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FEAR MONGERING MEETS BRINKSMANSHIP: A COMPREHENSIVE GUIDE TO NAVIGATING THE DEBT CEILING DEBATE

***As a courtesy to you, we're republishing our deep-dive on the Debt Ceiling topic. Originally published on May 11th, this piece walks through the current impasse and how we think it will impact financial markets and the broader economy. In addition we include analyses of prior impasses as reference points for comprehending the current setup.***

 

Conclusion: We expect the current debt ceiling debate to heat up substantially in the coming weeks, resulting in a measured pickup in volatility across global financial markets, primarily as a result of increased  volatility in the US Dollar being driven by the whims of D.C. politicking. Further, we expect the debt limit to be increased prior to any sort of default on any of the federal government’s obligations. And within that legislation, we would expect to see the groundwork laid for potentially meaningful fiscal reform ahead of the FY12 budget debate – an event that is likely to prove dollar bullish when it’s all said and done.

 

With the debt ceiling debacle looming over the horizon, we thought we’d use the opportunity to equip you with an in-depth guide for navigating the next 3-4 months of what is likely to be heightened volatility for global currency, bond, and equity markets. Even as QE2 expires in June, macro markets are likely to continue to gyrate on the whims and words of a few “inspired” politicians within our nation’s capitol.

 

FEAR MONGERING MEETS BRINKSMANSHIP: A COMPREHENSIVE GUIDE TO NAVIGATING THE DEBT CEILING DEBATE  - 1 

 

In short, while we accept the consensus belief that the debt ceiling will eventually be extended prior to any sort of default on the US government’s obligations, we do believe the events and rhetoric leading up to the passage of any deal will be anything but “smooth sailing”. As such, we are in the process of taking down our gross and net exposure within the Hedgeye Asset Allocation Model and Virtual Portfolio due to our expectation of heighted volatility in the months ahead. Below we explain the drivers of said volatility via an in-depth analysis of the current political situation and previous debt ceiling impasses.

 

Current Situation

 

Hitting the Ceiling: Congress created the statutory federal debt limit in the Second Liberty Bond Act of 1917 as a result of negotiations which resulted in securing financing for WWI and creating an additional check on the fiscal power of the executive branch/ruling party. While federal debt is appropriately divided between debt held by the public and intra-governmental debt, nearly all of it is subject to the limit. The powers that be at the time of creation appropriately intended the debt ceiling to be a reoccurring opportunity to reassess the direction of the US’s fiscal policy. It is, however, not without limitations, as the current consequences of not increasing the debt ceiling almost always outweigh the current consequences of extending it, making it quite toothless from a policy making point of view.

 

Creating Headroom: As indicated in Treasury Secretary Geithner’s most recent letter to Congress on May 2nd, we are scheduled to hit the current $14.294T debt limit on this upcoming Monday, May 16th. As such, Geithner & Co. must take “extraordinary measures” to ensure the US government has enough cash on hand to navigate the timing of cash flows in order to fulfill its existing obligations.

 

The first trick in his bag of is to declare a “debt issuance suspension period”. This allows him to suspend (until further notice) the issuance of State and Local Government Securities, prematurely redeem existing Treasury securities held by the Civil Service Retirement and Disability Fund, suspend the issuance to that fund as investments, and suspend the daily reinvestment of Treasury securities held by the Government Securities Investment Fund of the Federal Employees Retirement System Thrift Savings Plan. In addition, he may be forced to suspend the daily reinvestment of Treasury securities held as investments by the Exchange Stabilization Fund. For the sake of brevity, we’re not going to explore in this report the exact technical mechanisms by which these measures contribute to freeing up headroom under the debt ceiling, as the net result of each step is overwhelmingly benign as it relates to the economy and financial markets. For all those interested in digging into these processes a bit more, we are happy to follow up with you.

 

All told, in conjunction with “higher than expected tax receipts”, the aforementioned measures are expected to extend the Treasury’s borrowing authority until “roughly” August 2nd under current projections for financing needs ($738B through the September 30th end of FY11 as of April 27th). The Treasury has asked for a $2 trillion hike in the debt limit to accommodate financing through FY12 under current budget projections.

 

After the ceiling is hit on or around that date, the US government will begin to default on its obligations absent an increase in the debt ceiling or some form of temporary legislation exempting new issuance from being counted towards the statuary debt limit. What is being made clear by Geithner’s letters to Congress is that he considers any failure to pay any of the US government’s obligations (not just interest payments and principal redemptions on Treasury securities) as a detriment to the full faith and credit backing America’s hand shake. While we don’t often agree with the man, we do find common ground on this principle and we believe the vast majority of Americans would agree. Below is a list of federal government liabilities that would be directly impacted should the debt ceiling not get raised in time: 

  • US military salaries and retirement benefits;
  • Social Security and Medicare benefits;
  • Veteran’s benefits;
  • Federal civil service salaries and retirement benefits;
  • Individual and corporate tax refunds;
  • Unemployment benefits to States;
  • Defense vendor payments;
  • Student loan payments;
  • Medicaid payments to States; and
  • General operational expenses for federal government facilities. 

Net-net, the sheer breadth of this list alone gives us conviction that Congress will ultimately enact a permanent increase in the debt ceiling or at least kick the can down the road by temporarily upping the limit to accommodate borrowing needs through the either the remainder of FY11 or CY11. Of course, as with all of life’s many destinations, it’s the journey there that matters most. Given that, we offer the next section as a guide for the road ahead.

 

Political Stakes: Since 1960, Congress has passed legislation which increased (permanently or temporarily) or revised the definition of the debt ceiling 78 times – 49 times under Republican presidents and 29 times under Democratic presidents. So while it may seem like reaching the debt ceiling is a big deal at face value, in reality, increasing the debt limit is quite a common occurrence.

 

Judging by the political posturing and partisan rhetoric being thrown around Capitol Hill currently, however, we expect this round of Piling Debt Upon Debt to be anything but commonplace – especially with characters like Boehner and Reid leading the charge. The next few months will be full of enough headline-worthy news quotes, political posturing, brinksmanship, and enough fear mongering to rattle global financial markets. As we outlined at the beginning of the year, the 112th Congress is among the greatest risks to global financial stability. This summer we expect them to prove us right in spades.

 

As such, we’ve compiled recent quotes from politicians on either side of the aisle in an effort to outline the strategies and goals of each party in the upcoming negotiations. While paraphrasing would indeed save time and space, we find their messages better delivered by actually “YouTubing” these bureaucrats at face value.  Also, if we’ve learned anything from the near government shut down we’ve recently experienced several weeks back (over just $38.5B in “reported” budget cuts), it’s that neither side is afraid to send us to the edge of chaos in order to advance their political agenda.

 

Democrats

  • 5/9: Charles Schumer, Chairman of the Senate Rules Committee, NY: “Mr. Boehner needs to have an adult moment here and now… This next speech by the Speaker will be a litmus test on whether House Republicans plan to finally approach the debt ceiling as adults. So far many of them have not been responsible about this issue at all.”
  • 5/9: Roger Altman, Chairman of Evercore Partners, former Treasury Secretary under Clinton, and consultant of Sen. Schumer: “Markets could crash if it begins to look like Congress will allow a default.”
  • 5/10: Kent Conrad, Senate Budget Committee Chairman, ND: Unveiled a budget proposal which called for a 50-50 split between spending cuts and tax increases. The plan was immediately rejected by Republicans.
  • 5/10: Jay Carey, White House Press Secretary: “It is folly to hold hostage the vote to raise the debt ceiling to prevent the United States of America from defaulting on its obligations to any other piece of legislation… Maximalist positions do not produce compromise.” 
  • 5/10: Chris Van Hollen, MD: “We have identified some areas of common ground [in today’s bipartisan meeting]. The major areas of disagreement have not yet been engaged.” 

Republicans

  • 1/7: Mike Huckabee, former Governor of AR: “One of the things that gives a little bit of juice for the Republicans is that Senator Barack Obama in 2006 stood on the Senate floor with an impassioned speech, saying that we should not raise the debt limit, that it was the lack of leadership, and that George Bush was just completely derelict in duty by asking Congress to raise the debt limit… Mr. President, we certainly don’t think you’ve made this radical change in just a few years, so we’re going to take you up on it.”
  • 5/5: John Boehner, Speaker of the House, OH: “Instead of talking about billions [of budget cuts], I think it’s time to start talking about trillions. They should be actual cuts and program reforms, not broad deficit or debt targets that punt the tough questions into the future... Nothing is off the table except raising taxes.”
  • 5/5: Mitch McConnell, KY: “We face a crisis that makes the panic of 2008 look like a slow day on Wall Street.” Still, McConnell suggested to the Senate floor that he would only vote for an increase in the debt limit in exchange for “deep and permanent” cuts in federal spending.
  • 5/5: Steve King, IA: “I’d put the cutting off of all funds to ObamaCare on that debt ceiling bill and say, there’s going be no raising of the debt ceiling here by the House of Representatives unless we shut off all funding that is going to implement or enforce ObamaCare.”
  • 5/5: Paul Ryan, WI: “[Spending] caps in and of themselves, alone I don’t think our conference would accept that. The GOP wants a down payment of spending cuts… Knowing that we are very far apart between the president, the Senate and where we are, we are not under any illusion that we’re going to get some grand- slam agreement… getting a single or double instead of a home run is the goal of the talks… Tax increases are off the table and triggers for automatic tax increases are a cop-out for those who cannot cut spending.”
  • 5/9: John Boehner, Speaker of the House, OH: “To increase the debt limit without simultaneously addressing the drivers of our debt – in defiance with the will of our people – would be monumentally arrogant and massively irresponsible. It would send a signal to investors and entrepreneurs everywhere that America still is not serious about dealing with our spending addiction... It’s true that allowing America to default would be irresponsible, but it would be more irresponsible to raise the debt ceiling without simultaneously taking dramatic steps to reduce spending and reform the budget in the process.”
  • 5/9: Michael Steel, Spokesman for Boehner: “The American people flatly reject Senator Schumer’s call for a blank check for the Democrats who run Washington to keep their spending spree going. There’s no way an increase in the debt limit will pass without real spending cuts and reforms.”
  • 5/11: Eric Cantor, House Majority Leader, VA: “The substance of [Tuesday’s] discussions was trying to focus in on areas where we can cut spending and cut it big.” He affirmed house support for Boehner’s recent demands for trillions of dollars in budget cuts, saying “Anything less is not serious”

Tea Party

  • 4/10: Sarah Palin, former VP nominee and Governor of AK: “There needs to be an understanding in the GOP leadership that we cannot provide another tool for the liberals to just incur more debt, and that’s what raising the debt ceiling is going to allow again.”
  • 5/9: Michele Bachmann, MN: Recently stated that any vote to raise the debt ceiling must be attached to a bill fully de-funding ObamaCare. She also criticized Boehner for “squandering” an opportunity to cut spending in the latest continuing resolution.
  • 5/9: William Temple, Head of this fall’s Tea Party National Convention: “We’re telling Boehner and all of the House Republicans they came into office with Tea Party help. We now expect them to keep their promises and hold the ceiling on the national debt.” He added that the party would support a small increase if it were to be accompanied by a major policy win such as the repeal of ObamaCare. 

All in all, the gaping divide between the two ideologies on what it would take to collectively lift the debt ceiling by early August is omnipresent in their recent commentary. While it’s clear that some fiscal reform will be included in any legislation towards increasing the debt ceiling (US dollar bullish), it’s almost equally as clear that: a) it will fall short of current Republican demands (US dollar bearish) because the Democrats are, on the margin, willing to stand their ground and engage in this game of political brinksmanship (evidenced by GOP leaders backing away from their recent support of Paul Ryan’s Medicare reform plan); and b) as political brinksmanship inches us closer to the deadline, we are likely to see a measured increase in fear-mongering quotes that are likely to be the source of much consternation for global financial markets.

 

As such, we anticipate a broad-based pickup in volatility, given the heighted Correlation Risk we’ve seen across all asset classes to date. This tug-of-war on the US dollar is an acute risk that needs to be managed around, particularly from a timing perspective. In short, the playbook is as follows: Republican compromise = dollar DOWN; Democrat compromise = Dollar UP. Gaming Policy is about to get a little more challenging in the coming months.

 

Historic Impasses

 

Below we briefly touch upon prior debt limit impasses and how key financial markets fared in the months leading up to and just beyond the eventual increases.  Keep in mind that the charts below are not at all an attempt to forecast what might happen in the coming months; like history itself, no two debt ceiling periods are alike. Rather, the illustrations below are merely points of reference for pondering how the markets will react this time around.

 

1985: In September of 1985, the Treasury Department became unable to issue new securities as a result of the statutory limit on federal debt being reached. As such, it was forced to take “extraordinary measures” consisting of and similar to the maneuvers listed in the section above. The debt limit was temporarily increased on November 14, 1985 and permanently increased on December 12,1985 from $1.82T to $2.08T. In addition, the accompanying legislation granted the Treasury Department authority to declare a “debt issuance suspension period” in future debt limit impasses.

 

FEAR MONGERING MEETS BRINKSMANSHIP: A COMPREHENSIVE GUIDE TO NAVIGATING THE DEBT CEILING DEBATE  - 2 

 

1995-96: On November 15, 1995, the Treasury Department declared the first ever “debt issuance suspension period” and used “extraordinary measures” to finagle its way through the beginning of the next year. It subsequently notified Congress that it did not have enough cash on hand to pay the March 1996 Social Security benefits, at which point Congress responded by temporarily increasing the debt limit in an amount commensurate to the upcoming benefit distribution ($29B).  Just one day before the March 15th deadline, Congress acted to extend the temporary increase by two weeks until March 30th. And just one day before that deadline, Congress passed legislation permanently increasing the debt limit to $5.5T from $4.9T.

 

FEAR MONGERING MEETS BRINKSMANSHIP: A COMPREHENSIVE GUIDE TO NAVIGATING THE DEBT CEILING DEBATE  - 3 

 

2002-03: At several instances during this two year period, the Treasury Department had to declare “debt issuance suspension periods” (April 4, 2002-April 16, 2002; May 16, 2002-June 28, 2002; and February 20, 2003-May 27, 2003) and take “extraordinary measures” to smooth the timing of cash flows in order to meet the federal government’s obligations. The debt limit was permanently increased twice during this legislative impasse; first on June 28, 2002 to $6.4T from $5.95T and subsequently on  May 27, 2003 to $7.38T.

 

FEAR MONGERING MEETS BRINKSMANSHIP: A COMPREHENSIVE GUIDE TO NAVIGATING THE DEBT CEILING DEBATE  - 4

 

Summary

 

While we expect the US dollar to find a bid at some point in the coming months due to the market eventually looking through this impasse to the increased likelihood of meaningful fiscal reform in the intermediate term, we do think the weeks leading up this occurrence will provide another opportunity for the global currency market to vote against the short-term political compromises we continue to see out of Washington D.C. If anything, this exercise will continue to expose to the world just how far away both sides are from agreeing on a credible solution to the #1 issue driving the US’s long-term fiscal and balance sheet deterioration – entitlement spending. Over the near term, however, we expect the tough choices to continue to get punted to future sessions of Congress.

 

Darius Dale

Analyst

 

FEAR MONGERING MEETS BRINKSMANSHIP: A COMPREHENSIVE GUIDE TO NAVIGATING THE DEBT CEILING DEBATE  - 5 

 

Sources: US Department of the Treasury, CBO, Government Accountability Office, The Hill.com, Fox News, Congressional Research Service, and National Association of State Budget Officers.


European Risk Monitor: Greece at the Forefront

Positions in Europe: Long Germany (EWG); Sweden (EWD)

 

All eyes are back on Greece on the backdrop of increased European credit and political uncertainty over the last week.  As we continue to press, piling debt upon debt doesn’t end well – now the question remains the timing and form of a Greek debt default, restructuring, or some combination or hybrid of the two. Last week Jean-Claude Juncker candy-coated the issue and called for a possible “re-profiling” of Greek debt. What’s apparent is that EU officials will continue to extend & pretend, by delaying and/or re-allocating funds over the near to intermediate term to make concessions for Greece’s fiscal shortfalls. This should ultimately add support in the EUR-USD trade (around $1.40), but by no means reduce volatility in the pair.

 

Through increased pressure from EU officials, the Greek government is meeting this week to discuss a fifth austerity package, with plans to sell €50 billion of state assets to help pay down its bloated deficit. The headline risk associated with the talks continues to punish the capital markets of Greece and the rest of the periphery. Last week the Greek Athex (equity) was down -4.3%, and is down a full -25% since its ytd high in mid February. This morning we see yields of 10YR bonds from the PIIGS jumping, with Greece rising a full 44bps to just short of 17%, while Portugal rose 41bps to 9.63%!  A similar trend is seen with sovereign CDS, and the question remains just how much more likely a default of Greece is with CDS in the area code of 1400bps versus say 1300bps? After all, Lehman Brothers blew up around 600bps (see charts below).

 

European Risk Monitor: Greece at the Forefront - b1

 

European Risk Monitor: Greece at the Forefront - b2

 

Of the news and data causing consternation this morning (European equity indices are down 150-300 bps today):

 

1.)   Preliminary Services and Manufacturing PMI for May out for the Eurozone, Germany, and France, all fell considerably month-over-month (see chart below). As we’ve been highlighting over recent months, we’ve seen pockets of high frequency data slowing from the region’s largest countries. We remain bullish on Germany (currently in the Hedgeye Virtual Portfolio), but cautious as we monitor the data. Certainly Germany has not been immune to inflation (CPI stands at 2.4% Y/Y), however readings continue to come in under the EU average, and significantly below UK CPI at 4.5%.  

 

European Risk Monitor: Greece at the Forefront - b3

 

European Risk Monitor: Greece at the Forefront - b4

 

 2.)   Standard & Poor’s revised Italy’s credit-rating outlook to negative from stable, citing the nation’s slowing economic growth and diminished prospects for reducing government debt. If you’ve been following our work you’d know we’ve taken this tact for months on Italy (and also Spain).  S&P affirmed Italy’s A+ long-term rating. 

 

3.)   PM Jose Zapatero’s Socialist Party suffered a huge blow in state and municipal elections of the weekend, as expected. The opposition center-right Popular Party took share in virtually all 13 regional governments that were up for grabs. Zapatero conceded the defeat but ruled out early elections. The political fragility of his party’s rule make it all the more unlikely that the country will be able to pass further austerity measures to limit the budget deficit (9.3% of GDP).  The protests being called on the streets over unemployment should remain a permanent fixture, as a coherent strategy for growth and reduction in joblessness is nonexistent. 

 

4.)   German Chancellor Angela Merkel’s Christian Democratic Union Party (CDU) suffered a blow in a state election in Bremen over the weekend. Voters re-elected the Social Democrats (SPD) with 38% approval, followed by the Green Party at 23%. Merkel’s CDU fell 5pp from last election to 20%. The set-back follows two other defeats in state election ytd (Hamburg and Baden-Wuerttemberg), and highlights the cracks forming in Merkel’s foundation. Importantly, voting shows Merkel’s popularity continues to be punished based on her flip-flop on nuclear power following Fukushima.

 

 

Our European Financial CDS Monitor shows that bank swaps in Europe widened last week, with 36 of the 38 swaps wider and only two tighter. A major inflection, as expected, was Greek banks.

 

European Risk Monitor: Greece at the Forefront - b5

European Risk Monitor: Greece at the Forefront - b6

 

We’ll get a number of confidence readings from Europe this week as well as second revisions of Q1 GDP.  Today we added Sweden via the etf EWD on the long side to the Hedgeye Virtual Portfolio. Sweden remains a fiscally sober country (like Germany) with a strong growth profile of 4.5% this year. So long as the country continues to see demand for its goods from the EU, we like the country’s outlook given the Riksbank proactive rate hikes to head off inflation.

 

Matthew Hedrick

Analyst


The Correlation Risk: SP500 Levels, Refreshed

POSITION: Covered SPY Short

 

It’s a big up day for the US Dollar and a big down day for US stocks. This is The Correlation Risk.

 

The problem now is that Growth Slowing as Reported Inflation Accelerates (emphasis on the word Reported) is going to make the US economy look a lot like The Stagflation. And The Stagflation is bad for the market multiple.

 

Remember, Reported Inflation is a lagging indicator, whereas the USD/CRB relationship is a leading one. For the stock market, we’ll continue to summarize this as Deflating The Inflation (Q2 Macro Theme)– and as it occurs (May-July), you want to be managing risk to US Equities with a bearish bias. Short high, Cover low.

 

Across our 3 core risk management durations (TRADE, TREND, and TAIL), here’s where risk is priced today: 

  1. Long-term TAIL = 1377 remains resistance – long-term lower-highs are bearish (Japan)
  2. Intermediate-term TREND = 1321 is under siege today and needs to hold this week or this market could go a lot lower
  3. Immediate-term TRADE = 1315 is oversold, setting us up for another low-volume bounce to lower-highs YTD 

Ultimately, the only way out of this mess (for the economy and country) is via a strong US Dollar. That’s why Deflating The Inflation is going to be a bullish catalyst for stocks. From what time and price remains a question that we’ll be answering day to day.

KM

 

Keith R. McCullough
Chief Executive Officer

 

The Correlation Risk: SP500 Levels, Refreshed - 1


Daily Trading Ranges

20 Proprietary Risk Ranges

Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.

JCP: Storytelling Alert

Keith covered JCP in the Hedgeye virtual portfolio today. Make no mistake -- this a TRADE -- as he is managing risk ahead of storytelling at Ira Sohn Conference this week. We remain squarely bearish on JCP for the intermediate-term TREND and long-term TAIL.

 

JCP: Storytelling Alert - 5 23 2011 11 32 37 AM


GALAXY GROWS THE MARKET

Bumping our estimate up to HK$23-24BN for May

 

 

In the first week that includes Galaxy Macau, the market generated HK$775 million in gross table revenues per day, up from HK$528 last week and HK$640 million YTD.  It’s too early to determine how much Galaxy has grown the market since we only have one week of data and don’t know what the hold percentage was.  Given the strong opening of Galaxy, we are increasing  the bottom end of our projection range for the full month of May from HK$22 billion to HK$23 billion and are now estimating a range of HK$23-24 billion.

 

The opening of Galaxy Macau clearly had a positive impact on Galaxy’s overall market share.  The company garnered 17.8% share in the past week, pushing Galaxy’s full share to 12.2% for May to date, versus a trailing 3 month share of 10.1%.  The big market share loser in the past week was LVS, losing 330bps from its trailing share.  Surprisingly, MPEL only lost 90bps following the opening of Galaxy despite being generally considered the biggest loser to the new property.  MPEL’s share actually recovered a bit from last week’s month to date 13.2%, which was hurt by low hold, despite the opening of Galaxy.

 

The figures through May 22 are shown below:

 

GALAXY GROWS THE MARKET - macau1

 

The following table compares this past week’s average table revenue per day to the average for the past three months by property.  Interestingly, despite the impact of Galaxy Macau, every company generated higher revenue per day post-Galaxy than pre-Galaxy, except for LVS.  On limited data, it appears Galaxy has grown the market.  The one caveat here is that we have heard that Galaxy has offered a lot of junket credit in conjunction with the opening and some of the other players may have followed suit.  This may not be sustainable.

 

GALAXY GROWS THE MARKET - macau2


The Fat Tails of VaR

Conclusion: As if risk management wasn’t difficult enough, there is a strong case that the “institutionalization” of risk management may actually be increasing risk and market inflection points.

 

Not only have we seen heightened volatility in financial markets over the past couple of years, but we have also witnessed accelerating volatility.  On the first point, we’ve highlighted a chart of the VIX, which is a volatility measure on the SP500, going back three years, which shows the strong relationship between an extreme in Federal Reserve Policy and this increase in volatility.  In our view, extremely loose Fed policy has both shortened the business cycle, as well as increased price volatility.

 

The Fat Tails of VaR - 1

 

To the second point, in conjunction with this broad increase in price volatility, we have also witnessed a number of accelerations in sell offs in certain markets.  The most obvious example of this is the “Flash Crash” that occurred on May 6th, 2010 and resulted in a 900 point drop in the Dow Jones Industrial Index, a 9% decline and the second largest intraday decline in history.  Just as quick as it happened, the Dow regained most of its losses within minutes on May 6th.

 

The Fat Tails of VaR - 3

 

While the “fat finger” theory has been largely disproven, the explanation given in “Findings Regarding the Market Events of May 6, 2010”, a joint report from the SEC and CFTC, still seems somewhat inadequate.  According to the report, the “Flash Crash” was likely initiated by a large and unnamed mutual fund firm that initiated a massive sell order of 75,000 E-Mini contracts, which had a value of $4.1BN.  According to the report, the algorithm the trader used was set to “target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time.”  While in “normal” markets, this execution may have gone off without a hitch, the equity markets on May 6th were more volatile and less liquid than the typical trading day.  As a result, this sell order initiated a dramatic sell off as the broad market was overwhelmed with sell orders, which was then amplified by high frequency traders.

 

According to the joint report:

 

“The combined selling pressure from the Sell Algorithm, HFTs and other traders drove the price of the E-Mini down approximately 3% in just four minutes from the beginning of 2:41 p.m. through the end of 2:44 p.m. During this same time cross-market arbitrageurs who did buy the E-Mini, simultaneously sold equivalent amounts in the equities markets, driving the price of SPY [an exchange-traded fund which represents the S&P 500 index] also down approximately 3%.


Still lacking sufficient demand from fundamental buyers or cross-market arbitrageurs, HFTs began to quickly buy and then resell contracts to each other – generating a “hot-potato” volume effect as the same positions were rapidly passed back and forth. Between 2:45:13 and 2:45:27, HFTs traded over 27,000 contracts, which accounted for about 49 percent of the total trading volume, while buying only about 200 additional contracts net.”

 

Another aspect to the “Flash Crash” that has been discussed less, but is perhaps just as relevant structurally, is the evolution of institutional risk management and its impact on accelerating volatility in global markets.  Specifically, most large financial institutions that commit capital utilize a number of standard measures of risk to determine their exposure and risk.  The most common of these metrics is Value at Risk, or VaR.

 

Like many consensus risk management measures, VaR was developed after a risk management event.  In this case, it was the stock market crash of 1987 that led many large institutions to develop and institute this measure of risk to evaluate their exposures across trading desks, groups, and geographies.  While every financial firm likely has their own tailored definition, VaR is typically defined across a probability, time horizon, and portfolio.  By way of an example, a 3-day 97% VaR of $3MM implies that the given portfolio has a 3% probability of losing $3MM in a 3-day period.

 

Critics of VaR, and there are many, deride the risk metric because it typically assumes normal markets and limited trading within the probability period.  Further, it doesn’t account for the potential loss period effectively.  Typically, the loss distribution is a fat tail, so the 3% in the tail potentially has massive loss potential.  Our friend David Einhorn put it most succinctly when he said VaR is, “like an airbag that works all the time, except when you have a car accident.”  Now to be fair, some of this criticism has been taken to heart and institutions continually experiment with VaR and other risk management metrics to improve them.  One of the more recent derivations is LVaR, or Liquidity Value at Risk.

 

According to the Bank of International Settlements the key attribute of LVaR is, “the holding periods in the risk assessment are adjusted to account for market liquidity, in particular by the length of time required to unwind positions.”  The implication of this tightened risk management metric is that it creates a feedback loop of sorts.  As liquidity decreases, the trader’s ability to take risk, according to LVaR, decreases and the trader is then forced to decrease the size of the positions.  The potential snowball effect is that across the market, traders could be forced to sell positions into increasingly illiquid and one way markets as they are forced to reduce exposure.

 

The recent action in the commodity futures markets appears to suggest this type of selling is occurring.  In a chart below, our Energy Sector Head Lou Gagliardi, shows that the oil futures contract spread is at a 5-year high.  Under an LVaR analysis, as liquidity in the oil futures market decreases, the exposures available to many institutional traders may decrease, which creates a snow ball effect in terms of market activity.  In the scenario of an extreme long or extreme short position, market price accelerated volatility may be particularly pronounced.

 

The Fat Tails of VaR - 2

 

In fact, we have seen this in a number of commodity markets this month. In one day in early May, oil was down more than 8% and silver was down more than 20%.  As if risk management wasn’t difficult enough, there is a strong case that the “institutionalization” of risk management may actually be increasing risk and market inflection points. Be wary of the fat tails of VaR.

 

Daryl G. Jones

Managing Director


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