"You Are Here": Citi"s Stunning VIX Chart

Something snapped in the VIX complex, seconds after Friday"s early close, sending it to a new record low of 8.56 at 13:00:14 ET...

... which as we showed yesterday, was less than 10% of the all time VIX high of 89.53, hit on October 24, 2008.

However, while the Friday VIX snap - which is still on the feeds and thus wasn"t a fat finger error - is yet another indication of just how broken, and/or how overrun by vol sellers the market is, below we present two even more striking, longer-term perspectives on the VIX courtesy of Citi.

As Citigroup notes, even after the recent backup, the VIX index is in its 0.5th percentile – that is, historically it has been wider than currently on 199 out of every 200 days. In other words, the "you are here" on the chart below has never been more to the left.

But it is not just a question of having reached this low level of implied volatility. As much as anything it is about the extended period of time we seem to be spending there.

Which brings us to one of the most striking VIX charts we have seen: as Citi"s strategists note, over the last six months, VIX has spent more than 40 days below 10. Putting this staggering outlier in context, the index has never managed to accumulate more than 6 days that low, measured over the same time interval, over the last 30 years. Or, as today"s central bankers would say after one look at the chart below which they have created "perfectly normal."

Commenting on the above charts, Citi, which has turned increasingly bearish on credit in recent weeks, says that "implied vol is, in other words, sailing in the same unchartered waters as corporate credit", and concludes sarcastically, "why buy vol if you believe that any selloff is impeded by a central bank backstop?"

Why indeed?

So keep selling vol until one day vol finally explodes as CBs lose control, wiping out trillions in fake wealth in the process; just please don"t use the words "market" and "price discovery" until that happens.

Gresham"s Law

Authored by Ted Rivelle via TCW.com,

This year’s Nobel prize in economics was awarded to Richard Thaler, a pioneer of behavioral economics. But there is a tale told by a lesser known Nobel laureate, Kenneth Arrow. As a World War II weather officer, he was tasked with analyzing the reliability of the army’s long-range weather forecasts. His conclusion: statistically speaking, the forecasts weren’t worth the paper they were printed on. Captain Arrow sent along his report only to be told, “Yes, the General is well-aware the forecasts are completely unreliable. But, he needs them for planning his military operations.”

Okay, maybe you don’t actually need a Nobel prize to know that rationality in the decision-making department is often lacking. Case in point: the capital markets. While subtle and ingenious in construction, the capital markets are, nonetheless, driven by the mass action of millions. They are a reflection of ourselves and necessarily express both the summit of our knowledge as well as the pit of our fears, and everything else in-between. And, this brings us to the subject at hand: Gresham’s Law. Sir Thomas Gresham was a financier in the time of King Henry VIII and his name is, of course, attached to the principle that “bad money drives out good money.” Coin collectors of a certain age are familiar with the near immediate disappearance from circulation of all silver American coins once Congress had mandated the use of base metals beginning with the 1965 vintage. While all coins – silver and copper alike – carried identical legal tender value, it was the silver coins that vanished. Perhaps you are wondering what this has to do with bond investing? Everything!

Consider the state of financial markets as witnessed by metrics of implied volatility:

VIX Index

Source: Bloomberg

MOVE Index

Source: Bloomberg

Both indices hover at generational low levels. If markets were “run” today by humanity’s better angels of wisdom and rationality, you would have to conclude that Mr. Market has drawn on his collective insight and pronounced the capital markets to be safer now than at any other time in the past quarter-century. That is a stunning conclusion! But if rationality can’t explain a 25-year trough in expected risk, then we must necessarily conclude that there must be some other, less rational explanation. How about this: investors are, by and large, famished for yield and willing to underwrite most any risk to get some income. In short, the marginal price setter is “irrationally exuberant”, or dare we say it out loud? “Greedy.”

So, the age old tension that presents itself is this: there are those investors, the “value tribe”, that resists the general lowering in underwriting standards that comes with the aging cycle. The value guys believe that their principal is always precious and is best “wagered” when the return/risk profile is asymmetrically biased in favor of the investor.

The “momentum tribe”, in contrast, tends towards a belief that your capital must be kept working, otherwise “yield” is “needlessly” sacrificed.

Does it not stand to reason that, late in the asset price cycle, that the “momentum” money drives out the “value” money? Yes! Capital that lowers its hurdle rate of return and adapts itself to loose underwriting criteria will necessarily bid up asset prices to levels that become inconsistent with the criteria applied by the more discriminating pools of capital. The “clad” underwriting drives out the “silver.”

Now, admittedly, a win is a win, and momentum has been the winning trade. Whether intrepid or fool-hardy, “risk on” has won the year 2017. But do trees ever grow to the skies? Did Minsky not elucidate how extended periods of low volatility have the effect of masking financial pathologies, allowing them to metastasize throughout the system? Indeed! While the central bankers dream of a never-never land where wise scholars can direct the flow of irrational humans, the real world that the rest of us inhabit is decidedly messier.

How so? Long periods of low volatility often mean that some traders and fund managers become less concerned with closely scrutinizing what they own. Credit analysis is hard, and in an environment where prices become inelastic to the “fundamentals,” some conclude that the work involved in analyzing bonds is a case of the juice not being worth the squeeze. Low volatility environments remove incentives to trade, thereby degrading the quality of price information. Meanwhile, the low rate / high asset price environment removes the impetus for corporate frame breaking changes, and so low productivity businesses are “allowed” to just muddle along, restraining the Shumpeterian forces necessary for growth. In short, fundamental problems are systemically ignored by the collective. So, if you happen to see an emperor strolling about, happy and stark naked, you just shrug and move on.

But the worm will turn. It always turns. The collective gets jolted out of its slumber and suddenly realizes that capital is surrounded on all sides by clear and present dangers. The torrent of capital that flooded in under the FOMO banner may well become the most formidable ebb tide!

Before concluding one of our typical (i.e., informative and cheery) discussions, it’s worth a brief reminder that markets “vote” in the short-run and “weigh” over the long-run. Equities, real-estate, and bonds with “hair” have all voted, and we know how that has turned out. Meanwhile, we may not have heard enough from one of the most reliably smart guys in the financial markets. He seems to do a pretty good job of “weighing” and has one of the better (though far from perfect!) track records of forecasting recessions. Never heard of him? Oh, yes you have: he’s the yield curve, of course:

U.S. Treasury Yield Curve

Source: Bloomberg

Stocks roar to new highs. Tax cuts advance in Congress, I think. Consumer confidence revs while unemployment plumbs its lowest levels in decades. Yet, the yield curve just doesn’t seem to be buying it. Perhaps he has lost his mojo. On the other hand, even if he has misplaced his crystal ball, a flattening yield curve does more than just signal that growth and inflation prospects are viewed skeptically.

A flatter curve squeezes the term premium out of the equation for virtually all financial intermediaries. Less term premium means less net interest margin (NIM). Less NIM dis-incentivizes credit formation. Indeed, should term premia continue its vanishing act, we might find that it was the yield curve that helped put the “de” back into “de-leveraging.” Proceed with caution!

Second Crash Warning From The IMF – This Time It"s About Vol

Another week, another warning regarding financial crash scenarios from those keen minds at the IMF.

In “Here Is The IMF’s Global Financial Crash Scenario” last week, we highlighted the institution’s surprisingly candid discussion hidden away in its latest Financial Stability Report “Rising Medium-Term Vulnerabilities Could Derail the Global Recovery"…or as we paraphrased the IMF’s “politically correct way of saying the financial system is on the verge of crashing”.

As we noted previously, in the section also called "Global Financial Dislocation Scenario" because "crash" sounds just a little too pedestrian, the IMF uses a DSGE model to project the current global financial situation, and ominously admits that "concerns about a continuing buildup in debt loads and overstretched asset valuations could have global economic repercussions" and - in modeling out the next crash, pardon "dislocation" - the IMF conducts a "scenario analysis" to illustrate how a repricing of risks could "lead to a rise in credit spreads and a fall in capital market and housing prices, derailing the economic recovery and undermining financial stability."

This week the IMF has gone a step further, courting the mainstream financial media to publicise its warning about the dangers of historically low volatility and related short volatility strategies.

As The FT reports, The International Monetary Fund has warned that the increasing use of exotic financial products tied to equity volatility by investors such as pension funds is creating unknown risks that could result in a severe shock to financial markets. In an interview with the Financial Times Tobias Adrian, director of the Monetary and Capital Markets Department of the IMF, said an increasing appetite for yield was driving investors to look for ways to boost income through complex instruments.

“The combination of low yields and low volatility facilitates the use of leverage by investors to increase returns, and we have seen rapid growth in some types of products that do this,” he said.

It explains some of the short vol strategies that we’ve been expressing concern about for several years. To wit.

Mr Adrian’s warning comes amid increasing evidence that pension funds and insurance companies are venturing into riskier types of investments to gain income.

 

Some are also effectively writing insurance contracts against a market crash to pocket premiums. Last year the $14bn Hawaii Employees Retirement System said it was writing put options to boost its income, while other US pension schemes such as the South Carolina Retirement System Investment Commission and Illinois State Universities Retirement System have also hired outside managers to use option writing strategies. The IMF estimates that assets invested in volatility targeting strategies have risen to about $500bn, with this amount increasing by more than half over the past three years. Marko Kolanovic, head of macro, derivative and quantitative Strategies at JPMorgan, last month warned of “strategies that sell on ‘autopilot’”, and how risk management models that use volatility could be luring investors into taking on too much risk.

 

“Very expensive assets often have very low volatility, and despite downside risk are deemed perfectly safe by these models,” he wrote in a note to clients.

While we applaud this warning from the IMF, it’s absurdly belated and the short vol “horse” has long since bolted. Moreover, we think that the IMF is seriously under-estimating the magnitude of short vol risk in financial markets. Indeed, the IMF’s research department would do well to read the recent report from Artemis Capital Management which we drew investors’ attention to.

Artemis estimates that financial engineering strategies that are short vol, either explicitly or implicitly, amount to more than $2 trillion. However, both Artemis and the IMF are “on the same page” when it comes to what would unfold if there was a sustained spike in volatility. The FT continues...

The IMF believes that sustained low volatility increases incentives for investors to take on higher levels of leverage while causing risk models that use volatility as an important input to understate real levels of risk participants may be taking on.

“A sustained increase in volatility could then trigger a sell-off in the assets underlying these products, amplifying the shock to markets,” Mr Adrian said…

With equity implied volatility continuing to drop over the course of this year, investors who have bet that markets will remain tranquil have been rewarded. Yet the true quantity of complex products being sold that are linked to volatility of various assets is hard to ascertain due to such deals mostly being done in private. Regulators therefore find it difficult to map out the risks in the event of an unexpected market shock.

Minsky, Myopia, & Why The S&P 500 Is A Bloated Corpse

Authored by Raul Ilargi Meijer via The Automatic Earth blog,

According to Hyman Minsky, economic stability is not only inevitably followed by instability, it inevitably creates it. Complacent humans being what they are. If he’s right, and would anyone dare doubt it, we’re in for that mushroom cloud on the financial horizon. We know that because market volatility, as measured for instance by the VIX, the Chicago Board Options Exchange (CBOE)’s volatility index, is scraping the depths of the Mariana trench.

Two separate articles at Zero Hedge this weekend, one by NorthmanTrader.com and one by LPLResearch.com, address the issue: it is time to be afraid and wake up. And that is not just true for investors or traders, it’s true for ‘everyone out there’ perhaps even more. Central bank policies, QE and ultra low rates, have distorted the financial system to such an extent -ostensibly in an attempt to save it- that the depressed, compressed volatility these policies have created can only come back to life with a vengeance.

Feel free to picture zombies and/or loss of heartbeat as much as you want; it’s all true. Financial markets haven’t been functioning for years, and there have been no investors either, only gamblers and profiteers, as savers and pensioners have been drawn and quartered. Central bankers have eradicated price discovery, nobody knows what anything is really worth anymore, be it stocks, bonds, housing, gold, bitcoin, you name it.

If you make interest rates ‘magically’ disappear anyone can spend any amount of money on anything they fancy buying. And it’s not just traders and investors either. Scores of people think: look, I can buy a house, others think they can buy a bigger house, many will get into stocks and/or bonds, because prices just keep going up. Even savers and pensioners are drawn into the central bank Ponzi, often in an effort to make up for what they lose when their accumulated wealth no longer pays them any returns. Shoeshine boys are dishing out market tips.

Crypto may or may not be a new tulip, but many Silicon Valley start-ups -increasingly funded by crypto ICO’s- certainly are. There’s so much money sloshing around nobody can tell, or even cares, whether they are actually worth a penny. It’s all based on gossip multiplied by the idea that they will be smart enough to get out in time in case things go awry.

People mistakenly think that a market’s heartbeat can be found in for instance rising stock prices, the Dow, the S&P. But that’s simply not true. The S&P is a bloated corpse increasingly filling up with gases that will eventually cause it to explode, with guts and blood and body parts and fluids flying all around.

The US stock market’s heartbeat manifests itself in volatility, and the overall economy’s heartbeat in interest rates. Rising and falling volatility and interest rates is how we know whether a market is in good health, or even alive at all. They are its vital signs.

That follows straight from Minsky. Ultra-low rates and ultra-low volatility, especially if they last for a longer period of time, are signs of trouble. The markets the central banks’ $20+ trillion QE and ZIRP have created are bloated corpses that no longer have a heartbeat. They are zombies. But markets, unlike natural bodies, won’t die, they can’t. They will instead rise from their graves and take over Wall Street, the City, and then everyone else’s street.

Bernanke, Yellen, Draghi and Kuroda are sorcerer’s apprentices and Dr. Frankensteins, who have created walking dead monsters they have no control over. But the monsters won’t turn on them personally; that’s the tragedy here as much as it is the reason why they have worked their sorcery. They themselves won’t go bankrupt, other will. No skin in the game.

Enough with the metaphors. First, here’s NorthmanTrader:

Flatliners

In the movie Flatliners aspiring medical doctors tried to unlock the mysteries of death by, well, killing themselves. It was meant to be a controlled death of course, to flat line on the heart rate monitor for a few minutes to find out what wonders where to be found “on the other side” only to then return safe & sound thanks to medical intervention. Well, they soon found out the other side wasn’t everything it was cracked up to be and the main character soon got regular beatings as the sins of his past came back to haunt him.

In my view markets find themselves in a very similar script. The promise of investor nirvana where the pains of real life no longer matter. If you only pay attention to the record highs headlines it all looks rather fantastical these days. [..] any trader staring at the tape knows that we find ourselves in the most compressed price environment in history. This is not normal, there’s no heartbeat:

As I’m writing this I’m fully aware I may be viewed as the bear who cried wolf. After all I’ve been outlining structural risk factors for a while and markets have moved past my technical risk zones of 2450-2500 and most recently 2530. That’s what bubbles do. They blow past anyone’s expectations, they make believers of the unbelievers, make bears look like idiots and the most reckless look like geniuses. But an extreme market that only becomes more extreme is not any less extreme, it is just more extreme. As no risk is apparent these extremes are then dismissed as the new normal. Yet momentum driven price appreciation has absolutely zero predictive value of future price appreciation, it only appears as such at the time.

We find ourselves in a very unique point in history and in a world dominated by false narratives. It is a challenge to keep an analytical grip on reality, but I’ll try to tie a few threads together here to put everything in a macro context. Firstly the underlying base reality: Free money, easy money, whatever you want to call it, permeates everything we see in financial markets. Indeed I would argue price appreciation has been paid for with unprecedented and, in my view, unsustainable volatility compression. A couple of charts really highlight this. Most clearly perhaps is the precise trend line tagging we can observe in the correlated picture of price appreciation and volatility compression since the February 2016 lows:

The $VIX’s corollary, the inverse $XIV, embarked on an explosive near one way journey since the US election coinciding with over $2 trillion central bank intervention in just the first 9 months of 2017:

And it has continued to this day and just made another all time high this past week on a massive negative divergence. It is the magnitude of this volatility compression that explains the current trading environment we find ourselves in.

[..] Debt expansion at low rates continues to sustain the illusion of real prosperity for the 90%:

And then LPLResearch with another indicator that goes to show we’re dealing with a zombie here: stock prices are not moving, either up or down. Or rather, they’re moving up all the time, but in too small increments. Yeah, like that bloated corpse.

Where Did All the Big Moves Go?

There have only been eight moves of at least 1% for the S&P 500 Index so far this year—the least since 13 in 1995. The all-time record was an incredible three in 1963. What about a big move? The last time the S&P 500 moved at least 4% was nearly six years ago. In fact, the S&P 500 had four consecutive days with 4% (or greater) changes in August 2011. Other than 2008 and the crash of ’87, that is the only other time since the Great Depression to see four consecutive 4% changes. That isn’t anything like today’s action.

As the chart below shows, so far in 2017, big moves have been nonexistent; and even 1% changes have been rare. Per Ryan Detrick, Senior Market Strategist, “If you had forecast that the 11 months after the 2016 U.S. presidential election would be one of the least volatile periods ever, you would be in the minority. Then again, the last time we saw a streak of calm like this was the year after John F. Kennedy was assassinated in November 1963. Once again proving that the market rarely does what the masses expect and usually surprises us.”

You want a heartbeat. That tells you if a body or a market is alive, healthy, functioning. We don’t have one. We haven’t for years. But we will again.

Natural bodies can tend towards equilibrium, i.e. death. Markets cannot. They’re doomed to flatline, and then to always come back from near death experiences. They tend to do so in violent ways though. When volatility at last returns, so will price discovery. It won’t be pretty.

For The First Time Since January 2016, The Market Volatility Regime Finally Snapped

• August 17 marked the first time since January 16 when global equity, rates, commodity and FX vols all moved in the same direction. 


• At the same time, short-dated cross asset correlation continued to rise reaching a level of 50%, its highest level in over 1y.

For months on end, traders, analysts and pundits have been pointing to record low implied vol as a sign of pervasive complacency (and in some cases, "trader paralysis") in response to a market that made no sense, and where the only permitted direction was "up." That may finally be ending, and not just based on references to seasonal patterns that have zero relevance in a "new normal" driven by central bank asset purchases, but because the market"s artificial sense of calm is finally starting to crack, as observed by the recent surge in 20-day S&P realized vol.

And when realized vol starts rising, implied vol promptly follows, and when implied vol rises, it creates a feedback loops in which vol sellers are forced to cover, raising realized vol even more, pushing implied vol higher, and so on, as the current cycle of unprecedented volatility selling eventually ends, with either a bang or a whimper (spoiler alert: the former).

Meanwhile, as both volatility metrics rise, cross-asset volatility - traditionally an indicator of latent market stress - follows. And in what may come as a surprise to some, while most have been lamenting the blanket of broad market complacency in the past year, which in recent months have been validated by near record low global cross-asset implied volatilities....

... Bank of America points out that short-dated cross asset correlation has been rising over the past few months and currently stands at 50%, its highest level in over a year. Meanwhile, the correlation of cross asset vols may have also reached a turning point: August has been the first month in over a year to witness a simultaneous rise in global equity, rates, commodity and FX volatility. In fact, August 2017 marked the first month since January 2016 in which all cross asset risk measures rose modestly over the month, even if they still remain in significantly benign territory.

To BofA"s derivatives strategist Benjamin Bowler, this suggests that various pockets of the market are finally beginning to agree on the presence of risk, albeit to varying extents.

More ominously, on a consolidated basis as noted above, in August short-dated (3-month) cross asset correlation continued to rise reaching a level of 50%, its highest level in over a year. Historically there have been 3 distinct cross asset correlation regimes since 1995.

Interestingly, the broad upward trend started in Oct-03, well before the Lehman bankruptcy in Sep-08. This is related to the liquidity driven crush in asset risk-premia that helped drive investment leverage higher. Long-term correlation established a new regime starting some time in 3Q13, similar to the ’03 to ‘08 correlation environment. With the recent surge in cross-asset vol, that regime may now be ending too.

The good news, as BofA also points out, is that the uptick in volatility and credit spreads in most cases was modest in magnitude, leaving global cross asset risk metrics well within benign territory amid a backdrop of rising geopolitical tensions on the Korean peninsula. This means that it is still historically cheap to purchase efficient hedges ahead of what is already proving to be a catalyst-rich fall.

As a final observation, BofA then lays out the cheapest derivatives across the entire global derivatives universe, in other words, those which have the highest upside in case of a crash.

The chart below shows crash returns of different assets during historical tail events per unit of current OTM option implied volatility. Ranked by the average, the screen shows that the hedges which are most underpricing historical drawdowns are: US & EU IG credit payers, Gold calls and RDXUSD (Russian equity) puts: US & European IG credit payers still rank as the best value hedges across all assets in our universe followed by Gold (and Gold ETF) calls. In equities, RDXUSD (Russia), NIFTY (India) and TWSE (Taiwan) puts screen as top hedges while puts on NASDAQ (US Tech), Top40 (S. Africa) and ASX200 (Australia) rank as the most expensive.

Finally, those who want to hedge against a crash may want to avoid buying USDJPY puts: USDJPY puts once again are at the very bottom of BofA"s screen (most expensive tail hedge) as the ongoing geopolitical risk flare on the Korean peninsula has likely increased demand for JPY as a risk-off asset. In contrast, Nikkei puts, while belonging to the same region, currently rank as the cheapest DM equity hedge.

Morgan Stanley: "Well, That Escalated Quickly"

"Well, that escalated quickly."

That"s how Morgan Stanley"s chief cross-asset strategist Andrew Sheets summarizes events in the last week in his latest Sunday Start note, in which he describes how following one of the calmest stretches for stocks since the 1960s, an escalating war of words with North Korea hit late summer markets priced for relatively little vol with the result sharp and sudden: a 70% rise in the VIX index over three days, a 2% drop in global equities, and more than a few holidays disrupted. Fear not, though, because according to Morgan Stanley, whose outlook on the S&P is one of the most bullish on Wall Street, views last week"s events "as a standard equity correction within an ongoing bull market." With volatility bearing the brunt of the repricing over the last several days, that’s where some of the most interesting changes lie.

And while Sheets lays out his reasons why the bank"s advice to clients is just to BTFD - or in the context of N. Korea, BTFAONW - Morgan Stanley does caution that things could get serious if the one scenario many - most recently Jeff Gundlach - have been dreading, namely the rise in volatility, becomes self-fulfilling, with investors selling as volatility rises and markets move lower, driving more of both. As Sheets writes, "for this risk, I’d be watching if new lows in the S&P 500 are confirmed by new highs in the VIX. This scenario is also scarier if realised volatility can stay near implied (if it doesn’t, implied volatility can fall, reversing the cycle). As of noon Friday, 3m S&P 500 was priced for a daily move of 0.8% and EuroStoxx was priced for a daily move of 0.9%."

Finally, while the bank remains optimistic on equities, it adds that there is an exception: "we would not ‘buy the dip’ in US credit, where [we] see more risks, given weaker fundamentals, expensive pricing and limited upside in exchange for swimming against the recent tide."

Here is Sheets full Sunday Start note:

Well, That Escalated Quickly

Following one of the calmest stretches for stocks since the 1960s, an escalating war of words with North Korea hit late summer markets priced for relatively little vol. The result was sharp and sudden: a 70% rise in the VIX index over three days, a 2% drop in global equities, and more than a few holidays disrupted.

While the ‘why’ is worth discussing, the more pressing question is what happens next. For several reasons discussed below, we’d view this as a ‘standard’ equity correction within an ongoing bull market.

With volatility bearing the brunt of the repricing over the last several days, that’s where some of the most interesting changes lie.

Drawdowns happen. Since 1929, there’s always been a 30% chance that a 5%+ drop will occur at some point over the following three months. The S&P is off less than 2% from its all-time high, and (still) hasn’t seen a 5% correction since mid-2016, the longest such streak since 2004. Whether you’re bullish or bearish, I’d imagine there’s wide agreement that something like this would happen eventually. The bigger question is what’s driving the move. We don’t see it driven by a shift in fundamentals.

Let’s start with growth. Our economists continue to see solid global growth (4.3%Q SAAR in 2Q), which we believe will help to boost global equity EPS by double-digits this year. These views didn’t change in the last week, where, if anything 2Q DM earnings continued to surprise to the upside. If that’s right, it represents a key difference from the larger August drawdowns of 2011 and 2015. Watch China industrial production on Monday, where Morgan Stanley expects 7.5%Y versus consensus at 7.1%Y.

Policy also remains supportive, with real policy rates across the G3 still deeply negative. While there’s always a risk that the Fed’s upcoming conference in Jackson Hole will have a hawkish tone, that’s not our expectation and, if anything, our economists think the risk is tilted to Draghi sounding mildly dovish, given recent EUR strength. We forecast inflation to stay well below target across the G3 for another 4-5 months on our forecasts, providing flexibility to move policy slowly. Bigger risks loom next year, when higher inflation may take away this optionality.

Geopolitics is also fundamental. Relative to the five-year average, Korea CDS is 3bp higher while KRW is 3% lower. Korean stocks remain up 16% YTD, although volatility has almost doubled. These indicators are worth watching, but in aggregate it is hard to say they’re discounting an alarming scenario.

So, if it’s less about fundamentals, maybe recent moves are more technical. August is a month when more investors are out (or about to be out), lowering risk appetite and thinning markets. Even if more people were in, Korea is a legitimately hard risk to discount. And, as noted by Christopher Metli, in our Institutional Equity Division, there was an unusually high number of volatility shorts in the market heading into this week, which may help to explain (some of) the large swings in VIX. These moves have pushed the S&P 500 skew to its steepest levels on record.

That leaves two paths. One is that the rise in volatility becomes self-fulfilling, with investors selling as volatility rises and markets move lower, driving more of both. For this risk, I’d be watching if new lows in the S&P 500 are confirmed by new highs in the VIX. This scenario is also scarier if realised volatility can stay near implied (if it doesn’t, implied volatility can fall, reversing the cycle). As of noon Friday, 3m S&P 500 was priced for a daily move of 0.8% and EuroStoxx was priced for a daily move of 0.9%.

The other path, more likely in our view, is that this turns out to be a more ‘normal’ correction. The Morgan Stanley Global Risk Demand Index (GRDI*) has fallen to -3.6, an ‘oversold’ level seen only a handful of times over the last eight years. The volatility term structure has inverted, which has also tended to be a reasonable indicator of elevated fear. And we think there is capacity to add exposure eventually, especially in the US, where Prime Brokerage tells me net leverage is in the 20th percentile. Given the steepness in skew, calls may offer some of the most attractive ways to be brave in the US, while put spreads may offer the best value for those looking to hedge what is still a relatively mild pullback. Overall, our positioning would remain constructive.

Is there an exception? We would not ‘buy the dip’ in US credit, where my colleague Adam Richmond sees more risks, given weaker fundamentals, expensive pricing and limited upside in exchange for swimming against the recent tide.

"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.

"Why Does Extraordinarily Low Volatility Matter" Baupost Explains...

With elites increasingly sounding the alarm about the state of the stock market, and various market participants fearing the complacency is masking the fragility of the market"s true character; it is no surprise that Baupost"s recently named President and Head of Public Investments, Jim Mooney, has joined the chorus.

While Mooney (and Klarman"s) warning regarding market volatility is not new, perhaps the most interesting nuance is the "difference this time".

Confirming JPMorgan"s Marko Kolanovic"s concern that "we may be very close to a tipping point" as he explained that "low volatility would not be a problem if not for strategies that increase leverage when volatility declines," Baupost"s Mooney explains that crucial market structure differences between current times and the 2008 market crash could lead to an exacerbation of any stock market price readjustment.

A Period of Subdued Volatility

"Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits." — Hyman Minsky

...Realized (actual) and implied (anticipated) volatilities hover near their lowest levels ever. The most commonly referenced measure of equity market implied volatility, the VIX has traded at an average of 11 since late April. To put this level in context, since 1990 when the VIX was first created, the index has closed below 10 on only 16 days; seven of those days have been since May 1, 2017. The average closing of the VIX between 1990 and 2016 was about 20 versus a 2017 year-to-date average of roughly 12. Similarly, realized SPX 500 volatility has fallen, with the one and six month levels both at seven. ON these measures, 2017 is the least volatile year since 1965.

Not surprisingly, there is a fair bit of commentary attempting to justify today"s historically low levels. The most prominent explanation is that the low realized volatility, which results when asset prices march steadily upward with very few interruptions, naturally causes quantitative models to predict a continuation of subdued volatility, i.e. low implied volatility. Some suggest that dampened market fluctuations result from the consistent bid for equities provided by capital flows into passively managed index finds. Many cite limited realized volatility in underlying U.S> and global economic measures such as economic growth and inflation and conclude we are in a new era of stability. Finally, there is the abiding view that central banks will reliably deploy accommodative monetary policy to arrest any downward market moves.

These explanations almost certainly contain elements of truth, but it is hard not to see a bit of sophistry as well. While there may be a mathematical answer for why volatility is low when nearly every financial asset trades at all-time highs, common sense might suggest the opposite conclusion.

Why does extraordinarily low volatility matter?

The answer lies in volatility influence on risk-taking and, by extension, leverage. In any elevated market, one very important thing to identify is where leverage exists in the system — both that which is obvious and more perniciously, that which is hidden. While leverage is not directly responsible for every financial disaster, it usually can be found near the scene of the crime. Structural leverage linked to low realized volatility may well prove destabilizing and the precipitant, or at least an accelerant, for the next financial crisis. Realized volatility is a critical reference point for a substantial amount of investment activity. For many investors, the level of market volatility determines the level of risk incurred both in their portfolios as well as in many investment products. The lower the volatility, the more risk investors are willing to or, in some cases, required to incur.

Specifically, realized volatility is the essential input for Value-at-Risk (VaR) calculations, and determines the degree of leverage incorporated in a variety of quantitative and structured investment strategies. For instance, the models used by both risk parity and volatility targeting funds, which use volatility levels to determine asset allocations, have been signalling "risk-on" for some time. This has resulted in steadily increased portfolio leverage as realized volatility has fallen across asset classes. Additionally, certain structured short-volatility ETFs have algorithm-based selling and buying programs that automatically lever up and, critically,d own based on realized volatility.

Over the last several years, one of the most reliable winning betes has been shorting volatility in just about any asset class. Investors have generated significant returns with high Sharpe ratios by capturing the spread between higher implied volatility and lower realized volatility. As realized volatility has remained low, profits have mounted and assets deployed in these volatility-targeting and short-volatility trades have grown tremendously. However, it is hard to ignore that this strategy becomes less and less attractive as the absolute level of volatility declines and the spread between implied and realized volatility falls. As the saying goes, "what a wise man does in the beginning, a fool does in the end "

Although it is impossible to calculate with precision, the volume of assets whose performance is, in some manner, linked to volatility likely runs into the hundreds of billions of dollars. As such, any spike in equity markets realized volatility, even to historical average levels, as the potential to drive a significant amount of equity selling (much of it automated). Such selling would, in turn, further incresae volatility which would call for more de-leveraging and yet more selling.

We cannot know whether a dramatic increase in volatility is imminent or even inevitable, nor can we be certain that a spike in volatility would have cataclysmic results...although it certainly could. One thing, however, is for sure: anyone who is directly or indirectly shorting volatility at the current lows is betting current benign environment will persist. Our experience would suggest that, "benign" and "persist" are not words normally associated with one another.

In addition to our areas of regular focus, we have exposure to hedges designed to help protect the portfolio from a sustained change in the volatility environment.

Mooney concludes, rather ominously...

"As has been the case for longer than we would have imagined, we remain in a market that is broadly expensive and largely indifferent to risk.

This continues to be a time for patience and, above all, caution. If there is anything to be taken from Hyman Minksy"s words, it is that no one should be lulled into a false sense of comfort by the illusion of stability which surrounds us... We most assurdely, are not"

And if one wants a picture of what that looks like, Morgan Stanley recently explained...A violent rise in volatility could be driven by just a 3% to 4% one-day S&P 500 selloff.  Right now the risk is greatest in the VIX complex, and demand for VIX futures from three main sources could result in 100,000 contracts ($100mm vega) to buy in a down 3.5% SPX move.  For context VIX futures ADV over the last year is 230,000 (although has risen to as high as 700,000 in big selloffs).

JPM: "Investors Are Starting To Hedge Against A Crash"

It"s probably not a coincidence that in the same week in which one of the most level-headed investors of all, Oaktree"s Howard Marks issued an alarm on the current state of the market, that JPM has come out with not one (as discussed previously, Marko Kolanovic"s latest "tipping point" note last Thursday was blamed for the small and sharp selloff at the end of last week), but two reports in which JPMorgan makes it clear that not only is the market on the edge, but increasingly more traders, both institutional and equity, are getting ready for what comes next.

First, as another reminder, these are the 4 bullet points with which Marks summarized the current investing environment:

• The uncertainties are unusual in terms of number, scale and insolubility in areas including secular economic growth; the impact of central banks; interest rates and inflation; political dysfunction; geopolitical trouble spots; and the long-term impact of technology.


• In the vast majority of asset classes, prospective returns are just about the lowest they’ve ever been.


• Asset prices are high across the board.  Almost nothing can be bought below its intrinsic value, and there are few bargains. In general the best we can do is look for things that are less over-priced than others.


• Pro-risk behavior is commonplace, as the majority of investors embrace increased risk as the route to the returns they want or need.

One day later, Kolanovic added fuel to the fire, warning that with volatility at record lows, the upcoming mean-reversion will leave many in ruin, and that while there is still time to get out of the market, "we may be very close to the turning point":

"In what is akin to the law of ‘communicating vessels,’ once inflows in bonds stop, funds are likely to start leaving other risky assets as well, including equities. The FOMC statement yesterday alleviated immediate fears – normalization of balance sheet will start ‘relatively soon,’ but only if ‘the economy evolves broadly as anticipated.’ This reasonably dovish stance pushes this market risk out for a few weeks (the next ECB meeting is Sep 7th, Fed Sep 20th, BoJ Sep 21st). This gives volatility sellers and other levered investors a limited window to position for a seasonal pickup in volatility and central bank catalysts in September."

Not one to mince his words, the JPM head quant then compared the current period to the period just before 1987"s Black Monday, warning that "strategies that boost leverage when volatility declines, such as option hedging, CTAs and risk-parity, share similar features with the dynamic ‘portfolio insurance’ of 1987,” which “creates a ‘stop-loss order’ that gets larger in size and closer to the current market price as volatility gets lower.” Finally, from a timing standpoint, he said that as growth in short-vol strategies suppresses both implied and realized volatility, and with volatility at all-time lows “we may be very close to the turning point.”

* * *

Over the weekend, in yet another note from JPM, this time from the bank"s "flow" expert, Nikolaos Panigirtzoglou, he writes that none of the above should come as a surprise and that as a result, investors - both institutional  and retail - have started putting hedges against an equity crash.

Among the market feature he highlights is that the current put to call open interest ratio for S&P500 index options has been rising for most of this year, and that while this ratio had peaked in June and its current level is not extremely high, it nevertheless stands above its post 2014 average. What is more extreme, is the call to put open interest ratio for VIX options, which at almost 4.0, is close to historical highs.

To Nikolaos, the combination of these two observations implies that "there is greater demand for hedging against equity tail risk or a volatility spike relative to hedging against a typical equity market correction."

In other words, there is just the right amount of hedging for a crash.  And it"s not only institutional investors who are hedging. Retail investors have been also hedging.

Here are the details from Panagirtzoglou"s latest letter:

Our client conversations over the past few weeks have been dominated by the impending reduction of quantitative stimulus by the ECB and the Fed as the main risk markets are facing into the autumn. Our sense from these client conversations is that, as we approach September, the perceived likely timing of balance sheet shrinkage by the Fed and/or ECB tapering, investors have already started reducing their net exposure to risky markets via hedges in order to protect themselves against a repeat of the August 2015 correction. How consistent is this anecdotal evidence with our flow and position indicators?

One way of gauging institutional investors’ demand for hedges is by looking at the put to call open interest ratio for S&P500 index options, the biggest and most liquid listed index option market in the world. This put to call open interest ratio is shown in Figure 1. The ratio has been rising for most of this year. Although the ratio peaked in June and has declined somewhat since then, its current level remains above historical averages pointing to decent demand for hedging equity exposure. In fact, Figure 1 shows that since the oil price shock of 2014 the ratio has averaged at a higher level relative to previous years, i.e. there has been  structurally higher demand for hedging equity exposure since 2014 relative to previous years. The current put to call open interest ratio for S&P500 index options is not extremely high, but it stands still above the post 2014 historical average.

Another way of gauging institutional investors’ demand for hedges is by looking at the call to put open interest ratio of VIX options. The use of VIX options has risen exponentially since the Lehman crisis by investors seeking to hedge equity tail risk, credit exposure or volatility exposure. Several investor types such as vol targeting (equity or multi asset) funds or risk parity funds are structurally short volatility and we note VIX calls provide the most direct and liquid way to hedge their short volatility exposure.

This call to put open interest ratio for VIX options is shown in Figure 2. This ratio has been also rising for most of this year, especially over the past three months, as the collapse in equity index volatility to record low levels naturally induces demand for protection against a volatility spike. Typically, the open interest for VIX calls increases in low volatility periods as investors enter hedges, and declines after VIX spikes as investors unwind hedges. Similarly, the open interest for VIX puts increases in periods of high equity volatility as investors buy puts to sell equity volatility.

The main difference between Figure 2 and Figure 1 is that the call to put open interest ratio for VIX options stands at close to record high levels currently, while the put to call open interest ratio for S&P500 index options stands at just above its average since 2014. In other words, there is more extremity in the former implying greater demand for hedging against equity tail risk or a volatility spike relative to hedging against a typical equity market correction.

What about retail investors? Are they also boosting their hedges? We argued last week that the heavy buying of bond funds this year reflects, at least partly, the desire by retail investors to offset or hedge the rising AUM of their equity fund holdings. If this interpretation is correct then this year’s very strong bond fund buying is a reflection of strong demand for hedging by retail investors.

But retail investors are not only confined to buying bond funds for hedging. They also buy VIX ETFs, a universe which has also grown exponentially since the Lehman crisis along with VIX options. Retail investors continued to buy VIX ETFs this year albeit at a slower pace than last year. But their vol buying accelerated over the past month as the VIX index declined to record low levels. This is shown in Figure 3 which shows the cumulative flow into VIX ETFs vs. the flow into Inverse VIX ETFs.

And in Figure 4 which is provided by our Equity Derivatives Strategy team and which uses a more sophisticated calculation to estimate the net vega, i.e. sensitivity to each percentage point change in vol,

for the total universe of VIX related ETFs adjusted by their short interest. This vega stands at historical high levels currently.

Rising VIX ETF exposures are likely reflective of skepticism by retail investors, who are the main users of VIX ETFs, and who see the current combination of record low equity market volatility and record high equity  prices as rather unsustainable. Effectively, the collapse in both realized and implied volatility over the past months and the current record low level of the spot VIX index is inducing retail investors to buy VIX products on the expectation that volatility will increase. After all, uncertainty is high and the risk from central bank policy normalization seems significant. So establishing a long VIX exposure via ETFs at current levels appears on surface attractive as it implies a large potential upside, in the case that a negative shock, such as tapering or central bank balance sheet reduction, pushes the VIX up to much higher levels.

But this protection comes at a cost: as more money flows into long VIX ETFs, the VIX futures curve steepens making the negative roll more onerous and the cost of holding a VIX ETF for long rather prohibitive. As a result of the steepness in the VIX futures curve, popular VIX ETFs are currently losing close to 10% per month due to negative roll. If no negative shocks materialize over the coming months, it is likely that  negative-carry long-VIX positions are taken off, exerting downward pressure on the steepness of the VIX curve, from currently elevated levels.

Trader: "It's Going To Zero"

Authored by Peter Tchir via Brean Capital,

Momentum Trader: It’s going to zero!

Sales: Protection is worthless.  Why pay up for protection, it always turns out worthless?

Quant Trader: The skew and relative steepness makes timing critical on any purchase.  The theta decay is virtually impossible to overcome.

Desk Head: Why aren’t we selling more?

Bear Trader: Because we are at all-time tights and there is no #*#*!@$ value!  This is just #@*($& stupid.

Risk Management: I can’t let you sell more than you already have.  I’ve already increased limits and I’m extremely uncomfortable increasing them again.

All: Oh shut up!

Desk Head: You and your stupid risk limits are why we are all here in the first place! Had you let us sell more 2 months ago we wouldn’t all be here stuck trying to figure out what to do – we’d be sitting on great P&L and could relax, but no, now we are behind and have to sell as much as we can at the lows.

Bear Trader: This can’t possibly continue.  It’s already overdone and when it reverses, it is going to be UGLY!

Sales: All I’ve got is sellers.  No one wants or needs protection.

Quant Trader: It doesn’t even have to go lower, so long as it just sits here, the theta decay coupled with the funding arbitrage performs well.

Technical Trader: All support is broken, we are in uncharted territory.  This could continue.

Risk Management: I will concede that several new products seem to have changed the landscape and may have reset the boundary conditions.  I will review again.

Desk Head: Good!

Bear Trader: This is going to end badly.

All: It might, but not any time soon!

While this is a fictitious conversation, it is largely based on conversations I was part of in the spring of 2007 around CDS Indices.

Any similarity to conversations surrounding VIX yesterday are purely coincidental.

The sense that risk assets can only grind higher and that the value of any protection is useless, really seemed to reverberate throughout Wall Street yesterday as the S&P 500 hit all-time lows on 10 days realized volatility.

The types of conversations reminded me a lot of what was discussed in the Spring of 2007 – though who was right and who was wrong depended heavily on whether those conversations were had in late April or early June.

*  *  *

With stock turbulence evaporating further, betting on market swings has become cheap -- for real.

As Bloomberg details, for the first time since November, the S&P 500 Index’s one-month implied volatility has dipped below the gauge’s actual price moves from the previous 20 trading days, as VIX sank to its lowest close in more than two decades.

S&P 500 implied volatility was higher than realized for 108 straight days, the longest run since the 132 days ended Feb. 27, 2007... and most know what happened next.

The Last Time This Happened, China Devalued

"It"s quiet, too quiet", "the calm before the storm", "the deep breath before the plunge" - you name the idiom, there is nowhere it applies more than US equity markets (lowest closing range in 65 years).

Dow has done nothing for 8 days... the longest streak since 1952...

However, if ever there was a catalyst for chaos, it is the collapse in uncertainty around the Chinese Yuan...

As Bloomberg notes, the eerie stability in the yuan is reminiscent of the period leading up to China’s unexpected currency devaluation in August 2015. The one-year implied volatility of the yuan has dropped to about 4.7 percent, from about 8 percent at the beginning of the year.

Investors should be worried: The surge in volatility triggered by the yuan’s sudden depreciation two years ago rippled across the world and set off a rout in equities and other risky assets.

5 Head Scratchers

By Chris at www.CapitalistExploits.at

Market dislocations occur when financial markets, operating under stressful conditions, experience large widespread asset mispricing.

Welcome to this week’s edition of “World Out Of Whack” where every Wednesday we take time out of our day to laugh, poke fun at and present to you absurdity in global financial markets in all its glorious insanity.

While we enjoy a good laugh, the truth is that the first step to protecting ourselves from losses is to protect ourselves from ignorance. Think of the “World Out Of Whack” as your double thick armour plated side impact protection system in a financial world littered with drunk drivers.

Selfishly we also know that the biggest (and often the fastest) returns come from asymmetric market moves. But, in order to identify these moves we must first identify where they live.

Occasionally we find opportunities where we can buy (or sell) assets for mere cents on the dollar – because, after all, we are capitalists.

In this week’s edition of the WOW: 5 head scratchers

Today we"re going to blast through a few shards of information that have bloodied my windshield recently... but first some context.

The world is a web, interconnected at multiple levels but in it"s entirety it is one giant capital flow chart. This is why looking at events, trends and prices from multiple angles and with historical context is critical. It means that in order to understand global capital flows and the world at large investors needs to be generalists. Specialisation renders one towards narrow focus by necessity. There is nothing wrong with narrow focus when you need it so long as it can be brought into focus through a broad understanding.

Let"s therefore look at a number of topics.

1: Saudi Arabia Got WHAT??

In what I dearly wish was a delayed April fools joke the United Nations just elected Saudi Arabia to the Woman"s Rights Commission. No isht!

A quick reminder: this is the only country in the world which actually bans women from driving cars while implementing Sharia Law, which - for those among you who haven"t read the intricacies of - permits, among other heinous things, honour killings. Way to go UN!

Question: does this make the UN complicit in crimes against humanity committed by Saudi Arabia"s government? Oh, wait...

Why do I even mention this?

Davos men, the UN, the kleptocrats in Brussels, Washington, and sundry such creatures who muddy the halls of power are slowly losing their grip. This step - electing the fox in to guard the hen house - is a candid, dare I say it, balsy admittance to what we already knew. That they value money more than morals.

Why it"s important is because, in their desperate desire for riches, they just dealt another blow to the establishment"s credibility. Credibility rests on trust, and trust is easily destroyed. What these podium donuts have just done is provided additional kerosene to the anti-establishment fire, which - if they"ve not looked outside their windows - is smouldering around them.

When alternatives for governance are sought, as they are now, it doesn"t require a genius to understand that views and beliefs are translated into how capital gets allocated.

Ask yourself this.. If Davos Man is increasingly shown to be the morally bankrupt sociopath he is, then at what point does faith in Davos Man"s institutions and obligations (sovereign debt, I"m looking at you) get called into question?

2: Risk Party... I Mean Parity

In case you wondered what it was...

"Risk parity (or risk premia parity) is an approach to investment portfolio management which focuses on allocation of risk, usually defined as volatility, rather than allocation of capital."

Simplistically risk parity funds buy assets based on their implied volatility. If company X"s volatility drops, then the models allocate more capital towards company X. By buying more of company X this has the effect of causing volatility to decline further. You get the picture. I"ve written about this before when talking about a bubble in dumb money.

Imagine buying companies not based on their balance sheets, income statements, or any of that boring stuff but purely on how volatile their share prices have been. Imagine... These risk parity funds are completely price insensitive. They don"t even know what they"re buying and will just as happily buy company X if it"s trading at 200x earnings... so long as volatility is low.

Now, I would be remiss in mentioning that artificially low interest rates (thanks central banks) have had the effect of suppressing volatility in markets. These ETFs, coupled with sustained idiotic central bank policies, have created truly epic distortions in the markets.

And, just to prove that stupidity can last for quite some time, below is an updated chart on where things stand with this fun game.

3: Circling Back to the Saudis

I don"t know about you but I find that when I need to understand something a little better it"s often best to let the idea ruminate a little while before revisiting it. This allows it to mulch around in your brain, squeeze out the flatulent useless bits, and present you with what is usually be a better grasp on what really matters.

Sticking with this process, let"s revisit the first topic of this week"s WOW.

Curious minds should be asking the question: why on earth is the UN treating the Saudis like a cross between Mother Theresa and Ghandi?

Call me cynical but I reckon it"s usually always about the money. So the fact that grand master Mohammad Bin Salman Al Saud has decided to list a sliver (5%) of Saudi Aramco may well have a little to do with this.

We know there are problems in the Kingdom. Serious problems.

And no, I"m not referring to the fact their poor citizens are governed by a bunch of psychopaths with medieval beliefs who would still be living in caves if it weren"t for the black stuff under their sandals.

I"m talking about financial concerns around its now infamous decision in November 2014 to abandon its role as the global swing producer and ramp up production (even as global supplies were increasing and prices were collapsing).

Take a look at this:

Now take a look at this:

This is what a pegged currency looks like (Saudi riyal vs. USD).

I"ll let you put two and two together.....

Done?

Ok.

So you"re in a cash crunch, running the biggest budget deficits ever, you have to hold your currency peg which means dipping into your foreign exchange reserves, and you"re fighting a wall of supply from Iran (a topic for another day but you can go listen to my conversations on Iran here and here). What do you do?

You do what anyone would do. You sell stuff.

The "Kingdom" had their first ever bond sale last year and now they"re flogging Aramco to the world. The problem with all of these things is that you"re needing to interact with the rest of the world a tad more and that still requires "legitimacy". A "credible" seat at the UN should help, no?

I wonder how much they paid the bankers for that seat at the UN?

We"ll probably get some insight when we see where Aramco"s shares get listed, and by whom.

4: The Wisdom of Age

Just in case we think we can fathom what the future holds.

How much of what Emma witnessed in her 117 years on this ball of dirt could she have seen coming in her life?

The answer is not likely many things. But... identifying just one of the completely asymmetric changes that took place would have definitely been very, very well worthwhile for Emma. Imagine having had the ability and foresight to have invested in just one of the items Sprezza lists in its early phase... and hung on.

Identifying the trends could have been done but I dare say hanging on is likely the hardest thing for us humans to do.

5: And Lastly But by No Means Least

Did you see the massive rally in the euro?

I"ve a great number of thoughts on this which I share with Insider members this week, including what I think is a wonderful setup. I"d encourage you to join us.

After all, there are just a few days left in April, which means you can gain access to membership at the inaugural price... before the price goes up.

Until next time, have a good weekend.

- Chris

"The biggest mistake investors make is to believe that what happened in the recent past is likely to persist. They assume that something that was a good investment in the recent past is still a good investment. Typically, high past returns simply imply that an asset has become more expensive and is a poorer, not better, investment." — Ray Dalio, Founder, Bridgewater Associates

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