Matthew, Near Misses and Flash Crashes

Doug Nolan
 
 
Clearly, the National Hurricane Center, The Weather Channel, meteorologists and disaster consultants have succumbed to the cult of fear mongering. “Extremely dangerous” Matthew was poised to deliver death and vast destruction. A Thursday afternoon headline from CNBC: “Hurricane Matthew could inflict $200 billion in damage to coastal homes.”

While the damage will be significant, at least much of the Florida coastline dodged a bullet. The storm drifts 25 to 30 miles west and it’s a very different outcome. Yet most people will forget the seriousness of such a Close Call. Instead they’ll imbed the notion of “fear mongering” further into their thinking. The complacency that developed over a decade of no hurricane encounters will become only more instilled. Surely the next dangerous storm warning will be readily dismissed.

Going back to early CBBs, I have used a parable of a “Little Town on a River” that enjoyed booming growth and prosperity engendered by the newfound availability of cheap flood insurance. On the “financial” side, writing flood insurance during an extended drought was about as close to free money as one can get. It was exciting, sophisticated and lavishly rewarding. Truth be told, the insurance market was a rank speculative Bubble in disguise. On the real economy side, the building boom along the river powered a self-reinforcing generalized economic Bubble. The little town that got a lot bigger was wonderful and awe-inspiring. And it all came crashing down when torrential rains commenced and the undercapitalized “insurance” industry rushed to offload flood exposure (into an illiquid market).

As an analyst of risk, I was struck by a key hurricane Matthew data point. Apparently, five million new residents have relocated along the SE coast since the last major hurricane back in 2004. So the risk of a catastrophic event has risen significantly. Matthew’s near miss notwithstanding, risk will continue to accumulate so long as affordable insurance is readily available.

It was a week to ponder risk, from the SE coast to global markets more generally. There are similarities and important differences between property casualty risks and market risks. Casualty losses are generally random and independent. Actuaries can use historical loss data to calculate insurance pricing and loss reserves to ensure sufficient wherewithal to pay future damage claims.

Market (and Credit) losses tend to arise unexpectedly and in waves. They are specifically neither random nor independent. For the most part, those writing derivative “insurance” don’t hold reserves against future losses, expecting instead to sell and buy securities (or other derivatives) when necessary to hedge exposures.

In contrast to the weather, government policymakers have the capacity to significantly impact market behavior. Cheap insurance coupled with a decade without a major hurricane ensures a much higher probability of a catastrophic event. Similarly, eight years of unprecedented government market intervention/manipulation with attendant cheap market “insurance” virtually ensures a market calamity. Going on 30 years of central banks ensuring liquid and continuous markets have nurtured hundreds of Trillions of derivatives and unprecedented market vulnerabilities. A historic market liquidity event would seem unavoidable. Occasional market dislocations – and hints of calamity potential - have come to be called “Flash Crashes.”

Five Friday headlines from the Financial Times: “Pound Struggles to Recover After Plunging 6% in 2 Minutes”; “How ‘All Hell Broke Loose’ on Flash Crash Friday”; “UK Chancellor Seeks to Reassure Market After Pound Plummets”; “Brexit Bliss Suffers Rude Awakening with Flash Crash”; “Pound’s Plunge Joins Growing List of ‘Flash Crashes’”.

And Friday from Bloomberg (Sarah McDonald): “Pound Is the Latest Flash Crash That Traders Won’t Easily Forget.” The article summarized some recent Flash Crashes: May 6, 2010: U.S. Stocks (“Dow Jones Industrial Average tumbled as much as 9.2%”); October 15, 2014: U.S. Treasuries (“37-basis-point range during a 12-minute period”); August 24, 2015: U.S. Stocks (“$1.2 trillion of market value… erased”); Aug. 25, 2015: New Zealand Dollar (“8.3% intraday”); January 11, 2016: South African Rand (“9% in 15 minutes”); May 31, 2016: China Index Futures (“suddenly dropped… 10% daily limit”). And let’s not forget “frankenshock,” the January 2015 dislocation (39% move) in Swiss franc trading as the SNB untethered the swissy peg from the euro.

Perhaps traders won’t forget the latest Flash Crash. Yet markets have enjoyed a remarkably short memory when it comes to market dislocations. There are these days extraordinarily serious market issues to contemplate. Clearly, algorithmic trading has evolved into a major problem across securities, currency and commodities markets. Market liquidity in general presents a huge vulnerability. Trend-following trading strategies have grown to overpower - and overhang - the marketplace. Moreover, the proliferation of derivative-related dynamic-hedging trading strategies (options and swaps, in particular) deserves special attention.

Rather abruptly, Brexit risk this week returned to the forefront. The June Brexit vote amounted to a market Close Call. Markets recovered almost immediately, further emboldened that global policymakers have no tolerance for market instability. Additional QE from the Bank of England – along with as much extra as needed from the ECB and BOJ. More ultra-dovishness from the Fed. Clearly, UK and EU policymakers would work closely together to ensure the best possible outcome for, of course, the securities markets.

Global markets became so conditioned to assume the best. Today, there remains an underlying denial that the global backdrop is rapidly evolving. I wrote at the time that I believed Brexit marked an important inflection point. Complacent markets would be forced to recognized that they were no longer in control. The good old days of markets holding sway over policymakers had given way to an exasperated electorate majority ready to dictate real political and economic change. But with QE infinity and the tidal surge of liquidity, markets were determined to move briskly past the Close Call and reject any notion that the backdrop had fundamentally changed.

The pound was clobbered 4.1% this past week, in alarming trading action for one of the world’s most actively traded currencies. Suddenly, the markets have turned their attention to the potentially far-reaching consequences of a “hard Brexit.” Currency traders pointed to tough comments from French President Francois Holland: (Deutsche Welle) “’There must be a threat, there must be a risk, there must be a price, otherwise we will be in negotiations that will not end well and, inevitably, will have economic and human consequences,’ he said, adding that he believed Britain had voted for a ‘hard Brexit.’”

October 5 – Financial Times (George Parker): “Theresa May has denounced a rootless ‘international elite’ and vowed to make capitalism operate more fairly for workers, as she promised profound change to reunite Britain after June’s vote to leave the EU. In a speech to the Conservative party conference, Mrs May said the Brexit vote was a cry for a new start, setting out an agenda of state intervention, more workers’ rights, an assault on failing markets and a crackdown on corporate greed. The prime minister’s speech drew comparisons with the supposedly anti-business rhetoric of former Labour leader Ed Miliband, but one Tory official said: ‘Perhaps only a Tory government can save capitalism from itself.’ Mrs May told activists that the Conservatives would respond to the Brexit vote by putting ‘the power of government squarely at the service of ordinary working-class people…’”
Further from the FT: “But [the Prime Minister’s] comments also reflect her view that the Brexit vote was a symptom of a widening divide in Britain between London and the rest of the country, between a relatively affluent older generation and the young, and between a ‘privileged few’ and millions of ordinary voters struggling to ‘get by’. She suggested the Bank of England’s quantitative easing programme should draw to a close, saying that it had caused some ‘bad side effects’, pumping up asset prices but leaving people without assets, or living on savings, worse off.”
Is Britain’s new Tory Prime Minister challenging the global order? Is a conservative leader of a G7 country calling for the end of QE? Is Mark Carney’s job leading the Bank of England in jeopardy? To be sure, the world is changing fast, and the balance of power is shifting away from the securities markets and market-pleasing monetary stimulus.

Especially since 2012, global central bankers have fully embraced “whatever it takes.” This historic gambit just didn’t work, and this unfolding failure is proving extraordinarily divisive. 
 
Societies and political parties are deeply divided. Central banks from Tokyo to Frankfurt to Washington are deeply divided. This ensures an extraordinarily uncertain future. Things are simply no longer lined up for markets to always get their way.

The pound was not the week’s only notable market development. The Japanese yen declined 1.6%. Gold dropped 4.5% ($59) and Silver sank 8.7%. Natural gas surged 9.6%. Brazil’s Bovespa index surged 4.7%. While the S&P500 ended the week down less than 1%, markets had the feel of heightened vulnerability.

Some of the week’s most consequential moves were in global bond yields. German bund yields jumped 14 bps this week to 0.02%. Italian yields surged 20 bps, and Portuguese yields rose 25 bps to an almost eight-month high. UK gilt yields jumped 23 bps. Ten-year Treasury yields rose 13 bps to an almost four-month high.

Rising yields provided global financial stocks somewhat of a tailwind. Deutsche Bank rallied 4.4%, with Europe’s STOXX 600 Bank Index recovering 2.4%. Italian banks gained 2.4%. 
 
Japanese bank stocks rallied 3.4%. Hong Kong’s Hang Seng Financials jumped 3.2%. US Banks (BKX) jumped 2.8%. Indicative of the pressure on “low risk” equity yield plays, U.S. utilities (UTY) sank 3.6% this week.

Rising financial stocks notwithstanding, I’d be remiss for not suggesting that this week’s big movers (pound, yen, bunds, European periphery debt, Treasuries, gilts and gold) all have big derivatives markets. So are markets now more vulnerable to illiquidity and so-called “Flash Crashes” because of heightened stress (and risk aversion) at Deutsche Bank and the other big derivatives operators, more generally?

I’ll posit that to sustain the global government finance Bubble at this point requires both ongoing securities market inflation and ever-increasing monetary inflation. Rather suddenly it seems that global central banks are much less confident in QE infinity. There is serious disagreement in Japan as to how to move forward with monetary policy. And there were even this week rumors of ECB “tapering” ahead of the March 2017 designated end to its QE program. Say what? Are the ECB “hawks” ready to take control?

Meanwhile, markets seem to be pointing to an important downside reversal following this year’s historic melt-up in global bond prices. With Italian, Portuguese and UK bonds leading this week’s losers list, it’s tempting to imagine that fundamentals might start to matter again. 
 
And it’s going to be a real challenge to sustain global Credit growth in the face of rising bond yields. All bets are off if China’s latest attempt to tighten mortgage Credit actually works. 
 
That’s one scary Credit Bubble, and there are already indications that outflows are picking up again from China.

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