Something strange is happening in the market right now

In the past few days, the S&P 500 (SPX) has risen to all-time highs. I mean, that’s strange given our current economic back drop. But that’s not what I’m talking about.

What’s strange about the current state of the market?

While the SPX is at all-time highs, the volatility indices have been rising as well. These indices include VIX, VVIX, and VXX.

If you don’t know what these are, that’s okay. VIX is an index that tracks the implied volatility of the SPX based off how the options for that index are priced. It is what the one month expected move in the market is, in a sense. VVIX is an index that tracks the implied volatility of VIX based off how the options on VIX are priced. VXX is an index that tracks the volatility based off the weighted balance of the first two VX futures contracts which trade.

For now, let’s focus on VIX. On August 25^th, VIX closed at 22. As of today’s close on August 31^st, it is 26.4. In percentage terms, VIX was up today 15%. (Many people don’t like quoting VIX changes in percentage terms — I don’t care).

In 3 of the past 4 days, we have seen VIX close higher than where it opened. This has happened all while the SPX has hit all-time highs in each of the past four days.

VVIX — also known as the volatility of volatility — has shown a similar trend to VIX, rising in 3 of the past 4 days. VXX — which is based off the front two months of futures contracts on VIX futures — has also steadily risen and shown similar trends.

Realized volatility is far below implied volatility options are pricing in

The volatility that is implied by SPX options is much higher than the realized volatility we’ve seen in the past 30 days. According to my calculations, realized volatility for the past month has been under 10%. Meanwhile, VIX has held strong above 22, and has continued to climb in recent days as noted above.

Why is this strange to me?

In general, you tend to see VIX fall as SPX rises. In general, there is an inverse relationship between these two items.

Today, VIX rose by 15% while SPX fell by roughly 0.3%. According to my data, this has only happened 5 times going back to 1993.

Note: The above chart is in percentage terms.

I’m not the only one that has noticed

Mark Sebastian, from OptionPit.com and frequent guest on The Options Insider Radio noted the following:

What he is saying here is that there is a huge difference between the volatility being priced the NASDAQ 100 Volatility Index — VXN — and the S&P 500 Volatility Index — VIX. This is interesting to me because the NASDAQ 100 is composed of non-financial companies and is weighted heavily towards those tech stocks. The very tech stocks which have been going parabolic in recent weeks (some may even say months).

In addition, Matt Thompson noted the following:

The 5-day average contango, which is merely the difference in the implied volatility priced in by the front month futures contract and the second month futures contract is at 16.9%, which was at the 99^th percentile since 2004. Also he noted what I noted earlier, that the VIX is much higher than the realized volatility on SPX.

What does this all mean?

This could mean a number of things. Ultimately it means there is a lot of uncertainty in the market, and options are pricing in more volatility than the volatility that we’ve witnessed in the last month.

This could mean that big money is hedging their positions with put options on SPX or call options on VIX or buying VX futures, all of which could cause the premiums paid to rise.

In addition, the VX futures for October are pricing in extra volatility due to the upcoming election. The pricing of these October futures remains elevated when compared to the September and November VX futures prices.

Investors are nervous about what could come in the next month or two. And they have good reason to be.

There is still no agreement on extended economic stimulus that the American people desperately need. Republicans and Democrats have still not agreed to a deal. As of the last update I saw, Republicans proposed a $1.3 trillion stimulus, which was rejected by Democrats. The House, led by Democrats, passed a $3 trillion stimulus back in May. They said they would be willing to lower their demands to $2.2 trillion. No deal is in sight, and that could have investors spooked.

Fact is, we are in a bubble

The last time market closed at all-time highs with VIX this elevated was during the late 90s tech boom. That was a time period which also coincided with easy Federal Reserve monetary policy and high speculation in stocks.

We are seeing similar behavior in the tech stocks and work-from-home stocks today. Apple, Amazon, Google, Facebook, Tesla, Nvidia, Zoom, and AMD are all examples of stocks which are booming right now.

But the pain for the American people is far from over. Continuing claims continue to remain above 14 million. The unemployment rate is over 10%. The economy is attempting to recover slowly. But stocks? They’ve ripped to all-time highs at a much more rapid rate. And the disconnect between those two has investors nervous right now.

Dark pools are not buying this rally anymore either

In order to understand what’s happening, check out the Dark Pools. According to the Dark Pool Index over at Squeezemetrics.com, Dark Pools have printed under 45% for 17 days in a row. In general, a print over 45% is considered to be bullish, and there tends to be a slight lag between dark pool prints and stock market returns.

This is meaningful to me because Dark Pools bought the rally all through April well into July. But they aren’t buying anymore.

Perhaps we will begin to see a return of selling to the market in the coming days or weeks. I know I’m on high alert for that right now and will be ready to short this market when the opportunity presents itself.

WHY is the US facing deflationary pressures in the face of unlimited Fed interventions?

The US consumer price inflation report showed prices fell 0.8% month on month in April, dragging the annual rate of inflation down to just 0.3% as gasoline prices plunged more than 10%. However, the bigger news is that core inflation (excluding food and energy) has recorded consecutive MoM declines for only the second time in the series’ 63-year history – the last time was 1982.

Source

Why are we facing deflationary pressures in our economy? Especially when the US Federal Government has injected trillions of dollars into the economy in recent months?

Shouldn’t fiscal stimulus be inflationary? You are adding money to the system after all.

To answer these questions, let’s start with the concepts of inflation and deflation.

What is inflation?

You are probably already familiar with the concept of inflation. Real quick, inflation is a sustained increase in the price of goods and services through time.

Inflation occurs as a country creates more of their currency over time. This money printing means that each additional unit of currency becomes less valuable. As a result, you have to use more units of that currency to purchase some good or service.

During inflationary times, you don’t want to hold cash. Holding cash during inflation is like holding a depreciating asset which loses value every day.

Instead, you want to invest that cash in some asset that will appreciate in value during inflationary times, such as gold.

Now on to deflation…

Deflation occurs when there is a high demand for cash. Contrast this with inflation, in which there is a low demand for cash.

Some economists may disagree with this. But you have understand that deflationary pressures were at their worst coming out of the 2008 recession and now during this current recession we are in. These deflationary issues emerged as a result of the emergence of central bank interventions and the rise of the carry trade. More on that in a second.

Why is there a spike in demand for cash?

Volatility (or the price of money)

Volatility (which can be generalized to the VIX, due to the liquidity and vast usage of SPX as a proxy for all market volatility) can be understood as the price of money. How exactly?

Volatility in the market during a carry regime causes deflationary forces to take hold. The reason for this is as follows:

When volatility is high, seemingly safe investments appear (or even become) less safe investments. This effect decreases the moneyness of those assets (or how safe those assets are viewed with respect to cash). As a result, cash becomes king.

Cash becomes king due to margin calls or other risk-based rebalancing factors, which can lead to hard selloffs in assets of all varieties as the rush to cash becomes more common.

Rapid deflation is the result

Rapid deflation occurs as a result of this spike in demand for cash. Cash becomes more valuable to market participants during this time. This is due in part to uncertainty about future asset prices and other factors which exert downward pressures on those assets.

Without central bank interventions, you can end up in a situation of runaway deflation. Too many market participants chasings cash at the same time is going to push asset prices down. There is no way around this.

This is why in volatile markets, asset correlations tend to converge. All assets lose value due to margin calls and other factors mentioned above.

Just like a run on the bank, except with no bank

One way you can think of this scenario is just like a run on the bank, except there is no physical bank per se.

The limiting factor is how much cash is currently available in the system, how much central banks will allow the value of other assets to drop, and subsequently how much liquidity (cash) central banks will be willing to inject into this system.

Want proof? – Check out various markets in early March when selling was high

spx deflation 5-12-20

Remember the selloff in equities that took place near the end of February and beginning of March. A situation was created where there was a sudden dash for cash.

gold deflation 5-12-20

Gold prices exploded higher, then plummeted. Why else would gold prices collapse in the face of economic uncertainty in conjunction with insane printing by Central Banks?

tlt deflation 5-12-20

Treasuries also sold off after hitting historic highs in price (lows in yields).

btc deflation 5-12-20

Even Bitcoin lost 50% of its value during early March.

Why? Because many different market participants began dashing for cash. This created an environment where there were fire sales going on across assets.

Why deflation though?

As our M2 money supply increased in recent decades, there has been an associated decrease in the velocity of that money.

m2 5-13-20

The above chart shows the M2 money stock in red, which has increased significantly since 1990. The chart also shows the velocity of the M2 money stock, shown in blue.

Both of these values are indexed to January 1, 1990 as the starting point. While the M2 money supply has increased significantly, the velocity of that money has actually decreased steadily through time.

m22 5-13-20

If you look at these values with both being indexed to June 1, 2015 you can see a drastic difference in the direction of the M2 money supply and the velocity of that M2 money.

This chart doesn’t even include the velocity of the M2 money supply recently injected into the financial system in March and April 2020. You could expect that this figure has declined significantly.

What is the velocity of money?

The velocity of money measures the rate at which money is exchanged through the economy.

It is usually measured as a ratio of GDP to M2 money supply (in our case here).

High money velocity is a sign of a strong, healthy, expanding economy. Low money velocity is associated with recessions and contractions in the economy.

Low velocity of money means that for every new dollar being created, it’s not making its way into the real economy.

This is pushing on a string as Ray Dalio has called it, and is a signal that additional stimulus actions by the Federal Reserve have become less effective at stimulating the economy.

How is the carry regime responsible for this?

The carry regime is associated with underlying pressure towards deflation.

In the book, Rise of Carry (affiliate link*), the carry regime is associated with the following traits emerging in the economy:

High debt burdens
Limited economic growth
Low prospective returns to real investment (low- to zero-interest rate policies)

Debt burdens rise during this regime. This is due to the continuing decrease in long-term interest rates. It makes to so debt is cheap today, so why not borrow against tomorrow?

Credit demand collapses. There is only so much productive demand that need to be met. More credit becomes excessive and less beneficial to society as a result.

In a carry regime, inflation rates can be at a comfortable level then suddenly crash to deflationary measures. This is exactly what we have witnessed in the most recent CPI number that came out.

However, the carry regime doesn’t necessarily have to end.

If central banks can continue to increase money supply and accommodate the demand for cash while also increasing the sense that risks and debt are socialized, then the carry regime can carry on.

I believe we are nearing a time where central banks (1) understand the long-term ramifications of their actions or (2) keep pushing forward with easing policies until the ROI of those policies has diminished to nothing.

So, what’s the choice?

* Affiliate links help to support this blog. Amazon gives a small cut of each sale to me if you purchase through this link. Don’t click the link if you don’t want Amazon to pay me a referral fee.

What’s going on in the Collateralized Loan Obligation markets?

The leveraged loan is a $1.2 tn dollar market.

What is a leveraged loan?

A leveraged loan is a type of loan that is extended to companies or individuals that already carry a high debt burden or poor credit history.

CLOs (Collateralized Loan Obligations) are the largest buyer of leveraged loans. The CLO market itself is $700 bn market which means they make up about 58% of total leveraged loan market.

What risks are CLOs exposed to?

CLOs are exposed to risks related to credit downgrades. The issue going on today is that there are there are record number of loans rated B-/B3. This level is one notch above the lowest junk rated bonds.

Credit downgrades could have an effect of reducing value of a CLO portfolio. If the portfolio loses too much, asset-coverage tests will get set off.

What scenarios could play out if there are credit downgrades?

The first scenario that could play out is CLO managers are forced to sell debt at firesale prices. In the second scenario, they are forced to suspend cash payments to the riskier level, lowest equity tranche

What are CLOs worth now (April 20th, 2020)?

Presently, CLOs on a whole are receiving about 70 cents of every $1 in par value. The AAA tranche is still valued at $1 for every $1 par, due to its safer, lower returns. The lesser rated tranches, such as BB are only fetching 60 on every $1 in par value

How have CLO credit ratings been affected?

Moody’s was recently forced to cut rating on 859 CLO securities. These are ratings for the CLO securities and not the underlying leveraged loans themselves, which have undergone their own downgrades. This comprises of 20% of all bonds Moody’s grades

What is ACTUALLY going on in the repo market?

Dissecting what’s going on in the repo markets

There are two sides to every deal. The repo markets are no different.

On one side of the deal, there are banks sitting on a large supply of cash. On the other side of the deal, there are the hedge funds that are sitting on a large supply of Treasuries.

Banks lend cash to hedge funds and hedge funds place Treasuries as collateral to banks. Hedge funds are able lever up trades they make on Treasuries.

How do they do it?

One increasingly popular hedge fund strategy involves buying US Treasuries while selling equivalent derivatives contracts such as interest rate futures, and then pocketing the difference. This is an arbitrage strategy that hedge funds use that would generally yield small profits.

The trade is not profitable on its own, given the close relationship and price between the two sides of the trade. Hedge funds use leverage via the repo markets to increase returns.

In some cases, hedge funds take those Treasury securities they own, and place it as collateral in the repo market for cash. Those hedge funds then use that cash to increase the size of their trade and buy more Treasuries, and place it as collateral in repo market for cash once again. This process can be repeated over and over to leverage off the potential returns of this trade.

The arbitrage strategy above was once popular amongst dealer banks themselves. However, higher capital charges have led to their displacement by hedge funds, due to hedge funds greater ability to take on the risk of this trade.

There has been a growing clout of hedge funds in repo market, including Millennium, Citadel, and Point 42, which are very active in repo market and are also the most highly leveraged multi-strategy funds in the world.

So what really happened in September 2019 in the repo market?

This brings us to the market on September 16, 2019. The secure overnight funding rate (SOFR) more than doubled in the intraday range jumped about 700 basis points (repo rates typically fluctuate in an intraday range of 10 to 20 basis points).

The repo rate reached as high as 10% that day.

sept repo

Some have speculated that end of quarter pressures put on banks to meet those regulatory guidelines caused the repo spike.

However, you have to consider that these overnight funding Market issues arose in mid-September. Not at the end of September when you would expect banks to hoard more cash.

What happened in August and September that could have caused issues in the repo Market that rippled through hedge funds?

We turn our attention to Treasuries and their performance in August and September.

From July 31st 2019 to August 15th 2019 TLT (20+ year Treasury Bond ETF) increased almost 13%. This was following the Fed’s first-rate cut after the tightening cycle that we saw ultimately in December 2018.

tlt prices

The Fed cut the rate 25 basis points and the Treasury market responded with an outsized move on Long-Term Treasuries in anticipation more easy money Fed policies becoming a mainstay. The Fed reiterated that the rate-cut was a “mid-cycle adjustment”, but that didn’t stop Long-Term Treasury prices from surging.

From September 5th to September 13th the same Long-Term Treasury bond prices dropped 7%. This could be due to the fact that investors realized they over adjusted the price of long-term treasuries and were now adjusting prices down to reflect new expectations.

I believe much of the volatility in the overnight repo markets has to do with these large moves in Treasuries, which increased volatility in any trade related to Treasuries, which in turn would have an effect on leveraged trades made by hedge funds on Treasuries. Banks may have recognized this, and grew reluctant to provide cash funding to this market for this and other regulator reasons.

There is still a lot of research and learning I need to do on this, but these are my thoughts on the repo markets as of January 20, 2020. Please share your insights in the comments below.

The Federal Reserve is telling us there’s something wrong with hedge funds

Wall St Journal (Paywall)

One potential solution is to lend cash directly to smaller banks, securities dealers and hedge funds through the repo market’s clearinghouse, the Fixed Income Clearing Corp., or FICC.

Hedge funds currently borrow through a process called sponsored repo, in which they ask a large bank to act as a middleman, pairing their government bonds with money-market funds willing to lend cash. The bank then guarantees that the parties will fulfill their obligations—repaying the cash or returning the securities. Firms trading through the FICC contribute to a fund that would cover a borrower’s default. Critics of the new plan say if the Fed lends cash directly through the clearinghouse, it could end up contributing to a hedge-fund bailout.

The Fed’s aim, according to analysts, is to step back from temporary efforts to quell repo-market volatility and increase financial reserves. After September’s volatility, officials succeeded in suppressing year-end swings with temporary measures, such as offering short-term repo loans and buying Treasury bills.

With the Fed acting as a backstop to hedge funds, is this admitting failure in the repo market with repo operations? Maybe failure is a strong word. Let’s say that repo operations have been less effective at diffusing money market issues than they Fed anticipated?

Did the Fed believe these funding issues would go away after year-end, only to discover these issues aren’t going anywhere anytime soon?

This is an interesting development that I post about more in the days to come.

Update: Follow-up post here – What is ACTUALLY going on in the repo market?