The Fed’s $1.2 Trillion Short Volatility Position
Ten years ago, this year, the mortgage bubble nearly led to the collapse of the entire banking system. The Federal Reserve (or Fed) responded with an unprecedented level of monetary and fiscal stimulus to save the banking industry which cost American taxpayers nearly $4 trillion that we will undoubtedly pay on for generations to come. Very few involved went to jail and most of the executives walked away with large bonuses. The Fed justified this as a necessary means, but it was to cover up the easy-money policies of the Greenspan-led Fed. In October 2017 the Fed began its latest experiment – the selling of its $4 trillion balance sheet back to the public, which is about to crush the banks it so desperately needed to save ten years ago.
In October 2017 the Fed began selling off $10 billion per month ($6 billion of U.S. Treasuries (UST) and $4 billion of Mortgage Backed Securities (MBS)) of its $4 trillion balance sheet, which has never been attempted by a central bank in history. In January, and every quarter following, the amount of selling will incrementally increase according to a schedule laid out by our current Fed Chairman Janet Yellen. Before I can explain how selling these bonds is going to spell trouble for the banks, I think it’s important to review the actions the Fed took to save the banking system in 2008-09.
To keep the banking system from failing during the Great Financial Crisis the Fed first engaged in a debt-swap with the banks where the Fed exchanged newly printed Treasury bonds for the bank’s bad debts. Those bad debts were largely made up of mortgages that were underwater due to the deflationary shock which caused asset prices to fall. Once the banks were recapitalized, the Fed began a series of Quantitative Easing programs that exchanged those newly printed Treasuries for U.S. Dollars. The purpose of the QE programs was to lower short-term interest rates and boost asset prices – these programs were designed to encourage the banks to resume lending. The Fed also implemented Operation Twist, which swapped long-term Treasuries with short-term Treasuries, to bring down long-term interest rates. These programs initially worked exactly as the Fed hoped they would.
Unprecedented monetary expansions always have unintended consequences. The Fed has no control over what the banks would do with the money they received during these programs, and as it would turn out, much of it flowed into the stock market instead of the real economy. The other problem is that by 2012 the Fed owned $1.2 trillion of MBS which represents one-third of the entire U.S. mortgage market. Back in 2012, Jerome Powell, who is currently the incoming Fed Chairman, expressed concerns about how the Fed would eventually sell these Mortgage Backed Securities (MBS) without causing a strong negative reaction in the stock market. He expressed this concern because these Mortgage Backed Securities were acting as an implied short volatility position, which acts as a suppressant to normal market volatility. Simply put, selling off $1.2 trillion of MBS’s may lead to panic selling of stocks. If you are unfamiliar with what short volatility is, please refer to my December 1st update titled, “A Market Built on Nitroglycerin.”
Here we are five years later, and as of last quarter, the Fed has started unwinding their positions with little to no impact on the stock market. Starting in January the Fed is increasing the amount they are selling off from $10 billion per month to $20 billion per month, with scheduled increases each quarter. The $20 billion scheduled to sell this month with be split between $12 billion of UST’s and $8 billion of MBS’s. The implications of unwinding their balance sheet are huge. The purpose of Quantitative Easing was to lower short-term yields and boost asset prices, but it also increased long-term yields. What this should tell us is that by unwinding this program, short-term yields should rise (they are), asset prices should fall (they haven’t yet) and long-term yields should fall (they have been holding flat for a year now). Ultimately, it means that stock prices should start falling, long-term bond prices should start rising and short-term bonds prices should continue falling. After all, Newton’s third law of motion says: for every action, there is an equal and opposite reaction.
To test Powell’s opinion that volatility will come back to the markets, I charted the volatility index, (symbol VIX), against short-term yields, long-term yields, and the money supply. When two- or five-year Treasury yields rise, volatility rises. When ten-year Treasury yields fall, volatility rises. When the money supply falls, volatility rises. But volatility is currently at historic all-time lows, because the Fed, hedge funds, institutional money managers, and retail investors all over the world are heavily shorting volatility. Powell is correct – volatility will eventually rise as the Fed unwinds its balance sheet and when it does, it will lead to chaos in the stock market.
I’m not entirely convinced the Fed was expecting to sell off their balance sheet. The purpose of these money-printing experiments was to get the economy back on track. The Fed was likely hoping the public would refinance their properties as values rose, but as it turns out, people aren’t too interested in refinancing low-interest debts into higher interest debts. As far as the Treasuries the Fed was holding, by converting long-term debt to short-term debt, all the Fed had to do was wait until the economy recovered, then let their positions mature.
Except the economy didn’t recover (unless you believe that sub-3% economic growth is good). According to Dr. Harald Malmgrem, a senior aide to US Presidents John F. Kennedy, Lyndon B. Johnson, Richard Nixon, and Gerald Ford, the third quarter 2017 GDP should have been 1% (had the Bureau of Labor Statistics (BLS) used the official BLS deflator when calculating GDP growth). Had the BLS tossed out the rise in inventories or goods not sold, GDP growth for the third quarter would have been less than 1%. I can only imagine how the stock market would have reacted to 1% growth instead of the 3% growth rate that was printed by the BLS.
I realize I haven’t touched on how the Fed is about to crush the banks, but I felt that is was important to explain what the Fed’s intended consequences of their money printing scheme were and what will happen as they tighten the money supply. While the Fed intended to boost asset prices, they didn’t intend to create a speculative stock market bubble. The Fed has no control of what the banks lend the money out for and as we have seen, much of that money has been borrowed to buy stocks on margin – more so than any prior stock market bubble in history.
Many people look at their brokerage accounts and see this as “money good,” meaning that they believe they can sell their investments at any time to realize the value printed on their statements. Many also believe that the Fed will continue to prop up stock prices even in a downturn, but you should understand that at no point did the Fed directly buy stocks. Based on what we know about interest rates and the money supply, stocks should not be trading at these levels. I thought investors learned from the mortgage bubble of what happens when people buy assets on credit, but I was wrong. What I don’t understand is why investors think that the stock market won’t crash like the housing market did in 2008-09.
Over-leveraged markets, whether they are in tulips, tech stocks, houses, or cryptocurrencies, always go bust. It remains true that most Americans only invest in things that have already appreciated and are rising, and then lose their money when the inevitable crash comes. Perhaps I am fortunate enough to have clients that understand that the true path to wealth and prosperity is buying low, waiting and then selling high. For now, the stock market mania will continue until the day it doesn’t.
Before I wrap up this multi-part series for the week, I want to explain how interest rates work. If you ask most people what causes interest rates to rise, they will say, inflation. If you ask them what causes inflation, they will likely say, rising prices. If you ask them what causes rising prices, they’ll say inflation – and you get a circular loop. Yields are a function of supply and demand. When the Fed pumped the banks full of cash through Quantitative Easing, it caused short-term interest rates to fall because there was more short-term money available than there was demand. So, short-term yields fell until they found demand. The opposite happened with long-term yields. When the Fed engaged in Operation Twist, they took long-term money out of the market, so long-term yields had to rise until they found capital.
With that, next week we will take a deep dive into how the Fed manipulated the interest-rate market and how their latest move to unwind their balance sheet is going to put the banking industry into a precarious situation.
Q&A with Steve – Your Questions Answered
- Do you believe that the drop in the stock market on Friday and Monday is a buying opportunity or the beginning of something larger?
I believe the price moves on Friday and Monday are the beginning of something bigger. Now that the short volatility trades will be unwound starting on Feb 20th, volatility and selling will return to the market. Late stage economies and Bull markets are full of optimism, but with liquidity drying up, stock prices will find it difficult to return to their prior highs without central bank intervention.
- Why didn’t Jerome Powell step in to save the markets?
Powell has been quoted stating that it’s not the Fed’s job to keep people from losing money. The Fed knows yields need to fall, which they are trying to do by unwinding their balance sheet and tightening the money supply. That should cause asset prices to fall. And asset prices are falling. It’s only a matter of time before demand drops and yields fall.
- Is this volatility spike transitory?
No – The Fed did three successive Quantitative Easings which had the effect of lowering volatility and raising asset prices. As they continue to tighten by selling off their bonds, volatility will persist, and asset prices will struggle to keep rising.
- Future market swings will be equally as large?
That is very likely. The reason we saw such a big swing is that everyone is piled into risk assets and because of the “Yellen Put,” investors no longer feel that it’s important to hedge their risk. The dynamic of being invested in risk assets without any protection is a recipe for disaster.
- You said bond yields would rise, but they haven’t – why?
The retail public still views this as a good opportunity to buy and they have. When people perceive one asset being worth more than another, they will sell the less desirable asset to buy more of the one they want. In this case we are seeing people sell everything to buy stocks. Part of this is because of the record high level of debt being held by stock investors, the other part is due to algorithmic momentum strategies that are being forced to short bonds to buy more stocks.
I also thought more of the risk-parity or volatility-controlled products would be selling and they haven’t. Some of the products that blew up this week have not reached their termination date, which is set for Feb 20th. These products are buying more equities right now, but that won’t last much longer. If equities continue to sell and volatility rises, then they will make their shift to safety.
Trading volumes on the Treasury ETFs have been very high. Strong volume indicates the beginning of a trend (no), the continuation of a trend (not likely) or the end of a trend. Since yields and bond prices have been holding, it’s most likely the end of a trend.
Video Topic of the Week – Stocks, Bonds & the Fed
My thoughts on the wild ride in stocks and when bonds are likely to start rallying.
Chart of the Week –
Portfolio Shield™ Update
The February Morningstar® Investment Detail Report is now available and is linked below in this e-mail.
Work is progresses on tuning the Prototype algorithm. No new updates this week.
January Nonfarm Payrolls Report
The January payrolls report came in at +200,000 jobs, above expectations of +180,000 jobs. The November and December reports were adjusted down by -24,000, so the January report met expectations. Despite a strong headline number, the stock market choked on itself and had the biggest one-day drop since the last recession.
Aside from the headline, the data underneath wasn’t as optimistic. Hourly earnings for production and nonsupervisory workers, which represent 80% of all workers, rose a mere 0.1% on a month-over-month basis. On a year-over-year basis, wage growth is at 2.4%, down from 2.6% in September.
The workweek also fell to 34.4 hours worked compared to 34.5 hours worked. While 0.1 hours doesn’t sound like much, that is equivalent to a drop of 727,000 jobs – a significant drop in income. Some experts suggest the drop-in hours worked was due to weather, and if it was, the hours worked data should return to normal in the next couple of months.
Based on the January report, GDP growth for the first quarter is on track for a 1% annualized rate; far less than the 3-4% the Trump administration is hoping for and considerably lower than the 5-6% the stock market has priced in.
Gold / Silver Miners
Both mining funds have entered my target buy zone, but I haven’t pulled the trigger. Mining stocks usually lead the physical metals, but gold hasn’t sold off. Peter Brandt recently posted a chart showing that gold should fall from its current levels, which again leads to the question of if the miners will hold at their current prices while gold sells off.
A violation of my target buy points wouldn’t be good in the short term. The long-term view still holds as liquidity leaves the stock market and Congress inches closer to raising the debt ceiling. The U.S. Treasury is planning to issue $441 billion dollars of new debt by the end of March, which would certainly be a huge boost to gold (and bond) prices.
The timing of these hitting my target buy zone and Congress poised to act could play out well. At the moment we are ready to move, but we are waiting for confirmation of the price action to validate our entry. When the time comes, the higher risk portfolios will go in first – slowly, followed by the lower risk portfolios.
Weekly Broad Market / Economy Commentary
On Monday something unexpected happened – the entire short volatility structure broke as the Exchange Traded Funds holding these investments lost nearly 90% of their value in one day. According to the Prospectus for many of these funds, should they fall more than 80% in a day, the fund will be terminated and set for liquidation.
These short volatility funds are very risky, yet they didn’t stop pension funds, institutional money managers, hedge funds and the retail public from buying. While many said there was no way a termination event could happen, I wrote about this possibility a couple months ago. The ramifications of these funds terminating will have repercussions throughout the stock market.
A short volatility fund allows a buyer to bet that future market volatility will fall. With volatility at historic lows, shorting volatility seems like a bad idea, but it didn’t stop investors from piling their money into these funds. Because there weren’t enough investors to take the opposite end of the trade to buy volatility, securities dealers took the opposite end of the trade. To offset their risk, the dealers bought a long futures contract on the S&P 500 to zero out their volatility exposure. This is why as volatility fell, the stock market rose.
Upon liquidation, the dealers will need to sell their long S&P 500 futures contracts, which are worth hundreds of millions of dollars. My impression of a liquidation event would involve the dumping of these long futures contracts onto the market, but the liquidation event is being postponed for a couple weeks. This is being done to avoid a mass amount of selling into a stock market has become volatile. Following the mass selloff on Monday, retail buyers have plowed money back into stocks.
Investors have become accustomed to buying each small dip in stocks and with this being a large dip, investors are salivating to get their money in before the next big move up. In the absence of a mechanism controlling volatility, volatility will return in a big way. This is why on Tuesday the DJIA moved a total of 6,000 points during the day as it rapidly moved up and down.
Now that volatility has returned, nobody knows what this means to the markets. One can assume that price fluctuations will be large and rapid. High volatility just means that prices will have large fluctuations. While high volatility doesn’t determine the direction of prices, as those S&P 500 futures contracts are sold, it is likely that future price moves in the stock market will be negative unless there are enough buyers to absorb all of those contracts.
The good news is that when volatility rises – it jumped 115% in one day, there are other asset classes that eventually follow. Gold, which includes the mining stocks, follow volatility up. Bond prices rise too, as interest rates fall. This is a good sign for our current and proposed allocation for the portfolios.
To add to my narrative of falling bond yields and gold reaching new highs, the U.S. Treasury recently announced that they will need to borrow $441 billion by the end of March. This will be one of the largest debt issuances by the Treasury in any quarter. Notably, as I suggested in my last report on the seasonality of gold and bonds, that this large issuance is generally done in the first quarter of a calendar year.
If this issuance is approved, it will push the Treasury reserve balance at the Federal Reserve Banks back to or above their prior highs. This means that bond yields will fall, bond prices will rise, stock prices will fall, oil will fall, volatility will rise and gold will rise – assuming past price movements hold true. This will present a move in gold that should drive the gold and silver miners to new all-time price highs, along with government bond prices.