31st August 2015

Flash crashes, ETFs gapping, VIX spiking. Volatility is so du jour for 2015. Back in 1962, the world was learning to live with the volatile global environment aftermath created by the Cuban Missile Crisis. At that time, Walt Disney commissioned the Sherman Brothers to compose a song that could be translated into multiple languages and be featured as the song played at one of his attractions. It was said to represent “a message of peace and brotherhood”, however when Walt heard it, he said that it wasn’t lively enough, so he ordered the tempo be increased, the mood heightened and to introduce multiple harmonies. “More volatility!” is what Walt might well have said.

One of the ways I model volatility (the VIX) is by using a number of variables that I believe are representative of market liquidity. The Great Recession (“GFC” to those in Europe and Asia) re-taught an entire new generation of strategists, economists and fund managers the same lessons from the interwar years when the central bankers of England, France, Germany and the US played with the global financial system as a kitten plays with a ball of knitting wool. When the market perceives (rightly or wrongly, the market is always whatever Mr Market says it is) that liquidity is disappearing due to elevated present stress levels, the next evidential sign will be a spike in volatility.

In recent times, this has been observed in October last year (2014) when there were legitimate concerns voiced about declines in market liquidity. When there is evidence that the ability to accumulate or dispose of large positions in the secondary Treasury (US) markets cannot be executed without material price effects, that is sufficient grounds to say that there are liquidity issues present. Similarly in 2013 when the so-called “taper tantrum” played out; in March this year when 2 hours after the FOMC monetary policy statement was released, the Euro rose 3% against the USD in a four minute period, then fell almost the whole amount again 3 minutes later; and the Bund tantrum most recently (which I will go into some detail later here). All are notable examples that market mechanisms for price discovery have been placed under considerable stress and found wanting.

When Bear Stearns was sold for $2 to JP Morgan in March 2008, just before the Great Recession kicked off, the market still believed that liquidity levels were normal. Bear Stearns was viewed by many market participants as liquid, but insolvent. By the time Lehman Brothers collapsed in September 2008, the market realised that Lehmans was neither liquid or solvent, contrary to the protestations of Dick Fuld on both counts. As a result, liquidity dried up across the markets of many, many asset classes. Investors dumped Euro dollar bills in very material amounts. Investors clamoured over each other to buy US Treasuries which are of course denominated in US dollars. Hence the great reversal of the then-falling USD which then plunged almost every major currency trading against the greenback to levels not seen since some decades prior. As the ink dried on Jamie’s signature buying Bear in March 2008, the VIX was at 26.

As Lehman was “let go” in the third week of September 2008, the VIX was still only at 24 – obviously an even lower level than when Bear sold. I say “let go” because Dick Fuld to this day blames the 74th Secretary of the Treasury of the day, Hank Paulson Jr., as a co-conspirator against him due to “the other investment banks’ unbridled jealousy of the previous successes of Lehman Brothers” (I’m paraphrasing Dick here). Hank Paulson Jr. was a former CEO of Goldman Sachs (a previous employer of yours truly as well) and one of the many people at the upper echelons of power and control that Dick thought could’ve and should’ve “rescued” Lehmans, but chose not to. It is merely Dick’s opinion. Factually, Lehmans was insolvent. By the time the market understood the Secretary of the Treasury’s rationale and warranted explanation for “letting Lehmans go”, the sluice gates were opened and by mid October, the VIX hit a high of 69.4. It eventually peaked at 72.8 mid November of that year, 2008.

I have mentioned in previous commentaries that certain countries’ sovereign bonds have spent a considerable amount of 2015 in negative yield territory. If that fact in of itself wasn’t enough to cause consternation to your local bond fund manager or investment bank bond trader (do they even still exist?) then spare a thought for what else has happened to bond yields in 2015 aside from costing an investor his money to just hold. In the 3 months to June 2015, events played out on European exchanges that have since been referred to as the “Bund tantrum”. I do not know why this hasn’t had more Western press, especially given how powerful it sounds when spoken in German: “Bund Wutanfall”. Even pronouncing the W as a V, it’s almost positively “Winterfell”, isn’t it?

To demonstrate the current volatility in global markets, let us reference the German sovereign debt market. Quite frankly, when the global capital markets are in turmoil, German financial instruments are probably the only thing you really want to be left holding, apart from anything American or Swiss. Of the German sovereigns, the 1, 2, 3 and 4 year Bunds are currently returning negative yields.

The current yield of a German 1 year bund is -0.26%. In the current 52 week range, the highest a 1 year has yielded has been 0.03%. The lowest has been -0.32%.

The current yield of a German 5 year bund is 0.09%. In the current 52 week range, the highest a 5 year has yielded has been 0.27%. The lowest has been -0.16%. At the end of March this year, it yielded -0.15%, then by early June (3 months later) it yielded 0.22%. Two months later, early August, it was again back in negative territory, yielding -0.03%.

The German 10 year (currently 0.73%) has ranged from 1.07% to 0.04% in the last 12 months.

The German 30 year (currently 1.43%) has ranged from 2.06% to 0.44% in the last 12 months.

Some participants in the German bund market are facing severe wealth destruction on a colossal scale and possibly even reprimands (or unemployment!) for bond traders.

The volatility has not of course been limited to bond markets, with the VIX hitting this month, August, its highest level since 2011. Equities markets in China were down 15% in 5 days by August 27th; Japanese indices have fallen 7% in a week, and the global mainstay, the S&P500 was down 11% for the month of August last week but has since recovered and will see the month out down some -6%.

The issue therefore is this: with all the major central banks stating unequivocally that they stand at the ready to providing seemingly unending liquidity, why are we seeing again an increasing frequency of volatile moves in the market? My position is that the central bankers can provide as much liquidity as they want (and can) but if people/traders/investors do not want to trade, then no amount of “synthetic liquidity” (as I refer to central banker liquidity) can motivate them to do so. If market participants do not wish to participate, then the “real liquidity” does dry up and hence price discovery gaps aplenty. At the moment, investors are bunkering down due to concerns about China, oil prices, US earnings, US interest rate rises, EU debt sustainability, emerging markets resilience to US rate rises, global trade. There is no shortage of things to be concerned about. Should investors freeze up, then that is what will create a liquidity crisis and expect the VIX back up at 60+ for a short period of time. If investors push through and see through the noise, this does not need to happen.

The NYSE invoked Rule 48 earlier this week, which meant that traders no longer had to adhere to the usual practice of alerting the market if certain stocks are going to open at significant moves to their previous closes. On Monday, 1300 stocks and ETFs were suspended because open limits (which are double the usual 5-10% fall triggers) were breached in reaction to developments in Chinese equity markets. Given the US equities market’s volatile (remember, VIX spike was the highest since 2011) response to the Chinese situation that in reality has very little bearing on the earnings of US stocks, we await the inevitable further volatility that is going to ensue, once real events of profound material importance such as US interest rate rises do eventuate.

Marcel von Pfyffer



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