There are market crashes and then there are market crashes: by contrast to August 24, when the S&P500 melted down before our eyes in a sharp, violent plunge as something clearly broke in the link between ETF and vol models and the VIX itself did not report updates for nearly an hour for reasons that have still not been clearly explained, the recent global market crash has been far more contained, if not outright orderly. Or rather, orderly except for certain products like swap spreads and bank CDS which have seen a selloff which is on par, if not worse, than the 2008 financial crisis.
This, according to Citi’s Matt King, is the biggest surprise about the recent global market crash: how orderly it has been in some products, and how volatile, chaotic, and acute in others.
As King writes, “as relentless and unpleasant as the YTD moves in markets have been, they have also been remarkably orderly. Banks’ share prices may have dropped, but this seems more a response to fears of generalized pressure on net interest margins than of any concern about trading losses. Hedge funds’ returns have mostly varied between lacklustre and dismal, yet there has been remarkably little sign of outright distress or forced selling. And implied volatility across markets, while it has picked up, has been lower than would normally be associated with sell-offs of this magnitude (Figure 1 and Figure 2).”
King’s explanation for this is that “those suffering in the current environment are not so much our immediate clients – institutional investors running positions tactically against some benchmark and then being caught offside – as their clients, namely end investors, be they institutional or retail, managing strategic positions against long-term liabilities, who are much less likely to use vol or other short-term hedges and are more likely simply to sell.”
That covers the orderly part of the selloff; here is King on the disorderly:
Coming apart at the seams
Yet for all its apparent orderliness, a number of metrics have been showing signs of stress – and severe stress at that. The most widely reported is the move negative in $ government-swap spreads. But it coincided in credit with a sharp move negative in the cash-CDS basis (i.e. underperformance of cash bonds vs derivatives), and another move negative in the index skew to intrinsics (i.e. underperformance of single-name CDS relative to traded indices, Figure 3). As with government-swap spreads, both moves have been global, but more pronounced in $ than € or £.
To King what is “striking” is that in many respects these are the opposite of the moves which might normally be associated with market turmoil. Here’s why:
In a straight flight to liquidity or quality, government bonds are usually thought to outperform swaps, not underperform them. This is what happened in October 1998, or in 2007 to early 2008 (Figure 4). Similarly in credit, if there is a scramble to reduce long risk positions you might have anticipated the traded indices would underperform versus their constituents, as was the case in the sovereign debt crisis in 2011. These sorts of capitulatory moves have been visible over the past week, but only as a reversal of previous tendencies.
Superficially, there is no simple explanation:
Nor is an explanation obvious on fundamental grounds. Indeed, some have quipped that negative swap spreads – in which long-dated Treasuries trade wide to longdated swaps – imply that the US government’s credit quality is deemed by the market to be lower than that of a panel of banks. We have never liked that explanation: swaps involve no exchange of principal, a daily collateralized mark-tomarket, and hence greatly reduced credit risk relative to a bond purchase, for a start. But even the conventional view of swap spreads as a reflection of the cost of funding a long Treasury position on repo leads to the counterintuitive conclusion that it seemingly costs more to borrow cash for 30 years in $ secured against Treasuries than it does to borrow for 30 years unsecured.
Here is what King thinks is happening:
This does, though, point to what we think is the common explanation. The cost of funding, or more specifically of leverage, has everywhere gone up, as a direct consequence of leverage ratios and other constraints on bank balance sheet size. This has interacted with mutual fund outflows and fears about cash market illiquidity, producing a premium on liquid derivative instruments relative to their supposedly more plain vanilla cash cousins.
As such, the government-swap spread move is not really a reflection of either government or of bank credit quality, but rather of banks’ aversion to providing any financing which would clog up their balance sheet for long periods of time, and of providing financing against something as low-margin as US Treasuries in particular.
Just as the drop in market turnover has been more pronounced in govies than in credit, so it is actually the safer products (which employed more leverage, and where margins were lower) which in a balance-sheet constrained environment are most susceptible to seeing their previous liquidity premium turn into a liquidity (or balance-sheet) discount.
Likewise in credit, although negative bases in theory represent a potential arbitrage, where cash bonds can be bought and then the credit risk hedged with CDS, in practice most investors like to do such trades with leverage, ideally financed to term. It is exactly this sort of term financing of leverage on “safe” positions which leverage ratio and repo constraints (such as LCR and NSFR) have now made so difficult.
In principle the level of the basis has recently been so extreme that even unlevered positions would make sense. But so large have been the inflows to credit mutual funds in recent years – and so large is now the fear of illiquidity as such inflows turn to outflows – that investors seem (finally) to have been adopting a stance we have recommended for years, namely holding large cash buffers against potential redemptions and then selling index protection so as to try to neutralize their market risk.
Which in turn brings us to what DB’s Dominic Konstam wrote a week ago, when he summarized the global risk off catalyst as simply as the following: “it is a run on central bank liquidity, especially dollar based and there needs to be much more ($) liquidity.”
Which, as we also wrote recently, translates into something very simple: in their attempt to “fix” the market, central banks broke it, and the more they try to “fix” it, the worse it gets.
In a follow up article, we will look into the answers to the two key follow up questions: “why now” and “where next.”
via Zero Hedge http://ift.tt/1KgYNPe Tyler Durden