Regime Change
Doug Nolan
For the week, the VIX declined three points to 20.37.
The S&P500 was basically unchanged.
The Nasdaq100 increased 0.4%.
The KBW Bank Index added 0.2%.
Germany’s DAX increased 0.3%, and France’s CAC40 added 0.2%.
The UK’s FTSE100 slipped 0.1%.
Japan’s Nikkei 225 ended the week 2.5% lower.
Bitcoin fell 2.6%.
Investment Grade CDS was little changed at 57.7 bps, with Investment Grade spreads three narrower.
High Yield CDS declined six to 364 bps, while spreads narrowed 20 bps.
By the look of most of the week’s changes, it was all quiet on the western front.
August 5 – Reuters (Saqib Iqbal Ahmed):
“Wall Street’s most-watched gauge of investor anxiety logged its largest ever intraday jump on Monday and closed at its highest since October 2020, as traders scrambled to hedge against market volatility during a global selloff fueled by U.S. recession fears.
The Cboe Volatility Index jumped to a high of 65.73 before the market open, up about 42 points from its close on Friday.
The index pared gains and closed at 38.57, its highest close in nearly four years…
The surge in the VIX, which measures investor demand for protection against stock swings, dwarfed moves in the volatility index that took place during past bouts of intense selling - including the Covid-related massive selloff in March 2020, when the S&P 500 sank more than 10% in a single day.”
At Monday’s intraday lows, the S&P500 was down 4.3%, the Nasdaq100 5.5%, the KBW Bank Index 5.0%, Germany’s DAX Index 3.6%, France’s CAC40 3.1%, UK FTSE100 3.2%, and Japan’s Nikkei 225 Index 13.2%.
Bitcoin was 13.8% lower at Monday’s low and traded within a 16% range throughout the week.
At Monday’s intraday highs, Investment Grade CDS was up 7.6 to 66.9 bps – with a three-session spike of 14 bps – the largest increase since the March ’23 banking crisis.
High Yield CDS surged 33 to 403 bps at Monday’s highs, pushing the three-session gain to 72 bps (also most since the banking crisis).
During peak Monday panic, the market was pricing a 3.85% December policy rate, down an incredible 79 bps in four sessions.
At rate lows, market pricing implied 148 bps of rate reduction by year end.
Two-year Treasury yields sank as low as 3.65% in Monday trading, down 40 bps to a 15-month low.
At lows, two-year yields were down 71 bps in four sessions.
Panic buying.
August 6 – Bloomberg (Ruth Carson, Lu Wang, Vildana Hajric, and Bailey Lipschultz):
“The numbers flashing on trading screens on Monday were shocking even to market veterans.
In Tokyo, the Nikkei was down 12%.
In Seoul, the Kospi sank 9%.
And when the opening bell rang in New York, the Nasdaq plunged 6% in seconds.
Cryptocurrencies sank; the VIX, a gauge of stock market volatility, skyrocketed; and investors piled into Treasury bonds, the safest asset of them all.
Whether Monday’s wild gyrations mark the final bang of a global selloff that started to build last week or signal the beginning of a protracted slump is impossible to know.
On Tuesday, some of the worst-hit markets rebounded, with the Nikkei jumping more than 10% and US stock indexes posting 1% gains.”
The dollar/yen traded down to a low of 141.70 Monday – capping off a stunning four-session drop from the July 30th high of 155.22.
Dollar/yen was back to almost 148 early Wednesday on Bank of Japan crisis management.
August 7 – Reuters (Leika Kihara):
“The Bank of Japan’s influential deputy governor said on Wednesday the central bank will not hike interest rates when markets are unstable, playing down the chance of a near-term hike in borrowing costs.
The remarks by Shinichi Uchida, which contrasted with Governor Kazuo Ueda's hawkish comments made last week when the BOJ unexpectedly raised interest rates, boosted Japan's Nikkei share average and sent the yen sharply lower.
Uchida said the intense market volatility in the past week could ‘obviously’ change the BOJ's rate hike path if it affects the central bank's economic and price projections…
‘As we’re seeing sharp volatility in domestic and overseas financial markets, it’s necessary to maintain current levels of monetary easing for the time being,’ Uchida said in a speech…
‘Personally, I see more factors popping up that require us being cautious about raising interest rates,’ Uchida… told a news conference after the speech…
‘We won’t raise interest rates when financial markets are unstable,’ he said in the speech.”
August 7 – Bloomberg (Toru Fujioka and Yoshiaki Nohara):
“Bank of Japan Deputy Governor Shinichi Uchida sent a strong dovish signal in the wake of historic financial market volatility…
The yen weakened by more than 2% against the dollar, bond futures spiked higher and stocks rebounded immediately after his comments…
‘I believe that the bank needs to maintain monetary easing with the current policy interest rate for the time being, with developments in financial and capital markets at home and abroad being extremely volatile,’ Uchida said…
Uchida sought to dispel any notions his views might differ from the governor’s.
‘It’s not that there is a difference between the governor and me but rather that the situation has changed…
There is extreme volatility taking place in financial markets, so we need to be more cautious if that’s included as part of our policy reaction function.’”
Crisis dynamics triggered a policy response, a familiar scenario.
That it was the Bank of Japan quelling global crisis dynamics was highly unusual.
It was an embarrassing about-face.
A week earlier, Governor Ueda had sped up policy normalization, a hawkish shift compelled by the sickly yen.
Now, the spiking yen, unwind of the yen “carry trades”, and global market upheaval forced a hasty retreat.
Astonishing what a move to a 25 bps interest rate can unleash after decades of ultra-loose policy.
The BOJ in September 1995 cut rates from 1% to 0.5%.
Rates haven’t been above 50 bps since.
In March 2016 began the eight-year experiment with a negative (0.1%) rate.
This crazy experiment “officially” failed this week.
“Volatility Pros Say Record VIX Surge on Monday Was a Head Fake.”
“UBS Wealth CIO Says Wall Street’s Fear Gauge Flashing Buy Sign.”
“Despite Recession Panic, the VIX Indicates It’s Time to Buy.”
“S&P 500 is a Buy Whenever the VIX is Above This Number: RBC.”
“The VIX Just Did Something It Hasn’t Done Since 2008.
Here’s Why This Could Be a Buying Opportunity for Stocks.”
Was Monday's VIX spike the typical obvious signal (buy the dip, don't be one) - or might it have flashed something quite different?
The post-VIX spike stock rally was business as usual.
The panic buyers of market protection saw the value of their hedges sink rapidly into the end of the week.
And with option expiration next Friday, it would not be a stunning development to see a lot of put options expire worthless (again).
No matter what the market does next week, or over several weeks, I believe the long bullish cycle is in jeopardy.
Global Bubbles are in trouble everywhere.
And it’s not unreasonable to presume the great equities bull market concluded fittingly with a mania and blowoff.
We’ll look back to July as peak speculative melt-up.
August 7 – Financial Times (Steve Johnson and Will Schmitt):
“Investors poured record sums into exchange traded funds in July, highlighting the exuberance that gripped global financial markets…
Net inflows into ETFs globally hit $195bn in July, according to… BlackRock, totally eclipsing the monthly record of $169bn in December 2023.
About $124bn of that flowed into US-listed ETFs, the second-highest amount on record behind December’s $129bn.
The buying frenzy was wide ranging, with fixed income ETFs attracting a record $60.5bn, equity funds sucking in $127bn — their best month since December — and gold ETFs grabbing $3.2bn, the highest figure since March 2022.
Active ETFs in the US once again set a record for new investments with $27.9bn after previously setting high water marks in January, March and December…”
I see July’s record ETF flows indicative of peak speculation - in ETFs, stocks, corporate Credit, and leveraged speculation more generally.
Dollar/yen at 162 on July 10th is emblematic of peak yen “carry trade.”
And U.S. high yield spreads (to Treasuries) at a near multi-year low 297 bps on July 23rd – in the face of weakening economic fundamentals – I’ll cite as evidence of peak corporate “carry trade” enthusiasm.
I don’t see Monday as some run of the mill “volmageddon” bull market hiccup soon forgotten.
Not erupting so soon after manic speculation across markets. Markets Monday were flashing crash potential.
At Monday’s close, Japan’s Nikkei 225 Index had collapsed 20% in three sessions, with the TOPIX-Banks Index down 26.5%.
August 9 - Bloomberg (Anya Andrianova, Carter Johnson and Mia Glass):
“Speculative traders sharply pulled back on bets for a weaker yen amid wild swings in the Japanese currency and a vicious market selloff…
Hedge funds cut their wagers against the yen by 49,336 contracts to 20,243 in the week ended Aug. 6, CFTC data… show.
That’s the fifth-largest boost to trader sentiment in data going back to 2006…
‘The recent move in the yen has caused a significant unwinding of carry trades,’ said Yuya Yokota, a foreign-exchange trader at Mitsubishi UFJ Trust and Banking Corp...
Strategists at Morgan Stanley estimated that some 60% of yen-funding carry trades have been unwound in recent weeks — while acknowledging a large margin of error in that figure.
JPMorgan…, meanwhile, said about three-quarters of the global carry trade has been removed.”
So, the Bank of Japan pushes borrowing rates negative for eight years – with rates barely positive for decades – and resulting “carry trade” leveraged speculation is significantly unwound in a couple weeks?
I can’t see it.
Sure, there has been a huge unwind of liquid currency positions – and undoubtedly aggressive hedging of currency exposures.
But what about the other side of the trade - all the higher yielding instruments around the world bought on leverage?
I seriously question whether most EM bond and currency markets have sufficient liquidity to accommodate an aggressive deleveraging and “hot money” exodus.
More likely, the backdrop for global leveraged speculation has entered a so-called “New Regime.”
There’s problematic leverage now overhanging markets virtually everywhere.
Global derivatives markets may be off and running, but true deleveraging has barely got off the sofa.
On October 13th, 1989, the deal to finance the $7 billion leveraged buyout of UAL (United Airlines) collapsed.
The S&P500 sank 6.1% on the “Friday the 13th Mini-Crash.”
It didn’t matter that the S&P500 recovered 4.1% over the following three sessions.
The damage was done; Regime Change.
The UAL deal collapse sparked upheaval in the junk bond market.
Four months later, Drexel Burnham Lambert collapsed.
Indeed, October 13th marked a critical juncture for “decade of greed” high-risk speculative finance – junk bonds, leveraged buyouts, M&A, risky commercial real estate lending – a fledgling Bubble stoked to systemic excess by the Greenspan Fed’s response to the 1987 stock market crash.
The Bubble began to deflate.
By the next year, the economy was sinking into recession, and the banking system faced serious problems.
Other Regime Changes came to mind this week.
On July 2, 1997, Thailand lost its battle to maintain the baht’s peg to the dollar.
The newly floated currency quickly sank 20%.
Soon, so-called “Asian Tiger” currencies were all suspect.
The consequences of de-risking/deleveraging contagion were devastating for the likes of Indonesia, Malaysia, South Korea, and the Philippines.
Currency and bond market collapses triggered Credit contractions and economic depressions.
The fledgling “Asian Tiger” Bubbles, stoked to perilous excess after the Mexico bailout, collapsed catastrophically.
The March 2008 Bear Stearns collapse also comes to mind.
Six months later, the Treasury put Fannie Mae and Freddie Mac into conservatorship, and the following week Lehman Brothers, having lost access to repo borrowings, failed and – as they say, “the rest is history.”
Back to Monday’s VIX action.
We are told not to read much into the spike to 66 because of illiquidity issues in some instruments used to calculate the VIX price. Fair enough.
Yet the story from Monday is how quickly the entire spectrum of markets – stocks, Treasuries, corporate bonds, munis, currencies, and the derivatives complex – can dislocate into illiquidity.
Monday looked like a Regime Change day.
Momentous latent risks were revealed.
While it ended up not unfolding, there was palpable market fear of global de-risking/deleveraging being transmitted to the highly levered U.S. Credit system.
There are enormous domestic “carry trades,” where speculators have shorted Treasury and agency debt and used the proceeds to lever in higher-yielding corporate credit (bonds, private credit, structured finance, etc.).
An unwind of these types of trades would spark panic buying and a collapse in Treasury yields.
And when markets begin to dislocate – panic Treasury purchases, spreads blowing out, deleveraging, and illiquidity – I suspect concern turns to the stability of the massive “basis trade” (levered long cash Treasury bonds against shorts in Treasury futures).
There is enormous leverage in various perceived stable “basis trades” – where both sides of the trade are highly correlated and quite stable – such as Treasury cash bonds versus Treasury futures.
Playing these types of spreads is basically free money - unless something goes really haywire.
If the unwind in the yen “carry trade” marks a Regime Change in global levered speculative finance, these highly levered “basis trades” should be increasingly suspect.
When markets turn illiquid and start to go haywire, as they did Monday, the fear is that things could go really haywire – crash type haywire – if these powerful “basis trade” operators find themselves in trouble.
Such concerns would provoke a mad dash to the safety of Treasury bonds, which would trigger stress and dislocation in myriad trades that are short Treasuries.
The unwind of such “carry trades” would weigh heavily on general market liquidity – placing other levered trades – including “basis trades” – in jeopardy.
And that these “basis trade” players borrow aggressively in the money markets creates vulnerability to a Lehman Brothers type scenario.
I don’t want to get too far ahead of myself. But, then again, Regime Changes can unfold abruptly.
August 7 – Bloomberg (Lisa Du and Ruth Carson):
“In less than a week, Japan has completely upended the world’s expectations for its markets and economy.
The country was the darling of the financial world for over a year.
Its weak currency pushed the stock market to record highs and rekindled inflation after decades.
Then the Bank of Japan hiked rates last Wednesday and Governor Kazuo Ueda indicated he intended to keep going, helping trigger a sharp rise in the yen and wild gyrations across the global markets.
Traders and investors were forced to abandon strategies based on macro views that Japan’s currency would stay weak and interest rates wouldn’t rise too fast.
‘Without a doubt this is absolutely new ground for markets.
There’s soul searching everywhere now that we have a BOJ that seems hellbent on getting away from years of zero or negative rates policy,’ said Stephen Miller, a consultant at Grant Samuel Funds Management and former BlackRock Inc. fund manager.
‘Japan is now at the center of emergent worries — across everything, stocks, bonds, yen, credit, everything.’”
Quite a week.
By Friday, I’ll assume FOMC members were relaxed and thinking about their weekends.
Just markets being markets.
“Emergency meeting LOL!!!”
The reversal of hedges and the well-conditioned buy the dip crowd provide a potent combo.
And rallying markets will mask mounting liquidity issues, while keeping the Fed’s attention squarely on economic data.
Our central bank wouldn’t give Regime Change a second thought.
But how about the big levered speculators that must stay fixated on liquidity?
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