another, smaller ETF, then the AP has to adjust its inventory further for that ETF. And if the AP decided to hedge a lot of its FANG ETF market-making by warehousing a lot of Facebook stock, because, hey, everyone wants to own FANGs and they’re always going up, so let’s get limit long of them, then they might also have to adjust its inventory further as Facebook’s price falls.

And if Facebook is, say, a mega cap stock that features in other bigger ETFs, like the 8th biggest ETF in the world, the Nasdaq-tracking QQQ, then the 5% weighting of Facebook in that ETF forces inventory reduction for APs tracking the QQQ also. And if selling of the Nasdaq brings down other US stock indexes in sympathy, then selling of S&P500 futures will take place as people trade out of the 31bn dollar-a-day SPY ETF. And the AP might short the SPY itself to cover its position. And so on.

Yes, lots of people are selling Facebook shares Jack. And they may well be doing so for sensible fundamental reasons. But the vicious circle which links selling of Facebook to more selling of Facebook has been created by the role of APs in the provision of ETF liquidity.

That wasn’t a very nice story. 

BlondeMoney is sorry. Take the break now while you can. Worry about payrolls if you like. But the market structure right now is so incredibly fragile that there are much bigger worries ahead. At its peak, the CDO market was $2 trillion, approximately one-fifth of the size of the S&P500 market cap. ETFs, at 5 trillion right now, are equivalent to one-quarter of current S&P market cap.

Thanks. I need something stronger than tea now.

Sure, I’ll whip up a whisky cocktail for you. And don’t worry, BlondeMoney is putting the finishing touches to a report that will explain all of this in much more detail. Want to read it? Click here if so…

The Price Isn’t Right

Come on down, ladies and gentleman, for another round of The Price Is Right! Except, it’s not. Leslie Crowther was lying to you (or if you’re in the US, Bob Barker).

Leslie: Now, Ken, do you think the VIX at 17 means the stock market is going higher or lower?
Ken: Um, higher, I think, Leslie?
L: Ken, you know we didn’t trade at 17 for the whole of 2017, right? When stock markets hit record highs?
K: Well, yes, but, wasn’t 20 kind of an average level and now we’re below that so….
L: so what Ken? Come on Ken, I’m going to have to press you… [audience goes wild with excitement]

Poor old Ken. The trouble is, the market is whipped up into a frenzy and now it’s no longer clear what prices mean at all. Central bank easy money passed the baton to passive fund managers, who have been merrily investing along the lines of the indexes they track. Inflows into risky assets then compressed measures of risk such as the VIX, credit spreads, TED spreads, even bid/offer spreads. Central banks then looked like they were easing, even if they weren’t.

Just look at some of the measures that constitute the Chicago Fed’s Financial Conditions index, and ask how many of these are independent from the Passive Wall Of Money:

Not many. Almost all of these indicators have been driven by fund flows. Their price is not telling us anything about the expected future path of risky assets. So why are they being used for risk management?

We are now stuck in a frenzied feedback loop of cheap money driving cheap risk. As the table above shows, however, the feedback loop could easily flip the other way. We have already seen a much higher VIX impair the liquidity of the S&P Futures market – both suggesting the risk picture has changed. This could easily then filter into all the other indicators in the table.

Prices are dictating our judgement, rather than the other way around.

The central bank of the world’s central banks has taken note. The BIS has helpfully devoted a chapter in their recent Quarterly Review to the phenomenon of passive money. They argue:

1. Indexing reduces the stock-specific factors that drive the price of a stock
Surprise, surprise, when a stock goes into the S&P500 index, it becomes more correlated with it, given how passive money flows then scoop it up.

2. Companies change behaviour to get into an index
The larger the weight in the index, the more a rising tide will lift all boats. Small wonder then that companies are issuing more debt in order to become a larger part of bond indexes. The BIS note: ‘Regression results confirm that there is a statistically significant positive relationship between a company’s weight in the index and its leverage’

3. ETF flows are more volatile around risk events
Active funds may leap onto risk events and drive prices lower as they experience outflows, but ETFs are more volatile (see the red lines and crosses in the chart). Hence the flash crash environment we have become all too familiar with.

4. ETF trading doesn’t always hit the market
When an investor redeems from a mutual fund, they sell their holdings and it has a direct market impact. ETFs, on the other hand, don’t have to do this. Their market-makers just have to make a market. They can choose to hold onto the holdings they’ve been given. The BIS note: ‘after redeeming the ETF shares, APs can potentially warehouse the securities instead of immediately selling them in the secondary market’

In summary: 
1= fundamental factors driving asset prices are becoming less relevant
2= companies are compounding this by gaming the system
3= passive money can be volatile…
4= …but we haven’t seen its ultimate market impact as the holdings aren’t actually sold

Adding all of this up:
1+2+3+4 = prices are not telling us the truth, but when they do, the re-pricing will be violent

Come on down, ladies and gentleman, soon the Re-Price will be Right…!

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.