From the mind that brought you the Great Vega Short comes the next masterpiece on liquidity, volatility, contagion and everything else.
The world economy is fighting a fearsome wildfire as the European sovereign debt crisis burns its way closer toward the tinderbox of a second global recession. The insolvency inferno has no prejudice and will fuse to the flesh of any asset class fueling a blistering spiral of correlation and volatility. The third quarter of 2011 was characterized by explosive movements in equity markets as the S&P 500 index declined -14% in the worst performance since the crash of 2008. Global indices officially entered bear market territory with the MSCI All-Country World Index down more than -20% since peaking in May. The 10-year US Treasury yield reached the lowest level on record in September as credit markets braced for an economic slowdown. Over the quarter implied volatility increased +96% as the VIX index climbed to 42.96. If you heeded the omens of variance markets earlier this year you were richly rewarded by this increase in volatility.
A wildfire is blind and cruel in violently transforming the essence of any material to ash. In this sense the end-effect of fire is always correlation and volatility. The common method to extinguish a wildfire is by dousing it with water but what if this is not enough? Is it possible for fire to resist or spread through the addition of liquidity? Ironically in recorded history there is one such type of flame... Greek Fire. Greek Fire was the most feared weapon of the Byzantine Empire because water alone was powerless against its flames. The composition of the weapon is an ancient secret but modern scientists believe it was made with calcium phosphide (heating lime, bones, charcoal) which, upon contact with water, ignites spontaneously. Greek Fire was so difficult to extinguish that it was known to continue to burn even underneath bodies of water. The fire could fuse to any surface, including the sea, explode and spread uncontrollably. For this reason the ancient napalm was very effective in naval warfare and saved Constantinople from two Arab sieges. The guardians of the formula were so afraid it would fall into enemy hands that its secrets were eventually lost to time(1). For those who fought against Greek Fire a liquidity trap became a liquidity grave.
In the new era of global interconnectedness liquidity alone is not enough to extinguish Europe's Greek Fire. The smoldering flames of default are spreading impervious to fiat money creation. The unintended consequences of unprecedented intervention in markets are culminating in higher cross-asset correlations and violent price gyrations. All we left have to show for our three year liquidity orgy is the most correlated period in modern finance. The propensity for erratic movements in DJIA daily lagged returns is at the most extreme levels in over nine decades of recorded data. We are trapped in a binary market governed by the flip of a macroeconomic coin with deflation on one side and government bail-outs on the other. In this hyper-correlated market many alpha generating strategies resemble directional volatility trades.
The more global asset classes move in lockstep the more haphazardly the international response to the crisis has become. A currency war is raging as central banks alternate dousing sovereign insolvency flames with uncoordinated currency devaluation. Whether this is Brazil unexpectedly cutting rates by 50 basis points despite the highest inflation in six years or Switzerland pegging the Franc to the Euro to protect exports it is every man, woman, and central bank for itself. Every day we see new kinks in the armor of prior economic and political alliances that lay vulnerable to surrender in a vicious self-reinforcing cycle of devaluation. While public opposition grows to bail-out economics the Federal Reserve has very few credible stimulus options remaining to battle the inferno.
Greek Fire in Europe threatens to ignite a global recession and if you haven't already noticed, your alpha is burning. There are no safe havens and to survive the flames of the next decade we must embrace and harness their nature.