A Market Crash Flowchart

On February 5, a 28-sigma surge in VIX driven by a massive short squeeze in inverse VIX ETFs, catalyzed a 1000 point Dow drop, leading to the worst week for stocks in years.

Today, Trump's unofficial declaration of trade war - or at least the intent thereof - has sparked another 500 point Dow drop, just as the "experts" were giving the all clear .

However, while both events have discrete causal factors, what is behind the recent market instability is neither a Vol problem nor a trade problem, but a "years of pent up ultra low rates" problem, which after years of central bank vol suppression and market manipulation, is finally manifesting itself.

As Deutsche shows in the chart at the bottom, the background of the risk-off shift started in January, with the Trump administration's moves to depreciate the dollar ahead of mid-term elections, together with a shift of the type of interest rate rise from favorable to unfavorable, which in turn triggered the drop in share prices and the dollar. Deutsche describes the rise in rates that triggered risk-off as “unfavorable rise”.

Reflecting the sudden reflationary burst, 10y UST yields rose sharply from 2.32% on 22 November 2017 to 2.92% on 22 February. As a result, DB's US rates research team raised its end-2018 10y UST forecast from 2.95% to 3.25%, and sees further upside potential in the terminal real rate of Fed funds, the inflation risk premium and the term premium. It is also possible that a sudden burst of inflation could hit asset prices, as in the 1960s.

And while higher rates initially catalyzed the move lower in risk assets, stocks have subsequently been more influenced by the VIX. As shown in the chart below, recently the S&P500's P/E (more specifically, its risk premium) was determined by VIX.

Therefore, during a period when higher interest rates cause higher VIX, stock prices should fall. As DB explains, since 5 February, higher (lower) VIX has led to lower (higher) rates.

Putting it all together, Deutsche provides the following flowchart to explain why your net retirement account is suddenly a few percent less.


Antifaschistische blueskyranch Thu, 03/01/2018 - 16:07 Permalink

They left off..

- underfunded pension funds begin to leave equities for credit as .gov rates increase

- selling pressure creates a cascade of sells on equity

- further undermining the funding levels in pension/insurance/invest "balanced" portfolios

- triggering pensioner cash out rush for the door

- triggering further pension obligation liquidation

loop, loop, loop

In reply to by blueskyranch

Avichi Thu, 03/01/2018 - 16:03 Permalink

Tyler , nice analysis, looking at the VIX and S&P P/E Ratio chart seems the R-Squared is really screwy , look the data seems to be absolutely whacked.? Where as the VIX vs Stock market  Risk Premium  chart has acceptable R-Squared

taketheredpill Thu, 03/01/2018 - 16:40 Permalink


IF US10s have survived the test of 2.95% (top of 25 year channel?) and IF US10s yield keeps moving lower then next question is "what do Bonds know that Stocks don't"?


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