This is the third straight asset bubble in 12 years - 1. DotCom 2. Housing 3. Now this Debt Monetization bubble. In each situation, there were explicit incentives and malincentives that both inflated the bubble and amplified risks. For the housing bubble, we know that low interest rates coupled with securitization, coupled with lax lending standards, a "laissez-faire" regulatory environment, and all of Wall Street's privately traded and massively leveraged derivatives (CDO/CDS), all combined to create a financial Weapon of Mass Destruction. Granted, in this current era we won't find out what massive risks that Wall Street and the banks have conjured up this time - until after the fact. Yet, we can already discern by looking at public markets some very obvious incentives to increase, ignore and amplify risk, that will combine to create the all new financial WMD...
Reach for Yield and Ignore Economic Fundamentals
First the most obvious amplified risk stems from low interest rates and debt monetization programs which have set off a global "hunt for yield". Pension funds and indeed pensioners can't survive long-term on 1% interest rates, so they have been incentivized to take significantly more risks than they would like to otherwise. This phenomenon is manifest in the Junk bond market and also in the Municipal bond market, which as we see below has reached new multi-year highs.
Bear in mind, these are bonds, yet, they are still subject to a high degree of "volatility" when the shit hits the fan - as you can see to the left during 2008.
Also unlike 2007, when the U.S. was also sliding into recession, the stock market is not "discounting" an economic slowdown ahead of time. As one by one the various economic indicators roll over, the market simply shrugs it off and focuses on inbound liquidity supplied by Central Banks. The entire third quarter earnings season ending in this past October was a disaster with weak earnings from GE, McDonald's, Cummins, Walmart, Google, Fedex etc. All just ignored as the market levitates higher, in the face of eroding fundamentals.
Punished for Hedging
The hunt for yield is only half the problem though, because ironically, as we see in the first chart above, the options volatility gauge (VIX) in black has just hit a new multi-year low, even as the market is still within reach of its multi-year high. The VIX indicates the amount of market volatility as reverse imputed from options prices. Ironically however, the computers that price options use actual realized volatility as a stub for the VIX i.e. it's a circular reference. This "Black Scholes" based model of options pricing works great in a low volatility, slowly rising market, but as we have seen on many occasions, it underprices risk at market tops and overprices risk at market bottoms - which is exactly the opposite of what the so-called "Efficient Market Hypothesis" would predict. Those people who sold put options at the top in 2008 gleaned very little in terms of "premium" for selling the options, and were soon saddled with massive losses. Meanwhile, those who bought put options at the bottom in 2008, paid an enormous price and then were saddled with losses immediately as the market rocketed higher and the VIX collapsed.
As I said above, the fundamental flaw in this pricing mechanism is that the market making computers that price options, use recent historical volatility to price options e.g. the past 60 days for instance. And yet realized market volatility is always lower at market tops and higher at market bottoms. More to the point, as we see on the top chart, this QE period has produced some very long drawn out slow grinding rallies that have compressed the VIX into repeated oblivion. Ironically, even though the VIX is again very low now, hence making options prices "cheap", hedge funds that use options to hedge have substantially underperformed the market because their hedges keep losing money, since they have to be constantly rolled over and future priced volatility is generally higher than "current" priced volatility.
This is all just a long way of saying that Central Banks have made hedging very unprofitable, as this is the third year in a row of major hedge fund underperformance. Meanwhile, shorting volatility, using options or futures, has become a very profitable trade for the past four years.
This chart below, I also showed recently, confirms that the open interest number of protective put options relative to the number of speculative call options (blue line) is at a two year low, for the Nasdaq 100 ETF (QQQ):
The Mother of All Carry Trades
Lastly, I would be remiss in not again mentioning the carry trade risk that was created when the ECB's Mario Draghi gave tacit "support" to all Euro Area bonds. That created the incentive to borrow huge amounts in USD and then buy Spanish and Italian bonds. Yet another risk that will have to be unwound at some point.
In summary, sure, we are still left to guess "when" this all turns out, however, we already know "how" it all turns out, based on the incentives that have once again been put in place to amplify and ignore risk. By creating a one sided market that only rewards selling of risk insurance (VIX) and not buying risk insurance, puppet masters at Central Banks have guaranteed that hedgers and VIX short-sellers will all be reaching for protection at the same time, leaving no one on the other side of the market.
