Back From Skiing But The Markets Are Off Piste

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Includes: DRR, ERO, EUFN, EUFX, EUO, FXE, FXY, JYN, KBE, KBWB, ULE, URR, YCL, YCS
by: Polemic Paine

Ischgl in Austria. Loved it, but please don't go there as the bars are rammed enough at 4.30 pm, so busy that some poor girls had to dance on the bars and tables.

So whilst I was away, European banks ended up declining faster than if they had attempted 'La Face' or 'the Wall' or 'The Chute' that most resorts save for the nutters. Or as our group tend to call them, the 'Yeah yeah yeah you'll be just fine', which is the biggest oxymoron in skiing as it's reserved to describe the things you will be least fine attempting, resulting in 'Oh oh, I'll call the blood wagon'. Which is where we are with the markets.

Everyone thinks central banks have lost the plot. The nuts of negative interest rates has resulted in markets having such a hissy fit over their confidence in central banks that they have decided to do the opposite of anything their bossy parents are telling them to do. Fed raises rates, dollar falls. BoJ go negative on rates so the Yen goes ballistically UP. I fully understand that the Yen is not like any other currency as effectively it's a retirement fund for the population, so in times of stability heads abroad for nice high yield holidays and at times of risk comes rushing home to hide under mattresses. But if you have lost complete faith in a central bank, is it normal to hoover up its currency? Is it much like going long Weimar Marks because you think the Reichsbank has lost the plot? Or buying Zim Dollars because Mugabenomics is pants?

No. The faith in Central Banks is shot, but not to the point of the markets taking suicide pills. Buying JPY is part of the great leverage unwind, as is selling US$, as is selling high yield and selling banks who are built on leverage and as is selling the CDO cubed of leverage, bank CoCos.

The Eye of Sauron is now glaring down on the banks and the case for imminent disaster is built from an amalgam of old euro woes, toxic waste in balance sheets being forced to the surface by negative interest rates, commodity prices and a huge fear that global growth is going to stall to such an extent that, much as with oil prospectors, future global cash flow will not pay the global coupon. So prices are being driven down to levels where future cash flows are priced at the new expectation, which is close to zero and in my opinion overdone. In leverage products these moves are amplified and when you throw in convexity, scary things can happen in products that sound really scary, which scares the hell out of other markets as they may not understand them but do recognize large numbers when they see them.

Big numbers have been bandied around for the size of Deutsche Bank's balance sheet and the number of derivatives it holds. But derivatives do net off and are not a one-sided bet, though the fear is that the correlation matrices that drive the netting blow out. But one should never focus on the face value of a trade as to its true risk. For example, if I wanted to give you $100 now against a bet that the world will end tomorrow you should logically be happy to write a face value of $100 trillion on that as you would never have to pay out. A large face amount that doesn't represent your actual risk.

There is a big difference between the value of a bank stock (which may be a crisis for investors in that bank) and a banking crisis where the function of the banking system fails.

I do not believe the banking system is going to fail though there will be pain for bank bond and stockholders. But panic resides in credit markets and liquidity is apparently so dreadful that proxy hedging through bonds, equities, CDS and anything else that is tradable is causing trouble in other assets. These moves are in themselves interpreted as further disaster which whips things up further and the doom rolls through the markets. I note that we are at one of those points of a panic where each asset class is looking at the next for clues as to where it should go. Equities looking at credit, credit looking at bonds, everyone looking at oil, FX looking at everything and doing its usual impression of a girl on a chair who has seen a mouse, then equities and USTs looking at USDJPY and reacting even though USDJPY is following them. All of this is corroborated by the best macro back story that fits to justify the latest twists in liquidity and leverage adjustment, but actually overall best represents a confused market that can reverse direction in an instant.

Liquidity is back in vogue as a problem, but I am not going to express my thoughts again on that as they can be found here, (Liquidity, the Market is not a third party price guarantee system) other than to reiterate that the market does not owe you the bid you feel you deserve.

Leverage though is the usual culprit and no doubt there will be calls to regulate against it soon as someone high up will deem it as bad for us as driving at 55mph on a 50mph regulated empty dual carriageway. The analogy of speed limits is not one I bring up glibly as there are many parallels to market regulation where binary rules do not fit all cases and certainly restrict efficiencies. We are best served training all drivers to be experts, letting them work out road conditions for themselves and to regulate their own speed rather than introducing arbitrary rules designed to cap at the lowest common denominator. But self-regulation sees the envelopes of efficiencies challenged to the point of instability. Which has led me to derive a 'Polemic Principle' based on the famous 'Peter Principle' of management with a handful of Minsky thrown in.

"Markets will always leverage to their own level of instability"

In support of that idea, read this wiki post on the Peter Principle substituting in 'leverage product, risk, derivative or risk manager' where fit.

The Peter principle is a special case of a ubiquitous observation: Anything that works will be used in progressively more challenging applications until it fails. This is the "generalized Peter principle". There is much temptation to use what has worked before, even when it may exceed its effective scope. Laurence J. Peter observed this about humans.[1]

In an organizational structure, assessing an employee's potential for a promotion is often based on their performance in the current job. This eventually results in them being promoted to their highest level of competence and potentially then to a role in which they are not competent, referred to as their "level of incompetence". The employee has no chance of further promotion, thus reaching their career's ceiling in an organization.

Peter suggests that "In time, every post tends to be occupied by an employee who is incompetent to carry out its duties"[2] and [the corollary] that "work is accomplished by those employees who have not yet reached their level of incompetence." He coined the term hierarchiology as the social science concerned with the basic principles of hierarchically organized systems in the human society.

He noted that their incompetence may be because the required skills are different, but not more difficult. For example, an excellent engineer may be a poor manager because they might not have the interpersonal skills necessary to lead a team.

Rather than seeking to promote a talented "super-competent" junior employee, Peter suggested that an incompetent manager may set them up to fail or dismiss them because they are likely to "violate the first commandment of hierarchical life with incompetent leadership: [namely that] the hierarchy must be preserved".

Call in the palliative care team if you like, but I'm ready for all that gamma hedging in cross assets that has spilled out of credit to cause as much pain on the way back up as it just did down. Especially in USD/JPY which has seen consensus flip from 130 to sub 100 so fast, it's time to see it break up through 115.