Deutsche: "We Are Almost At The Point Beyond Which There Will Be No More Bubbles"

Whereas many Wall Street strategists enjoy simplifying their stream of consciousness when conveying their thoughts to their increasingly ADHD-afflicted audience, the same can not be said for Deutsche Bank"s Aleksandar Kocic, who has a troubling habit of requiring a background and competency in grad level post-modernist literature as a prerequisite for his articles among the handful of readers who don"t already speak exclusively in binary. Here is an example of Kocic"s "unique" narrative style:

Volatility is a consequence of speed and speed is the result of fear. Acceleration of movement is a defensive maneuver, a tool of retreat -- high speed and high volatility represent sophistication of flight (flight to quality is an example of the speed event). However, absence of volatility is not necessarily synonymous with absence of fear. Volatility is low not only when things become predictable, but also if the distribution of risks causes paralysis, when the state of no change, regardless how uncomfortable it might be, becomes the least undesirable of all alternatives.

While a passage like that is far more likely to have been taken from a book by Lacan, Derrida, Deleuze and Guattari, Foucault or any other prominent POMO-ists, in this case it comes from Kocic" year end outlook which encapsulates many of the themes we have covered recently, most notably his recent take on the interplay between volatility and leverage, a topic which anyone who has read Minsky is quite familiar with, yet which Kocic decided to give it his unique post-modernist spin with the following "spiraling leverage" chart from one month ago...

... which he described as follows: "spiraling leverage cannot continue indefinitely. At some point, the bubble becomes too big and cannot be subsumed by a bigger bubble – the damage of its burst would become irreparable. Therefore, when that moment comes -- and we believe that moment is now – the market is facing a following dilemma."

• Permanent state of exception: We continue to operate in a regulated environment. Leverage is limited, but care is taken not to overconfine the system so we avoid the Japanese scenario. While this appears as a prudent approach to reality, it implies giving up all the ideas of unlimited growth, something that made US economy look better than the rest of the world. Compared to what we have seen before, this means settling for much less than this country is used to aspiring. Although a reasonable proposition, it is emotionally a difficult choice that is and will remain subject to substantial political manipulation. It is unlikely that populist narrative will not continue to challenge this choice [ZH: hey, one can just blame the Russians, right?]


• Flirting with high tail risk : Deregulation and deficit spending could result exactly due to abandoning the first path, as its direct challenge, under political pressure that American economy can restore its old status and resume its pace of the previous decades. This is a serious tail risk as it is playing against the backdrop of considerable overhang of the post-2008 one-side positioning. Central banks are massively short convexity in this scenario. Any inflationary maneuver, or anything that would be a bear steepener of the curve, could force disorderly unwind of the bond trade and reinforce the trend thus creating another crisis from which there could be no way out.


• Forced deleveraging: An overly hawkish Fed forces rates higher and triggers a disorderly unwind of the bond trade, thus forcing the system to deleverage. This is the policy mistake.

The Deutsche Banker"s conclusion was stark and certainly dramatic:

"The tension created by these three choices is in the center of both economic and political discourse. It will shape the market dynamics in the future, beyond the near term. Taper tantrum and the US presidential elections were the two most recent episodes that have highlighted the risk distribution opened by these choices. Policy mistake appears less likely at this point. The financial conditions are as loose as they have ever been. Fed hikes are only going to tone this down, but it is very difficult to see how they can create overly tight financial conditions and cause economic slowdown. Nevertheless, negative convexity of the central banks in the bear steepening or generally high rates scenarios are making risk of volatile deleveraging alive."

Of course, Kocic could (far simply) have said that it takes more and more debt to kick the can, and keep the world"s biggest asset bubble ever created - with the explicit backing of central banks - from bursting. This is precisely what Bank of America"s Barnaby Martin did in far less words one month ago:

"the irony in today"s world is that central banks are maintaining loose monetary policies to generate inflation…in order to ease the pain of a debt "supercycle"…that itself was partly a result of too easy (and predictable) monetary policies in prior times."

* * *

In any case, fast forward one month later when Kocic picks up where he left off on his favorite "spiraling leverage" diagram, and decides to once again paraphrase Minsky"s conclusion that "stability is destabilizing" using just a few hundred extra words than is necessary, although since he does so in a "cool", Pomoist way, here is the paraphrase:

Persistent low volatility is like a sirens’ song. Low uncertainty engenders high leverage which leads to compression of risk premia and further buildup of risk, which, in the long run, destabilizes the system causing ultimately volatile deleveraging. This is generally harmful for the economy and requires stimulus injection in order to create an economic turnaround leading to subsequent decline in volatility and gradual releveraging as the system recovers. When described in terms of leverage and volatility, economic trajectories exhibit quasi-periodic pattern. These dynamic are shown in the Figure as trajectories in the vol-leverage plain across several “cycles”.

 

Starting with the internet bubble in 1999, we reach the 2001 recession and subsequent recovery on the back of the real estate boom (2003-2007). The figure suggests that after each volatile deleveraging (e.g. 2000 and 2007), subsequent sweep leads to a bigger bubble. After each sweep, amplitudes grow bigger and the damage more substantial, requiring a heavier hand in terms of policy response as crises they create become deeper and recoveries longer and more difficult.

Kocic then reuses the same chart he showed back in November to indicate the four distinct endgames should the leverage cycle be pushed into one of four final states of "instability."

Where the narrative differs from last month, however, is in the slight but perceptible shift to Kocic" conclusion: he now appears resigned that the current twist of the vol spiral is also the last one, beyond which the current financial and monetary system will no longer exist, something his just as gloomy colleague Jim Reid concluded not too long ago and which we described in "This Is Where The Next Financial Crisis Will Come From."

Here is Kocic explaining why we may be approaching the end of financial history (at least as we know it):

It is clear that the spiraling trajectory cannot continue indefinitely; it has to stop at some point beyond which there will be no more bubbles. In many ways, it looks like the post-2008 represents the last lapse. A new game has to be reinvented for the old future to materialize, or a different paradigm altogether has to take over.

As to what happens next, after the two sweeps of the spiral, both of which culminated with crashes, Kocic reverts back to his forecasting self and writes that "we arrived at the juncture point (2017) from which four possible trajectories emerge, none of them are looking very attractive at this point." For those who may have forgotten the November report, here they are again:

• Throughout the post-crisis period, policy response has been designed around an attempt to avoid the lower left corner of low volatility and low leverage. It is safe to say that we have been able to stay clear of this outcome.


• At this point, with regulated financial sector and restricted leverage, we have found what appears to be a “reasonable” base case trajectory – a middle ground between Japanese style liquidity trap and repeat of the same mistake of the previous lapse -- with regulated markets, lower leverage, and subaverage growth (a.k.a. Permanent state of exception).


• Alternatives represent risk scenarios and correspond to volatile outcomes. The lower right corner is the policy mistake territory of forced deleveraging (without inflation) triggered possibly by overly aggressive Fed.


• The most acute risk is associated with the path leading to the upper right corner where possible deregulation and reckless fiscal spending could trigger rise in inflation leading to stagflationary outcome with potential currency decline and forced unwind of the bond trade. Both of these trajectories represent high risk alternatives to be avoided.

Unfortunately, as recent social events have demonstrated, the current "reasonable base case" of a "permanent state of exception" is becoming increasingly improbable because the forced surreal financial relationships are starting to tear apart the social fabric itself. Not only that, but the fact that the "stability" has only been bought thanks to some $15 trillion in central bank liquidity is lost on only the biggest fools, and socialists, pardon - MMTers - in finance. Here again is Kocic:

As much as the base case trajectory appears as “reasonable” and a worry-free choice, its biggest problem is its legitimation. Easy money provided by central banks to restore growth was easy for capital, but not for labor. Policy response to crisis added further to inequality by blowing up the financial sector and inviting speculative rather than productive investment. The Keynesian bond which ties profits of the rich to the wages of the poor seems to have been severed, cutting the fate of the elites loose from that of the masses and the well-being of the economy. 

Confused? You can thank Bernanke and Yellen for president Trump. Anyway, Kocic continues:

 With subaverage growth and highly skewed wealth distribution, the economy is converging towards what for a growing majority increasingly resembles a zero sum game. To the vast majority, that is saying that the best days are behind us. This is the most difficult aspect of the base case scenario: There has been no political system in modern history -- inclusive, exclusive, democratic or oppressive, all the same – that has promised anything but better future to its constituents. For any ideology the gradient between the present and the future has always had to be positive. It is difficult, if not impossible, to conceptualize any political narrative capable of making the reverse acceptable. And in a context where economic growth is a universal metric of progress, problems  with the base case become even more acute. The legitimation of the base case will continue to define the populist narrative as a voice of change. Politics will be shaped along the lines of looking to disrupt the status quo with quick short-term fixes, which could emerge as outright triggers of stagflationary trajectory.

Well, considering that years and decades of endless political lies that "the future is brighter" is the reason why the world finds itself on the edge of a social, political and financial catastrophe, and which has made a handful of people richer than their wildest dreams while pushing the vast majority of the population into considering that socialism - and even communism - may be a wise alternative to capitalism, perhaps it is not so bad that for once the truth will be told and someone will have the temerity to admit that no, the future will not be better, especially when one admits that after the next crash - and the wars that follows - the future, or as it will be known then, the present, will be the worst since the world wars.

And finally, for those who lament the disruptions to the status quo by populist elements promising "short-term fixes", well just look where said status quo got you: a world where the markets have to close their eyes and pretend they can exist forever in the artificial, central-bank created "permanent state of exception."

Which, thankfully, is impossible.

Eric Peters: Today"s Opportunities Include Negative Convexity, Complexity, Illiquidity, Leverage, Or All The Above

From the latest Weekend Notes by Eric Peters, CIO of One River Asset Management

Anecdote

“What are the odds we come across an opportunity in the coming 4yrs to earn 20%?” the investor asked his team.

“High,” they answered. “The odds are 100%,” he said, having seen this movie a few times. “So our cost of capital is 5% per year (20% divided by 4yrs), plus the 1% we earn on cash,” he said. His team nodded.

“Under no circumstances should we deploy capital unless it earns well more than 6% per year from here on out.” It made sense.

“What do we see that earns more than this hurdle?” he asked. His team’s list was as short today as it was long in 2016, 2011, 2009, 2003, 1998, 1997, 1994, 1992, 1990, 1987, etc. Today’s few opportunities have much in common with previous peaks: negative convexity, complexity, illiquidity, leverage, and/or all the above.

“Investors confuse a 7.5% average annualized return target with a 7.5% annual return target,” he explained. “They’re entirely different things.”

Targeting average annualized returns allows you to accept what the market gives you, while targeting annual returns forces you to leverage investments near peak valuations to hit your bogey. “Typical pension and endowment boards want incoming investment returns to consistently exceed outgoing flows.”

So most investors attempt to produce the highest return every year, no matter what it takes. “But that’s the wrong objective. Never underestimate the value of cash and patience in achieving the real goal; superior returns over the complete cycle,” he explained.

“Markets tell you what to do if you listen,” he said. “Near the highs, few opportunities exist to earn substantial returns, so you should take little risk. Near the lows, opportunities to earn attractive returns are abundant.” You should take a lot of risk. “This sounds simple because it is. It’s obvious. But obvious is not easy.”

Deutsche: Every Time We Asked "How Much Lower Could Vol Go” Things Would Become Unpleasant

According to Deutsche Bank"s Aleksandar Kocic, we live in a reflexive world, one where "the Fed knows that the market knows and the market knows that the Fed knows that the market knows, so everyone knows, but pretends that nobody knows and the game goes on." That pretty much covers much of modern market analysis which, like some mutant version of the Heisenberg Uncertainty Principle, implies that it is impossible to know the value of assets without also taking into account what the Fed thinks about said value, and what it will do in response to the valuation manifesting itself in the form or asset prices.

There"s more to it.

Following up on last week"s note, in which the DB derivatives analyst looked at the market"s current "metastable" state from the perspective of Minsky dynamics - a series of constantly shifting disequilibria which vary in leverage and volatility (the lower the vol, the higher the leverage until the system tips over and is forced to reset)...

... to analyze what may be the exogenous "circuit breaker" that finally snaps the fake calm of the past 9 years of central planning, overnight Kocic put it all together in his latest report which converges on most of the tropes he has been discussing over the past year, including the build up of negative convexity by way of continued state of exception, misallocation of capital, buildup of tail risk, and metastablity, and explains why markets are caught in a "Sachzwang – a factual constraint residing in the nature of things that leaves no choice but to perpetuate the existing conditions."

For those unfamiliar with Kocic"s latest metaphysical allegory for capital markets - which would be everyone - this is how he explains it. As usual, a PhD in philosophy is recommended, and increasingly, required.

Continued pressure on vol is shaping to become the signature mode of this year. Its decline from its post-elections high at 95bp (in terms of 3M10Y) to its near all-time lows of 55bp in less than 12 months has been a function of general distribution of risks and persistent supply of convexity through complacency, transparency, liquidity, and predictable monetary policy. Politics no longer matters -- increasing negative newsflow has created political bottlenecks which have eroded the ability to produce consensus resulting in a noisy status quo. Yield enhancement strategies seems to be everywhere. Credit spreads have compressed to their post-2008 lows while risk premia and volatilities have collapsed across the board.

 

At the same time, this state of affairs is causing a buildup of negative convexity out-of-money by way of continued state of exception, misallocation of capital, buildup of tail risk, and metastablity. The market is vulnerable to bear steepening of the curve with Fed massively negatively convex to inflation risk. One would expect that vol would find support in the face of these risks. However, there does not seem to be any meaningful signs of resistance levels at this point. Investors are aware of the underlying risks, but are implicitly forced to ignore them in order to survive the short-term demand for return.

Unlike the chess "zugzwang", in which the player is forced to make a move, making their position significantly weaker, and would thus rather not move at all, in the Kocic world, the equilibrium market state is a suffocating paralysis under which the only option is making no move at all, thereby perpetuating the paralysis. The final outcome - as we are confident the metaphysical analyst will eventually unveil - is Cosmic Death... a state of 0 Kelvin in which central planning crushes one"s will to exist, let alone trade, or some other similarly dramatic philosophical narrative.

Markets are caught in a Sachzwang – a factual constraint residing in the nature of things that leaves no choice but to perpetuate the existing conditions.

 

Short-dated volatility continues to probe new lows in tune with other  measures of risk premia. There has been hardly any departure from the trend. As gamma collapsed, vol sellers have been moving along the surface and ironing out the calendars. This is causing collapse of horizons and general paralysis which further perpetuates status quo. Time is gradually coming to a stop – this is the real collateral damage of the existing dynamics.

Perhaps he is right: instead of a "VIX supernova", maybe the fate of the market is a singularity of ever-shrinking volatility and trading and infinite boredom, one in which everyone withers away as neither newsflow nor decisions matter. If so, it would certainly explain the next part: angry clients who know the final outcome, yet are reluctant to concede that they have become irrelevant pawns in a game which is no longer winnable.

These ominous vol lows are triggering unpleasant memories of the past episodes of complacency and their aftermaths. Every time we asked the question: “How much lower could vol go”, things would become unpleasant.

And yet, as the saying goes, maybe this time it is different, at least for rates traders. Here - according to Kocic - is why and how it is different.

To be blunt, when it comes to future rates volatility, there is very little to be learned from its history at this point. Most of the past market mechanisms, and by that we mean pre-2007, are no longer in place. Mortgage negative convexity is no longer transmitted from home owners to capital markets. Monetary policy shocks used to arrive from the front end of the curve, and active convexity hedging, and with it, bid for vol, went hand in hand with carry, steeper curve, and generally higher risk premia. In contrast, post-2008, the MBS convexity hedging has practically disappeared – while housing market continues to expand, hardly any of its negative convexity is being transmitted to the capital markets. Monetary policy seems to be largely administered through the back end of the curve – more stimulus during QE meantflatter curve, less carry, but also potentially higher volatility. Management of stimulus unwind has now become a major source of convexity supply -- Fed’s communication with the markets has been the key reason for compression of risk premia. On top of that, financial conditions have been as loose as ever. Tight fiscal policy, stricter regulations and positive supply oil shocks, together with global QE, have compressed long rates to the point that remaining playground for the Fed has been reduced to a mere 50-60bp range. On this restricted landscape, nothing is super exciting anymore. The Fed’s main concern is how to get unstuck without getting unglued.

To be sure that concern will become a trigger for wholesale market panic if the Fed raises rates by another 50-60bps while long rates fail to budge in parallel. In fact, it will be especially ironic if it is the Fed"s rate hikes that unleash the yield curve inversion and thus, the next recession, something another DB analyst - Dominic Konstam - suggested would happen two months ago. And speaking of vol regime variances, Kocic also explains what he perceives to be the biggest disconnect between past and present vol regimes.

Lots has changed relative to pre-2008. Vol is still a carry game, but the market is effectively less negatively convex then before. Monetary policy now dampens volatility instead of generating it, and economic volatility is lower. During the  period of active convexity hedging, carry was an opportunity to buy vol – existence of carry allowed mortgage hedgers to spend some of that carry to hedge their convexity exposure. That supported an extra    premium for rates volatility, on top of general uncertainty reflected by other markets. The Figure shows a history of 3M10Y rates gamma overlaid with the FX vol index (CVIX). We note the spread between the two in the first half of the first decade. With disappearance of convexity transmission mechanisms, carry is now seen as signal to sell vol.

Having establishing the disconnect between present and the past volatility regimes, how does Deutsche Bank see its future? Before answering that, Kocic revists the Minsky Dynamics aspect of historical crisis formation he discussed last week:

In our view, interplay between volatility and leverage is the framework that gives the most straightforward tool for understanding the future path of volatility. We have discussed this relationship in our recent publication. Here, we extend this interaction to a broader context of buildup of leverage and management of subsequent crises across multiple cycles. To recap, we argued that there is a logical relationship between leverage and volatility. Low uncertainty engenders higher leverage which in turn leads to additional compression of risk premia and a buildup of risks. Ultimately the system becomes unstable and results in a crisis, which in turn forces the system to deleverage in a highly volatile manner. In a way, continued prosperity and stability in itself is destabilizing leading to riskier lending as the asset prices of collateral decline. This is the essence of Minsky"s take on financial markets.

However, what is most interesting for Kocic, is the question of "what comes after each crisis, namely how is the recovery engineered and economy brought back on track." His answer:

To be specific, let’s choose as the starting oint 1999, the beginning of the internet bubble and follow (in the clockwise direction) the subsequent economic trajectory in the vol-leverage plane in the Figure. As the economy is heating up, volatility declines and leverage increases until the bubble bursts sometime in the late 2000. There is a volatile deleveraging for the next 2-3 years when low rates and expansion of the real estate market created conditions for the turnaround and beginning of another cycle. The only difference is that, this time around, the bubble was bigger and the limits were more extreme. Instead of being a periodic object (e.g. ellipse), the trajectory now becomes an outward spiral – in the second sweep, the leverage is higher and risk premia compression more extreme leading, naturally, to a deeper crisis and a need for an even more extreme measures of recovery.

Of course, one could (far simply) say that it takes more and more debt to kick the can, and keep the world"s biggest asset bubble ever created - the explicit backing of central banks - inflated. This is precisely what Bank of America"s Barnaby Martin did in far less words yesterday:

 "the irony in today"s world is that central banks are maintaining loose monetary policies to generate inflation…in order to ease the pain of a debt "supercycle"…that itself was partly a result of too easy (and predictable) monetary policies in prior times."

Alas, sounding philosophical has emerged as a calling card for quite a few financial pundits, as saying the same thing over and over (for 9 years) has lost much if not all impact and has to be spiced up in any possible way. Like, for example, using Finnegans" Wake or Ulysses as one"s stylesheet.  In any case, when charted, Kocic"s argument looks as follows:

Where Kocic is concise, and accurate, is in what he says next, namely that "spiraling leverage cannot continue indefinitely. At some point, the bubble becomes too big and cannot be subsumed by a bigger bubble – the damage of its burst would become irreparable. Therefore, when that moment comes -- and we believe that moment is now – the market is facing a following dilemma."

• Permanent state of exception: We continue to operate in a regulated environment. Leverage is limited, but care is taken not to overconfine the system so we avoid the Japanese scenario. While this appears as a prudent approach to reality, it implies giving up all the ideas of unlimited growth, something that made US economy look better than the rest of the world. Compared to what we have seen before, this means settling for much less than this country is used to aspiring. Although a reasonable proposition, it is emotionally a difficult choice that is and will remain subject to substantial political manipulation. It is unlikely that populist narrative will not continue to challenge this choice [ZH: hey, one can just blame the Russians, right?]


• Flirting with high tail risk : Deregulation and deficit spending could result exactly due to abandoning the first path, as its direct challenge, under political pressure that American economy can restore its old status and resume its pace of the previous decades. This is a serious tail risk as it is playing against the backdrop of considerable overhang of the post-2008 one-side positioning. Central banks are massively short convexity in this scenario. Any inflationary maneuver, or anything that would be a bear steepener of the curve, could force disorderly unwind of the bond trade and reinforce the trend thus creating another crisis from which there could be no way out.


• Forced deleveraging: An overly hawkish Fed forces rates higher and triggers a disorderly unwind of the bond trade, thus forcing the system to deleverage. This is the policy mistake.

Deutsche Bank"s conclusion:

"The tension created by these three choices is in the center of both economic and political discourse. It will shape the market dynamics in the future, beyond the near term. Taper tantrum and the US presidential elections were the two most recent episodes that have highlighted the risk distribution opened by these choices. Policy mistake appears less likely at this point. The financial conditions are as loose as they have ever been. Fed hikes are only going to tone this down, but it is very difficult to see how they can create overly tight financial conditions and cause economic slowdown. Nevertheless, negative convexity of the central banks in the bear steepening or generally high rates scenarios are making risk of volatile deleveraging alive."

Ironically, it was yesterday"s sharp bear steepening that was largely cheered by markets:

If they only knew.

"What Happens When The Market Can No Longer Pretend": Charting Today"s Minsky Moments Dynamics

Back in July, Deutsche Bank"s derivative strategist Aleksandar Kocic believed he had found the moment the market broke, which he defined as a terminal dislocation between market and economic policy uncertainty: as he wrote 4 months ago, it was some time in 2012 that markets "lost their capacity to deal with uncertainty.”

It was also some time in 2012 that traders and market participants realized central banks have not only taken over the market, but have no intention of ever leaving as the alternative is a crash that wipes out 8 years of artificial "wealth effect" creation and puts the very concept of fractional reserve and central banking in jeopardy.

This intention was confirmed last week when as Kocic again wrote overnight, it became clear - once again - that Central Banks’ main agenda "is management of the risk of policy unwind" which has two different aspects, especially for those who still believe there is such as a thing as a "market." Kocic explains:

• On one hand, it is reassuring that Central Banks are cognizant of severity of the risk and are showing appropriate flexibility in adjusting their reaction functions to incorporate these realities.


• On the other hand, this is less good because it does not allow the market to reposition and, thus, normalize. By soliciting feedback from the markets, Central Banks are further encouraging bad behavior making things potentially worse by postponing the resolution further into the future.

This is also the "nightmare scenario" envisioned by Eric Peters: a world in which central banks inject more and more liquidity and "stimulus", and yet inflation does not rise, resulting in greater and greater financial inflation, i.e., asset bubbles, and a Fed chair who is confused about the "mystery" of inflation.

Yet while the Fed is mystified by the lack of "real economic" inflation - just because it is unwilling to admit it has blown yet another bubble - investors are mystified by something else entirely. As Kocic explains, the common theme constraint in this world in which central banks are focused on "risk policy unwind", the same risk they created, is that investors, and people in general, are facing fixed long-term liabilities. In such a world, "with continued political pressure to reduce taxes and avoid more deficit spending, welfare programs and safety nets are being further dismantled and, through continued privatization, those costs are being passed onto consumers. This means that long-term liabilities are not going down any time soon; if anything, they are most likely to continue to grow"

In this environment, in which demographics + debt + disruption = deflation, "investors are looking for higher returns and money managers are pressured to deliver in an increasingly challenging environment as risk premia continue to compress across the board. The dilemma money managers are facing is either to engage in short term risky strategies or face redemptions."

This is another way of saying "you will either become part of the crowd or your career is over." And since most financial professionals have conceded, and are indeed part of the crowd, "anything that would disturb this mechanism is likely to make markets unhappy and cause “tantrums” which could escalate and potentially trigger unwind of the existing positions creating a situation that would be difficult, if not impossible, to manage."

Since this forces current flawed monetary policy to persist and remain "transparent, predictable and overly accommodative", it further reinforces "bad behavior and focus on short term strategies with disregard to their long-term consequences." Which is Kocic"s traditionally verbose way of saying all traders care about is the year end bonus; as for what happens after, to paraphrase Louis VX, "Apres moi, le deluge."

In practical terms, this means that while markets appear to be locally stable, they "are effectively dancing on the edge of metastablity whereby practically any non-trivial shock can be destabilizing" as "people had abandoned any long-term agenda and have concentrated all the efforts on extracting as much as possible in the near term." This goes back to what Kocic said back in June when he first defined the market"s "metastable" (dys)equilibrium, and predicted that eventually it would lead to "cataclysmic events."

Picking up where he left off, Kocic explains that investor confusion, or rather schizophrenia, is the result of an "overhang of almost a decade of unprecedented stimulus and one-sided positioning" which has made "the market is vulnerable to violent selloffs."

 This is a consequence of Central Banks’ complicity and shrinking of the horizons – the future is degrading into an optimized present. At this point, there is an implicit symbolic pact between Central Banks and the markets.

This brings the old trope created by Kocic when he looks at the interplay between the Fed and markets as manifestations of second, third and higher level intentionality, or as the DB analyst puts it, "the Fed knows that the market knows and the market knows that the Fed

knows that the market knows, so everyone knows, but pretends that nobody

knows and the game goes on."

 Which, of course, is the $64 trillion question, "what happens if there is an exogenous

circuit breaker and we can no longer pretend?" Or, what happens when the Fed can no longer fake that things are normal...

But what?

Which brings us to the question of crisis catalysts - what is the "non-trivial" shock that will break the current cycle of metastability and unleash the next "cataclysm."

To answer, Kocic looks at the interplay of volatility and leverage in history, one "which defines the dynamics of the economy. Generally, reduced uncertainty engenders higher levels of leverage which in turn leads to additional compression of risk premia and a buildup of risks. Ultimately the system becomes unstable and results in a crisis, which in turn forces the system to deleverage in a highly volatile manner. In a way, continued prosperity and stability in itself is destabilizing leading to riskier lending as the asset prices of collateral decline. This is the essence of Minsky"s take on financial markets."

And since it has become the Fed"s sole purpose to prevent this mean reversion from taking place, perhaps ever, ultimately the tension in markets boils down to this simple question: how long can the Fed prevent the "Minsky moment" from asserting itself, sending volatility soaring and ending the current unstable state, ironically by injecting ever more of the one catalyst that unleash the next crisis: debt.

Below is Kocic" explanation of what the Minsky dynamics for the "new, centrally-planned, normal" market look like, how the interplay of vol and leverage could spark the next crisis, and what catalysts could send the world spiraling into a state of currency, and unconstrained, crisis. 

The forgotten horizon: Where the wild things are

 

Excess liquidity can cause asset bubbles and market crises. However, excess liquidity cannot do it alone; it must be helped by deregulation and an asset that can convert liquidity into inflation. So far, both of these factors have been under control post 2008 – the financial sectors have been regulated and an asset class capable of forming a bubble is not on the horizon. However, and this is where the risk lies, as there is political pressure to deregulate the markets and inject additional fiscal stimulus, the door is being open for unprecedented liquidity injection to backfire in the long run.

 

What should we do if we really have to worry beyond the short-term horizon? In our view, the experience of the past eight years could hold a key to understanding the response of the markets to potential normalization in rates and volatility. Since the early days of the crisis, we have had four episodes of violent selloff with repricing of similar intensity: QE1, QE2, Taper tantrum, and 2016 US Presidential elections. However, each time, that the market was addressing different kind of risk with a distinct pattern of repricing of the volatility surface.

 

In order to establish cognitive coordinates of the problem which allow us to generalize the past experience, we discuss the general framework of volatility evolution in the context of leverage. There is a relationship between leverage and vol which defines the dynamics of the economy. Generally, reduced uncertainty engenders higher levels of leverage which in turn leads to additional compression of risk premia and a buildup of risks. Ultimately the system becomes unstable and results in a crisis, which in turn forces the system to deleverage in a highly volatile manner. In a way, continued prosperity and stability in itself is destabilizing leading to riskier lending as the asset prices of collateral decline. This is the essence of Minsky"s take on financial markets.

 

During the conundrum years of the mid-zero-zero decade, there were several factors that led to subsequent instabilities and the 2008 crisis. In addition to low rates catalyzing the growth of the housing market, we had an increasingly predictable monetary policy on the back of further reduction of economic uncertainty and transfer of convexity risk to the banks’ balance sheets without a clear transmission mechanism to the capital markets. This led to continued decline in volatility and compression of risk premia as investors sought higher levels of risk in order to insure stable returns. This is the period of lowest volatility and highest leverage. In order to capture these dynamics, we describe the market behavior in terms of leverage and volatility (or risk premia), see the figure below. In this space, there are four quadrants corresponding to different regimes and the market trends with quasi-cyclical trajectories capturing the evolution of financial markets as they transition through different operating modes.

 

The low-vol/high-leverage state is intuitively easy to understand -- we have already seen its full realization during the conundrum years, about a decade ago, and are currently getting a taste of its modified version. High-vol/high-leverage would correspond to the period of unsustainable public or private debt, such as the ones observed in certain emerging market economies, with typically high inflation and currency problems. High-volatility/low -everage would correspond to forced and disorderly deleveraging. Low-volatility/low-leverage is a regime we are trying to avoid.

 

 

The figure captures generalized trajectories of volatility and leverage as seen in the last 10-15 years. This approach is a conceptual relative to the Minsky’s idea of endogeneity of financial crises. To illustrate the market evolution in this context, we start our journey somewhere in the lower left quadrant and follow the trajectory along the ellipse in the clockwise direction. We can think of this starting point as being some time around the middle of the last decade. As the risk premia compress, leverage increases leading to higher levels of risk taking, which results in a crisis. The volatility spikes up while the system begins to deleverage. At some point the government steps in and for awhile there is an uncertainty about whether it would be able to contain the crisis without causing serious long-term side effects.

 

Volatility continues to grow despite the decline in leverage until there are first signs of relaxation and market stabilization. As vol goes through a turnaround the system continues to deleverage, we are leaving the upper half of the plane. The success of policy response up to that point brings in some optimism about future economic growth and risk premia begin to compress.

 

We are currently in the lower half plane. As we transition from the lower right to the lower left quadrants, the policy unwind begins. During taper tantrum, the system faces a dilemma between forced deleveraging (e.g. unwind of the Fed balance sheet and disorderly bear steepener) or gradual deleveraging with uneventful exit and transition deeper into the lower left quadrant (this is denoted as the “Base case”). This path requires some fine tuning as efforts are made not to overregulate the system and slip into a deflationary trap.

 

At around the same vol levels, during the 2016 presidential elections, new risk is resurfacing. With protectionist rhetoric and promises of additional fiscal spending, the risks of opening corridor to high inflation and currency crisis is back on the table, but this time, due to massive growth of retail balance sheet this becomes entangled with uncertainty about the long-term monetary policy response in this context.

A Market In Which "Shocks No Longer Shock": Deutsche's Kocic Explains How To Trade It

Back in June, one of Wall Street"s more philosophical derivatives strategists, DB"s Aleksandar Kocic looked at the state of the market and postulated that far from "stable" the existing risk  "equilibrium" is one which can be described as "metastable", the result of widespread complacency, and which he compared to an avalanche where "a totally innocuous event can trigger a cataclysmic event (e.g. a skier’s scream, or simply continued snowfall until the snow cover is so massive that its own weight triggers an avalanche." Putting it in his usual post-modernist style, Kocic said that "complacency encourages bad behavior and penalizing dissent – there is a negative carry for not joining the crowd, which further reinforces bad behavior."

This is the source of the positive feedback that triggers occasional anxiety attacks, which, although episodic, have the potential to create liquidity problems. Complacency arises either when everyone agrees with everyone else or when no one agrees with anyone. In these situations, which capture the two modes of recent market trading, current and the QE period, the markets become calm and volatility selling and carry strategies define the trading landscape. But, calm makes us worry, and persistent worrying causes fear, and fear tends to be reinforcing.

Kocic framed the current state of the market as follows:

Unfortunately, the relentless grind ever lower in volatility, which as reported yesterday has resulted in both the lowest average September VIX on record...

... as well as the lowest September monthly settlement on record and only the second sub-10 monthly settlement... 

... appears to have finally unsettled Kocic" expectations, even if ever so tacitly implied, for a spike higher in suppressed vol, and as he writes in his latest ruminations on volatility, "as volatility continues to be unfazed by what lies ahead in the near term, short of surprises in inflation, we are likely to linger at low levels."

Following up to his note from last week, which explained how the Fed"s fake "transparency" killed long-term investor, Kocic writes that "as transparency became the word of the decade, by its very nature it created the forces that push everything to the surface. Things exist thanks only to the attention they produce. There is no room for ambiguity." 

Which ties in to the current news cycle, a relentless barrage of flashing red headlines, one scarier than the other, yet which on aggregate have zero adverse impact on volatility, and certainly on risk assets, which on Friday spiked to a new all time high following the latest last-second VIX-smash. Or, as Kocic puts it, "although shocks (political and other) keep arriving in the market, they seem to be appearing at what looks like predictable time intervals (usually, on Fridays). Practically every week, there is a new issue that eclipses the previous one, and we lose interest in past issues, before there is any semblance of resolution."

And with traders" attention spans already severely lacking, this habituation to hyperbolic, staccato newsflow means that not only is the market not discounting the future as Matt King postulated several months ago, but it is no longer able to even respond to the present, to wit:

Shocks, if they are predictable, lose their spell and gradually become facts of life. Predictable political shocks feed back into their source. Due to their antagonistic character, they gradually erode the ability to make consensus and reduce the ability to legislate, making further reforms at least questionable, if not highly unlikely. The market “euphoria” (aka the Trump trade) that followed immediately after the elections is being perceived as increasingly remote. Despite all the promises of reflation of the economy, fiscal stimulus, expectation of economic turnaround, no change is on the horizon. We are stuck with the status quo, albeit a noisy one.

So what does this mean for risk assets, and markets? According to the Deutsche analyst, "despite all the distortions and disruptions introduced by the central banks’, which has created a semi-permanent state of exception, markets have not lost one main characteristic, their adaptability. As the markets are getting inoculated against event risk, volatility continues to be under pressure. While we are distancing ourselves from the idea of political change, the Fed is seen, once again, as the main source of volatility. However, the Fed’s position is an uncomfortable one. The main problem it faces is the balance between preventing inflation from becoming a risk while at the same time not causing a rapid and substantial rise of rates. This requires a high level of fine tuning. It means that the Fed has to continue with rate hikes, but the hikes have to be done carefully without triggering the bond unwind."

The implication for vol traders is that contrary to warnings of market "metastability" and "suppressed cataclysmic vol events", Kocic - in many ways pulling a Hugh Hendry of his own - comes to the admission that fighting the Fed"s control over vol has become a futile pastime, and even though further complacency is in the cards, "continued vol selling" is encouraged.

... the market gradually, and reluctantly, trails behind the Fed, one hike at a time, and adjusts expectations on the go, without taking a longterm view on the Fed. It is difficult to see how this can lead to any excitement capable of inspiring higher volatility. As long as things evolve according to this scenario, everything shoiuld remain “predictable” with occasional noise that the market has learned to ignore. This is an environment that is bearish for volatility. It fosters further complacency and encourages continued vol selling.

Finally, Kocic takes a "Greek" detour and asks whether in this environment, in which every shock is ignored by a market now programmed to sell vol no matter what, "there is hope for Gamma?" Here is his answer:

In our recent publications, we have extracted one possible measure of liquidity from the volume data of Treasury futures. This measure quantifies sensitivity of the price to changes in trading volume. The liquidity index is expressed as a negative log of this sensitivity, so that large sensitivity corresponds to low liquidity and vice versa. The figure shows the (smoothed) liquidity (on the inverted axis) overlaid with the 3M10Y– low vol goes hand in hand with high liquidity.

Liquidity has a logical connection with volatility. This starts at the very short end and propagates across the term structure: By making a price, market makers are implicitly short volatility for which they are required to allocate risk capital and the bid/ask spread (which is an indirect measure of liquidity) is the compensation they receive for this risk exposure. All else equal, the ability to hedge an option is a function of liquidity of the underlying, and the option prices should reflect that. From the figure, we note that post 2004, with the disappearance of mortgage negative convexity hedging and the growth of  volume on the exchanges, liquidity has been providing a lower bound for gamma – whenever gamma reached this lower bound, it has been pushed up. Also, the departures from that lower bound have been increasingly rarer and short lived. This holds not only for rates, but for equities as well.

As volatility continues to be unphased by what lies ahead in the near term, short of surprise in inflation, we are likely to linger at low levels. In that context, liquidity constraints are going to define the lower bound on gamma.

As a reminder, none of this is new: those who have traded this market (for more than just a few years) instead of merely commenting on it, will recall all those vol traders who lost their jobs in early 2007 when vol crashed so hard, there literally wasn"t a swaptions market. If Kocic is right, vol traders in 2017 (and perhaps 2018) will suffer the same fate. Of course, the 2007 episode is best remembered not for the the vol linked pink slips, but the explosion in VIX shortly thereafter and the resultant near collapse of the US financial system. Despite the Fed"s relentless pressure, trillions in liquidity injections and vol selling, we see nothing that has changed since then, and no reason why this time will be different.

Meanwhile, The "Next Big Short" Is Quietly Blowing Up

Back in March, when we detailed the ongoing catastrophic deterioration in the US retail sector, manifesting itself in empty malls, mass store closures, soaring layoffs and growing bankruptcies - demonstrated most vividly by the overnight bankruptcy of Toys "R" Us, the second largest retail bankruptcy in US history after K-Mart - we said that "just like 10 years ago, when the "big short" was putting on the RMBX trade, and to a smaller extent, its cousin the CMBX, so now too some are starting to short CMBS through the CMBX, a CDS index which tracks the values of bonds backed by various commercial properties. They are betting against securities backed by malls in weaker locations where stores could close in quick succession, triggering debt defaults."

We dubbed this retail short via CMBX the next "Big Short" trade, and others promptly followed.

In a subsequent post just a few days later, we underscored why the correct way to short the great retail collapse was not so much through stocks, but CMBX:

The trade, as we discussed before, is not so much shorting the equities where a persistent threat of a short squeeze has burned the bears on more than one occasion, but going long default risk via CMBX or otherwise shorting the CMBS complex. Based on fundamentals, the trade indeed appears justified: Sold in 2012, the mortgage bonds have a higher concentration of loans to regional malls and shopping centers than similar securities issued since the financial crisis. And because of the way CMBS are structured, the BBB- and BB rated notes are the first to suffer losses when underlying loans go belly up.

As we also noted, cracks had started to appear. As of mid-March, prices on the BBB- pool of CMBS have slumped from roughly 96 cents on the dollar in late January to 87.08 cents last week, index data compiled by Markit show.

So fast forward 6 months to today, when Goldman Sachs - a firm known to dabble with prop positions in both RMBS and CMBS in the past - itself takes aim at the CMBX trade, and in a report by Marty Young, writes that the "CMBX market doubts viability of US retail malls," which highlighting the dramatic crash in select CMBX issues we touched upon over half a year ago.

Explicitly using the term coined here first, and calling it the next "big short", Goldman writes that while 2017 has generally been a year of low volatility and tight spreads across most asset classes, the CMBX market has been a notable exception. Spreads on CMBX 6 BBB- have widened 300bp since the start of the year and now trade 385bp wide to CDX HY (Exhibit 1). More notable, the trade appears to be accelearting to the downside, and in the past six weeks alone, spreads have moved more than 100bp.

In other words, in a world in which all asset classes appears to be only going up, CMBX, and specifically the CMBX 6 BBB- tranch, has indeed emerged as this year"s "Big Short."

What has driven such a significant sell-off, Goldman asks, and then provides the following answer. 

A market narrative has emerged that CMBX 6 BBB- is the next “big short” of brick-and-mortar retail. The “death of retail” story is nothing new, but fresh fears have arisen this year that 2017 marks the tipping point. Following an inexplicably weak holiday retail season and a raft of store closures and bankruptcies this year, concerns are growing that the pace of deterioration has inflected higher for brick-and-mortar retailers. Although the disruption from e-commerce has been clearly visible for more than a decade, store-based retailers have been unprepared for the onslaught of online retail (“The Store of the Future,” Profiles in Innovation, August 2, 2017). The market’s increasing anxiety over regional malls and traditional anchor stores is also evident in retail stocks. Exhibit 2 shows that as equity markets have grown enthusiastic about the big names in e-commerce, they have grown only more negative on department stores. These struggling anchors in turn threaten the mall ecosystem. Markets have been acutely concerned with Sears in  particular this year: Exhibit 3 shows that, with a spread level of roughly 3500bp, the CDS market is implicitly pricing a high likelihood that the company experiences distress.

For those who are unfamiliar with the basis of the trade, Goldman lays them out, as well as providing a detailed perspective on whether this "Big Short" has (much) more room to run.

First, what is it?

CMBX 6 BBB- is a synthetic, equal-weighted index of 25 CMBS mezzanine bonds that were rated BBB- at issue and issued between March and December of 2012 (CMBX 6 has AAA through BB tranches, but in this report we focus on the BBB- layer as it has been the focus of markets this year). Retail is the largest underlying property type (39%), which explains the exposure to negative retail sentiment. Office (27%) and lodging (11%) properties are second- and third-largest property types, respectively. The average loan-to-value (LTV) of the underlying collateral was approximately 64% at origination, with a debt service coverage ratio (DSCR) of approximately 1.9x. While the average deal was comprised of a pool of 64 loans, the top 10 loans account for nearly 55% of each deal on average, with the largest loan averaging approximately 10%. Most of these loans have a maturity of ten years, and thus will mature in 2022.

The tranched nature of CMBX reference entities is critical from a pricing perspective and distinguishes the product from corporate CDX. Since the most junior tranches in a CMBS deal incur losses first, there is a potential convexity to the spreads on CMBX BBB- as they need to price the possibility that these tranches could be completely wiped out. Put differently, even though CMBX 6 contains roughly 1,600 loans overall, the performance of the BBB- tranches is tied significantly to the lowest-quality mortgages in the portfolio, which is not offset by a strong performance of the aggregate portfolio. This is what makes CMBX 6 BBB- particularly vulnerable to the headwinds facing regional malls.

Exhibit 4 shows in four charts how a unique market narrative has formed around CMBX 6 BBB-. First, the spread on the BBB- tranche of CMBX series 7 ? a largely similar product comprised of CMBS issued in 2013 ? has also widened meaningful this year, but the move has been far more pronounced for the 6 series. Second, while the spreads on the synthetic index have widened hundreds of basis points since January, the spreads on the CMBS cash bond underliers have widened only a fraction of that. This deviation between cash and index could, to a degree, represent stale pricing marks on the cash bonds, given the limited trading volumes in the bond space. However, there have been enough trade prints in the sector to indicate that the pressure on spreads has been felt more acutely in index than in cash. Third, when CMBS investors have come under pressure in the past, spreads have widened at every level of the quality spectrum. This time, however, the more junior tranches have clearly underperformed, suggesting markets are pricing a scenario in which distressed assets default en masse. Fourth, the open interest in CMBX 6 BBB- has increased significantly this year, consistent with the story that this is the new "big short."

Goldman next lays out the "bear case" which as one can imagine, is substantial.

Retail malls face significant pressure from online retail, which continues to grow at roughly 15% each year, as well as fast-fashion chains and off-price retailers. Moreover, many of the anchor stores on which malls depend appear to be experiencing difficulties, and 2017 has seen the big department stores announce a host of store closures. The CDS market appears to be pricing in a high probability of distress at Sears, which would send a tremor through the mall ecosystem. And some malls have co-tenancy clauses that can amplify the impact of the department store distress by allowing other tenants to reduce their rent if an anchor closes. The slew of store closures is not limited to anchor stores, as malls are grappling with the poor performance of many national retailers. Given its significant retail exposure, CMBX faces the same headwinds that currently plague mall REITs.

The nature of the CMBX product makes it especially vulnerable to a retail downturn. First, as we noted before, CMBX is a tranched product, which means that if losses for a deal are severe enough (i.e., exceed the tranche detachment point), the recovery rates on the bonds can be 0%. By comparison, high yield corporate bond defaults usually have material recovery value. Second, the 25 deals that comprise CMBX 6 are not homogenous and the high-risk mall loans are not evenly distributed among them. If the high risk loans were spread evenly across the 25 deals, it is likely that, even if we assumed 100% losses on all of these loans, no one deal would incur sufficient losses to affect CMBX 6 BBB- in the aggregate (i.e., deal-level losses would never reach the attachment points). However, the high concentration of high-risk loans in a handful of deals threatens large losses on the product as a whole from a relatively small number of defaults.

Finally, a popular narrative that has helped drive this year’s spread widening is that Sears – commonly a tenant for many of the weaker malls in CMBX 6 – is itself at risk of imminent default. The CMBX market is worried that, if Sears defaults, it jeopardizes many of these weaker malls. For example, the Midland Mall in Midland, MI defaulted on its loan last year shortly after the Sears at that location closed. While it is  difficult to tie the default directly to the Sears closure, the loss of a large tenant likely increased the pressure on the mall. Earlier this year, J.C. Penney announced plans to close its store at Midland Mall, demonstrating the potential spiral that struggling malls face upon losing a tenant like Sears. Since many of the at-risk malls in CMBX 6 share the same few large tenants such as Sears, J.C. Penney, and Macy’s, a round of store closures or a bankruptcy filing from a single retailer could do disproportionate damage to the CMBX portfolio.

To be sure, Goldman then goes through the bull case, and looks at the remittance data, which - so far - show no major signs of trouble (readers can bother their friendly Goldman sales coverage for the full report), suggesting that it is possible that the CMBX market may be getting ahead of itself. Or perhaps, like in the case of TOYS bonds, which snapped from par to 20 cents in the matter of days, what the market is underestimating is the risk of a sharp, downward inflection point as the economy, and especially US consumer, slows down further, resulting in another step wise spike in defaults.

Goldman"s analyst reports as much and notes, that while the CMBX "big short" may work, it will require an inflection in performance. Here is the conclusion.

Brick-and-mortar retailers have been fighting competition from e-commerce for years. This long-running trend is visible in the rising e-commerce share of retail sales, declining same-store sales numbers, and increasing numbers of store closures. These trends, combined with the highly leveraged nature of CMBS deal structures, have fueled a bearish market narrative that has repriced the mezzanine tranches of CMBX significantly wider. This view has been particularly focused on scenarios where a subset of the lowest-quality malls generate a large number of mortgage defaults.

So far, such a deterioration in mortgage quality is not yet visible in recent vintage delinquency performance data. We find the bearish narrative persuasive, but to realize the defaults being priced by CMBX 6 BBB- will require a future deterioration in mortgage performance, which our analysis suggests would be a departure from historical predictive relationships. In our view, this “top-down” assessment highlights the critical importance of modeling the “bottom-up” credit stories. As described above, it is not hard to construct scenarios with significantly higher default losses than what we find using our narrative-free statistical analyses, and structured CMBS bonds would be highly exposed to such a collapse of the retail sector.

What Goldman is effecitvely saying is that absent a recession, or a market crash, the trade may have little widening left. Which, of course is ironic, because just several days ago, it was also Goldman that calculated that the risk of a market crash has soared to roughly 67%, as high as it was before the dot com and Global Financial Crisis crashes:

 

One final "hedging" observation from Goldman: in case the cautiously optimistic outlook is unwarranted, will a potential implosion in the CMBX 6 result in systemic risk? Here is Goldman"s answer:

The spread widening in mezzanine CMBX tranches – and not in more senior tranches – is pointing to an expectation of high default rates on a small number of low-quality malls. If this bear case were to be realized, it would not likely cause a systemic risk event comparable to 2008, due to the low amount of mall debt relative to the amount of residential mortgage debt outstanding prior to the financial crisis. If commercial mortgage losses were to occur due to severe declines in commercial property price across all sectors – including retail, office, apartment and hotel – the impacts could be greater, given the large amount of commercial real estate exposure on US bank balance sheets. But this is not the risk scenario that CMBX markets seem to be pricing.

Of course, if a Goldman is wrong, and a terminal collapse in CMBX 6 does prompt the next systemic crisis - which of course won"t be catalyzed by the losses in this segment of the Commercial Real Estate market but due to a sharper deterioration in the broader economy, all that would result in is another bailout from the Fed because as Deutsche Bank said earlier today:

"... by continually using stimulus to deal with crises and not letting
creative destruction take over, you make a subsequent crisis more likely
by passing the problem along to some other part of the global financial
system, and usually in bigger size. In a fiat currency world,
intervention and money creation is the path of least resistance. In a
Gold standard world, mining new gold was the only stable way of
increasing the money supply. we think this leaves the current global economy particularly prone to a cycle of booms, busts, heavy intervention, recovery and the cycle starting again. There is no natural point where a purge of the excesses is forced by a restriction on credit creation."

"Visions Of Cataclysms": Why Eric Peters Is Starting A Long-Vol Fund

Is the recent streak of record low volatility about to end?

While countless analysts, pundits and traders have previously talked their book (if not staked their reputation) on claims VIX is set for an imminent mean-reverting spike, so far that has not happened and in fact net spec positioning in the VIX just hit a record short print as of the latest CFTC week.

And yet, on Friday night, in a notable change to the low-vol regime, Interactive Brokers announced it would hike volatility product margins ahead of what it warned could be a 100% surge in the VIX, a move which will be promptly copied by most if not all trading platforms. Will this then become a self-fulfilling prophecy - should maringed out traders decide it makes more sense to close out vol shorts than to add more cash - it is too early to know, however, in a separate confirmation that the current low-vol regime may be ending, last week JPM"s quant strategy team reported that "following robust performance in 1H ‘17, PnL of short vol premia stagnated over the past month... We see further risk for short vol from both rate increase as well as CB balance sheet renormalization."

YTD, short vol PnL (+5.1%) exceeds that of traditional beta (+4.2%) and value (+4.1%). Momentum YTD PnL of -5.2% arose from a broad-based decline across global equity indices (-5.1%), sovereign bonds (-2.1%), currencies (-1.4%) and commodities (-12.0%). Carry was flat (+0.9% YTD) as it was buffeted by positive bond carry (+3.9%) and negative equity index carry (-1.6%). Over the past month, short vol has stagnated at 0.26% and momentum has continued its decline by - 0.71%.

And with no further P&L to be made from selling vole, the question again emerges: is the vol-selling party coming to an end?

To answer that question today in abstract terms, we give the podium to our favorite Sunday morning commentator, One River Asset Management"s CIO Eric Peters, who today in lieu of his traditional weekend notes, has penned a piece titled: "The Case for Long Volatility" in which he explains that a surge in volatility is inevitable for one simple reason: human imaginations will soon run rampant with visions of cataclysms... something which that other derivatives guru, DB"s Aleksandar Kocic also said precisely two months ago, when he predicted that the "Market"s Current "Metastability" Will Lead To "Cataclysmic Events."

Some of the key excerpts from Peters" note:

To sell implied volatility at current levels, investors must imagine tomorrow will be virtually identical to today. They must imagine that bond yields won’t rise despite every major central bank looking to hike interest rates and exit QE. They must imagine that economies at or near full employment will not create inflation; that GDP will neither accelerate nor decelerate; that governments will tolerate historic levels of income inequality despite citizens voting for the opposite; that strongly rising global debts will be supported by decelerating global growth. And volatility sellers must imagine that nine years into a bull market, amplified by a proliferation of complex volatility-selling strategies and passive ETFs with liquidity mismatches, that we will dodge a destabilizing shock to market infrastructure. I can imagine a few of those things happening, but neither sustainably nor simultaneously. It is much easier to imagine a tomorrow that looks different from today.

Zero interest rates and quantitative easing left yield-starved investors with few ways to achieve their target returns. Wall Street’s engineers developed many wonderful solutions to this problem. Their magnificence is matched only by the amount of negative convexity now lurking in investment portfolios.

As volatility declined, investors have had to sell even more of it to sustain sufficient profits. This selling reinforces the trend lower, which produces an illusion that legacy volatility shorts are less risky today than yesterday. Lower volatility thus begets lower volatility. And this also ensures that quantitative models reduce overall portfolio risk estimates, which allows (and in many cases forces) investors to buy more assets at prevailing prices. This in turn reduces volatility, reflexively. Naturally, the reverse is also true. Rising volatility begets rising volatility. And given the unprecedented volatility-selling in this cycle, I can imagine a historic reversal.

And at that point, investor imaginations will run rampant with visions of cataclysms. It is always thus, it is who we are. Confidence in a tomorrow that is indistinguishable from today will vanish, replaced by some new hysteria. It could be real or imagined. It could even be a bullish blow-off mania like 1999. Or maybe an endogenous crash, like 1987, when market moves were disconnected from the real economy. But the catalyst doesn’t really matter. What matters is recognizing that at this late stage, with implied volatility where it is, and asset valuations where they are, if you can imagine a tomorrow even modestly different from today, you must begin finding thoughtful ways to get long volatility.

Peters has imagined precisely that, and as a result, the CIO writes that he sees a "compelling opportunity developing in the months ahead" to go long volatility, and is launching a fund to capture it.

* * *

His full note below (link):

The Case For Long Volatility

I have an active imagination. A blessing and curse. I’m not alone. Of our many defining features, imagination is the greatest single thing separating us from other creatures. There is no higher power. Our ability to conceive of a tomorrow that is better than today is a precondition to discovery, invention. And these two things quite naturally stack, compound. Their summation has lifted us from the Stone Age to the space station. The journey has only just begun. This should be obvious to everyone but the most hopeless pessimist.

Along our upward trajectory are periodic interruptions. Some are natural, such as plagues. Others are economic, particularly depressions. But most are political, and the greatest arise when nations imagine future states of the world that are different and incompatible. These ideological conflicts can be devastating, lasting for years as hot or cold wars, but even so, they have barely restrained our rise. The motive force of humanity’s imagination, ambition, and drive to build better lives for our children is such that nothing has suppressed progress for long.

Economically speaking, our ascent is defined by rising productivity, the spoils of which determine prosperity. In modern times, we have imagined various ways to distribute this wealth; socialism, communism, free-market capitalism. I can imagine other approaches; the Chinese are exploring one. But even within existing constructs, there are nuances. Today in the West, capital owners collect a disproportionate share of profits relative to laborers. There is no intrinsic reason that this degree of inequality cannot persist. But in modern history it never has.

The private sector overwhelmingly sees itself as a more capable steward of research and development capital than governments. However, an examination of innovations traceable to state-funded initiatives during the past century suggests otherwise. I suspect the failure of Soviet communism led western free-market capitalists to imagine every element of our system to be superior. I imagine someday we will regard that black and white conclusion as foolish. China’s unprecedented economic rise and breathtaking technological advances should prompt Western self-reflection. So far it has not. I can imagine this being forced upon us.

In fact, I can imagine many things. I can imagine almost everything, except of course, things that never cross my mind. Those are unknown unknowns, Black Swans. In my lifetime, not a single such creature has reversed human progress, let alone markets. Not for long anyway. Lehman was not a Black Swan. I worked there for seven years and we spent most of them imagining the firm abruptly failing. Black Swans are generally magnificent, indistinguishable from magic - the internet, smartphones, cloud computing, quantum entanglement. The big risks are skewed to the upside, and manifest frequently. That is why we no longer live in caves. Yet periodically, our imaginations run wild with visions of cataclysms. I imagine that will never change.

In theory, investors compound savings at a rate commensurate with the upward slope of human progress. But people can pay anything they choose for assets and their derivatives. They periodically earn higher returns than that slope would indicate by bidding up prices far in advance of actual growth. However, they cannot do so forever without the gap between today’s reality and tomorrow’s promise becoming a chasm, prone to collapse. That said, almost any price can be justified if the slope of progress steepens, and every so often, something new appears that allows investors to imagine it will. But in modern history it never really has.

This leads me to investing. Which is principally about medium to long-term trend following. To obsess over much shorter time horizons is to imagine you can consistently outsmart people who imagine themselves smarter than you. A quick check on the number of billionaires who made their fortunes imagining such nonsense will tell you all you need to know on that topic. Anyhow, trend following is theoretically easy; over the long-term conditions improve. But because we base asset prices partly on their future value, and as every solvent investor imagines that trajectory to be upward, prices are almost always elevated relative to today’s reality - and thus prone to corrections. So trend following is easier said than done, and can be improved upon by periodic tactical adjustments, hedges.

With that in mind, it is hard to overstate the extraordinary nature of today’s landscape. All previous periods of extreme asset valuation required investors to imagine a vastly different tomorrow, a wildly optimistic future, a steeper slope. But today they expect the opposite. Due to unfavorable demographics and over-indebtedness, investors expect the slope to flatten, perhaps forever. Yet because of this flattening, they also imagine perpetually low interest rates, which they then use to justify extreme valuations across other asset classes in an endogenous loop that is increasingly disconnected from the real economy. This is the dominant pricing model for global assets today. I can imagine it continuing for a while still, but not in perpetuity.

Implied volatility is the price that connects two sets of people; those seeking to offload risks and those prepared to shoulder them. When imaginations are running wild, implied volatility is high, reflecting disagreement and uncertainty about what those risks are, and/or how they will resolve themselves. Low implied volatility reflects just the opposite. We are now at historic lows.

To sell implied volatility at current levels, investors must imagine tomorrow will be virtually identical to today. They must imagine that bond yields won’t rise despite every major central bank looking to hike interest rates and exit QE. They must imagine that economies at or near full employment will not create inflation; that GDP will neither accelerate nor decelerate; that governments will tolerate historic levels of income inequality despite citizens voting for the opposite; that strongly rising global debts will be supported by decelerating global growth. And volatility sellers must imagine that nine years into a bull market, amplified by a proliferation of complex volatility-selling strategies and passive ETFs with liquidity mismatches, that we will dodge a destabilizing shock to market infrastructure. I can imagine a few of those things happening, but neither sustainably nor simultaneously. It is much easier to imagine a tomorrow that looks different from today.

Investment banks and asset managers devise creative strategies to make money once valuations exceed reasonable levels. These perpetual prosperity machines typically combine leverage and alchemy, transforming real risk into perceived safety. Examples abound. But in this cycle, a proliferation of cleverly disguised volatility-selling strategies has dominated. Zero interest rates and quantitative easing left yield-starved investors with few ways to achieve their target returns. Wall Street’s engineers developed many wonderful solutions to this problem. Their magnificence is matched only by the amount of negative convexity now lurking in investment portfolios.

As volatility declined, investors have had to sell even more of it to sustain sufficient profits. This selling reinforces the trend lower, which produces an illusion that legacy volatility shorts are less risky today than yesterday. Lower volatility thus begets lower volatility. And this also ensures that quantitative models reduce overall portfolio risk estimates, which allows (and in many cases forces) investors to buy more assets at prevailing prices. This in turn reduces volatility, reflexively. Naturally, the reverse is also true. Rising volatility begets rising volatility. And given the unprecedented volatility-selling in this cycle, I can imagine a historic reversal.

And at that point, investor imaginations will run rampant with visions of cataclysms. It is always thus, it is who we are. Confidence in a tomorrow that is indistinguishable from today will vanish, replaced by some new hysteria. It could be real or imagined. It could even be a bullish blow-off mania like 1999. Or maybe an endogenous crash, like 1987, when market moves were disconnected from the real economy. But the catalyst doesn’t really matter. What matters is recognizing that at this late stage, with implied volatility where it is, and asset valuations where they are, if you can imagine a tomorrow even modestly different from today, you must begin finding thoughtful ways to get long volatility.

And just like that, the "fat tails" funds are back.

Deutsche: The Fed Has Created "Universal Basic Income For The Rich" And Now It Can't Get Out

Two weeks after Aleksandar Kocic highlighted the moment in 2012 when the market stopped caring about newsflow and reality, and, in a word "broke" with pervasive complacency setting in regardless of macro uncertainty...

... Deutsche Bank"s post modernist master of stream-of-consciousness narrative is back with a new essay dissecting his favorite topic, the interplay between the Fed and markets, the so-called "umbilical limbo" that connects the two in the form of ultraeasy monetary policy and QE in general, and more importantly, the narrative that the Fed has spun over the past ten years, which while supportive of risk assets, has concurrently resulted in what Kocic calls a "permanent state of exception" from normalcy as a result of the Fed decision to defer the financial crisis indefinitely.

It is the unwind of this exceptional state, created symbiotically between the Federal Reserve and the markets, that is the source of consternation for markets, and manifests itself in the upcoming "tricky" renormalization of both the global rate structure, and the unwind of central banks" balance sheets and trillions in monetary stimulus. And, quick to revert to his favorite philosophical abstraction, Kocic notes that more than anything the Fed is hardly eager to "disown" the power it has been exercising for years in its attempt to avoid, or at least delay the next crisis:

The Fed (and central banks in general) carries an implicit responsibility for orderly re-emancipation of the markets, which makes stimulus unwind especially tricky. This highlights the deep dichotomy of power: While a state of exception is an exercise of power, there is a clear tendency to disown that power. And the only way to avoid facing the underlying dilemma is to never give up the power. This creates a new status quo -- a permanent state of exception.

In practical terms, this confirms what we have been warning about for years, namely that the Fed is increasingly "acting as a non-economic actor" - and a price-indescriminate one at that - whose "communications with the markets (“removal of the fourth wall”), excessive accommodation, unconditional support for risk, convexity supply to the market, etc. in place, its role is aimed more and more at achieving “social” and not necessarily financial goals."

In some ways, this was to be expected at a time when the traditional defender of social goal, key among them stability - the government - is increasingly unable to perform its duties due to a record and growing ideological chasm between the left and right, which has forced the Fed to resort to preserving the social order through the only "monetary channel" under its control: pushing asset prices to ever higher nosebleed levels, in hopes of boosting the confidence of the general public that "all is well, just look at the S&P", a trope most recently adopted by none other than Donald Trump.

Stock Market at new all-time high! Working on new trade deals that will be great for U.S. and its workers!

— Donald J. Trump (@realDonaldTrump) July 15, 2017

At its simplest, this boils down to merely perpetuating the capital markets" status quo, or as Kocic calls it "Monetary policy continues to be supportive for stocks, bonds and USD at the same time."

This has been a radical departure from traditional relationships across different assets (in the long run, the two can only rally if the third one sells off). These correlations are the gift to the market. In the past years, owners of US risk assets and bonds (as a “hedge”) have been enjoying persistent positive externalities allowing them to make money on both stocks (the underlying) and bonds (the “hedge”).

To market participants who observe the lack of solid economic growth coupled with a global market cap that just hit a new all time high, this divergence creates a sense of deep confusion, yet one which few are willing, or able, to challenge in keeping with the mantra of "don"t fight the Fed."

Still, problems are increasingly emerging, most recently from Bank of America, which in a note yesterday urged the Fed to finally "take that punch bowl away"...

... and warning that the longer the Fed"s status quo persists, the greater the risk of a violent renormalization, i.e., crash. 

If we are wrong and central banks do not take away the punch bowl, things will get much messier eventually. “Bubbles” may form that will eventually burst, leading to much higher volatility than necessary. Keeping rates low in response to persistent positive supply shocks that keep inflation low could lead to imbalances, with a painful eventual correction. Central banks did this mistake before the global crisis and kept monetary policies too loose as inflation was low, ignoring very easy financial conditions, excessive and sometimes irresponsible credit expansion and a housing price bubble. We do not believe, or at least we hope, they will not repeat the same mistake twice.

 Amusingly, BofA was hopeful that central banks had learned their lesson from "making this mistake before the global crisis" adding that "we do not believe, or at least we hope, they will not repeat the same mistake twice." And yet, last week"s events cast significant doubt on this "hope."

There are other problems with perpetuating a "permanent state of exception",not least among them the fact that the market will remain broken via an "indefinite suspension of traditional market exchange" which also means that the Fed must reinforce its control over risk prices every day through a "continuous uninterrupted exercise of power."

In essence, it is all about diluting the possible downside of stimulus unwind -- an attempt to have an option to obfuscate without losing one’s credibility. With traditional market rules and relationships breaking down, central banks appear to be chasing the illusive target, which means that victory and the final goal are not well defined, which in turn insures the persistence of the “battle” and indefinite continuation of the state of exception. This implies indefinite suspension of traditional market exchange, which means continuous uninterrupted exercise of power that must be won every day.

Kocic previously touched on this topic, calling it a state of market "metastability", in which the "persistence of low volatility causes misallocation of capital. This is how complacency leads to buildup of risk – it is the avalanche waiting to happen."

He continued:

Complacency is a source of metastability. It has a moral hazard inscribed into it. Complacency encourages bad behavior and penalizing dissent – there is a negative carry for not joining the crowd, which  further reinforces bad behavior. This is the source of the positive feedback that triggers occasional anxiety attacks, which, although episodic, have the potential to create liquidity problems. Complacency arises either when everyone agrees with everyone else or when no one agrees with anyone. In these situations, which capture the two modes of recent market trading, current and the QE period, the markets become calm and volatility selling and carry strategies define the trading landscape. But, calm makes us worry, and persistent worrying causes fear, and fear tends to be reinforcing.

Fast forward to Friday, when in his latest tangent he points out that in order to minimize the "fear" experienced by market participants caught in the metastability trap, they have no choice but to be comforted each and every day by the central bank exercising its "power" by perpetuating the "indefinite suspension of traditional market exchange", something it can only do if the motives of all actors - central banks and investors - are aligned:

Everyone is incentivized to participate in the reinforcement of the state of exception, while various forms of contestation of the power are inhibited. For example, attempts at shorting bonds are penalized by a steep curve, protection against volatile unwind is discouraged through wide vol calendars, negative carry etc.

And yet this daily interference leads to the abovementioned build up of imbalances, which for a Fed now focusing on its "social" role results in a layering of paradoxes:

The fuzziness of its objectives, as seen through obfuscation of the objective function and metrics (a.k.a. moving the goalposts), has become a policy tool that undermines the power of a reality check. Collapse of short-dated volatility is a referendum on the near-term power of central banks, and softening of long-dated (and forward) vol represents first signs of acceptance of its extension and possible permanence.

Therefore, when going back to the original postulate, the discontinuity between existing and future policy, it is clear why the Fed is concerned, especially at a time when as the Deutsche Bank strategist writes, QE has become nothing more than "universal basic income for the rich."

The accommodation and QE have acted as a free insurance policy for the owners of risk, which, given the demographics of stock market participation, in effect has functioned as universal basic income for the rich. It is not difficult to see how disruptive unwind of stimulus could become. Clearly, in this context risk has become a binding constraint.

Putting it all together, Kocic - perhaps not surprisingly - urges his readers to revert to a state of learned helplessness, to borrow a term, and effectively not fight the Fed, at least as long as the Fed remains dovish:

In our view, as long as the Fed remains dovish, there is little upside in holding gamma. Although the market is vulnerable to event shocks, in the absence of additional information, it would be difficult to endure the time decay of a long gamma position. If anything, reshaping of the curve is likely to lead to steepeners and more curve volatility. Curve gamma is currently trading at all-time lows and could be perceived as a better value as a potential hedge against event risk.

Yet while the current episode of metastability appears firmly entrenched - in fact the longer it persists - the more volatile the outcome, although here in a surprising relent, even Kocic appears to have given up and and suggests that the "permanent state of exception" may indeed be... permanent:

"Vega is a different story. Given the continued tension between the Fed and the market, from this vantage point, higher vol in the future looks almost inevitable, but given a possibility of a (semi-) permanent status quo and the state of exception, this might be a long shot."

Still, not everyone has thrown in the towel: as BofA"s Michael Hartnett wrote two weeks ago, "monetary policy will have to tighten to raise volatility, reduce Wall St inflation, and reduce inequality. There are two ways to cure inequality: you can make the poor richer, or you can make the rich poorer. The Fed will reduce its balance sheet in the hope of making Wall St poorer." 

At this moment, whether or not Hartnett is right, is the most important question for both the market and Janet Yellen.

* * *

Kocic" full note below

Umbilical limbo

For a short while, last week’s FOMC meeting and Janet Yellen’s testimony were perceived as a disruption of the Fed’s narrative from relatively hawkish towards a softer, more dovish, version. Subsequent bull steepening has signaled the Fed’s convergence to the market. In our view, this apparent change in Fed rhetoric should be understood in a broader context. Since it was first announced, unwind of stimulus has been a source of anxiety for both the markets and the Fed. And, as the Fed had already established a channel of communication with the markets, in the recent months, their dialogue has revolved mostly about the two sides reassuring each other. Although the recent shift towards a more dovish stance might be seen as an inconsistency, on a deeper level it is perfectly in line with the existing order of things.

Permanent state of exception and a new status quo

Crises are about contradictions, but when we move beyond the crisis things become paradoxical -- we are no longer content with rehabilitation of the traditional rules and values, but require a different type of thinking. And, while contradictions usually have resolutions, paradoxes generally don’t, although their understanding is not always beyond conjecture. Some 18 months ago we argued that the concept of the state of exception offers another perspective on the post QE market functioning (FIW Derivatives, 29-Jan-2016). We summarize it briefly again, to have everything in one place.

In its core, policy response to the crises was an extension of what in a political context is known as the state of exception: Market laws had to be suspended to restore normal functioning of the markets. The intrinsic contradiction of this maneuver is resolved only by understanding that suspension is temporary. Stimulus will have to be unwound. However, the accommodation has been in place for a very long time, during which traditional transmission mechanisms have atrophied and investors’ mindset has changed in a way that has altered irreversibly their behavior, the market functioning and its dynamics.

Engineering a state of exception comes with considerable risk. The Fed (and central banks in general) carries an implicit responsibility for orderly reemancipation of the markets, which makes stimulus unwind  especially tricky. This highlights the deep dichotomy of power: While a state of exception is an exercise of power, there is a clear tendency to disown that power. And the only way to avoid facing the underlying dilemma is to never give up the power. This creates a new status quo -- a permanent state of exception.

In essence, it is all about diluting the possible downside of stimulus unwind --  an attempt to have an option to obfuscate without losing one’s credibility. With traditional market rules and relationships breaking down, central banks appear to be chasing the illusive target, which means that victory and the final goal are not well defined, which in turn insures the persistence of the “battle” and indefinite continuation of the state of exception. This implies indefinite suspension of traditional market exchange, which means continuous uninterrupted exercise of power that must be won every day.

Everyone is incentivized to participate in the reinforcement of the state of exception, while various forms of contestation of the power are inhibited. For example, attempts at shorting bonds are penalized by a steep curve, protection against volatile unwind is discouraged through wide vol calendars, negative carry etc. The fuzziness of its objectives, as seen through obfuscation of the objective function and metrics (a.k.a. moving the goalposts), has become a policy tool that undermines the power of a reality check. Collapse of short-dated volatility is a referendum on the near-term power of central banks, and softening of long-dated (and forward) vol represents first signs of acceptance of its extension and possible permanence.

The Fed is acting as a non-economic actor. With its communications with the markets (“removal of the fourth wall”), excessive accommodation, unconditional support for risk, convexity supply to the market, etc. in place, its role is aimed more and more at achieving “social” and not necessarily financial goals. Monetary policy continues to be supportive for stocks, bonds and USD at the same time. This has been a radical departure from traditional relationships across different assets (in the long run, the two can only rally if the third one sells off). These correlations are the gift to the market. In the past years, owners of US risk assets and bonds (as a “hedge”) have been enjoying persistent positive externalities allowing them to make money on both stocks (the underlying) and bonds (the “hedge”) . In this way, the accommodation and QE have acted as a free insurance policy for the owners of risk, which, given the demographics of stock market participation, in effect has functioned as universal basic income for the rich. It is not difficult to see how disruptive unwind of stimulus could become. Clearly, in this context risk has become a binding constraint.

In our view, as long as the Fed remains dovish, there is little upside in holding gamma. Although the market is vulnerable to event shocks, in the absence of additional information, it would be difficult to endure the time decay of a long gamma position. If anything, reshaping of the curve is likely to lead to steepeners and more curve volatility. Curve gamma is currently trading at all-time lows and could be perceived as a better value as a potential hedge against event risk. Vega is a different story. Given the continued tension between the Fed and the market, from this vantage point, higher vol in the future looks almost inevitable, but given a possibility of a (semi-) permanent status quo and the state of exception, this might be a long shot. We see forward volatility as the best way to hedge this risk without the consequences of time decay. We favor intermediate sector for buying forward vol, either outright or synthetically. Although the lower right corner, which takes advantage of the inverted surface, is trading cheap and has nominally better ageing properties, it remains vulnerable to supply.