Fragility: Don't Shoot The Messenger

Summary

• What do you divine from the systematic strat unwind we saw from June 27 through July 7?
• Hopefully, you learned something about market fragility.
• If you didn't, then here's what you should have taken away.

The investing community has a penchant for shooting the messenger.

I don't know how many times I've heard readers on this platform dismiss my posts with the tired, old "fear sells" refrain over the past six months.

To be clear, Heisenberg isn't "selling" you anything. All Heisenberg does is writes posts - posts which you're free (figuratively and literally) to read or not read at your leisure.

Additionally, what I try to do is communicate something about the extent to which the market has become exceedingly fragile due to a number of factors including the evolution of market microstructure.

If I didn't know that to be true, then I wouldn't be saying it. It's just that simple. That is, I don't have an agenda. If this market were getting less risky, then that's what I would be saying.

So again, don't shoot the messenger just because the message isn't what you want to hear.

What's disconcerting about the current state of affairs is how the reflexive nature of the relationship between central banks and investors is interacting with modern market innovations to create what amounts to a one-way trade.

Consider this from the brilliant Aleksandar Kocic (full note here):

Everyone is incentivized to participate in the reinforcement of the state of exception, while various forms of contestation of the power are inhibited. For example, attempts at shorting bonds are penalized by a steep curve, protection against volatile unwind is discouraged through wide vol calendars, negative carry, etc. Collapse of short-dated volatility is a referendum on the near-term power of central banks, and softening of long-dated (and forward) vol. represents first signs of acceptance of its extension and possible permanence. In this way, the accommodation and QE have acted as a free insurance policy for the owners of risk. As long as the Fed remains dovish, there is little upside in holding gamma.

That would be risky enough already, but what you have to understand is that it's being perpetuated and amplified by modern market innovations. Everyone can now sell volatility (XIV) and thanks to proliferation of emerging market vehicles, everyone can be a carry trader.

Meanwhile, systematic strats like CTAs and risk parity are allowed (indeed "forced") to lever up as volatility (VXX) remains artificially suppressed.

I've talked about all of this before, but it's underappreciated by retail investors and indeed, by the vast majority of investors in general. What that means is that in the event circumstances conspire to finally tip the first domino, the people who you might look to for explanations after the fact aren't going to have any.

The writing is on the wall if you're just willing to look. And indeed, you needn't look very far. Bloomberg's Dani Burger, for instance, documented the multi-sigma CTA drawdown extensively as it unfolded in the wake of Mario Draghi's comments in Sintra, Portugal, on June 27. Dani writes for a mainstream financial news media outlet and her articles are free. You don't need a terminal and you don't need access to sellside research - so again, it's not like this stuff is some kind of conspiracy theory and it's not like it isn't out there for everyone to peruse.

CTAs had their worst two-week stretch in a decade during what can only be described as a rates mini-tantrum that saw DM bond yields spike dramatically. And here's the thing, CTAs are probably still long. Have a look at these charts:

(Deutsche Bank)

Why do you think Janet Yellen leaned so dovish in her testimony on Capitol Hill this week? It was at least in part aimed at keeping the systematic unwind from getting any worse. See the orange line in the left pane above? See how it plunges and then rises? That plunge was the rates mini-tantrum and the (partial) recovery was the relief rally that Yellen triggered this week. What you see there in the right pane suggests CTAs are still leveraged. Which means if the rates rally, Yellen engineered reverses and bonds (TLT) sell off too hard, too fast, CTAs will have to get out.

That's just one example of the type of fragility I mentioned above.

Of course, the most precarious setup is elevated inverse and levered VIX positioning courtesy of the rising popularity of VIX ETPs. I've been over this and over this, but the gist of it is that because of the low starting point, even a small VIX spike looks like a huge percentage and that could cause inverse and levered strats to panic-buy VIX futs into a volatility spike.

Normally, I quote Deutsche Bank's Rocky Fishman on this, and if you're interested in his latest, you can read it here, but for the sake of citing multiple sources, consider the following out late last month from BofAML:

Elevated levered & inverse VIX positioning could amplify vol in a fragility event. In their quest for yield, market participants have increasingly turned to inverse volatility products to generate positive carry. Current positioning in these products is near all-time extremes at -$110mn vega (Chart 10). A volatility spike may pressure investors in these products to trim their positions, thus exacerbating the rise in vol. Apart from this, the gross vega outstanding in inverse and levered VIX ETPs stands near $200mn vega, not far from the all-time high of $250mn vega registered in Apr-16. Mechanically, when vol increases, inverse vol products become overexposed to volatility and thus need to buy vol to reset their exposure. Similarly, when vol spikes, leveraged long products become underexposed to vol and also need to buy vol to reset their leverage. Thus, in a fragility event, this implicit “short VIX gamma position” can further exacerbate a vol spike.

That data is from last month, but you get the point. This is about fragility.

I see a lot comments on my posts here along the lines of "at some point there will be a correction and you'll say 'I told you so.'"

That completely misses the point.

I'm not telling you that "eventually they'll be a correction." If that was all I had to say, then I wouldn't be writing, because saying that isn't saying anything at all. That's like saying "eventually, it will rain."

Rather, what I'm telling you is that the vast majority of macro commentary you read here and elsewhere is written by folks who do not have a solid grasp of modern market structure. Which means they do not fully appreciate the risk inherent in this setup.

This isn't to say that markets can't correct without tipping a domino. We can, and probably will, get a normal (or a "healthy" to use a worn out cliche) correction without any kind of severe unwind.

But what I'm telling you is that the conditions are in place for something to "snap" - as it were. That's what happened on the morning of August 24, 2015.

Critics will say that odds are we would quickly pick up the pieces and markets would recover were that to happen. But that's so obvious an assessment that I'm not sure it even qualifies as a criticism. Of course, the odds are markets would recover. I only know of one or two commentators who contend that things are going to fall apart completely and stay that way - and I am definitely not one of those commentators.

All I want people to understand is that the interplay between extraordinary central bank policy and market innovations has set the stage for more events like August 24, 2015.

If that's not something that's worth examining, then I don't know what is.

Again, don't shoot the messenger.

Analyst’s 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.