On this week’s MacroVoices podcast, host Erik Townsend interviews Zero Hedge regular contributor, Eric Peters, CIO of One River Asset Management who – having correctly predicted the recent record VIX spike (See “Why Eric Peters Is Betting All On A Volatility Eruption” from Jan 7)- discusses the latest explosion of volatility, and its implications for markets as the global economy exits what has become one of the longest business cycles in history and heads toward the next recession.
The discussion begins with what has been the most talked-about topic of the past month: the blowup of short-volatility products that had earned retail traders millions of dollars in profits during the expansion.
While pundits on CNBC have given investors the all-clear to buy the dip and get back in, believing that all the fiscal stimulus from the Trump tax plan will almost certainly drive asset prices higher again, Peters is much more circumspect: As growth slows and inflation creeps higher, Peters believes markets will anticipate the recession by dumping stocks and bonds lower before the next recession even begins.
And risk parity, which has been a reliable strategy for years, will quickly turn toxic, helping establish a negative feedback loop that will continue to drive bonds and stocks lower…
The problem with products like XIV, which make it possible for retail investors to place extremely risky bets on volatility in a manner that makes them extremely exposed to their own ignorance…
But what, specifically, triggered this blowup, Townsend asked? Was it, as we suggested earlier this month, an intentionally malicious attempt by traders spoofing the VIX complex to manipulate the VIX and trigger the cascading selloff amplified by the product’s explicitly high convexity?
Peters believes there are several fundamental factors that contributed to the selloff, but the poor design of products like the XIV greatly contributed to the selloff.
There’s no question that, in an economy and in a financial system where there’s the level of debt that we have and the sensitivity to interest rates, rising rates are kind of a pre-condition to equity market disruptions and selloffs. I think that the level of volatility selling and its integration into risk models across virtually every type of investment strategy are contributors.
And, having gone through such a long period with very, very little movement, I’d say that many people’s trading books were robust for relatively small moves. But once you’ve passed a certain move – and I think in this case it was probably the S&P down 3-ish% that triggered a whole series of different adjustments that people needed to make to their books and their option books – that then amplified the move in volatility and led to this blowup in the VIX product. But you have to remember that these VIX products were extremely ill-designed. And they were very vulnerable to this. They’re a rare thing that you see in our industry, which is they had a predefined stop loss. And markets are pretty good at finding stop losses and triggering them.
I started my career in the commodity pits, and I witnessed firsthand how the commodity pit is built around finding stop losses on the top side of the bottom side of markets. So I think the market did a great job of finding the stops – and in this case finding the weakest ones, which were in the VIX complex – and hitting them.
But I don’t think that that really explains why this move happened. Why did we get the first leg down, and why are markets starting to move with very little news flow? And, again, that’s something that’s difficult to explain for a lot of people that are trying to do it.
To be sure, there’s plenty of evidence to suggest that XIV and other short-volatility products behaved exactly as they were supposed to during this month’s volocaust. So, what does Peters mean when he says these products are poorly designed?
Specifically, he’s referring to the fact that the larger these products become, the easier it becomes for sophisticated investors to suss out where the stops are, and bet against the fun accordingly…
Number one, I think they were very likely inappropriate for a lot of people that bought them. They’re classic late-cycle type products that, in many respects, are designed to try to create returns in a world where it’s difficult to find returns. And late cycle you tend to see these things pop up that provide enhanced levels of carry, or some type of return that looks safe and is a lot less so.
They were likely inappropriate for people. But I assume that people had a sense for that. I think the design flaw, specifically, is to have a large retail product that has the ability to fall to zero in a day, provided there are a number of conditions met. But, principally, the front month VIX future has to go up 100% for it to lose 100% of its value – means that product, by design, the bigger it gets, the more likely it is that as the VIX moves up in a rapid way the market is able to anticipate that there is a very, very large fire.
And they know exactly where to stop losses. And the market will tend to suck itself up, or the VIX market will tend to suck itself up to that level, because it knows that it has a forest fire at that level.
One of the most befuddling phenomenons to emerge this year across markets is the unraveling correlation between the US dollar and Treasury yields. Typically, they move in lockstep. But recently the dollar has been sinking while yields have continued to climb?
So, how does Peters square this? He believes markets are anticipating that the US economy is heading for a debt-induced recession, which will only be exacerbated by the Trump tax bill and deficit-expanding budget agreements. Because of this, investors are reasoning that interest rates can’t rise too much before causing serious harm to parts of the US’s economy – which explains the dollar’s move.
For rates, political factors like rising wealth inequality across the developed world are creating a loss of confidence in the US economy and the belief that politicians will continue to implement what Peters calls “de-globalization” policies…
The rates, it’s a tricky – and I say it’s tricky because we can all recognize that we have extremely low nominal interest rates relative to history. And we’re not far above 5,000-year lows. We still have major central banks in the world with severely negative interest rates. And there’s still an awful lot of bonds that are trading at negative interest rates globally.
So interest rates, just generally speaking, are very low. Debt is extremely high. And inflation has remained low. So we’re somewhat caught in a dynamic where it’s extremely difficult for rates to go up very high without raising a significant burden on economies. The only way to alleviate that burden is to create more inflation.
But I think, as everyone looks at the world as they see it today, they go, well, it’s going to be difficult for inflation to go up very far. Consequently rates can’t go up very far, because if they do they’ll, essentially, bankrupt economies. And obviously they won’t bankrupt the whole economy.
They’ll pressure it enough that the economy will tip into a significant recession. People’s mental model is, roughly speaking, that. And so they look at it, and they go, well, rates are very low, but they can’t really go much higher without sinking economies and recession – consequently, they’re going to be around the same unless inflation moves up substantially.
That last part I think is what’s necessary. And, ironically, it’s what the major economies in the world are really seeking to deliver right now. They’re not looking to deliver a 1970s-type inflation.
We’ve reached that tipping point within society where income inequality has become sufficiently large that we’re seeing political shifts, whether it’s here in the US, in the UK, in Germany – certainly in those three places – where there’s clear pushback by the mid-skill worker against low wages, low wage growth.
As these things happen, as political winds shift, we’re seeing some of the natural consequences. Which is, let’s call it de-globalization. I don’t think it’s going to be a radical de-globalization. But it’s pretty clear that we’re seeing policies in these various countries that, on balance, are going to lead to less globalization.
Those factors, combined with already very low unemployment, should lead to higher levels of inflation. I think we’re starting to see that right now. And that’s the thing that’s going to allow interest rates to move higher.
Peters says he envisions a correction happening before a recession begins because the Fed is already signaling that it can’t afford to be there to rescue markets without introducing even more risk into the financial system. This shift in the Fed’s stance from actively interventionist to passive – which is necessary for the central bank to position itself to react to the next crisis – is one factor that could contribute to a marked drop in equity valuations. The government’s carefree spending will push inflation higher in an economy where low unemployment and high debt levels will create a natural constraint on growth…and equity markets will internalize this in the form of a correction that could arrive months before the next recession begins.
The Fed will continue to welcome this volatility, Peters says, for fear that markets will end the business cycle with P/E on the S&P 500 above 25, setting them up for a massive, destabilizing correction…
But the Fed is anticipating this “nightmare scenario,” and its shift in communication reflects that.
I think that your insight is absolutely correct in that the world that I’m framing is one where monetary policy and its ability to interact with financial markets and the economy is going to look awfully different from what we’ve grown accustomed to. And that’s going to create a really interesting market.
Incidentally, I think that you’re seeing clear confirmation of this in the way the Fed is speaking. So, unlike 10% correction out of the blue that I’ve seen over many years, this time around we haven’t seen a Fed member come out and say we’re going to be really supportive of the Markets.
In fact, every single Fed governor who’s spoken in – there have probably been five in the past couple of weeks. And then there was Yellen a couple of Fridays ago on her way out. They all said that it is rather capable of dealing with the decline in equity markets and asset prices, and you should do just fine, and we’re not really worried.
I think that what they are in the process of doing is they are beginning to shift the way they communicate with the markets and they’re signaling that they’re no longer going be there the way that they have been.
And there are a few reasons for that. I think number one is because they recognize that, at 4.1% unemployment, and a trillion-and- a-half- dollar tax cut, and a 300-billion- dollar budget boost, and a 90-billion- dollar hurricane recovery spend, and then something that amplifies it with infrastructure spending – they’re looking at this and saying, there’s just literally no way this is not going to lead to higher levels of inflation.
This growth-constrained scenario that Peters envisions, will create major problems for risk parity funds as the new economic environment causes stocks and bonds to plunge, creating a scenario for risk parity funds where deleveraging leads to a vicious feedback loop.
The eventual blowup could make their horrific performance during this month’s selloff look tame by comparison…
There’s a short answer and a long answer to that. Maybe I’ll try for a medium answer. The biggest problem in the investment industry today, the portfolio construct that investors have come to rely on, which is a brilliant construct really pioneered by Ray Dalio – he naturally has done incredibly well from this, and it’s been a fantastic strategy – this risk parity strategy.
And, while there’s certainly more complexity to it that just being long equities and leveraged funds, let’s just view it as that strategy for a moment. It’s essentially what the dominant portfolio has become at all the major investors, pensions, endowments, etc. in the industry. And the beauty of that portfolio has been that you’ve been able to own risk assets and then you’ve been able to own a hedge, which is a leveraged bond portfolio, and that hedge has actually paid you a positive return.
The problem is when equity valuations become very high and interest rates get very low it’s difficult for that strategy to continue to perform very well. All else being equal. Now, however, if you add modest inflation into the formula, that portfolio actually becomes pretty toxic.
That’s the environment I think we’re entering into. And that’s why, ultimately, I see some of these shocks like this most recent market shock as just being trail markers on this path to a much more difficult investment environment.
In summary, while Peters doesn’t envision a return to 1970s-style inflation, given the structural shifts in the US economy, combined with anti-globalist policies instituted by politicians across the West, markets are looking extremely precarious, and investors who are optimistic about the growth prospects of the Trump administration’s fiscal policies should keep this in mind.
Listen to the whole interview below: