Doug Noland: The VIX and the Scheme

There was little market reaction to Emanuel Macron’s widely-anticipated big victory in the French presidential election. The euro actually retreated somewhat, in a “sell the news” dynamic. European equities ended the week mixed. European bonds were somewhat more interesting. Bund yields declined three bps, while Italian yields jumped nine bps.

“Risk On/Risk Off” analysis was rather inconclusive this week, though there were some indications of waning risk embracement. U.S. equites came under modest selling pressure. The S&P500 declined 0.3%, while the broader indices were weaker. The midcaps fell 1.1%, and the small cap Russell 2000 declined 1.0%. With Macy’s earnings badly missing estimates, retail stocks came under heavy selling pressure. This sector has given the bears a bit of life. Financial stocks were also under notable pressure. The banks (BKX) fell 1.3% and the broker/dealers (XBD) lost 1.5%. The Transports were hit 2.1%.

The general market was resilient in the face of ongoing Washington dysfunction. It’s not that surprising that President Trump’s firing of FBI Director Comey had a much greater impact within the media than in the markets. It’s my view that markets are more dominated by liquidity flows and speculative dynamics than by the Trump agenda.

As for speculative dynamics, the Nasdaq 100 (NDX) and Morgan Stanley High Tech Index (MSH) traded at record highs this week, while the Semiconductor index (SOX) is within striking distance. For the week, the NDX gained 0.7% (up 16.9% y-t-d), the MSH rose 0.6% (up 19.6%), and Semiconductors surged 3.4% (up 15.3%).

Financial stocks were at least somewhat weaker on modest downward yield pressure. Ten-year Treasury yields dipped two bps to 2.33%. One could see a faint bid to safe haven assets supporting the fledgling Risk Off thesis, although the yen (down 0.6%) this week didn’t indicate risk aversion. U.S. equities market leadership has clearly narrowed.

Monday from Bloomberg (Samuel Potter): “U.S. stocks ended virtually unchanged near all-time highs, while the dollar rose with Treasury yields as volatility drained from financial markets after a convincing defeat of populism in France’s presidential election. The CBOE Volatility Index slumped to its lowest closing price since 1993. The S&P 500 Index rose by less than one point to close at a fresh record.”

There were a number of articles discussing the VIX’s “lowest closing price since 1993.” There was the typical focus on a stable U.S. and global growth backdrop and buoyant corporate profits. What’s missing from the discussion is the reality that global markets have developed into a sophisticated financial Scheme.

Going back to early-CBBs, I’ve devoted a significant amount of analysis to contemporary finance and the proliferation of complex risk intermediation, derivatives and market “insurance.” It seems rather clear to me that the interplay between contemporary finance and New Age central banking has over years nurtured history’s greatest market distortions and asset Bubbles.

Past writings have attempted to differentiate actual insurance from market “insurance” such as put options on the S&P 500 (key factor in VIX levels). Actual insurance – i.e. auto and home casualty – provides protection against generally independent and random loss events. Actuaries are skilled at using vast historical databases for fairly accurate forecasts of future claims/losses. Policies are priced to ensure sufficient reserves for future losses along with a profit surplus.

Securities market “insurance” is an altogether different animal. Market losses are neither independent nor random, but instead tend to unfold in unpredictable waves. Future losses are unquantifiable. Markets generally grind higher only to break lower in episodes that catch most by surprise. As such, losses tend to be biggest when they were expected to be the smallest. With historical data so deceptive, pricing such “insurance” becomes more of a speculative endeavor. And the longer the history of low “claims” the more likely an ugly black swan lurks somewhere in the future.

Over the years, I’ve used the parable Writing Flood Insurance During a Drought. Such enticing returns attract a bevy of players keen to participate in the lucrative insurance business. And, importantly, cheap insurance distorts market activity, in the process spurring progressively risky behavior in the Financial and Real Economy Spheres. In the end, financial and economic Bubbles unfold with a distorted and colossal cheap “insurance” market at its putrid core.

Why is the VIX – and other market “insurance” – so extraordinarily cheap? First taking a global Bubble perspective, I would suggest that the foundation of cheap “insurance” rests upon the perception of a relatively stable global Credit backdrop. Financial Conditions remain loose throughout much of the world. Sovereign yields persist close to historic lows around the globe, while Corporate Credit conditions continue to be ultra-loose. Of course, such conditions have been largely dictated by “whatever it takes” central banking with its near-zero rates and massive QE liquidity operations. There is faith, as well, that the heavy hand of Beijing will ensure sufficient Credit to achieve 6.5% 2017 Chinese GDP growth. And, for China and the world, that’s become an enormous amount of Credit.

Many would counter that the Federal Reserve and others have commenced normalization, with the U.S. central bank even discussing reducing the size of its balance sheet holdings. Yet such measures do close to nothing to dissuade market participants from the now deeply ingrained notion that central banks will quickly resort to zero/negative rates and more big liquidity injections in response to incipient worries of illiquidity.

Bull markets create their own self-reinforcing liquidity. Bear markets are the inevitable market self-correction after a period speculation and excess. History teaches us that markets cycle through periods of perceived ebullience and abundant liquidity followed by bouts of fear, illiquidity, dislocation and the occasional crash. In the final analysis, market-based Credit and securities-based finance have inflated to such an incredible degree that policymakers can no longer tolerate even the thought of a market down cycle. At least that is the basis for market “insurance” pricing these days.

The greatest ongoing criticism I have with contemporary central banking is that it has essentially guaranteed Continuous and Liquid Markets. Markets (after witnessing 2008 policy responses and then five years of “whatever it takes”) perceive this guarantee to be stronger today than ever before. And it is this assurance of Liquid and Continuous Markets that has become the pillar of modern derivatives trading strategies and markets.

Derivatives markets – particularly for “insurance,” risk sharing/intermediation and speculative leveraging – are fundamental to contemporary finance. And much of this boils down to those that sell market “insurance” are dependent upon highly liquid markets that allow the easy offloading (“dynamic hedging”) of risk previously written. Derivative players must be able to sell securities and establish positions that will generate the cash-flows to pay “insurance” losses on contracts they’ve sold (but not reserved for). And it all works wonderfully until it doesn’t – until a market episode unfolds where selling begets selling into sinking markets, more hedging, illiquidity and, at some point, counterparty issues.

The VIX is low because markets assume that central bankers won’t allow any such market illiquidity episode. Yet I believe just such an outcome is likely because of the markets’ faith that it’s highly unlikely (with the VIX trading as low as 9.56 this week).

So let’s touch upon what has become a sophisticated global financial scheme. First of all, (securities and derivatives) markets have become Too Big to Fail on a scope so beyond the 2002-2008 period – on a global basis. With the perception that central bankers and policymakers will not tolerate a significant market correction or recession, writers of derivative market “insurance” need not factor in the possibility of significant losses into the pricing of their products. It’s become Moral Hazard on an unprecedented scale.

There’s a major Reflexivity component at work. Cheap market “insurance” spurs risk-taking. Why not push the envelope with risk and employ added leverage, confident that inexpensive protection is readily available? This ensures that loose financial conditions spur Credit expansion, asset inflation, spending, corporate profits, rising incomes and government receipts/spending. Perceived wealth inflates tremendously, if not equitably. Rising price levels throughout the economy support the view that the future is bright, encouraging reinforcing flows into financial assets – further depressing the price of market “insurance.” Moreover, a prolonged period of low market yields boosts the relative return appeal of myriad variations of writing market protection (selling flood insurance during a drought).

May 10 – Financial Times (Robin Wigglesworth): “The global exchange-traded fund industry smashed past the $4tn in assets mark last month, as the gingerly improving performance of active asset managers this year does little to dent investor appetite for cheaper, passive alternatives. The entire ecosystem now boasts 6,835 ETFs and exchange-traded products (a broader category), from 313 providers, and total assets of $4.002tn at the end of April… ETFs and ETPs gathered a record $37.94bn last month, which was the 39th consecutive month of net inflows and brought this year’s total so far to $235.2bn – smashing 2016’s inflows of $81bn at this point of the year.”

I’ll pose the question this way: Why shouldn’t the VIX be extraordinarily low with “money” now consistently flooding into the ETF complex? In contrast to previous boom periods where flows would swamp active managers (that may have been keen to build cash levels), “money” arriving at one of thousands of ETFs will be immediately and predictively used to purchase securities. Some might be alarmed by what would be viewed traditionally as rather conspicuous market speculative excess. Not these days, however, in the age of central bankers antsy to deploy liquidity backstops. And the more likely that an abrupt reversal of ETF flows risks disrupting the markets, the more confident market operators become that central bankers will act swiftly to thwart sell-offs before they attain momentum. All part of the Scheme.

And with rates so low, equities essentially win by default, especially when they have been so outperforming other asset classes. And while central bankers are not likely to resort to the liquidity spigot in the event of minor pullbacks, players have grown quite confident that corporations, with their enormous buyback programs, are anxious to buy on any weakness. CEOs clearly find it more attractive to support this financial Scheme with stock repurchases than to deploy their cash hoards for productive investment with unclear return prospects.

What could go wrong? Lots of things. It’s a basic premise of Credit Bubble Analysis that market distortions are problematic, cumulative and inevitably resolved. Sooner the better. Central bank liquidity backstops spur myriad excesses that in the end will expand beyond the capacity of central bankers to sustain system liquidity. There are accumulations of speculative positions, leverage and maladjustment that evolve into Credit and liquidity gluttons. Over time, market misperceptions and distortions become deeply embedded. And, as we’ve witnessed, the greater the excesses the more confident are the markets that central bankers will have no alternative than to provide liquidity backstops. So, market yields remain stubbornly low in the face of efforts to tighten monetary policy, exacerbating excesses throughout the risk markets and the overall global economy. No Conundrum.

I expect U.S. system Credit growth to surpass $2.2 TN this year, roughly broken down by the government sector ($850bn), Business ($750bn), Household Mortgage ($350bn) and Consumer Credit ($250bn). Another big federal deficit is expected, with the perception of a blank checkbook ensuring that deficits inflate until the markets decide otherwise. Rising home prices coupled with low mortgage rates ensure a 2017 expansion of mortgage borrowings. Loose financial conditions and record debt issuance would seem to ensure another big year of Business debt growth. And while there appears to be some tightening in subprime auto and Credit cards, I would be surprised to see Consumer Credit expand by much less than 2016. As such, the relatively stable outlook for U.S. Credit growth certainly supports the global liquidity and market backdrop.

The situation in Chinese Credit is altogether different. Credit growth (Total Social Financing and government borrowings) is on track to approach a record $3.5 TN this year. But I wouldn’t be stunned neither by $4.0 TN or a crisis-induced rapid Credit slowdown. April lending data was out Friday. Total Social Financing (TSF) expanded $201bn during April, down from March’s $307bn. New Loans expanded $159bn during the month, about a third greater than expected. Bank lending took up some of the slack from a sharp decline in various “shadow banking” components. Overall mortgage Credit growth slowed during April. TSF (which excludes government borrowings) expanded a record $1.205 TN during the first four months of the year.

From my analytical perspective, China has evolved into the key marginal source of global Credit. Why is the VIX – along with the price of other market “insurance” – so low? Because of the market perception that Beijing these days has everything under control. Notable complacency, yes. At the same time, and making things more intriguing, I don’t believe markets are all too confident in China prospects over the intermediate and longer-term. So, we’ll continue to monitor closely for indications of escalating Chinese instability. After an “inconclusive” past five days in the markets, Risk On/Risk Off will be monitored diligently once again next week.

Original Post 13 May 2017

Categories: Doug Noland, Perspectives