“Crazy Things” Happen with Bond Math at ZIRP & NIRP

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Cross Asset Contagion & High Volatility in Manipulated Markets.

By Alex M., Founder of Macro Ops:

We’re investing in some truly interesting times. Check out the index below from Credit Suisse depicting contagion risk across global markets and asset classes. It’s now showing the highest global correlation since the index was created:

2016-09-14-alex-m-market-contagion

It’s interesting because normally correlations rise during a bear market. But right now we’re hitting record highs while many global markets are still in an old cyclical bull.

These high linkages are why, on Friday’s sell-off, there was hardly a drop of green in any market around the world.

This type of cross asset contagion is concerning, but not at all surprising. It’s the direct result of central banks tickling investors into a yield frenzy, with little to no regard for credit quality or any other risk factor. This has resulted in an increasing amount of capital crowding into already extended assets.

And the correlations are further exacerbated by the prominence of quant driven funds whose algos are all positioning (making buying and selling decisions) off the same metrics.

There’s a great post on the systemic risks created by quant funds from Global Slant. Here’s an excerpt below and you can find the whole article here (emphasis mine):

While in Greenwich Ct. one afternoon I will never forget a conversation I had with a leading quantitative portfolio manager. He said to me that despite its obvious attributes, “Black Box” trading was very tricky. The algorithms may work for a while [even a very long while] and then, inexplicably, they’ll just completely “BLOW UP.”

To him, the most important component to quantitative trading was not the creation of a good model. To him, amazingly, that was a challenge but not especially difficult. The real challenge, for him, was to “sniff out” the degrading model prior to its inevitable “BLOW-UP.” And I quote his humble, resolute observation “because, you know, eventually they ALL blow-up“…as most did in August 2007…

…I asked, “Why do they all ‘BLOW UP?’ What are those common traits that seem to effect just about every quantitative model despite the intellectual and capital fire-power behind them? And if they all eventually ‘BLOW UP,’ then why are we even doing this?”

He answered the second part of the question first…and I paraphrase…“We are all doing this because we can make a lot of money BEFORE they ‘BLOW UP.’ And after they do “BLOW UP,” nobody can take the money back from us.”

He then informed me why all these models actually “BLOW UP.” “Because despite what we all want to believe about our own intellectual unique-ness, at its core, we are all doing the same thing. And when that occurs, a lot of trades get too crowded…and when we all want to liquidate [these similar trades] at the same time…that’s when it gets very ugly.“ I was so naive. He was so right.




This is a problem. “We are all doing the same thing” leads to crowded trades. And crowded trades don’t tend to work out because “when we all want to liquidate… at the same time” things get ugly. If Friday is any indicator, we should expect a buffet of ugly, or as Hillary would say, a “basket of deplorables,” sometime in the near future.

The main reason for all this volatility we’ve been seeing in the markets lately is rates. Specifically, the Fed’s drive to put the rate hike narrative back on the table, and also disappointment over recent ECB and BOJ action — or I should say inaction.

The 10-year yields of both the Japanese and German debt have been rising. Germany is now positive again and Japan is a hair below zero.

These recent spikes in yield are driven by three things:

  1. Both central banks are nearing the limits of what they can purchase (there’s not many qualified bonds left).
  2. They’re both wising up to the fact that negative rates, especially further out on the curve, hurt financial institutions and are by their very nature, deflationary.
  3. And investors who bought negative yielding bonds only did so hoping for capital gains (greater fool theory at work). But now that both central banks appear to be letting off the QE gas a bit, holding NIRP’ed bonds makes less than zero (nirped?) sense.

Because of the crazy things that happen with bond math when at zirp and nirp, the “fools” who bought into Japanese and European negative coupon bonds too late in the game have taken large losses over the last couple of weeks.

These losses, combined with rising rates, are no doubt causing repositioning within portfolios that should continue to affect equities.

The Fed meanwhile has been on a coordinated media blitz, trying to get the market to buy into the potential for a rate hike before the end of the year. Many attributed Friday’s selloff to Fed President Eric Rosengren’s hawkish speech on Friday, where he warned that a “reasonable case” can be made for a rate hike to keep the economy from “overheating.”

But the data tells a different story. The latest ISM print was horrible and nominal GDP and inflation are well below where the Fed wants them.

Yet these central bankers are still trying to temper risk enthusiasm in the markets. They now find themselves stuck with a slowly deteriorating economy that can’t stomach a rate hike and an increasingly speculative market that needs higher rates to cool its jets.

Which concern pushes the scale for them?

My personal opinion is that the Fed is jawboning about raising rates because they know that they can’t. The FOMC doesn’t have a lot of confidence in the economy’s strength and they don’t want to stir up unnecessary trouble in an already contentious election year.

Expect the recent increased market volatility to continue into the Fed meeting next week. We’ll be trading light to protect our capital until then. By Alex M., Macro Ops.

Creating a situation worse than 2008? Read…  New SEC Money-Market Fund Rules Forcing a Liquidity Squeeze?



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  13 comments for ““Crazy Things” Happen with Bond Math at ZIRP & NIRP

  1. Petunia
    Sep 14, 2016 at 7:21 pm

    Every scam eventually runs out of money. Whether it’s a CDO ponzi where over time the money starts coming in slower than it’s going out. Or whether you can no longer front run your own positions to manipulate the prices upward. They all blow up because they don’t have enough real underlying value to hold up the prices.

  2. Sep 14, 2016 at 7:53 pm

    One factor not mentioned is that “management” believes in and acts on model forecasts only as long as the forecasts tell them what they want to hear.

    IIRC the economic models used by Long Term Capital Management, based on the Black, Merton, Scholes option valuation equation, were ignored by the LTCM in the weeks leading up to its collapse, when they first “doubled down,” and then went “all in,” based on their “gut feel” when the economic storm clouds were forming.

  3. polecat
    Sep 14, 2016 at 9:11 pm

    Doesn’t that chart remind one of a rock … skipping on water ……

    so what does the rock eventually do … it sinks !

  4. Camerons
    Sep 15, 2016 at 12:04 am

    …“We are all doing this because we can make a lot of money BEFORE they ‘BLOW UP.’ And after they do “BLOW UP,” nobody can take the money back from us.”
    In other words, swindle. No one has gone to prison for their crimes. Wells Fargo is the latest but won’t be the last.

    Those models work under certain circumstances weather handled by human traders or by computers. Those models have brought devastations in the past and will do so again.
    Will there be another bailout?

    But none of this matters. Capital destruction will continue and ZIRP, NIRP, QEs can’t stop it. The end of this cycle is here. Central banks have limited ability to stretch it a little longer. Negative rate absurdity implies deflation and falling earnings.
    Stock market valuations reflect the earnings/profits in the long run. Central bankers have an inverted view. They think that earnings are a reflection of the stock prices so If they prop up the stock markets then earnings will do well. The so called “wealth effect”. Alas it doesn’t work that way but in the meantime they’ve served the wealthy very well.

    • Graham
      Sep 15, 2016 at 5:05 am

      “Central bankers have an inverted view. They think that earnings are a reflection of the stock prices so If they prop up the stock markets then earnings will do well. The so called “wealth effect””

      I’m not convinced they do. I think they aim to amass as much wealth as possible without being lynched in a revolution or locked in prison.
      The whole concept of what they do – renting currency – is a tight mathematical route to total wealth assimilation.
      If they didn’t want this – they wouldn’t be running a debt money scheme that can only do that and has no chance of doing anything else. It’s in the maths.

      When you realise what debt money actually is, and calculate the simple exponential debt you know that this is the most dangerous and powerful scheme of theft on the planet, bar none.

  5. Marty
    Sep 15, 2016 at 5:03 am

    At the same time the Fed heads are threatening a rate increase–forward guidance, don’t ya know–the creepy Rogoff comes out with his book about our real future: cashless zirp.

    http://www.wsj.com/articles/hostage-to-a-bull-market-1473456611

    Dear Lord, deliver us from egg heads…

    • Petunia
      Sep 15, 2016 at 8:30 am

      Just a comment on the cashless society. Yesterday, I had lunch at a chain restaurant, when I asked for the check I was told I could not pay, not even in cash, because the computer was down. I was literally held hostage in the restaurant, luckily the computer came back up within minutes. I could not pay and I could not leave because the staff is unable to calculate a check and accept payment manually.

      During the massive flood in Baton Rouge, Louisiana last month, ATT service went down for days and so did the power. If you didn’t have cash to spend it was likely you could not transact.

  6. Doug
    Sep 15, 2016 at 6:46 am

    When you realise what debt money actually is, and calculate the simple exponential debt you know that this is the most dangerous and powerful scheme of theft on the planet, bar none.

    Bingo. Fiat currency requires exponential growth in a finite world. The seeds of its own destruction were embedded in its inception. IMO, this is a key concept to convey to people who aren’t financially savvy.

    • Graham
      Sep 15, 2016 at 12:33 pm

      It’s not even the fact it’s FIAT, although it helps, it’s the interest charged. With 0% interest it would be a flat loan – no problem – but as soon as even 0.0001% interest is charged it immediately forms an exponential debt function that is mathematically impossible to ever repay.

      The FIAT is relevant though because it is the only currency one can use with debt money – gold standards fall by the wayside because it’s a linear, finite resource that will never stick to an exponential function.

      Credit money is the only honest coin, because when it’s in your pocket it’s yours. With debt money – that ten dollar bill is accruing a debt to someone, somewhere, because it only exists because it was borrowed into existence.

      The damage of debt money is of course magnified by Fractional Reserve Banking, and in this case the tail wags the dog because the FRB clearing banks loan money out, and then borrow from the central bank to shore up their reserve fractions – i.e. debt is driven primarily by the lending banks and enabled by the FIAT debt money that makes sure the central bank is the eventual winner.

      The only way out of this is revolution, such as the US war of independence that allowed the US to escape from the UK/European banking interest demands.

      • Sep 15, 2016 at 2:02 pm

        While the changes required may be revolutionary, a “wigs on the green” revolution should not be required.

        One of the first requirements is a recognition and internalization that specie money is gone, it ain’t coming back, and fiat currency, backed by the full faith and credit of the government (such as it is) is the new norm.

        This implies a need to amend the U. S. Constitution to eliminate the phrase “ …make any Thing but gold and silver Coin a Tender in Payment of Debts;… (Section 10). (In point of fact this appears to prohibit only the *STATES* from issuing fiat currency, but does not to apply to the federal government. President Lincoln had fiat greenback currency issued during the Civil war, avoiding borrowing huge sums, so there is legal precedence, even with the restrictive clause, for the direct governmental issuance of fiat currency.) With the direct issuance of fiat currency by the government, the use of Federal Reserve “notes” can be eliminated, obviating the need to pay interest on this created “money.”

        The second major problem is that more than 90% of what circulates as “money” in the US is actually “bank credit,” upon which interest is paid. There appears to be no intrinsic reason why this must be so. It is also *HIGHLY* dangerous in that the “money supply” is largely controlled by the bank[ster]s, who can make enormous amounts of “money” appear and disappear, at their whim. What is suggested is that the “loan loss reserves” be gradually increased (bank leverage reduced) such that “bank credit” represents no more than 10% of the money supply in circulation, with the rest actual or virtual government fiat currency (greenbacks).

        This has two major benefits: (1) “interest” does not accrue with the fiat currency; and (2) the money supply is stabilized, so that violent credit contractions when the banks credits disappear are minimized (e. g. 2008) and inflation can be controlled by limiting the expansion of the “money” supply through “bank credit” creation.
        It should NOT be assumed this will be some sort of fiscal “Utopia.”

        For one thing a large number of individuals will become unemployed by the elimination of a number of highly paid, albeit redundant and nonproductive “management” positions, and it will fundamentally change the structure/operation of the retail banking business.

        For another, a way must be found to expand and contract the currency supply to avoid changes in its value, for example during the harvest season, when the farmers sell the majority of their crops, and there is a large demand for “cash” (increasing its value and depressing crop prices).

        As for the risk of inflation, we would be exchanging one set of “currency experts” for another, so would be no worse off in that respect, and we would largely avoid paying interest on the currency in circulation.

      • Sep 16, 2016 at 1:36 am

        “It’s not even the fact it’s FIAT, although it helps, it’s the interest charged. With 0% interest it would be a flat loan – no problem – but as soon as even 0.0001% interest is charged it immediately forms an exponential debt function that is mathematically impossible to ever repay.”

        I have to disagree. It’s not impossible at all. Your range of thinking is far too narrow mate.

        There’s an easy way around this. You use Government mandate to outlaw transactions in that currency and create a new one.

        Bingo.

        You can get repaid. Might be in something else, but what are you going to do about it?

        • Graham
          Sep 16, 2016 at 9:19 am

          “”as soon as even 0.0001% interest is charged it immediately forms an exponential debt function that is mathematically impossible to ever repay.”

          I have to disagree. It’s not impossible at all. Your range of thinking is far too narrow mate.”

          If true, you’ll have to explain how one can pay back the capital + interest, when only the capital has been issued… any ideas?

  7. Sep 16, 2016 at 1:26 am

    “They’re both wising up to the fact that negative rates, especially further out on the curve, hurt financial institutions and are by their very nature, deflationary.”

    PLEASE!

    You can’t seriously suggest Central Banks did not know negative rates were deflationary before they instituted them!

    Of course they knew that. Negative rates destroy capital and savings.

    Duh.

    Anyone with an IQ above room temperature can tell you that is DEFLATIONARY!

    Not even the morons in banks and central banks could not know that.

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