Prisoner's Dilemma: Will Investors And The Fed Collaborate?

Tyler Durden's picture

The recent market weakness (selling off in equity indices and widening in credit spreads) shares many elements of the previous dips this year, which should give bulls some comfort (the Italian- and Cyprus-led dips didn't last very long). However, there are elements which are concerning - as Citi notes, positioning in long equity and credit positions are notably 'long', and how weak cash credit has been this time around. As Citi points out, investors and the Fed are trapped in a prisoner's dilemma. Will everyone collaborate (investors hold to cash positions & dovish Fed) or betray (investors start unwinding cash positions & hawkish Fed)? The strategy each player follows will determine whether the weakness this time around is to be faded (like the previous ones this year) or not.

The following discussion - via Citi's credit team - relates to 'widening' in credit spreads but is just as useful in considering the weakness in equity markets since the cap[ital structure arbitrage-led relationship between equity and credit as liabilities on the balance sheet of a 'firm' means that any disconnect cannot last long.

Via Citi,

The recent widening on the back of concerns about a “rates back-up” (and its potential to create substantial selling pressure across many asset classes) shares, at least on the surface, many of the characteristics of two widenings we’ve experienced this year: the “Italian”- and “Cypriot”-led widenings in the second half of February and March, respectively. In those two cases, the widening faded after one or two weeks.

This time around, the credit index has not started to tighten (rally yet)...

However, as we show below, positioning this time around seems more stretched than in previous widenings and cash credit has been much weaker than anytime this year. As we argued last week, we are at a pivot point, and we expect US yields (on the back of the Fed’s message next week) to give direction to the market.

(Upper pane - credit positioning is the most 'net long' since 2011... Lower pane - equity margin account debit balances highest ever)


In all the three widenings this year, the weakness has been led by synthetic products, with

(i) real money investors holding to their cash positions and hedging with synthetic instruments (indices, single name CDS and options) and


(ii) fast money investors playing the momentum with, again, synthetic instruments.

This is very clear when we look at how the bond-CDS basis (Figure 3 below - a measure of how derivatives are used to hedge relative to cash positions actualy reduced), the index skew (Figure 4 below - i.e. basis between the index and its single name CDS constituents - which is basically a measure of how much demand for quick-and-dirty macro protection is relative to more selective derisking) and index implied volatility have during all three widenings (Figure 5 below - how much protection is being bid)

In all cases, the demand for synthetic hedges led these metrics to widen.

However, at least in the Italy- and Cypriot-led widenings, investors unwound hedges after one or two weeks, causing all the bases to normalise, implied volatility to fall and index spreads to tighten.

Although our feeling is that the sequence of events this time around will follow a similar pattern, there are a few developments this time around which are markedly different from the two previous widenings this year.

First, as the chart above shows, reported long risk positions have risen to the highest since May 2011. Although our impression when talking to clients is still that they are “long but not extremely long” and that they are trying to “be prudent”, the starting point this time around regarding investor positioning seems to be much more stretched judging from the results of our survey.

Second, the extent to which investors have used synthetic index hedges this time around seems to be much higher, judging from how client positioning via iTraxx Main has changed since the beginning of each of the three widenings this year – see Figure 6 (above).

Third, and probably most importantly, although cash spreads barely moved during the Italian and Cypriot-led widenings, they have widened significantly this time around – see Figure 7. Is this time any different then?

In our view, the synthetic market has played its leading part already and it is the cash market that we should be watching. We believe the crowded long risk cash / short risk synthetic trade will be unwound soon, but it’s very different if that happens because investors unwind the synthetic short or because they start unwinding the cash long.

Bernanke’s words next week will be very important for investors to decide the best course of action in the current prisoner’s dilemma they face regarding cash unwinds.

Investors are realising that trying to save themselves ahead of anybody else (i.e. be the first unwinding cash positions in size) may be what gives the final push to the large widening they were trying to protect against. Wouldn’t it be better if everyone held to their cash positions? Central banks would generally agree on this – will they play the “collaborative” approach? If everyone collaborates, this widening will be like the previous ones this year.

Most credit investors we have spoken to actually seem to believe that, after a 70bp move in 10yr US yields, the Fed is more likely to strike a more dovish note at next week’s FOMC to break the sharp upward trend than to allow it to continue unchecked.

But positioning is a problem as we highlighted above and the Fed may not be as dovish as the market would like next week.

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sitenine's picture

The fear of the coming crash is so great that everything will be tried before the final end. Nothing surprises me anymore. I don't personally give much of a shit what 'investors' do or do not do anymore. There is no rule of law, so what good would caring do anyway? Fiat paper promises should be forgotten right now. These debts won't be paid, and we've known that for a very long time now. I say let them think they can save the system, because it's giving us all time to prepare. So as much as they are doing the wrong thing, at least they are helping those who know the value of hard work and know how to prepare for hard times.

lasvegaspersona's picture

I tend to agree. I've talked to 2 congresscritters and a senator...all think they can fix things, no one is preparing the people for a fall.

there is and has been info out there for at least 4 years that something bad is coming. All who heed the warnings will be as ready as they can. The rest laugh at us as doomers...oh well. I've done my part. good luck to all..

CPL's picture

Most assassins through out history have known that cyanide goes well with something sweet with almonds in it to mask the flavour of the cyanide.

This goes for the prisoners dilemma quite well, because there really can only be a couple of survivors left to really make it worth anyone's effort at the end of the 'game'.  Don't trust the offer of short term gain for long term pain.  Congress people and Senators are already being led to the gallows in either selection they pick with rose coloured glasses.  Option One; their electorate will tear them apart.  Or option Two; they end up in the executive veal fattening pen and force fed all the sugary crap they can swallow until they burst (and replaced the same day).

Like those running the show need another cadre of 'older well heeled useful idiots' because there are always more to pick from.  Odd how the political model follows a crack dealer.  Just takes a suit, some stamped platitudes on a cue card, bit of marketing and suddenly you've got another sock puppet willing to tap dance for a currency backed with nothing and power that won't last more than the time in the chair they sit in.

So why are you even talking to them?  Talk to a herd of goats, at least they'll honestly appear confused rather than mask their fear and bewildering ostrich position with a sputtered remark about economies and community. 

They aren't worth the air in your lungs to pay attention to.  And now because you've talked to them, the only political action that's happened is you've probably managed to get on one of those numerous lists of people I hear about.  I would suggest leaving where you are and never looking back.  That's the price of political action in the world now because their is no political discourse the 'representatives' of the public body are capable of performing...other than recycle oxygen for the office plant life.

Prisoners_dilemna's picture

contrite tit-for-tat is, or was a good long term strategy for the PD.

but the fed has been fucking us for just about a century now. why are we still playing??

oh yeah, PD like fed forecasts are based on models that really dont reflect the complexness of decisions we must make...

ie. do I Audit the Fed or Occupy my Couch for another episode of Big Bang Theory.

CPL's picture

The odd thing is technology changed their end game.  Same technology that they invested into heavily to collect, manage and monitor is now the the boat anchor tied around their necks.


I wouldn't provide either position with any effort.  Big Bang has jumped the shark and the Fed just will one day simply not exist if only for a minor notation in a forgotten journal in a shuttered library of a Political person's name that nobody remembers.

Subscribe to a different model.  I like to call it do something else.  Gym, golf, volulenteering, gardening.  There is so much procedural stuff that people are going to need to learn quickly once this turns over.  This to the side of the more than likely 100% crop failure of the world's bread baskets which is another mess that nobody in the media has bothered exploring.  

You know, because crops love tornados, wild fires and drought.  For three years.  I'm going to hazard a guess that functional food stockpiles of everything are a little shallow right now after 7.2 billion people plough through a massive drop in production.  In fact I'm more that willing to bet substitution is happening like these articles that surface and get buried.


Donkey, buffalo, even human DNA taint most South African meat


Experts say it's likely human DNA could be found in meat


Never mind the horse meat, your burger might be part human


If you are in Europe, you've been eating it for three years as South Africa is the 'brazil' of most of Africa and Europe...(and Russia and the US).  Just look at all those 'beef' exports and where they go.  It a big business.  Otherwise it's a story that got snuffed out and part of the way to protect yourself from this shell game is to be involved both in the urban and rural situations in your area.  

Step one:  Disregard the government.  

Step two:  Start working in a framework of common sense. (if a 10 pound box of hamburgers is 10 dollars, and a pound of wrapped fresh hamburger is 6's probably not meat in those burgers)

Step three:  Enjoy people free meat.

I'm still sticking to my idea last year that Pork products are getting rarer and long Pork products are on sale.

Atomizer's picture

If you build it, they will come..

Social Media (GRAPHIC CONTENT) - By Deek Jackson

Poor Zuckerburg, good luck holding your stock above 10 bucks..


HulkHogan's picture

Terrible video. Now I'll have nightmares for months.

Spastica Rex's picture

Your mom has complex graphs and projections.

tradewithdave's picture

No.  As Martin Zweig's obituary will attest.  The timeline is not long enough.

The plan won't work unless they can convince John Q. Public to fight the Fed... just one time.

Nobody move or the Chair shoots himself.  Con Air. 


April 2012:



Mototard at Large's picture

The first one to defect gets the best deal!  Should be interestisng to see who makes the dash for the cash/door first.

q99x2's picture

More important question, the answer to which we know, will algos collaborate with the FED?

knukles's picture

Will everybody cooperate?
Everybody under the sun is going to piss, moan, beg to differ, have a better plan, cry the sky is falling, argue just to prove themselves right, be distracted and manipulated, cry the wealth of man is being endangered, blamed for being racist for disagreeing with something or other, change sides of the aisle, be tapped and spied upon, audited by the IRS, not audited y the IRS, worried sick about being audited by the IRS, the MSM will agree its all good, the reality-0-sphere will puke, and otherwise all will be harmony, goodness, holding hands and singing Kumbayah.

Fucking kidding me?

disabledvet's picture

this sounds an awful lot like and "Over There" problem. I can definitely see the Fed "in response to uncertainty" toe-jamming those US rates to "at or near zero" on the entire yield curve "just in case." So sure...i'll listen to what he says. But what the Fed DOES strikes me as a far bigger deal. "We're getting to the point of default" now...with Detroit "yet another in a long line of record breakers." Europe joined that club years ago in my view. Just ask Japan. "How have low to zero interest rates benefited their recovery?" And the answer of course is "not at all." So I say again "yet again the USA finds itself being the marginal buyer of everything produced on the entire planet." I really have a hard time seeing inflation being able to take hold ANYWHERE right now.

knukles's picture

De only probem wid Dee-triot be cain't prints our own monieeeees

 -Paid for by the Modern Monetary Theory Foundation

Umh's picture

I wouldn't take it. Would you?

shermacman's picture

Well of course the "investors" and the Fed have to collaborate. They don't much choice, do they? Unless they decide to go short or cash out...

tradewithdave's picture

The Fed is the "investor"... you can't co-llaborate with yourself... you can just laborate... like a labrador. 

New_Meat's picture

First prisoner who punches out: ftw!

andrewp111's picture

Talking about a 70 bps rise in the 10 y is kind of misleading and overly melodramatic. It is only half that if you look at actual Treasury auction data (they don't sell 10y notes all that often), and the trading data is very volatile but has been on a general uptrend for a whole year.

The bottom seems to have happened on July 16 2012 at 1.46%^TNX+Interactive#symbol=^tnx;range=1y;compare=;indicator=volume;charttype=area;crosshair=on;ohlcvalues=0;logscale=off;source=undefined;

Move along, nothing to see here.

Aurora Ex Machina's picture

The only real Game winning strategy is co-operation (or not playing, which only works short term in this world, you have a horizon of existential non-existence to worry about). This ain't hard, it's what has driven all the Trading Scandals we've seen.

The only reason the rest of this is playing out is because you're being lead by fuckwits. Or Morons. Or G-D deluded fanatics. Or a parasitical force we think might be abhuman. [Like Toxoplasmosis in cat lovers - we actually think this is the cause, and are attempting to narrow it down, but it's far more virulent and violent than the feline version. 2 billion people, largely in the West infected, this is not good].




The only real question left is the why's to the suicidal behaviors.

JohnG's picture



Fade.  Don't play.



NoWayJose's picture

Anyone lucky (smart?) enough to have ridden the equity rocket this long into 2013 should be cashing out before the world recognizes that the reality of tapering cannot meet the expectations of tapering.

kito's picture

Dow pushes higher and gold it or not....its still the primary trend.....

ZeroPoint's picture

It matters not. Even if gold lost 90% of its paper market value in the crash, it will still hold more value than paper.

sbenard's picture

IF the Fed were smart, they would begin "tapering" immediately. But then, if they were smart, they wouldn't have begun this no-win game in the first place. Bernanke has painted us into a corner! Greed will win out first, but lose out over the long run. We ALL lose this game in the end! Calamity is certainty. Plan and prepare accordingly!

ZeroPoint's picture

Or they can go Shawshank, grab the gold, food, farmland, guns & ammo and tunnel their way out.....