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What This Market Move Means

Let us first describe the action that has taken place over the last few trading days.   The 16% drawdown that occurred last summer because of the Greek and Eurozone crisis took a bit over 2 months, even with the May 5th flash crash.  The current drawdown of over 18% has taken only 13 trading days, and much of that drop happened in just a few days:

Quick drop, even for the demon of our own design

My general feeling is that this move is nothing like the correction that happened in the summer of 2010, it feels a lot more like the dry up in liquidity that happened after Lehman Brothers imploded.   What really stands out, aside from the quick drop in the S&P 500,  is the precipitous drop in US interest rates across the board.  The current 10 year rate of 2.29% represents nearly zero future growth OR a significant flight to perceived quality regardless of what S&P says:

Rates at Global Financial Crisis levels?

My feeling is that the recent market moves have little to do with S&P ratings downgrade and much more to do with a flood of money out of Eurozone areas along with a significant level of fear regarding a double dip recession.  My double dip recession fears are significantly smaller than most pundits out there.  I do believe it is possible we are in a small recession or entering into a recession, but I do not believe that the magnitude of this drop could reach anywhere near 2008.  I also believe that the US Federal Reserve is more than eager to do anything in their power to dampen the blow.  Those actions are made significantly easier by a total lack of inflation, persistently slow recovery and large unemployed population.

The largest question to answer is how the Eurozone crisis gets resolved and what a significant default would mean to the European banking system and the global financial markets.  My own feeling is that sovereign defaults are less of binary outcome than corporate defaults like AIG or Lehman Brothers.  They do not happen overnight.   After Lehman went under, the fear that drove the markets lower was that you could not lend your money to anyone because they will not pay you.  What really drove the fear of contagion was the immediate lack of liquidity by corporations after there was any subtle hint of insolvency.  Suddenly, people withdraw money from all banks and massive global companies cannot fund themselves in overnight markets (General Electric).  The liquidity issue should not occur on the same scale with developed governments as it does with private corporations.  The Eurozone can print Euro’s for Greece, or Greece can start printing Drachma’s again.   In addition, global central banks are injecting massive amounts of liquidity via easy monetary policy as a response to the 2008 slowdown.  The Fed is lending money to anyone who will ask, which should help stop the system from seizing up like it did in 2008.

As final comparisons, it is important to look at where we are.  The global economy is not in a an overly exuberant “boom” cycle.  Investors are still fearful and the global recovery has been slow.  Corporations and investors have not been expanding at overly ambitious rates, so it is hard to see how the pullback could be nearly as strong.  It is also important to look at what caused most of the pain – the housing market.  Housing prices are already depressed and it is difficult to see another huge drop in prices unless we believe in a massively pessimistic outlook.

I could look for many data points to try to back up my own lack of immense fear such as corporate profits, earnings yield on the S&P 500, or the lean operations of S&P 500 companies.  Instead, I wanted to point out an interesting market signal which is the difference between what the VIX and longer dated VIX futures.  In 2008, the VIX spiked to about 80% and the 7th VIX futures contract spiked to about 45%.  In 2010 the VIX spiked to about 45 and the 7th VIX futures contract spiked to about 35.  In this latest drop, we saw the VIX spike to 48%, but we only saw the 7th contract spike to 27.5% which was only slightly higher than what it reached in March of this year:

Not the same reaction on the longer end of the curve

This is not the perfect symbol, but I would say that it indicates the volatility markets are saying this is a short lived drop rather than a return to depression like economic and market conditions.

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7 Responses

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  1. stewart says

    Does your chart reflect what you said it does? In 2008, the 7 month seems to lag the near month until after the latter peaked, then it stayed higher for some months.. In 2010, they seemed to move up in lock step, and again, the 7 month stayed elevated for a couple of months after the near month receded. This time (and only with a couple of days under the belt) there appears to be a lag.
    I wonder if isolating the events with a shorter time frame (say in 4-6 month chunks) might give a more accurate picture? Maybe with the shorter time frame bar charts might be useful.
    I think your reasoning about the trigger is good. Perhaps a chart with showing the Eurobor/Libor spread would help show this?
    But the US is not without its stress points; did you see the chart noted in the FT Alpaville blog yesterday showing how BofA’s CDS curve had risen 100 bp at the long end and went virtually flat all the way out fro a contango in one day?

  2. SurlyTrader says

    Your point is a good one. In the 2008 time period there was a decent lag between the VIX spiking and the 7th month VIX futures. In the May 2010 flash crash, they moved in lock step and my argument would be that the markets now *expect* 2008 again. Market participants base their fear on recent experiences and in 2008 they had nothing to look back to except for the great depression…which meant nothing to the market participants. This would imply that the moves should occur more in tandem like they did in 2010.

    From what I can see, it seems that liquidity is still out there. Corporate bond issuance is still going on with oversubscriptions of multiple times. This really feels more like a *RISK OFF* trade en masse. An interesting other question is how much the haircuts on US treasuries caused investors to pledge more collateral. It is possible that the 1-2% increase in haircuts was significant to hedge funds or other leveraged players which caused a sharp deleveraging.

  3. wsm says

    Even going with your VIX vs VIX futures relationship (which I think is an interesting idea), I would disagree with your conclusion to be sanguine regarding today’s fear level vs. 2008′s.

    To wit – the 80 vs. 45 spread that you point out from 2008 is EXACTLY the same percentage spread (43.8%) as the 48 vs 27 spread we saw a couple days ago. Thus, at least in terms of a spread relationship, it IS “the same reaction on the longer end of the curve”.

  4. theta says

    What haircuts to the US treasuries are you referring to? Treasuries have rallied significantly in the past few weeks.

  5. SurlyTrader says

    Institutions often use the Repo or Reverse-Repo market as a way short term facility for borrowing. In a repo agreement you pledge collateral (usually treasury or agency securities) to the counterparty and receive cash in return. The haircut is how much the counterparty (usually a bank) discounts the securities that you pledge as collateral. In this process riskier securities are given a large haircut because the counterparty is worried that the value of the security will change too quickly to cover the cash that they gave you as a loan. If treasury securities are viewed as more risky due to their lower credit rating, then the counterparty would increase the haircut to cover that risk. So far I have not seen the haircuts increase, but it was a concern going into the downgrade:
    http://online.wsj.com/article/SB10001424053111903635604576472600045259640.html

  6. theta says

    OK, so you agree that there hasn’t been any haircut. And the “evidence” you are bringing up is one of those clueless articles written by the useless journalists, the same ones who predicted that yields would rise after the downgrade. Obviously the opposite happened.

Continuing the Discussion

  1. Read before dawn « Florin Citu linked to this post on August 16, 2011

    […] nice piece with a positive view on current market […]



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