Volatility

Consumers are paying an easy $35 dollars per barrel over what they would otherwise dole out for a barrel of oil if fund managers didn`t use the benchmark futures contracts as their own personal ATMs.

Two years ago, in January 2010, Zero Hedge wrote "This Is The Government: Your Legal Right To Redeem Your Money Market Account Has Been Denied" which became one of our most read stories of the year. The reason? Perhaps something to do with an implicit attempt at capital controls by the government on one of the primary forms of cash aggregation available: $2.7 trillion in US money market funds. The proximal catalyst back then were new proposed regulations seeking to pull one of these three core pillars (these being no volatility, instantaneous liquidity, and redeemability) from the foundation of the entire money market industry, by changing the primary assumptions of the key Money Market Rule 2a-7. A key proposal would give money market fund managers the option to "suspend redemptions to allow for the orderly liquidation of fund assets." In other words: an attempt to prevent money market runs (the same thing that crushed Lehman when the Reserve Fund broke the buck). This idea, which previously had been implicitly backed by the all important Group of 30 which is basically the shadow central planners of the world (don't believe us? check out the roster of current members), did not get too far, and was quickly forgotten. Until today, when the New York Fed decided to bring it back from the dead by publishing "The Minimum Balance At Risk: A Proposal to Mitigate the Systemic Risks Posed by Money Market FUnds". Now it is well known that any attempt to prevent a bank runs achieves nothing but merely accelerating just that (as Europe recently learned). But this coming from central planners - who never can accurately predict a rational response - is not surprising. What is surprising is that this proposal is reincarnated now. The question becomes: why now? What does the Fed know about market liquidity conditions that it does not want to share, and more importantly, is the Fed seeing a rapid deterioration in liquidity conditions in the future, that may and/or will prompt retail investors to pull their money in another Lehman-like bank run repeat?

With Corn hitting its highs again, we are reminded that global food production has been hitting constraints as rising populations and changing diets hit against flattening productivity, water and fertility constraints, and the likely early effects of climate change. As was described in the recent all-encompassing theory of global-collapse, there is general agreement that one of the contributing factors to the rolling revolutions beginning at the end of 2010 was increasing food prices eating into already strained incomes. It is unclear how much impact easing has had on food prices this time, weather has very much made its presence felt (as we noted here). From one omnipotent force (central bankers) to another (hand of god), the fear is that more broadly, food is likely to be a more persistent problem than oil supply. This is because we require almost continual replenishment of food to stay alive and avoid severe social and behavioral stress - food is the most inelastic part of consumption. This says nothing of the pernicious inflationary impact that will likely quell the kind of free-flowing printing so many hope to see from China et al.

Market-top economics could be an entire university course, if people cared enough about such phenomena.  Most only consider the signs of a market top months or years after a crash when some unyielding economics researcher puts the pieces together.  As human-beings we have developed an uncanny ability to rationalize what we know to be bad news and convince ourselves, "This time is different," despite the fact that it usually never is. In a previous article we provided analysis on economic/equity decoupling (cognitive dissonance) and showed that the economy as we know it cannot persist--we are either due for a literal gap-up in leading economic conditions, or we are due for a serious correction in US equities.  With today's 5.4% slip in existing home-sales, let's go with the latter.

Is it us? Today felt very nervous. The equal narrowest range in S&P 500 e-mini futures (ES) in over 3 months along with dismally low volume and even worse average trade size as we peaked over July 5th's swing high and fell back. Aside from the farcical trading in the big Dow supporting stocks that we just noted, most asset classes traded along with stocks - in a very narrow range. The big movers were oil - up over $92 - on Israel-Iran tensions (among other things) and the major financials - which in general have retraced all of their post-EU Summit euphoria now (with MS breaking down 6% today). EURUSD did its by no standard dip and rip through the US open to EU close and ended the day unchanged. Treasuries limped a little higher in yield (~1-2bps). VIX plummeted to 15.45% (zero premium to realized vol), down 0.75vols - its lowest close in over 3 months - but this was not enough to provide any more juice for stocks which meandered, ending fractionally higher. Gold and Silver slithered sideways - with a very modest upward bias as Copper was helplessly led a little higher by Oil's exuberance and a slight limp lower in the USD on the day as the AUD extends its gain to 2% on the week against the greenback. We can't help but reflect on this chart as we see a retest on low volume and low average trade size following the very same path as last year. For now, complacency rules.

Hedging basic equity positions with options is nothing new. Buying Puts or selling calls to protect or enhance your position is not uncommon. The relative price that is paid (or received) for that protection is the implied volatility - it is the lever with which supply and demand for protection is turned. Strategies to hedge large equity positions have become more and more complex (as more and more complex instruments have become available). A more advanced strategy is to buy risk-reversals (long out-of-the-money VIX calls against short out-of-the-money VIX puts) which creates a 'synthetic long volatility position' to hedge the long equity underlying position. This strategy has been very successful in hedging downside in the S&P 500 since the crisis began. The last few weeks has seen the return from the hedged strategy converge to the S&P 500's performance and we suspect this has been the trigger for exits. This unwind of a very popular risk-reversal hedge in VIX options is implicitly like selling volatility - hence the dramatic outperformance of front-month vol even as stocks and credit are not soaring to such highs. Watching the skew between VIX calls and puts may give us some sign that this exuberant compression is over.

There is a strange delayed reaction between the initial exposure of weakness in the financial system and the public’s realization of the truth, sort of like Wile E. Coyote dashing off a cliff in the cartoons only to continue running in mid-air above the abyss below.  It is a testament to the fact that beyond the math, there is an undeniable power of psychology in our economy.  The investment world naively believes it can fly, even with the weight of endless debt around its ankles, and for a very short time, that pure delirious oblivious belief sustains the markets.  Eventually, though, gravity always triumphs over fantasy…

VIX is now trading with a 15 handle - at its lowest since early April. At current levels of exuberant complacency, the S&P 500 should be trading over 1400 and HY credit spreads back at 500bps. The volatility term structure has collapsed in the last month or two as it appears that there remains an extremely well-capitalized vol-seller at the front-end of the curve - unafraid of risk flares as they pick up those nickels in front of the European steam-roller. We can see two reasons for this compression (from a fundamental perspective): extreme confidence in NEW QE appearing shortly (and suppressing vol as it does) or more likely a vol steepener out beyond the German judge's decision on Spain's bailout constitutionality - or just call-writing retail monkeys following TD Ameritrade's CEO's advice - what could go wrong.

Ben Bernanke will deliver the semiannual report on monetary policy to the Senate Banking Committee Tuesday. The market is hoping and praying that the Chairsatan will make it rain. He won't. In fact, as explained earlier, it is likely that Ben will say absolutely nothing of significance today and in a world in which only the H.4.1 matters, this is not going to be taken well by the market. Of course, if Benny does crack and promises to push the S&P to 1450 just in time for the re-election, all bets are off.

UPDATE: Biggest down day in Faceplant since 5/29 (down 8%) to close at $28.25 on double recent volume.

This was the narrowest day's range in S&P 500 e-mini futures (ES) in over three months and volume was dismally slow as it clung to its 50DMA amid larger than normal average trade size. Elsewhere, markets were anything but dead. Commodities dipped and ripped with WTI breaking back over $88 on Saudi news and Silver/Gold/Copper all ending around unch on the day but leaking off their highs into the close (though well off lows). For a while 'bad was good' as the retail sales print prompted QE-on-esque trades with Gold up, USD down, and Treasury yields plunging to near-record-lows. FX and commodities appeared to catch up to stock's more sanguine view of things from Friday but once there, Treasury yields reversed and rose into the afternoon as EURUSD continued to rally back well into the green (repatriation?) dragging the USD down 0.25% from Friday's close. Credit notably underperformed equities on the day (with HYG stumbling into the close). It seems everyone is waiting with baited breath for Bernanke's speech tomorrow and VIX (which is back in line with realized vol for the first time in 5 months) limped higher by around 0.4 vols to 17.1%.

"Thank you ZIRP, may we have another." This is what the 1.6 million workers who have invested their retirement money with America's largest pension fund, California's CALPERS, may want to ask Chairman Ben following the firm's just announced results for Fiscal 2012 (ended June 30). The end result: +1% nominal return, which means a negative real return. And this is even including the now traditional end of June ramp which this year came courtesy of the now largely irrelevant European summit, which nonetheless ramped stocks and likely meant the difference for Calpers between positive and negative on the year! Sadly just one "another" year would not be enough, but a whopping 7 more would be needed, because as is well known, for all actuarial purposes Calpers, as well as the bulk of US pension funds, use a 7.5% discount rate. In other words, Calpers missed the minimum return it needs to not require overfunding by, oh... 87%. Here is Calper's Mea Culpa: "CalPERS 1 percent return is below the fund’s discount rate of 7.5 percent, a long-term hurdle lowered recently in response to a steady decline in inflation and as part of CalPERS routine evaluation of economic assumptions." At this rate, courtesy of ZIRP and the destruction of equities as an asset class, until the 2s30s is flat, and we have terminal wheelbarrow lift off, Calpers will no choice but to keep revising lower and lower until its discount rate is negative in line with the imminent advent of NIRP. Good luck with those actuarial tables with a negative discount rate.

Things are getting a little 'strange' in Europe. European equity markets (and voatility) have disconnected from the reality of European corporate, financial, and sovereign credit. As the massive bifurcation in sovereign yields continues - with Spain near record-highs and Swiss/German at record-lows - equities are still significantly higher post the EU-Summit (and vol massively so) as credit of any kind is dramatically wider. Specifically, 1) Europe's broad equity index is massively outperforming credit post EU Summit; 2) Europe's broad equity index Vol is majorly disconnected from XOver credit; and, 3) Europe's broad equity index is in-line with GDP-weighted sovereign risk BUT dramatically dislocated from Italian and Spanish risk (that is reflective of the core of the stress). Just as we have seen in the US, the method of choice for 'pumping hope' into equity market valuations is through the levered selling of volatility - it seems some-one/-thing with very deep pockets is getting awfully brave as Europe's VIX drops to near pre-crisis levels (and its steepest in months as short-term complacency surges).

Europe slipping into (light) ROff (and then out). Recurrent picture of Hard Core grinding tighter, Soft Core doubling down on that . Peripherals drifting wider with Italy eventually further off the 6% mark and Spain at 6.77%. Equities about unchanged after all.

BKO eventually closing on a historic -0.060% low.

Slow dragging day, if it wasn’t for the EUR jogging back and forth all the time. Something gotta move, I guess.

S&P 500 e-mini futures (ES) traded up to almost perfectly recapture their 415ET close from last Friday after a 15-point, 30-minute ramp out of the gates at the US day-session open recouped five days of losses - as once again - we go nowhere quickly. Just for clarity: China GDP disappointed and provided no signal for massive stimulus; JPM announced bigger than expected losses, cheating on CDS marks, and exposed just how large their CIO was relative to income; Consumer sentiment printed at its worst this year; and QE-crimping inflation printed hotter than expectations - and we get a more-than-30 point rally in the S&P. Whether the fuel was JPM squeeze or another big European bank biting the liquidity dust and repatriating cajillions of EUR to cover costs (or Austria needing some cash for a debt payment), what was clear was equity market's outperformance of every other asset class - with the late day surge for a green weekly close particularly noteworthy. Apart from unch on the week, ES also managed to close right at its 50DMA, revert up to credit's less sanguine behavior intra-week, and up to VIX's relative outpeformance on the week (as VIX ended the week with its steepest term-structure in over 4 months). Treasuries ended the week 6-9bps lower in yield at the long-end (2-3bps at the short end) but the USD's plunge, on the absolute rampfest in EURUSD, took it back to unch for the week. Despite the USD unch-ness, Oil and Copper surged (on the day to help the week) up 2.5-3% on the week while even Gold and Silver managed a high beta performance ending the week up around 0.5%. ES ended the day notably rich to broad risk assets - and wil need some more weakness in TSYs and carry crosses to extend this - for now, the steepness of the volatility slope, velocity of squeeze, and richness of stocks to risk makes us a little nervous carrying longs here.

As Euro area policymakers continue to ‘muddle through’ the crisis, everyone's favorite FX Strategist - Goldman's Thomas Stolper, summarizes the decline in the EUR so far as due to slower growth and easier monetary policy, together with growing EUR short positions. Of course, the root cause of both developments is the political crisis in the Euro area. The uncertainty about the stability of the institutional framework of the Euro area forces front-loaded fiscal tightening, which in turn damages growth. In response, the ECB eased policy more than expected, while the Fed, did not ease as much or as early as many projected. Despite today's ecstacy in EURUSD, Stolper believes the EUR is unlikely to strengthen materially as long as this situation persists especially as the potential for the ‘fiscal risk premium’ to rise on the back of daily headlines that are dominated by disagreement and dispute remains. In an effort to clarify his thinking, Stolper identifies eight key issues that will determine the outlook for the Euro. Most of them relate to the Euro area crisis. The most interesting ones are possibly the timing of a recovery in the periphery, the ability of France and Germany to develop a common vision for further integration, and the evolution of fiscal policies in major economies outside the Euro area. He concludes that the risks in the near term remain substantial.