Submitted by Finster
The Greatest Short - why all correlations are moving to 1
Why do all correlations go to one recently, even in asset classes or sectors which traditionally have moved with a negative beta?
I will attempt to provide an explanation, which rests on understanding the fractional reserve banking system and it's intermediation of the currency we use in everyday purchases as well as in investing. As providers of the currency to banks money is a liability. Your deposit is a liability on the bank's balance sheet. During a period of credit expansion as the US housing bubble prior to 2008, as well as the funding of governments like the Greek deficits after joining the Euro zone or the lending for the US unfunded wars after 9/11 the banks provide currency. They extend their balance sheets, take on loans and bonds as assets while providing currency to the markets. Essentially the banks go short currency according to the leverage of their balance sheets. The margin required from them is their deposit with the central bank. The resulting stream of fresh cash has an expansionary effect on the economy and drives prices higher, as additional funds become available to pay for existing scarce goods or fund projects. Asset prices tend to rise and inflate the asset side of the banks balance sheets, permitting them to book MTM gains on their positions, while not actually conducting trades or testing the market by selling off the assets and accordingly reducing the money stock while extinguishing their liabilities. In essence IFRS has permitted banks to cash in on phantom gains achieved in a disequilibrium of supply and demand of investable goods versus currency.
Once the credit cycle turns and a credit crunch sets in, the banks have to mark down their assets and a vicious cycle of deleveraging sets in. In essence banks have to sell assets to repurchase the currency they have issued through the granting of demand deposits and credit. If the banks had held on to all the phantom capital gains through the expansion cycle, the reduction might be achieved in a symmetric way, shrinking the balance sheets. But if not all bank capital was saved, a shortfall will be registered.
Systemically we are seeing the biggest short sellers in history here. Short currency, long loans and assets. Every short seller has to cover in a squeeze. The great conflict in our times is the question how this short squeeze will be handled: Will the short sellers be required to come up with undiluted currency and sell off their books or will their margin holder (the central bank) provide them with the necessary units. Previously during the credit expansion the creation of new currency units dispossessed all previous holders of currency by a proportional amount according to the amount of currency created. As long as a real factor expansion of the economy took place, the price level might not have been moved too much by this or in the case of rapid credit expansion to fuel a speculative bubble have distorted the relative price levels substantially. The difficulty of spotting this mechanism is embedded in our use of currency as an accounting unit, as well as a unit of transaction.
In our current environment, credit expansion has been exponential world wide up to the great crisis of 2008. Now the currency shorts (the banking sector) has to cover in the face of falling asset prices. The FED's decision through TARP and the FASB's decision to suspend mark to market accounting for many securities only disguises the true value of bank assets that might have to be sold to buy back the currency in deleveraging. On the way up the credit expansion fuelled inflation through the creation of new units. Now the system immanent deflation is being prevented by another round of credit expansion and a time lagged debt forgiveness through negative real interest rates. The margin holder of the banking system is stealth covering the shorts through an architecture of synthetic interest rates, as well as handing back currency units by buying overpriced assets.
The most blatant and obviously invisible short is the US Treasury: Funding by the FED, the PBoC and the fractional reserve system is providing currency for expenditure of the US government, which is running unprecedented deficits. The banking system through this action long US paper and short currency. If this currency would ever have to be repaid in kind, it would create the greatest US-$ rally in history (read an oversupply of paper and an undersupply of dollars to repay it). This would be associated with immense deflation.
The entire fractional reserve banking system rests on the premise that the short currency long assets/loans trade works, by creating a future economy that provides real greater output to sustain the circulated currency, because expunging it through deleveraging is a dangerous process for bank balance sheets and a deflationary event. The great question at the present time is: Has the recent credit expansion provided the US or Europe with an economy which can sustain the currency stock in circulation with it's accruing interest or has the malinvestment been so bad, that the currency amount in circulation is unsustainable and the resulting deflation will be met by central bank debt forgiveness to the currency shorters.
When banks create currency on their balance sheet and trade it for an asset, they sell something they do not have and which they have to repurchase in the future! This mechanic in an environment of latent deleveraging, and massive policy intervention by central banks and governments generates 'Risk on, Risk off' and the banking systems gyration towards selling short currency or covering versus all possible assets is pushing all correlations to 1. You're short currency and long assets/loans or the other way round. Bank balance sheets have moved to aggregate sizes greater than many underlying economies, so their choice of short currency long assets/loans moves the underlying price levels profoundly. The fact that US Treasury paper is accepted collateral with the FED and most banks makes this asset the most liquid marginal trading object for playing this trade. This marginal utility makes it uniquely valuable in the current environment. It is a risk buffer for banks and on a scale for liquidity it marks the very top, while mark to model and non liquid investments mark the bottom. As banks do not need to hold capital against US Treasury paper, they do not incur opportunity cost by holding it.
For the private and institutional investor the fundamental question in this market is: Do I go long currency or long assets/loans (credit). If you go long currency, you effectively take the opposite side of the banks. Is this a wise choice? If the banks are forced to cover on their currency unmitigated and undiluted, you will will hold a powerful asset that will go up in a short squeeze. But will policy makers permit that to happen? It is a bet on deflation and bank balance sheet impairment. If you hold the view that negative real interest rates, creation of additional currency units by the central banks and reflation will dilute your stock of currency, then it might be better to hold assets which benefit from inelastic demand or the eventual indemnity granted to the banking sector for its short. Currency or assets. Do we bet with the banking sector or against the banking sector? They are short currency, will we go long?
In a follow up, we will observe the effects of negative real interest rates on the relative price levels and a possible distortion of the asset and consumer prices in the run up to this crisis