Biting The hand That Feeds: Global Contagion

Prelude

I've been wanting to speak about this broad global-macro topic for what seems to be eons now. For some readers it may be a tad distasteful because some technicalities are involved and jargon tossed around like confetti; but such is the case when the complexities of interconnectedness and contagion are laid fully bare for all to see, and appreciate.

I was actually synthetically long (via buying put options on an US-traded ETN that tracked the short end of the VIX) back in September when global equities were experiencing their fiercest sell off in more than a year, when the S&P 500 briefly breached 1820 and blood was flowing down the gutters of Wall Street. Panic was then the name of the game, and it would not have been possible to avoid glancing at those "doom and gloom" punts that were never in dearth. People were calling for 1700 or even 1600 to be attacked. But those calls never materialized, and those fellas who were oh so brazen about their "within the realms of possibility" claims seemed to vanish before the markets proceeded to crucify their calls (and reputations).

And the impetus and final catalyst for the sell off was? No one really knew, or knows even till today. The panic was of course over exaggerated, as is with all other episodes of market hysteria. I initiated my synthetic long on US equities roughly 2% off the lows on the SPX (a pat on the shoulder for myself) and subsequently rode it up till when the SPX was about 1950 (where my systems indicated that there might have been some resistance to the upwards move). After which I liquidated my position for approximately a 60% total return (of course the initial outlay when that position was establish was but a portion of my holdings). The ensuing price action proved how wrong I was. Extrapolating from the time I exited my synthetic long till today, I technically missed out more than 70% of the entire up move from trough to peak.

To me, as fascinating and sensationalized the rout of September was, the sequel was actually the portion of this entire episode that stole the show. Most participants and news outlets were focused on deducing bases for what can be reasonably termed a stock market crash, and for good reasons. Like all human beings, the psychology of the markets loves to remember pain while forgetting the hand that feeds them; or in this case the days where prices march up ever so higher into the blue yonder of the clear skies.

To me, the entire up move from the lows of 1820 to the current cycle highs of 2080 (a 14.28% delta) which was unprecedented in its consistency and record streak of positive daily closes, plus the number of days that prices managed to stay above the 5-period moving average, was something I still muse about today (yes, even as the Shanghai Composite  just had its worst day, down 5.4%, since 2009). The psychology and the sheer arcanum of the freely traded markets of this great world can never be entirely comprehended. Ever. I'm absolutely certain about this.

The synthetically long trade on equities via buying puts on a ETN that tracks the short end of the VIX curve paid off nicely but was shy of the lows and wasn't as good a trade as it should have been in retrospect. 70% of potential upside was not captured by the trade. Chart also highlights how amazing the current run up in US equities has been

The synthetically long trade on equities via buying puts on a ETN that tracks the short end of the VIX curve paid off nicely but was shy of the lows and wasn't as good a trade as it should have been in retrospect. 70% of potential upside was not captured by the trade. Chart also highlights how amazing the current run up in US equities has been


Contagion

Traders and investors like myself who sat through the European Sovereign Debt Crisis of 2011 will know full well of what the term financial contagion practically entails. Back then it was a term loosely attributed to every ebb and flow of asset prices, because when CDS (credit default swaps) spreads were of the PIIGS were at all time wides, and when Greece was on the precipice of triggering a technical credit event by defaulting on its sovereign obligations, every passing hour was mayhem for those poor private institutions, national banks, central banks, supranational financial entities, or anyone for all intents and purposes.

Contagion was dully not a word to be taken lightly when the weight of an entire continent's present and future monetary system is borne by a tiny nation called Greece, when it restructured its debt. I will never forget how intense those moments were when holders of the original series of GGBs were asked to stomach a 70% haircut on their principal under the so called debt restructuring program; all in the process when hedge funds held out under English Law because they believed they could contest the legality of the Greek government's retroactive legislation. It was the mother of all dramas, and the king of all soap operas.

GGB prices across the maturity spectrum were swinging so wildly while collapsing to cataclysmic lows by the hour that CDS spreads were pricing in an almost certain default (when writers of those swaps started to price those instruments outright instead of in their usual spread terms). If taken in isolation, the situation would not have been as severe as it was. That wasn't of course the case; the dumping of Greek assets translated not only to much wider credit spreads across the entire non-core Periphery, but crashing asset prices and fire sales coupled with incredible flares in implied volatility across the board. It was truly bonkers.

With such events happening, you would bet your house that there were again those making their "within the realms of possibilities" claims that the European Monetary Union  was going to be dismantled. Claims that the de-monentization of the the Eurozone and the currency block was imminent and that German would reintroduce the Deutschmark while Greece would resurrect its Drachma. As we know, those never happened, like most fables and tale that these deceivingly eloquent storytellers love to tell.

Fast forward 2 years and we know that Europe has once again emerged in one piece, albeit badly rattled and still stuck in its own deflationary rut. Name your reason, the power of collusion between the Troika and other central banks, a self-resolving imbalance in the market, the jawboning and sheer mutiny of the ECB, multiple attempts at successfully restructuring Greek debt... Whatever you wish it to be. The fact is that Europe avoided the worst. But that didn't stop the markets from learning a thing or two about financial contagion.


Contagion is to The Market What Gravity is to Physics

The European Debt Debacle was a mere manifestation of the inherent risks markets faced on a daily basis. If the adverse "wide fire" like effects of financial interconnectedness were any better known, we would have subsequently seen actions being taken to address the underlying problem of too much fodder for the untamed baby that is the markets. If central planners knew any better, they would have acted. They didn't. Until this week. But more on this later.

Markets have been long placated by the easy policies of the Federal reserve's QE programs; QE1, QE2 , the Maturity Extension Program (or Operation Twist as it was more commonly known), QE3 et al. The Fed's ZIRP (zero interest rate policies) have been stoking capital flows across the global financial markets ever since the nadir of 2009. Then came the BoE (Bank of England) with its £375bn LSAP in monetary easing which at last checked was not yet withdrawn or tapered down despite the relative resilience of the English economy (surely the brightest spot in Europe for the past year, and the second cleanest dirty shirt of the G7 behind the US). Couple that with the BoJ's (Bank of Japan) always-on afterburners of national debt monetization which just a year ago started to include Japanese equities and ETF, but soon to be extended to every marketable security out there was the BoJ starts to be the majority occupant of not only the domestic bond markets but the global equity markets; if you thought the Fed's monetary policies were that of a rouge bandit, the BoJ's were that of a fully grown scimitar-wielding Yakuza. An entire separate thread on Japanese monetary and fiscal policies need to be started to even start to cover the pure insanity of the BoJ's historic measures, but for now just remember that the Japanese are targeting a ¥80trn (that is a "T" for trillion) annual expansion of its monetary base through its uncapped and open ended bazooka of mammoth scale. This is the largest bout of QQE (dubbed the Quality-Quantitative Easing, although one would be hard pressed to find the quality in such times of desperation) undertaken by any central bank by any relative or absolute measure. Truly stunning!

The music doesn't just stop at the holy trinity of the Fed, BoE, and BoJ; the triad responsible for most of the centrally planned monetary largess over the last half decade or so, and can therefore fairly be thanked for the out performance of equities over the same period vis a vis other similarly risky asset classes like HY credit.

In this chart provided by Deustche Bank's Asset Research team, one get's the appreciate the sheer monolithic scale of central bank asset creation through their individual monetary easing programs. All of these 4 central banks have one thing in common, that is they share the same zero interest rate policies (ZIRP), actually make that negative interest rate policy (NIRP) for the ECB. Collectively, this gang is unstoppable in their pillage

In this chart provided by Deustche Bank's Asset Research team, one get's the appreciate the sheer monolithic scale of central bank asset creation through their individual monetary easing programs. All of these 4 central banks have one thing in common, that is they share the same zero interest rate policies (ZIRP), actually make that negative interest rate policy (NIRP) for the ECB. Collectively, this gang is unstoppable in their pillage

Chart compiling data across the 4 central banks illustrating the individual additions of central bank reserves an assets into the global monetary system broken down to each source. You can see which party is doing all the heavy lifting in our current stage. The question is also if the total figure will continue its downwards trend or see a prompt continuation to the upside

Chart compiling data across the 4 central banks illustrating the individual additions of central bank reserves an assets into the global monetary system broken down to each source. You can see which party is doing all the heavy lifting in our current stage. The question is also if the total figure will continue its downwards trend or see a prompt continuation to the upside

In this somewhat outdated chart, it is apparent even to the naked eye how dependent markets have grown to the loose monetary policies of central banks, the Fed in this case. Notice how the equity markets trot ever higher during times of asset creation but fall when the Fed's inkjets cool down. Also notice how peculiar the latter stages of the transmission have become when in spite of the risk and eventuality of Taper, equities continue to head north

In this somewhat outdated chart, it is apparent even to the naked eye how dependent markets have grown to the loose monetary policies of central banks, the Fed in this case. Notice how the equity markets trot ever higher during times of asset creation but fall when the Fed's inkjets cool down. Also notice how peculiar the latter stages of the transmission have become when in spite of the risk and eventuality of Taper, equities continue to head north

Besides the aforementioned central banks, there is one more less known about bank that has only until recently grabbed headlines. The bank in question is the PBoC (People's Bank of China) and its policies and dynamic approach to handling the dragon of China's economic growth plus the very dangerous shenanigans that come with all that growth. In the next addition to this "Biting The Hand That Feeds" series, we will move on to talk about how the PBoC might have just fired the first shot across the centrally planned bow, and how in under 24 hours we saw the markets staging an immediate knee jerk reaction almost in protest to the PBoC's actions overnight.