Volatility

The second bond auction of the week prices uneventfully, with the Treasury selling $21 billion of 10 Years at a yield of 2.043%, better than the 2.045% When Issued, and better than last month's 2.08%. Yet keep in mind that inbetween the March auction and today, the 10 year hit nearly 2.40%, so don't let the apparently stability give the impression that there is no volatility under the surface. Unlike the yield, the Bid To Cover dropped from last month's 3.24 to 3.08, which while week for recent auctions was just below the TTM average of 3.12. What is of note is that Dealers had to once again take down more than half the auction, or 50.5%, with the last time there was more than a 50% takedown being back in November 2011. Of the balance 11% went to Direct, and the remainder or 38.5% to Indirects. Overall, a quiet auction and now we just have tomorrow's $13 billion 30 Years to look forward to as total US debt approaches the $15.7 trillion milestone next on its way to the $16.3 trillion debt ceiling breach in 6 months. In the meantime enjoy fixed coupon bonds: for in one month, the FRN cometh.

While equity trading last March trading was affected by the excess volatility arising from the Fukushima explosions a year earlier, and the Japan earthquake induced volatility in general, today's monthly volume update by the NYSE shows that no matter what the reason for the volume collapse, toplines for banks and traders will suffer, on both a Y/Y as well as sequential basis. Per the NYSE: "European and U.S. Cash ADV Down 13% and 24% Year-over-Year.... NYSE Euronext European cash products ADV of 1.6 million transactions in March 2012 decreased 12.7% compared to March 2011, but increased 0.5% compared to February 2012. NYSE Euronext U.S. cash products handled ADV in March 2012 decreased 23.6% to 1.8 billion shares compared to March 2011 and decreased 0.6% from February 2012." An even bigger year-over-year collapse took place in the one product which everyone thinks is taking the place of individual stock trading: the synthetic CDOs known as ETFs: "NYSE Euronext U.S. matched exchange-traded funds ADV (included in volumes for Tape B and Tape C) of 222 million shares in March 2012 decreased 29.3% compared to March 2011, but increased 4.1% compared to February 2012. In the first quarter of 2012, NYSE Euronext U.S. matched exchange-traded funds ADV of 221 million shares was 21.8% below prior year levels." The YoY collapse in trading volumes for derivatives was less compared to cash, but the sequential drop from February 2012 was even more pronounced: "NYSE Euronext global derivatives ADV in March 2012 of 8.1 million contracts decreased 11.5% compared to March 2011 and decreased 15.4% from February 2012 levels." We can only hope that banks have found some innovative ways of compensating for this collapse in overall market participation, such as traditional revenue pathways like underwriting and advisory fees, as well as lending and arbing the carry trade. Alas, as the following Bloomberg piece points out, this will hardly be the case, as Zero Hedge has warned previously.

It seems the short-end of the volatility term structure is snapping shut on a few nickel-in-front-of-a-steamroller gatherers...

Imagine the world economy as an armada of ships passing through a narrow and dangerous strait leading to the sea of prosperity. Navigating the channel is treacherous for to err too far to one side and your ship plunges off the waterfall of deflation but too close to the other and it burns in the hellfire of inflation. The global fleet is tethered by chains of trade and investment so if one ship veers perilously off course it pulls the others with it. Our only salvation is to hoist our economic sails and harness the winds of innovation and productivity. It is said that de-leveraging is a perilous journey and beneath these dark waters are many a sunken economy of lore. Print too little money and we cascade off the waterfall like the Great Depression of the 1930s... print too much and we burn like the Weimar Republic Germany in the 1920s... fail to harness the trade winds and we sink like Japan in the 1990s. On cold nights when the moon is full you can watch these ghost ships making their journey back to hell... they appear to warn us that our resolution to avoid one fate may damn us to the other.

Simply great piece on Volatility and more.

The black swan is probably the most widely misunderstood philosophical term of this century. I tend to find it being thrown around to refer to anything surprising and negative. But that’s not how Taleb defined it. Taleb defined it very simply as any high impact surprise event. Of course, the definition of surprise is relative to the observer. To the lunatics at the NYT who push bilge about continuing American primacy, a meteoric decline in America’s standing (probably emerging from some of the fragilities I have identified in the global economic fabric) would be a black swan. It would also be a black swan to the sorry swathes of individuals who believe what they hear in the mainstream media, and from the lips of politicians (both Romney and Obama have recently paid lip service to the idea that America is far from decline). Such an event would not really be a black swan to me; I believe America and her allies will at best be a solid second in the global pecking order — behind the ASEAN group — by 2025, simply because ASEAN make a giant swathe of what we consume (and not vice verse), and producers have a historical tendency to assert authority over consumers. But black swans are not just events. They can also be non-events. To Harold Camping and his messianic followers who confidently predicted the apocalypse on the 21st of May 2011 (and every other true-believing false prophet) the non-event was a black swan. Surprising (to them at least) and high impact, because it surely changed the entire trajectory of their lives. (Camping still lives on Earth, rather than in Heaven as he supposedly expected). To true-believing environmentalists who warn of Malthusian catastrophe (i.e. crises triggered by overpopulation or resource depletion), history is studded with these black swan non-events.

Just last week we highlighted the behavioral bias writ large in the Mega Millions lottery via Dylan Grice's boredom discount concept. The same psychological tendency that overprices lottery tickets (relative to their expected value) seems very evident in the price action of everyone's favorite economy market tech-stock, Apple (and most specifically Apple Options). Since the price of Apple's shares skyrocketed above $500 (around early February), two rather significant (and very concerning) patterns have emerged. The first is the rotation from Apple stock into options as Apple options volumes erupted - almost tripling since the start of the year (from very stable levels for the past few years). Call option volumes have also massively increased relative to Put option volumes. However, while this suggests 'new' entrants lining up to buy their Apple lottery ticket, it is the 'pricing' of these options that is most worrisome as while dropping $1 on a lottery ticket will not break the retirement account - the divergence between Apple Options volatility and the broad market's volatility suggests a huge demand and willingness to overpay. Volatility tends to be the cleanest way to judge demand for options and since late January, the premium for Apple options has exploded (even as its share price rose and rose - breaking the empirical link between the two) as the 'optical cheapness' of Apple options compared to Apple's share price drew in the lottery ticket-buyers. Of course this in no way points to an end to the buying of Apple lottery tickets but the recognition of 'overpaying' - even as Apple's share price reaches all-time highs once again and the overpayment reaches 2008 highs - will eventually slow demand for a levered bet on a new life (but as a bookie market-maker you'd be willing to take that trade bet free-money from punters every day) or maybe covered-call writers will just soak it all up again.

In a very thin market, the S&P futures came very close to hitting their 50 DMA on Friday. The S&P futures went from a high of 1,418 on Monday, to trade as low as 1,372 on Friday. A 46 point swing is healthy correction at the very least, if not an ominous warning sign of more problems to come. There were 3 key drivers to the negative price action in stocks this week. All 3 of them will continue to dominant issues next week.

Two weeks ago we noted that all those banks that 'invested' in Spanish and Italian 'Sarkozy' carry-trades post LTRO2 are now under-water on their positions (on a MtM basis). The last week or so has seen this situation deteriorate rather rapidly with Spanish yields now backed up all the way to mid-November levels (and notably Spanish equities below their November lows) removing all the LTRO-exuberance leaving all Spanish banks under-water on their carry trades (should they ever have to MtM). At the same time, the critical aspect of LTRO (that is reliquifying tha banks to avoid the credit contraction vicious cycle that was beginning) has also failed. LTRO-encumbered banks now trade with a credit spread on senior unsecured (but now hugely subordinated) paper of 305bps on average (compared to non-LTRO-encumbered banks trading at 180bps on average) - back up near January's worst levels and almost entirely removing any of the tail-risk-reduction expectations that LTRO was supposed to provide. As Peter Tchir notes, there are two types of credit losses - default/restructuring (Greece and soon to be Portugal/Spain et al.) and bad positioning (or forced selling as risk becomes too much to bear - Spanish Govt/Financial credit) - these two sources of self-fulfilling pain are mounting once again. The simple truth is that without endless and infinite LTRO (or printing) funding for banks there is not enough demand for Europe's peripheral junk (as the Spanish auction highlighted) and the lack of performing collateral means the next stage will be outright printing (as opposed to a veiled repo loan) and that fact is beginning to creep into US financials as systemic contagion spreads.

The Deepwater Horizon incident demonstrated that most of the oil left is deep offshore or in other locations difficult to reach. Moreover, to obtain the oil remaining in currently producing reservoirs requires additional equipment and technology that comes at a higher price in both capital and energy. In this regard, the physical limitations on producing ever-increasing quantities of oil are highlighted, as well as the possibility of the peak of production occurring this decade. The economics of oil supply and demand are also briefly discussed, showing why the available supply is basically fixed in the short to medium term. Also, an alarm bell for economic recessions is raised when energy takes a disproportionate amount of total consumer expenditures. In this context, risk mitigation practices in government and business are called for. As for the former, early education of the citizenry about the risk of economic contraction is a prudent policy to minimize potential future social discord. As for the latter, all business operations should be examined with the aim of building in resilience and preparing for a scenario in which capital and energy are much more expensive than in the business-as-usual one.

As it now stands, the US economy faces a “fiscal cliff” in early 2013 – meaningful Government spending cuts AND tax increases at the household level. Nothing like a double whammy, now is there? Unquestionably this is one of the reasons why the Fed has pledged to leave short-term interest rates low for some time. So what happens if nothing is changed and both tax increases and spending cuts are allowed to materialize? Although it’s an approximation, the deadly combo could shave 1.5% plus from US GDP next year. Estimates from the Congressional Budget Office are for a more meaningful contractionary impact. And that’s before the ultimate global economic fallout influence of Europe and China slowing. But there is a larger and very important issue beyond this, although the “cliff” is something investors will not ignore and could be very meaningful to forward economic and financial market outcomes, especially given the relative complacent market mood of the moment.

The week ahead will offer significant inputs to our views. ISM and payrolls will likely set the market tone for the next few weeks. Despite the softer signals from regional surveys, Goldman expects the ISM to improve at the margin relative to last month’s print. In contrast, it expects payrolls to grow by 175k, down from last month’s 227k jobs gain. FOMC minutes will likely show that Fed officials had a discussion on further easing but are unlikely to offer strong hints about the likelihood and possible timing of a third round of Quantitative Easing.

It appears that these days a EUR1 trillion hot liquidity injection (such as that from the ECB's LTRO 1+2) will buy you about 3 months of breathing room. Then the ostriches have no choice but to pull their head out of the sand, especially in Europe, where after three months of spread tightening, and hence the belief that "all is fixed", things are starting to turn ugly again: sovereign government spreads are beginning to widen, Europe is demanding more money from the IMF (i.e. America, even as the BRIC countries are starting to consider a world without the USD as a reserve currency, and are now forming their own bank) to boost its firewall, strikes are promptly converting to riots, Italian bank stocks are being halted due to rapid moves lower, the LTRO stigma trade is at 2012 wides, in short everything we grew to know and love in Q3 and Q4 of 2011. Ironically, having papered over the symptoms courtesy of fresh new money, the underlying causes were never addressed, and only got worse as the deteriorating European economic data suggests. What is scary, as UBS shows, is that this is just the delayed carryover from 2011! Just like the US which had the benefit of abnormally warm weather to mask a "bounce" in the economy which was never structural, so Europe had a relatively quiet quarter in terms of newsflow. Things are about to change: read the following for why the eye of the hurricane is about to pass over Europe and why this time around there is $1.3 trillion less in firepower to delay the onset of reality.

In the not quite 100 years since the founding of your institution, America has exchanged central banking for a kind of central planning and the gold standard for what I will call the Ph.D. standard. I regret the changes and will propose reforms, or, I suppose, re-reforms, as my program is very much in accord with that of the founders of this institution. Have you ever read the Federal Reserve Act? The authorizing legislation projected a body “to provide for the establishment of the Federal Reserve banks, to furnish an elastic currency, to afford means of rediscounting commercial paper and to establish a more effective supervision of banking in the United States, and for other purposes.” By now can we identify the operative phrase? Of course: “for other purposes.” As you prepare to mark the Fed’s centenary, may I urge you to reflect on just how far you have wandered from the intentions of the founders? The institution they envisioned would operate passively, through the discount window. It would not create credit but rather liquefy the existing stock of credit by turning good-quality commercial bills into cash— temporarily. This it would do according to the demands of the seasons and the cycle. The Fed would respond to the community, not try to anticipate or lead it. It would not override the price mechanism— as today’s Fed seems to do at every available opportunity—but yield to it.

In advance of ever louder demands for more, more, more NEWER QE-LTROs (as BofA's Michael Hanson says "If our forecast of a one-handle on H2 growth is realized, then we would expect the Fed to step in with additional easing, in the form of QE3") , it is an opportune time to demonstrate just what the traditional monetary "plumbing" mechanisms at the discretion of the Fed are, and more importantly, just how completely plugged they are. So without any further ado...