Deutsche Bank Explains The Five Biggest “Market Conundrums”

While pundits contemplate whether the bitcoin bubble is bigger, smaller or the same size as the dot com bubble, few are willing to admit that day to day events in the equity market are just as ridiculous, bubbly and bizarre as what takes place in the crypto realm. To address this lack of coverage, yesterday Bloomberg was nice enough to publish an article titled "What to Worry About in This Surreal Bull Market" which however only barely touched the surface of just how truly insane capital markets have become, a market which as Citi said last week, even central bankers are worried they have lost control over.

So overnight, as human traders no longer comprehend what is going on in a market dominated by machines and controlled by central bankers, and only know to BTFD, Deutsche Bank's Masao Muraki took it upon himself to explain five of the most prevalent, and confusing, market conundrums.

We present his analysis below in its entirety for the sake of (carbon-based) traders' sanity.

Market upsets: Rationally explaining five conundrums

Change in market tone since September:  From 2016 through August 2017, global interest and forex rates and stock prices were strongly influenced by 10y UST yield movements. This led investors  globally to focus on US rates. However, since September this simple landscape has changed, creating headaches for bond, forex, and stock market investors. In this report, we highlight five conundrums (questions) and our proposed explanations for them. Rationally explaining recent market moves will be essential to forecasting next year's market.

Our global financial research team's view is that “the current combination of strong economic conditions, low interest rates, low inflation, and narrow credit spreads are supporting a rise in value of  risk assets.”, “If the risks (such as difficulties with negotiating a higher US debt ceiling as 8 December approaches) do not materialize, and conditions remain stable (though the path would gradually  narrow), then risk asset prices will likely keep rising."

The key focus for 2018 will be the sustainability of low interest-rate/spread/volatility conditions and the Goldilocks market

Five market conundrums

  • Question 1: Japanese stocks' divergence from our approximation model (US stocks/forex)
  • Question 2: Ongoing stock rally (rise in P/E due to decline in risk premium)
  • Question 3: Ongoing yield-curve flattening
  • Question 4: Ongoing decline in interest-rate and stock-price volatility
  • Question 5: Ongoing tightening in credit spreads

Question 1: Japanese stocks' divergence from our approximation model (US stocks/forex)

90% or more of Japanese stock movements through August were explainable via a multiple regression model using US stock prices and forex. Forex movements could mostly be explained by US interest-rate movements.

Since Japan's 22 October Lower House elections, Japanese stocks including financials have diverged upward from our approximation model. Japanese stocks fell sharply following the 9 November volatility shock, and by 15 November had returned to near our approximation model (Figures 3-4, 20). At that point, we noted that the focus was on whether stocks would revert to the trend implied by our model or diverge again. Recently volatility decreased, and stocks have begun to diverge upward from our model again.

See Figures 4-6. Since September, stock-market volatility has been a major factor behind TOPIX's divergence from our model. This appears to be because some of the funds that flowed into the market during this year's Japan stock rally (from macro hedge funds, CTA etc.) have adjusted risk positions (stock positions) based on implied volatility in option-marke . In our view, the determinants of present Japanese stock-price levels appear to be (1) US stocks (particularly the Dow Average), (2) USD/JPY, and (3) implied volatility of stock prices in US and Japan. We think the third factor in particular should be uppermost in investors' minds, though its sustainability is questionable.

* * *

Question 2: Ongoing stock rally (rise in P/E due to decline in risk premium)

Japan and US stock prices continue to rise. This reflects the impact of (1) fundamentals, in the form of strong Jul-Sep results announcements, and (2) a rise in P/E amid the Goldilocks market conditions created by low interest rates and USD weakness.

Obviously, share prices are equivalent to EPS x P/E, and the inverse of P/E is earnings yield. As shown in Figures 7-10, the earnings yield in Japan, the US, and Europe can mostly be explained by the term premium observed in bond-market (the yield premium for long-term bonds due to price fluctuation and illiquidity risk) and the risk neutral rate (average forecast short-term interest rate over the next 10 years).

A one standard deviation decline in term premium causes stock prices to rise 2.5% in the US, 1% in Europe, and 5% in Japan. A one standard deviation increase in forecast short-term rate results in increases of 2%, 2.75%, and 7.8%. The recent decline in term premiums have led to a rise in P/E via a decline in risk-free rate and equity risk premium.

* * *

Question 3: Ongoing yield-curve flattening

Flattening European and US yield curves are a source of frustration for investors who had forecast steepening. Fed fund rate hikes amid structurally low interest rate conditions have (1) raised the average forecast short-term rate, but (2) have conversely lowered the term premium (Figure 11-12). Dominic Konstam from our Rates Strategy team estimates 2.25% as the fair end-2017 level for 10y yield.

Francis Yared from our Rates Strategy team sees US tax reforms as the main driver over the next 2-3 months. Our base scenario is for the passage of a mid-sized tax cut (increasing the fiscal deficit by $1.5trn) in early 2018. We expect long-term rates to rise due to the above factor and above-trend US economic growth. Matthew Luzetti from our US Economics research team estimates a neutral real short-term rate (neutral for economy) of 0.3% and a neutral real 10-year rate of around 1.5% (Figure 13). If we assume the Fed achieves its 2% inflation target, this would imply a neutral nominal 10-year rate of around 3.5%, suggesting ample room for long-term rates to rise.

Peter Hooper from our US Economics research team, does not expect the change in Fed Chair to have a significant impact on monetary policy. Chair-designate Powell is likely to be strongly opposed to the Taylor Rule or other limitations on Fed behavior. Powell lacks the specialist economic and monetary policy knowledge of previous Fed Chairs, but has front-line financial and capital market experience. He may also be more receptive to arguments about a structural decline in inflation than Chair Yellen. However, it is unclear whether he would continue to support an approach that combines a regulatory and supervisory response to monetary disequilibrium (excessive risk-taking) and monetary policy to optimize inflation and employment. Also, his biggest point of difference with Yellen is likely his stance on deregulation for largest banks.

* * *

Question 4: Ongoing decline in interest-rate and stock-price volatility

As shown in Figure 17, interest rate and stock-price volatility are both at all-time lows.

In Figures 15-16, US interest-rate volatility is approximated using (1) the percentage of MBS held by general investors (other than the Fed or banks), (2) neutral interest rate minus real Fed funds rate, (3) net inflows to bond funds minus net inflow to stock fund, and (4) repo positions on dealers versus debt securities outstanding. In our view, this model suggests that the fall in interest-rate volatility was led by (1) a decline in general investors' ratio of MBS holdings (they tend to buy volatility to hedge convexity risk), (2) a narrowing gap between the neutral interest rate and real Fed funds rate (which implies the required level of rate hikes; a contraction reduces future interest-rate policy uncertainty), and (3) fund inflows to bond funds (signifying expansion in bond index funds due to a graying population seeking stable income). Conversely, the decline in (4) due to tighter regulation should act to increase volatility.

In the stock market, we think a structural decline in volatility has resulted from (A) an increase in investors adopting a volatility targeting strategy (following volatility trends), (B) an increase in hedge funds and individual investors seeking option premiums and capital gains from selling volatility (shorting VIX or selling various option types) (Figure 19), (C) the shift of capital from active to passive funds (including AI funds), and (D) an increase in minimum variance investing as an alternative to bonds.

While we recognize the structural factors that are depressing volatility, we are also concerned about the risk of a sudden spike. We have noted a historical pattern of moderate volatility decline followed by sudden dramatic increase (normalization) in volatility (Figure 17). There is possibility of greater volatility amplitude than in the past because of the participation of less-experienced retail investors in addition to traditional volatility selling entities of hedge funds.

* * *

Question 5: Ongoing tightening in credit spreads

Since late October, widening corporate bond and CDS credit spreads (Figures 28-29) have been a subject of market debate. This trend has recently receded due to an excess liquidity and investors' search for yield.

The default rate (Figure 30) clearly shows that the corporate credit cycle reversed. The recovery in energy prices and stiffer competition for bank lending (relaxed lending conditions) are supporting a turnaround in bad corporate loans and credit costs. The SLOOS data released on 6 November showed that banks' lending stance has eased (Figures 33-35).

Nevertheless, corporate debt levels remain high. There are signs in areas such as subprime auto loans, credit-card loans, and CRE (commercial real estate collateral) loans that credit and economic growth may be nearing an end.

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Bitcoin Flash-Crashes To $8,500, Then Rebounds As Biggest US Exchange Breaks

Chaos: Bitcoin bounced back $1500 from the lows, rising as high as $10,400 from nearly $2000 lower just an hour earlier, before trading in a range around $10,000.

*  *  *

Update: The crash is continuing with Bitcoin now collapsing below $9000...

Ethereum and Litecoin are also under pressure.

Numerous exchanges and trading platforms are suffering outages.

*  *  *

Having soared in the last 24-48 hours to as high as $11,395 this moring, Bitcoin has just tumbled back below $10,000...

While a notable pump and dump, this drop is a mere 13% (following an 8% drop overnight after initially breaking $10,000).

There is some chatter than Bitcoin flash-crashed to as low as $9130 on Coinbase...

Remember on November 8th to 10th, Bitcoin crashed 30% amid rumors of its death.

image courtesy of CoinTelegraph

And as we noted previously, Bitcoin crashes at least once every quarter...


Amid a record day for traffic, Coinbase website is down once again...

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Best Beige Book Anecdotes: “It’s No Longer Possible To Build A Starter Home For Under $200K In Cleveland,” And More

While many, and certainly the FOMC, tends to gloss over the periodic Beige Book report, it does provide a snapshot of the US economy, if not in quantiative terms, then in qualitative anecdotes, some of which can be rather amusing at times.

First, here are the big picture economic assessments of the Nov. 29 Beige Book, which was prepared by the St. Louis Fed based on information collected on or before Nov. 17, 2017. First, on overall economic activity, courtesy of Bloomberg:

  • Retail spending largely flat; outlook for holiday sales generally optimistic
  • Residential real estate activity remained constrained, with most districts reporting little growth in sales or construction
  • All districts reported that manufacturing activity expanded, with most describing growth as moderate
  • Some respondents concerned or uncertain about impact of potential changes to taxes and other policies

Employment and Wages:

  • Reports of tightness in the labor market widespread
  • Wage growth modest or moderate in most districts; increases most notable for professional, technical, and production positions that remain difficult to fill
  • Many districts reported that employers were raising wages and increasing their use of signing bonuses and other nonwage benefits to retain or attract employees


  • Most districts reported modest to moderate growth in selling prices and moderate increases in non-labor input costs
  • Construction-material costs rose in most regions, with many districts reporting increased lumber costs and increases in demand for materials due to hurricane rebuilding efforts
  • Fuel prices rose, with multiple districts reporting upward pressure on oil and natural gas prices

And while the above is nothing that we didn't know, here are some of the more notable anecdotes from the various regional Feds:

  • Boston: Residential contacts expressed concern about the possible impact of the tax reform bill in Congress, which they feared could increase the cost of buying a home and disrupt the housing market
  • New York: Rents across New York City have edged down overall, led by the high end of the market, where landlord concessions have remained steady at high levels
  • Philadelphia: Retailers and banking contacts reported no signs of inflationary pressure, while homebuilders reported increases for various construction materials, including lumber and products containing petroleum
  • Cleveland: One homebuilder reported that he can no longer build a starter home for less than $200,000, given rising input costs
  • Richmond: An IT service provider noted that it was able to raise prices considerably in recent months without losing any customers
  • Atlanta: District contacts noted that Florida tourism activity bounced back after Hurricane Irma with the exception of the Florida Keys
  • Chicago: One contact indicated that machinery exports to Canada were artificially high as stricter regulations on emissions that begin in 2018 pulled sales into late 2017
  • St. Louis: Multiple contacts in Louisville reported rising construction costs, and a Memphis contact noted a significant increase in lumber prices
  • Minneapolis: A rural Wisconsin banker noted that tight labor was pushing up starting wages, but longer-term employees were seeing smaller increases similar to previous years
  • Kansas City: Respondents in the energy industry continued to focus on operating within cash flows, but said private equity capital remained readily available
  • Dallas: Some banks reported that labor was becoming a bigger issue than regulatory compliance; A clothing retailer noted that Houston-area stores benefited from the Astros playoff and World Series excitement, as well as some additional spending by flood victims
  • San Francisco: Contacts in Seattle noted continued strong demand for commercial office space, driven mainly by demand from large technology companies

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Market Snapshot: How have expectations for Canada’s fossil fuel use and <b>crude oil</b> production …

Release date: 2017-11-29. The National Energy Board projects energy supply and demand in its series of reports known as Energy Futures.

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John McCain Holds The Keys To Tax Reform’s Fate

Anybody who was watching the July Senate floor vote on the Republicans' bill to repeal and replace Obamacare will remember the audible gasps that John McCain elicited when he surprised his own party by voting against the plan. And now just four months later, he's gearing up to do it again.

According to the New York Times, McCain may once again decide the fate of one of the Trump administration's top legislative priorities.

The senator from Arizona has been tight-lipped about whether he will vote ‘yea’ or ‘nay’ on the bill, which was voted out of the Senate Banking Committee yesterday with the support of Bob Corker and Ron Johnson, who have both expressed reservations about the plan – Johnson had even said he wouldn’t vote for it.

As the NYT points out, McCain has staked his career on a platform of fiscal responsibility, and has bucked his party by voting against tax cuts in the past.

McCain’s skepticism of tax cuts stretches at least as far back as 1994. At that time, he was fretting about being fiscally responsible now that Republicans had seized control of Congress. “I think we would be making a terrible mistake to go back to the 80s, where we cut all of those taxes and all of a sudden now we’ve got a debt that we’ve got to pay on an annual basis that is bigger than the amount that we spend on defense,” McCain said.

“Mr. McCain has voted against big tax cuts before, including two that passed under another Republican president: George W. Bush In that case, he bucked the majority of hi party on the grounds that the 2001 and 2003 cuts overwhelmingly benefited the rich – a widespread criticism of the current Senate legislation and the bill that has already passed the House. Mr. McCain is also a deficit hawk and could find it had to swallow a tax cut that will add around $1.5 trillion to the federal debt over 10 years.”



“In 2001, as Republicans forged ahead with a $1.35 trillion tax cut, Mr. McCain became one of two Republican senators to vote against the bill’s passage. He said he could not accept that changes to the bill lowered the top individual tax rate to 35% and delayed tax relief for married couples.”


‘We had an opportunity to provide much more tax relief to millions of hard-working Americans,” Mr. McCain said in a speech on the Senate floor. ‘But I cannot in good conscience support a tax cut in which so many of the benefits go to the most fortunate among us, at the expense of middle-class Americans who most need tax relief.’


Two years later, Mr. McCain voted against another round of tax cuts. In his remarks in 2003, Mr. McCain again cast doubt on the need to use ‘billions of federal dollars to cut taxes for our nation’s wealthiest.’ The deal breaker that time was that his fellow lawmakers would pass such cuts while rejecting legislation that would have allowed members of the military to get tax breaks on profits from selling their homes.

Several of McCain’s associates said they wouldn’t be surprised if he voted against the senate bill, which he has criticized for being too generous with the wealthy.

“’I don’t know,’ Douglas Holtz-Eakin, policy adviser to Mr. McCain’s 2008 presidential campaign, said when asked how his former boss would vote on the tax overhaul. ‘For most people there are going to be things in there they don’t like and the question is what is preferable, the status quo or the bill.’”

During the 2000 Republican primary, when he ultimately lost out to George W Bush, McCain positioned himself as the candidate of fiscal restraint, advocating paying down the debt over tax cuts for the rich.

“We ought to pay down the debt, and we also ought to make Social Security solvent,” he said.

More recently, Mr. McCain has been toeing the party line on taxes.

In 2006, Mr. McCain supported extending the Bush tax cuts on the basis that letting them expire would represent a tax increase.

The tax plan that Mr. McCain crafted in 2008 during his presidential run against Barack Obama was even more mainstream Republican. He called for lowering the corporate tax rate to 25 percent from 35 percent, phasing out the alternative minimum tax and doubling the value of exemptions for each dependent to $7,000 from $3,500.

Anyone who was paying attention to McCain’s explanation for opposing the Republican health care plan will remember that one of his reason for opposing the bill was its lack of bipartisan support. Given the intensely partisan atmosphere that has persisted in Washington for much of the last decade, this sounds like an excuse for voting against the bill out of spite.

At the end of the day, McCain and fellow Trump opponents Bob Corker and Jeff Flake aren’t running again. They’ve already suggested that they find Trump and his agenda repugnant.

And with the Republicans’ razor-thin majority, three no votes would be enough to kill the bill, which is expected to be brought to the floor for a vote tomorrow.

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VIX – From Fear Index To Greed Index

Authored by Peter Tchir via,

We have all heard the VIX or volatility index referred to as the Fear Index or Fear Gauge.  Rising VIX was meant to signal fear in the markets.  That is how most investors have historically thought about VIX and traded it (directly or through Exchange Traded Products).

I have gone back in time and combined the total assets under management of XIV and SVXY (two short VIX products) and UVXY and VXX (the two largest long VIX products).  There are others and it doesn't account for the fact that UVXY incorporates leverage, but the point is the same.

The funds that in theory helped investors 'hedge' their portfolios went from being the dominant species to those that enable investors to sell volatility.

Short VIX Funds are Larger than Long VIX Funds (source Bloomberg)

This has rarely been the case.

Typically investors had more interest in hedging their portfolios despite the evidence that the long VIX ETFs and ETNs had to continually perform reverse splits as their share prices drifted lower (some would argue "raced" lower is a more accurate description).

While the products looking to benefit on a volatility spike still attract inflows (otherwise their assets under management would be even lower), they have lost the competition to the VIX sellers.

The only other gap of similar size and duration was in late August 2015 - AFTER the market sold off and volatility spiked.

This time, it is occurring as stock markets are near all-time highs and VIX is still close to the all-time low it set just a few weeks ago (VIX is only calculated since 1990).

Whether this has finally reached a stage of complacency is anyone's guess, but the "Golden Goose" of selling VIX that I wrote about in March of this year - is clearly not a secret.

I'm not overly concerned about complacency, it is after all, a slow and typically low vol period for domestic markets, but it is something that investors need to focus on.

A spike in volatility could be far more problematic than the market is prepared for as even a small spike could turn into a larger problem with so many people positioned the other way.

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Maryland Schools Forced To Cancel Baltimore Field Trips Due To “Escalating Violence”

In light of the ongoing wave of violent crime in Baltimore, school officials in nearby Carroll County have been forced to halt school-related trips to the city - including a marching band’s scheduled performance in the Mayor’s Christmas Parade this weekend - citing "escalating violence."  The field trip ban was imposed by the Carroll County Sheriff's Office "in response to parent concerns regarding the safety of students."  Here's more from The Baltimore Sun:

Schools spokeswoman Carey Gaddis said the order is based on a recommendation from the county Sheriff’s Office, and will stay in place until the beginning of the next semester in late January, when it will be revisited. She said the order was sent to school principals last week.


Sheriff James T. DeWees recommended the measure during a meeting with school system officials “in response to parent concerns regarding the safety of students during field trips to venues in Baltimore City,” according to a statement from the sheriff’s office. The move is intended to “limit the risk to students and staff.”


“In light of recent violence in the traditional tourist areas of the city, the sheriff agrees that the best course of action is to temporarily suspend travel to Baltimore City venues,” spokesman Cpl. Jonathan Light wrote in the statement.

Of course, as we pointed out recently (see: America's Urban War Zone: Baltimore Doubles Chicago's Homicide Rate In 2017), Baltimore is on track to exceed 400 homicides in 2017 for the first time in the city's history and has more than doubled Chicago's homicide rate on a per capita basis.

As the Sun notes, two field trips to Baltimore have been cancelled so far after parent's received a rather disturbing email from Carroll County schools spokeswoman Cary Gaddis citing "escalating violence."

Field trips are still being considered on a “case-by-case basis,” Gaddis said, but the policy has caused at least two forthcoming trips to be canceled: a planned field trip Friday to the Maryland Science Center by third-grade students from Westminster Elementary School, and Francis Scott Key High School’s band appearance in the Christmas parade in Hampden.


Both schools cited the county’s new policy as the reason for the cancellations.


“Due to escalating violence reported in Baltimore City, and consultation with law enforcement and Maryland Center for School Safety, we will not be sending any students on field trips to Baltimore City at this time,” said an email sent to Westminster parents and guardians Nov. 22.


"When they’re not contained but they’re walking around an area, walking around the city ... we don’t have as much control,” she said. The Sheriff’s Office does not send a deputy along with students on field trips, she said.

Of course, support of the field trip ban is mixed with at least one Democratic legislator in Baltimore blasting the decision of the Carroll County Sheriff's Office as "misguided and disappointing" while declaring the city is "still a safe place to visit and walk around and explore our cultural sites"...

Delegate Brook Lierman, a Baltimore Democrat who lives downtown, called the notion that the city is unsafe for visitors “misguided and disappointing.”


“While we are experiencing an uptick in crime, there’s no denying that, it is still a safe place to visit and walk around and explore our cultural sites,” she said. “I love living in Downtown Baltimore and want and hope students from around the state can come visit the great neighborhoods and institutions we have in the city.”


Andy Smith, the Hampstead parent who sent the email to the sheriff and school officials, said he is satisfied with the school system’s decision.


"This is one of those things where being overly cautious is probably the best policy, rather than waiting for something to happen that you can’t undo,” Smith said.


“We’re trying to keep in mind the safety of our students,” she said. “That’s something we have to pay attention to.” seems that Washington D.C. isn't the only place where politicians find it convenient to ignore statistics.

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North Korea Warns “The Whole US Is In Range” After Successful Launch Of “New Type” Of ICBM

Following the successful test-firing of its longest range ICBM yet today, Yonhap News reports, citing North Korean media, that North Korea will make an important announcement at noon Seoul time (10:30pm ET).

Presumably, Kim's comments will be a braggadocio reaction to President Trump and General Mattis' comments (begins around 6:30):

Mattis warned "[North Korea] R&D is accelerating and they now appear to have the capability to launch an ICBM attack on anywhere in the world" to which Trump replied "we will take care of it... it is a situation we will handle."

Trump then tweeted later this evening: "After North Korea missile launch, it's more important than ever to fund our gov't & military! "

North Korea announces that it successfully test-fired a new type of ICBM today.




None of which is news as we already reported these details.

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“It’s All One Single, Giant $22 Trillion Position”: How Market Risk Became Systemic Risk

As excerpted from Fasanara Capital’s “Positive Feedback Loops and Financial Instability: the blind spot of policymakers.” The next time a Fed chair or macroprudential regulator argues that “there is no leverage in the market”, send them this.

QE and NIRP have two predominant effects on markets: (i) relentless up-trend in stocks and bonds (the ‘Trend Factor’), dominated by the buy-the-dip mentality, which encapsulates the ‘moral hazard’ of investors knowing Central Banks are prompt to come to their rescue (otherwise known as ‘Bernanke/Yellen/Kuroda/Draghi put’), and (ii) the relentless down-trend in volatility (the ‘Volatility Factor’).

The most fashionable investment strategies these days are directly impacted by either one or both of these drivers. Such strategies make the bulk of the overall market, after leverage or turnover is taken into account: we will refer to them in the following as ‘passive’ or ‘quasi-passive’. The trend impacts the long-only community, crowning it as a sure winner, making the case for low-cost passive investing. The low volatility permeates everything else, making the case for full-investment and leverage. The vast majority of investors these days are not independent from the QE environment they operate within: ETFs and index funds, Risk Parity funds and Target Volatility vehicles, Low Volatility / Short Volatility vehicles, trend-chasing algos, Machine Learning-inspired funds, behavioral Alternative Risk Premia funds. They are the poster children of the QE world. We estimate combined assets under management of in excess of $8trn across the spectrum. They form a broad category of ‘passive’ or ‘quasi-passive’ investors, as are being mechanically driven by two main factors: trend and volatility.

*  *  *

How Market Risk became Systemic Risk 

Let's give a cursory look at the main players involved. As markets trend higher, no matter what happens (ever against the shocked disbeliefs of Brexit, Trump, an Italian failed referendum and nuclear threats in North Korea), investors understand the outperformance that comes from pricing risks out of their portfolios entirely and going long-only and fully-invested. Whoever under-weighs positions in an attempt to be prudent ends up underperforming its benchmarks and is then penalized with redemptions. Passive investors who are long-only and fully invested are the winners, as they are designed to be bold and insensitive to risks. As Central Banks policies reduce the level of interest rates to zero or whereabouts, fees become ever more relevant, making the case for passive investing most compelling. The rise of ETF and passive index funds is then inevitable.

According to JP Morgan, in the last 10 years, $2trn left active managers in equities and $2trn entered passive managers. We may be excused for thinking they are the same $ 2trn of underlying investors progressively pricing risk provisions out of books, de facto, while chasing outperformance and lower fees.

To be sure, ETFs are a great financial innovation, helping reducing costs in an expensive industry and giving entry to markets previously un-accessible to most investors. Yet, what matters here is their impact on systemic risks, via positive feedback loops. In circular reference, beyond Central Banks flows, markets are helped rise by such classes of valuations-insensitive passive investors, which are then rewarded with further inflows, with which they can then buy more. The more expensive valuations get, the more they disconnect from fundamentals, the more divergence from equilibrium occurs, the larger fat-tail risks become.

In ever-rising markets, ‘buy-and-hold’ strategies may only possibly be outsmarted by ‘buy-the-dip’ strategies. Whatever the outcome of risk events, be ready to buy the dip quickly and blindly. As more investors design themselves up to do so, the dips are shallower over time, leading to an S&P500 that never lost 3% in 2017, an historical milestone. Machine learning is another beautiful market innovation, but what is there to learn from the time series of the last several years, if not that buy-the-dip works, irrespective of what caused the dip. Big Data is yet another great concept, shaping the future of us all. Yet, most data ever generated in humankind dates back three years only, in and by itself a striking limitation. The quality of the deduction cannot exceed the quality of the time series upon which the data science was applied. If the time series is untrustworthy, as is heavily influenced by monumental public flows ($300bn per months), what trust can we put on any model output originating from it? What pattern recognition can we really be hopeful of getting, in the first place? May some of it just be a commercial disguise for going long, selling volatility and leveraging up in various shapes or forms? What is hype and what is real? A short and compromised data series makes it hard, if not possible, to really know. Once public flows abate and price discovery is let free again, then and only then will we be in a position to know the difference.

Low volatility does what trending markets alone cannot. A state of low volatility presents the appearance of stuporous, innocuous, narcotized markets, thus enticing new swathes of unfitting investors in, mostly retail-type ‘weak hands’. Weak hands are investors who are brought to like investments by certain characteristics which are uncommon to the specific investment itself, such as featuring a low volatility. It is in this form that we see bond-like investors looking at the stock market for yield pick-up purposes, magnetized by levels of realized volatility similar to what fixed income used to provide with during the Great Moderation. It is in this form that Tech companies out of the US have started filling the coffers of not just Growth ETF, where they should rightfully reside, but also Momentum ETF, and even, incredibly, Low-Volatility ETF.

Low volatility is also a dominant input for Risk Parity funds and Target Volatility vehicles. The lower the volatility, the higher the leverage allowed in such players, mechanically. All of which are long-only players, joining public flows, again helping the market rise to record levels in the process, in circular reference. Rewarded by new inflows, the buying spree gathers momentum, in a virtuous circle. Valuations are no real inputs in the process, volatility is what matters the most. Volatility is not risk, except for them it is.

It goes further than that. It is not only the level of volatility that count, but its direction too. As volatility implodes, relentlessly, into historical lows never seen before in history, a plethora of investment strategies is launched to capitalize on just that, directly: Short Volatility vehicles. They are the best performing strategy of the last decade, by and large. The problem here is that, due to construction, as volatility got to single-digit territory, relatively small spikes are now enough to trigger wipe-out events on several of these instruments. Our analysis shows that if equity volatility Doubles up from current levels (while still being half of what it was as recently as in August 2015), certain Short Vol ETFs may stand to lose up to 75% or more. Moreover, short positions on long-vol ETFs can lose up to 250% of capital. For some, ‘termination events’ are built into contracts for sudden losses of this magnitude, meaning that the notes would be prematurely withdrawn. It is one thing to expect a spike in volatility to cause losses, it is quite another to know that a minor move is all it takes to trigger a default event.

On such spikes in volatility, Morgan Stanley Quant Derivatives Strategy desk warns further that market makers may be forced to rebalance their exposure non-linearly on a spike in volatility. A drop in the S&P 500 of 5% in one day may trigger approximately $ 400mn of Vega notional of rebalancing. We estimate that half a trillion dollars of additional selling on S&P stocks may occur following a correction of between 5% and 10%. That is a lot of selling, pre-set in markets, waiting to strike. Unless you expect the market to not have another 5% sell-off, ever again.

It’s All One Big Position

What do ETFs, Risk Parity and Target Vol vehicles, Low Vol / Short Vol vehicles, trend-chasing algos, Machine Learning, behavioral Alternative Risk Premia, factor investing have in common? Except, of course, being the ‘winners take all’ of QE-driven markets. They all share one or more of the following risk factors: long-only, fully invested when not leveraged-up, short volatility, short correlation, short gamma. Thanks to QE and NIRP, the whole market is becoming one single big position.

The ‘Trend Factor’ and the ‘Volatility Factor’ are over-whelming, making it inevitable for a high-beta, long-bias, short-vol proxy to disseminate across. Almost inescapably so, given the time series the asset management industry has to deal with, and derive its signals from.

Several classes of investors may move to sell in lock-steps if and when markets turn. The boost to asset prices and the zero-volatility environment created the conditions for systemic risks in the form of an over-compensation to the downside. Record-low volatility breeds market fragility, it precedes system instability.

Systemic Risk is Not Just About Banks: Look at Funds

The role of trending markets is known when it comes to systemic risks: a not sufficient but necessary condition. Most trends do not necessarily lead to systemic risks, but hardly systemic risks ever build up without a prolonged period of uptrend beforehand. Prolonged uptrends in any asset class hold the potential to instill the perception that such asset class will grow forever, irrespective of the fundamentals, and may thus lead to excessive risk taking, excess leverage, the formation of a bubble and, ultimately, systemic risks. The mind goes to the asset class of real estate, its undeterred uptrend into 2006/2007, its perception of perpetuity (”we have never had a decline in house  prices on a nationwide basis’’ Ben Bernanke), the credit bubble built on banks hazardous activities on subprime mortgages as a result, and the systemic risks which emanated, with damages spanning well beyond the borders of real estate.

The role of volatility is also well-researched, especially low volatility. Hayman Minsky, in his “Financial Instability Hypothesis’’ in 1977, analyses the behavioral changes induced by a reduction of volatility, postulating that economic agents observing a low risk are induced to increase risk taking, which may in turn lead to a crisis: “stability is destabilizing”. In a recent study, Jon Danielsson, Director of the Systemic Risk Centre at the LSE, finds unambiguous support for the ‘low volatility channel’, insofar as prolonged periods of low volatility have a strong predictive power over the incidence of a banking crisis, owing to excess lending and excess leverage. The economic impact is the highest if the economy stays in the low volatility environment for five years: a 1% decrease in volatility below its trend translates in a 1.01% increase in the probability of a crisis. He also finds that, counter-intuitively, high volatility has little predictive power: very interesting, when the whole finance world at large is based on retrospective VAR metrics, and equivocates high volatility for high risk.

Both a persistent trend and prolonged low-volatility can lead banks to take excessive risks. But what about their impact on the asset management industry?

Thinking at the hard economic impact of the Great Depression (1929-1932) and the Great Recession (2007-2009), and the eminent role played by banks in both, it comes as little surprise that the banking sector captures all the attention. However, what remains to be looked into, and perhaps more worrying in today’s environment, is the role of prolonged periods of uptrend and low-vol on the asset management industry.

In 2014, the Financial Stability Board (FSB), an international body that makes recommendations to G20 nations on financial risks, published a consultation paper asking whether fund managers might need to be designated as “global systemically important financial institution” or G-SIFI, a step that would involve greater regulation and oversight. It did not result in much, as the industry lobbied in protest, emphasizing the difference between the levered balance sheet of a bank and the business of funds.

The reason for asking the question is evident: (i) sheer size, as the AM industry ballooned in the last few years, to now represent over 15trn for just the top 5 US players!, (ii) funds have partially substituted banks in certain market-making activities, as banks dialed back their participation in response to tighter regulation and (iii) , funds can indeed do damage: think of LTCM in 1998, the fatal bailout of two Real Estate funds by Bear Stearns in 2007, the money market funds ‘breaking the buck’ in 2008 amongst others.

But it is not just sheer size that matters for asset managers. What may worry more is the positive feedback loops discussed above and the resulting concentration of bets in one single global pot, life-dependent on infinite momentum/trend and ever-falling volatility. Positive feedback loops are the link for the sheer size of the AM industry to become systemically relevant. Today more than ever, they morph market risks in systemic risks.

Volatility will not forever be low, the trend will not forever go: how bad a damage when it stops? As macro prudential policy is not the art of “whether or not it will happen” but of “what happens if”, it is hard not to see this as a blind spot for policymakers nowadays.

The addiction that could not be let go

In conclusion, markets are being brought into an unstable equilibrium, at risk of snapping violently. The stability of markets resembles the one of a pendulum held in vertical position: a small disturbance is able to create large swings. The swing can be so violent as to send tremors across the real economy, thus jeopardizing the hard earned progress on recovery in growth rates and unemployment of recent years. If positive feedback loops are ignored and bubbles are left unchecked, that may one day most unambiguously qualify as a policy mistake: the addiction to monetary steroids and price control that could not be let go, on time. A bust that was entirely predictable, if only macropru conditions had been a real target, and short termism had not prevailed.

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Blowback: CNN Pushes Plan To “Ban The Term ‘Fake News’”

Authored by Paul Joseph Watson via,

CNN is now pushing an effort to “ban the term fake news” after the slogan became synonymous with CNN itself thanks to President Donald Trump.

In a CNN opinion piece written by Hossein Derakhshan and Claire Wardle, who are affiliated with the globalist Council of Europe, the authors argue that the term “fake news” has “become meaningless” and lost its power because politicians (primarily Donald Trump) have hijacked it as a way to “undermine” the media establishment.

The authors decry the fact that many people now believe the mainstream media peddles “fabricated stories” and that information monopolies are being challenged by the ability for “anyone in the world” to have a platform.

Complaining that “less powerful agents can harm large institutions or established individuals,” Derakhshan and Wardle warn that trust in institutions is declining and that only through intervention at the level of “public education” (ie indoctrination) can this be reversed.

Of course, the real reason media elites want to clamp down on the term “fake news” is because its original intention, to smear and discredit opponents of Hillary Clinton, right of center media outlets, and people who distrust the mainstream media, has completely backfired.

This was illustrated yet again by Donald Trump’s tweet earlier today when he suggested that a “fake news trophy” should be awarded to the network that has been responsible for the most inaccurate reporting.

“Fake news” was one of many excuses trotted out after November last year to push the narrative that President Trump’s election was somehow illegitimate.

In reality, a major Stanford University study found that “even the most widely circulated fake news stories were seen by only a small fraction of Americans,” and that the most widely believed fake news stories were those that benefited Hillary Clinton.

Fake news had virtually no impact on the election, but the establishment media weaponized the term as part of an agenda to silence and censor voices of dissent, including media platforms, that had opposed Hillary Clinton’s presidential campaign.

In addition, mainstream media news coverage in the weeks leading up to the election was 91% negative towards Trump, according to a study by the Media Research Center.

The Podesta emails also revealed how mainstream journalists were completely in bed with the Clinton campaign and even ran stories by them before publication.

The “fake news” narrative has completely backfired on the political establishment and the media because it has acted as a boomerang, showing the mainstream media to be the most consistently dishonest entity of all.

Is it any wonder therefore that the political class is now so keen to retire the term altogether?

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