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.”

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.