Moral Hazard And The Illusion Of Efficient Markets

| About: iPath S&P (VXX)
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Summary

It's time to talk about the market's topic du jour again.

Over the past several days, the chorus of folks warning about low volatility has grown still louder.

Here's my latest take on this along with some important excerpts from the voices that matter.

It's time to talk about volatility again.

These days, it's always time to talk about volatility.

That's why I do it a lot.

In many ways, suppressed volatility is the defining feature of markets in 2017. It is the story.

Indeed, volatility (or the lack thereof) has become such a hot topic that it's spawned a cottage industry for explanations and theories about why we're seeing what we're seeing (incidentally, I was the first to characterize the cacophony of opinions about low volatility as a cottage industry and much to my chagrin, another outlet later hijacked that characterization without even attempting to properly attribute it).

One analyst recently described the situation as a "VIX-ation."

For quite some time now, a handful of folks on the Street have been warning that the interplay between VIX ETPs (NYSEARCA:VXX) and systematic strats for which volatility is an input is embedding a non-negligible amount of risk in markets.

Recently, those whispers have turned into shouts as it's suddenly dawned on everyone why this dynamic is dangerous. In other words, it's not just the quants and derivatives strategists that understand this anymore.

And that's a good thing because quants and derivatives strategists have a hard time communicating in a way that even approximates English. Thanks to the fact that this has become a hot-button issue, some folks have translated what might as well be hieroglyphics into warnings that real people can (sort of) understand.

Recall this from a Bloomberg Op-Ed by Dean Curnutt, CEO of Macro Risk Advisors:

With great thanks to the central banks, market participants have increasingly learned to live in the moment.

Asset prices are full, but negligible volatility encourages exposure to them without any discomfort. There are losses here and there, but in general, the daily experience of mild moves is the relevant, affirming scorecard. Further, low volatility serves not as just an anxiety-reducing palliative, but also is a mathematical driver of trade sizing codified into hundreds of billions of risk managed investment strategies. Volatility control products, for example, gear up or down exposure to the equity market based on the level of realized volatility versus a preset target. Because of the diminutive daily moves in equity indices, products such as volatility control move toward their maximum long exposure. The sell signal for volatility control and other strategies like it is unambiguous: a rise in realized volatility. Stewards of capital should be actively considering the potential knock-on effects that result from contractual deleveraging triggered by the inevitable volatility spike.

That situation is exacerbated by VIX ETPs. As a reminder, there are over 40 VIX ETPs at this point, with an aggregate AUM of just under $4 billion.

As Goldman wrote last month, they generate "an average daily trading volume of $2.6 billion [and] accounted for about 118 million vega per day over the first quarter of 2017 or about 22% of the total open interest in the VIX futures market."

(Goldman)

If you're interested in why and how those products create systemic risk, I wrote about it on Thursday here.

But let's think about it more broadly. Consider the following out this week from Deutsche Bank's brilliant derivatives strategist Aleksandar Kocic:

Complacency has moral hazard inscribed into it. It encourages bad behavior and penalizing dissent - there is a negative carry for not joining the crowd, which further reinforces bad behavior. Persistence of low volatility causes misallocation of capital. This is the main danger. Endemic complacency, which continues to take hold of the markets, is likely to play an increasingly adverse role the longer markets continue to operate as they recently have. Although volatility remains depressed, the risk is being pushed to the tails. And, as volatility continues to decline, a buildup of tail risk is likely to become more acute, as probability of volatile unwind increases.

Those bolded bits are key. It's the same issue those who really want to bet on spread decompression in credit markets face. Making those bets costs a lot of carry, and in the current environment, no one wants to be the guy/gal who isn't still picking pennies in front of the steamroller because after all, those pennies add up.

Part of the reason this environment persists is the rapid "mean reversion" of volatility after event-driven spikes - or, put differently, the quick collapse of volatility as everyone buys the dip.

Visually, that looks like this:

VolCollapse

(BofAML)

But is that warranted?

That is, how is it possible that the market can price indeterminacy so much more efficiently now than in the past?

That question is especially pressing when you consider just how uncertain the political backdrop is.

Well, Deutsche Bank's Rocky Fishman (who is quickly becoming a go-to source for the mainstream financial media on this topic) is out with a new piece on Saturday and his answer is that the "efficiency" you think you're seeing is an illusion. Here's Rocky:

Quick outbursts of vol have not brought follow-up vol - driving sharp reversals in short-term vol.

Volatile moments have not turned into volatile periods. Several of this year's most volatile moments (the Comey news, the tech selloff, Brazil's selloff) saw both implied and realized volatility drop quickly post-event. Perhaps via investors monetizing just-in-time hedges purchased as protection for these specific moments may have helped implied vol drop. Efficient markets? In a sense market movements are getting concentrated in the bigger-vol days, interspersed with range-bound periods. This bears resemblance to efficient market hypotheses that expect markets to absorb new information instantaneously, yet we know that's not how things work - as time passes, markets understand the impact of catalysts in new and deeper ways.

Right. Which means what you're seeing isn't the product of efficiency, but rather the product of everyone being afraid to be afraid (and no, there are no typos there).

As Citi's Matt King put it this week, "investors [are] struggling to reconcile significant longer-term negatives with what remains an almost overwhelming technical for now."

King was referencing central bank liquidity, but this is all the same "technical." It's all the fear of missing out in the face of a market structure that is, for the time being anyway, set up to perpetuate the existing dynamic.

But for those inclined to think this can last in perpetuity, allow me to simply close by reiterating what Deutsche's Kocic said in the excerpt cited above:

Complacency has moral hazard inscribed into it.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.