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3 Things - Volatility, The Fed And Yield Spreads

Tyler Durden's picture




 

Submitted by Lance Roberts via STA Wealth Management,

Volatility Warning Signs

Since the end of the Federal Reserve's latest QE program, market volatility has picked up markedly. Since October, as QE came to its final bond buying conclusion, the drain of liquidity begin to financial market activity. As shown in the chart below, there have been three fairly sizable selloffs last quarter of 7.9%, 5.0%, and 4.3%.

VIX-SP500-010815-2

Not surprisingly, those selloffs gave birth to sharp spikes in volatility of 118%, 99% and 46.9% currently.

Since the beginning of QE-3, at the end of 2012, the financial markets have been on a seemingly unstoppable rise. While virtually 100% of all economists, analysts, and financial bloggers are currently expecting a continuous rise in asset prices for several more years, the one constant has been a steady decline in volatility. The lack of "fear" in the financial markets has been the "sirens song" for investors to step up to the casino table and place their bets in a seemingly "can't lose" bet. Each dip has now taught investors that such moments are fleeting, and those declines are best ignored. That is a dangerous lesson, to say the least, as things may now be changing.

The chart below shows a 6-month average of the volatility index. By smoothing the index, we can get a clearer picture of the trend of volatility over time. As shown, the trend of volatility has been in a steady decline since the beginning of 2013 but is now showing signs of making the first turn higher since the 2011 debt-ceiling debate market rout.

VIX-SP500-010815

As shown by the red arrows, historically the turns higher in the smoothed volatility index have either occurred near major market peaks or during major bear markets. While it is clear that we are currently NOT in a major bear market as of yet, the turn higher in volatility is a clear warning sign that the six-year bull market in equities, one of the longest uninterrupted runs in history, may be nearing its end.

Is The Fed Still Saving Your Bacon?

Speaking of these successive V-shaped, "Buy The Dip", market corrections as of late, it really isn't something new. Ever since the beginning of 2013, the financial markets have steadily "bounced" their way higher with seemingly each sell-off being magically lifted off support just before real "panic" set in. Is that just a coincidence? Maybe not?

The chart below is the weekly changes the Federal Reserve's balance sheet. As shown, each "V-shaped" action in equities has been marked by a relative decline, and subsequent surge, in assets on the Fed's balance sheet.

Fed-Balance-Sheet-SP500-010815

While the latest weekly change has not been published yet, I have noted an "estimated change" in balance sheet assets (red vertical bar) that would coincide with the last "ramp recovery" in the markets following the end of December and early January sell-off.

There is little doubt that the Federal Reserve has a vested interest in ensuring that financial markets continue to move higher as consumer confidence is critically important to keep the global deflationary pressures at bay. The danger, of course, is that continuing to increase the deviation in asset prices from long-term trends, as discussed recently, leads to terrible outcomes. Of course, it is "different this time," right?

Yield Spread Is Falling

One of the arguments used to support the ongoing bull market in equities has been the yield curve. As long as the yield curve is not inverted there is absolutely no danger of a recession, and therefore you should be long equities. The chart below shows the spread between the 10-year and 3-month Treasury bonds.

Yield-Spread-10-3-010815

As you can clearly see, the analysis is correct.  There has not been a recession when the spread between these two interest rates is positive. However, here is the problem - yield spreads tend to fall extremely quickly.

As of the close yesterday, the interest rate on the 10-year bond was a 1.95%. With the continuing rise of the US Dollar relative to the Eurozone and Japan, I fully expect that interest rates could fall very close to 1% this year. With the Federal Reserve threatening to start increasing interest rates in the next few months, it will not take much to push the yield spread close to zero.

While portfolios should currently be weighted towards equities, as the long-term bullish trend remains intact, it is important to remember that the supportive underpinnings are deteriorating. Valuations are elevated, bullishness and complacency are high, and deviations are at extremes. The combination of these ingredients has never led to a profitable conclusion and expecting a different outcome this time will likely lead to excessive disappointment.

 

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Thu, 01/08/2015 - 16:21 | 5638534 Hitlery_4_Dictator
Hitlery_4_Dictator's picture

Eh, I'm not afraid. My nig obama, he got this.

Thu, 01/08/2015 - 16:27 | 5638545 Sudden Debt
Sudden Debt's picture

The Fed won’t wait that long before to step back in, by june we may expect another QE that will blow away all the others.

So the most important thing to watch is the dollar and the euro. 

If the dollar gets to strong, they put a brake on it as a weaker dollar is key for the American economy.

Just look at Japan before they started the QE binge, the Yen was getting to strong and Abe did everything to crush it. Yellen will do the same once the trade deficit number come in and show up negative.

And the following shortsqueeze will catapult the markets up while crushing every short fund to go boom.

Thu, 01/08/2015 - 17:33 | 5638855 ultimate warrior
ultimate warrior's picture

I have been thinking a lot lately about when/how the fed unleashes another QE program and I am starting to think they won't go big on QE4. I think they will go in increments of maybe 10-20 billion a month with no mandate. That way they can say this is only "temporary" and yet they can begin propping assets back up while also saying the economy is doing ok just not great. They might also see that Japan going all in with huge stimulus hasn't worked so they may take the approach of gently easing back into the propping up game.

Thu, 01/08/2015 - 19:03 | 5639198 Sudden Debt
Sudden Debt's picture

Once you start printing you can’t go back.

When you have a reserve  urrency, you need to have a constant deficit to maintain it and that’s slowing down now.

the fed’s balance sheet is nearing 5 trillion and it will implode in value if they don’t keep propping assets up.

America has a current deficit of 1 trillion plus a year and there’s not enough money in the world left on extra to keep funding it on the open market.

There’s simply no way back without extreme hard cutbacks and politicians never do that. It’s a 4 year timeframe and than it just resets.

America has a vast Army, it’s scaling down in europe right now and closing bases this year already. Funding that machine takes a lot of money that the US doesn’t have. But all what’s holding the dollar together is it’s army, same for the english empire and every empire before.

cutting down was their first sign to but it took a black swan like WOII to give up it’s power over it’s colony’s.

 

Thu, 01/08/2015 - 17:34 | 5638857 mmanvil74
mmanvil74's picture

So the charts pretty much prove that the FED is directly or indirectly "supporting" stock prices.  This is pretty much old news by now, however, it may explain why "it really is different this time".  QE in the US wasn't here before 2009 so in an important sense, it IS different this time.  

The big question of course is will the FED continue supporting equity prices in the same way or to the same degree in the future as it has over the last six years.  One would generally assume the answer is yes, the FED will continue easy(er)(est) money policies forever until the system really does blow up a la hyperinflation.  

I think it is pretty clear from the Japan example that once rates touch zero and QE begins, there is no going back.  The ECB is about to launch QE and any sign of (spx) market weakness will likely bring the FED right back into another QE.

At this point, via QE, we have basically allowed the direct interference in free markets by entities with unlimited money creation powers.  Yet, somehow, out of all of this, we experience DE-flation.  Amazing.  Really.  Amazing.

The only explanation I can come up with as to why we have deflation and not inflation, which is based on my relatively amateurish understanding of global finance, is that none of this QE is "real" money ie. capital, it is debt.  And adding debt on top of more debt is not the same as "printing" money, it is more akin to increasing a person's credit card balance (adding credit), than it is to increasing a person's bank account balance (adding debit), except in this case the "person" is our entire economy and all of the independent players in it.  

Increasing a credit line with QE does not necessarily induce more spending or lending, especially if the underlying income and assets of the debt laden entity go unchanged or decline.  If I can't find productive investments, I will not take on more debt, even if the bank dangles almost free money infront of me, because either way, I still have to pay it back.  

Adding money to one's bank account balance (a debit) most certainly would induce spending and higher inflation but that is not what QE effectively acheives (which is probably why the very idea of distributing money directly to consumers is now being circulated at the ECB).  But notice the difference in spending behavior if the money that was given to consumers had to be paid back, vs. money that was given and never had to be paid back.

At the end of the day, real income producing entities (consumers and businesses) have to willingly take on more debt for QE to acheive any long term broad based inflation, and there are only so many (few) of us "real" income earners left, especially after you subtract all of the costs of our socialized governments, which is why we've seen large increases in student loan debt and sub prime auto debt in the US, since these represent the only under-maximized debt seekers available in the market.  This is another reason why Obama lowered the down payment requirements for FHA loans to 3%, to help the hedge funds unwind their now profitable positions in US residential real estate and bring on ever more marginal borrowers.

The "bedrock" of the entire global financial system are US treasuries, backed by nothing more than "debt printing" not "money printing".  It is for this reason interest rates are falling not rising, there is no way for rates to rise when the underlying asset is "thin air".  The net result from QE has been to create asset bubbles, perpetuated by the entities/banks/hedge funds that are closest to the debt spigot.  They then take the free debt money and speculate on a variety of asset classes (first oil and spx, then greek bonds, now Chinese equities).  The bubbles seem to be moving around from asset class to asset class, leaving semi-busted markets in their wake (eg. oil, greek bonds), all the while drawing profits back up to the biggest players in the game.  But from the FED's perspective, better to have asset bubbles than no inflation at all.

Thu, 01/08/2015 - 18:10 | 5639017 max2205
max2205's picture

When the 10 yr hits zero it will be the moment we can all say we are fucked

Thu, 01/08/2015 - 16:31 | 5638560 deeply indebted
deeply indebted's picture

So.. Print more "money!" Then we just sit back and watch the animal spirits catch up. Oh, wait.. We've tried that already, haven't we?

Thu, 01/08/2015 - 16:31 | 5638563 buzzsaw99
buzzsaw99's picture

so btfd then?

Thu, 01/08/2015 - 16:35 | 5638578 pocomotion
pocomotion's picture

Hey Sudden,,,  We've both been here at 0hedge a while...  Just asking a small correction in usage -- "to", too and two. I want you to know two things.  There is too many problems to count even after you see the first two (2). 

ok, carry on....

Thu, 01/08/2015 - 16:40 | 5638595 Sudden Debt
Sudden Debt's picture

To wrong too’s isn’t two bad he

Thu, 01/08/2015 - 16:45 | 5638612 BandGap
BandGap's picture

Don't you mean "are" instead of "is"?

 

Glass houses, stones and all that.....

Thu, 01/08/2015 - 20:55 | 5639614 pocomotion
pocomotion's picture

Shocking, simply shocking.

Thu, 01/08/2015 - 16:41 | 5638600 ebworthen
ebworthen's picture

Markets up 1.8% in a day after being down 1.8% a couple days before.

4%-5% swings in days and oil down 50%+ in a month is going to shake some things out.

Thu, 01/08/2015 - 16:50 | 5638648 BandGap
BandGap's picture

Yes, the frequecy and amplitude increases with each spasm. Oil has stayed in a tight range even when squeezing shorts. It is heading down another $5 before the end of this month. 

 

https://www.youtube.com/watch?v=3mclp9QmCGs

Thu, 01/08/2015 - 16:52 | 5638660 new game
new game's picture

indicies moving in lock step. it's like they are taking marching orders. wow, feel so happy to be on the side lines. at my age i couldn't do it. more power to ya if ya makin money. only possible trade will be oil when see capitulates...

Thu, 01/08/2015 - 16:52 | 5638661 Chad_the_short_...
Chad_the_short_seller's picture

It's about time to go long uvxy again. Think I'll re enter at the close. Tomorrow and next week should be VERY interesting.

Thu, 01/08/2015 - 17:17 | 5638788 Ewtman
Ewtman's picture

How anyone can believe the FED will be capable of re-flating the collapsing credit bubble is mystifying. 

The Fed's days are numbered

http://www.globaldeflationnews.com/the-creature-from-jekyll-island-the-e...

Deflation will win

http://www.globaldeflationnews.com/inflation-vs-deflation-part-1which-on...

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