We’ve heard endless explanations for the market’s big “Oops!” and the return of volatility.
The commentary is focused on the Fed and its sister central banks as they begin to prepare for inflation and trim their balance sheets.
For a long time before the sell-off, my good friend Doug Kass has been something of a voice shouting at us: “Kill the quants before they kill our markets!”
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Here’s Doug, explaining himself:
I believe the precipitous market drop in the last week has little to do with the projected course of interest rates or, for that matter, fundamentals. It likely was a function of the distorted, dangerous world of new investment products and strategies…. [T]he proliferation of short vol, volatility trending, and risk parity strategies when combined with an explosion of leveraged ETFs and ETNs—many of which were derivatives of derivatives and had no business existing except to please gamblers—had altered the market structure…
Banks at Risk
There is an interesting thing about ETNs.
These are exchange-traded notes. And while I don’t want to get too arcane on you, a key feature of them is that there has to be a bank or a guarantor on the note.
Even though we’ve had at least two shortfall ETNs literally blow up and go to zero, the investors in those funds are going to get “something.” If you put in your withdrawal request while there was still a price, there is a good case that you are due your money.
And of course, the ETN fund doesn’t have any money.
But the bank that guaranteed the ETN is on the hook. One of the ETNs was evidently backed by Credit Suisse. Credit Suisse made an announcement before the market opened yesterday morning that they had 100% of their liabilities hedged out in the marketplace.
Of course, they didn’t say hedged out to whom, and that will make us all wonder about counterparty risk; but we won’t have answers on that for a long time. While a significant amount of money is involved, it is not life-threatening to a bank the size of Credit Suisse.
More like annoying than life-threatening.
I think ultimately the collapse in high-yield will break out into “the Big One.”
You watched this last week as the VIX fell out of bed. I am telling you that what is going to happen in the high-yield market is going to be more—much more—of the same.
It’s going to seemingly fall out overnight. The bids are going to disappear, and high-yield bonds are going to be sold to what are essentially distressed-debt funds at distressed-debt prices.
Further, as we get into late 2018 and then into 2019 (not to mention 2020), the amount of high-yield debt that has to be “rolled over” becomes significant. And it is obviously going to have to be rolled over at higher interest rates.
The outcome is going to closely resemble one of those “agony of defeat” moments from the old Wide World of Sports TV show. We’re talking some spectacular face plants. When that happens, you do not want to be involved, unless from the short side.
The Fed’s Role
The Fed is inadvertently increasing the risk for these funds by raising rates.
Now, frankly, I don’t think the Fed should be paying any attention to how much pain they are causing the high-yield bond market when they make decisions on interest rates.
In theory, you should be a big boy to be playing in that market. Except that there are a lot of mutual and ETF funds that allow very small mom-and-pop operations to reach for yield.
By the way, did anybody else notice that the high-frequency traders who are always bragging about how they provide liquidity to the markets simply disappeared as the markets fell through the floor?
Where was this liquidity they were talking about?
They have the inordinate privilege of front-running everybody’s money, taking basis points from every trade, on the theory that they are providing liquidity. And they simply withdrew it via their completely quantitatively computer-controlled system.
High-frequency trading should be reined in, and any bid or ask prices submitted by computers should be made to last for at least 0.5 seconds. Slow enough for a young trader with good twitch speed to hit the button on their own computer and execute.
That would, of course, mean that volumes on the NYSE drop significantly, but that’s volume we don’t need; it’s meaningless. It’s not there when you need it—witness this past week.
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