The Authorities (forced to) step up to the plate:

Things are getting wilder by the day – it is said that markets stop panicking when Central Banks start panicking, and it appears that they have now done so. According to Goldman Sachs, there have been 14 days in the last 23 when the S&P 500 has moved up or down by more than 3%, the highest concentration since 2009.

The moves in US equities for the last week have been, shall we say, unusual.

12/3: Limit Down

13/3: Limit Up

16/3; Limit Down

17/3: Limit Up

18/3: Limit Down

The Fed cut rates by 0.5% on the 3rd March and then again over the weekend of 14/15th March, bringing rates down to 0-0.25%, seemingly in tandem with the Central Banks of New Zealand, Australia and South Korea, whilst the Bank of England also did their bit, cutting the UK base rate to just 0.25%, followed up a few days later by a further cut to just 0.1%, boosting their Quantitative Easing (QE) programme by another £200 billion at the same time.

There has been a blizzard of spending and market support announcements by global authorities.

$1.5T in Repo (US)

$1.1T Commercial paper relief (US)

$1T in US fiscal stimulus

$750B QE from ECB

$700B QE from the Fed

$600B bank loan guarantee (France/UK)

$500B in loans (Germany)

$300B in Japanese stimulus (proposed)

$100B in fiscal stimulus across Europe

£200 billion in QE (UK)

The Fed has announced several packages of measures, with a bewildering array of acronyms, (see here for the technical details, including what they all mean – and are aimed to do). The planned US Corona virus relief package aimed at businesses (rather than the stock market) amounts to c $1 trillion and was passed this week by the US Senate whilst the UK too has joined the fray, announcing a £350 billion package to help small businesses who could collapse in the aftermath of the decline in trade. France too has plans to pump over €500 billion into its economy to try to mitigate the worst effects, whilst even Germany is now talking openly about “fiscal measures”, likely to the same extent.

Yet, the markets initial response was negative – both Asia and Europe fell 4% or more on Monday, Wall Street followed and even more concerningly, signs of systemic fragility continued to escalate [1], as US Dollar demand goes parabolic. As feared by some, banks are refusing to lend Dollars on to Corporates (or anyone else either), creating a liquidity freeze, most directly felt by firms trying to raise shorter term cash to pay wages or creditors.

Some speculate that the US needs to put up nearer to $2 trillion in a TARP (Troubled Asset Relief Programme – which is what was used in the 2008-09 crisis) to deal with the problem once and for all, though we may note that this is being demanded by financial analysts and equally we may ask why it would not lead to the same thing as the 2008 rescue package did – i.e. where we are now!

But the markets have flatly rejected the various measures announced by either falling sharply or continuing to do so. Why?

1) Rate cuts don’t kill a virus. Markets appear to be in the process of discounting a long-term demand shock, as companies run out of customers and money to pay bills, leading to a vicious circle where one corporate default leads to another and so on. Lower interest rates do not spur lending to small firms in this situation- in fact the banks would more likely hoard cash themselves and deposit it with the Fed risk-free, to avoid any potential credit risk.

2) In “normal” times, monetary stimulus (QE) would lead to a situation whereby cash was a hot potato, with investors keen to invest in nearly any asset with a higher yield than cash – but in a period of heightened risk-aversion, cash becomes a desirable asset class in itself. Printing more of it does not reduce that demand – a rise in asset prices does that…

3) It looks at least on the surface that Central Banks are panicking – as the opening line in this piece suggests, that is useful to a point, but does there comes a point where all the actions of the authorities to stop the spread of the virus start to become a negative sum game? In short, is the “cure” worse than the disease?

There is no doubt that global authorities have bent over backwards to do what they can, but the question is – will it work? As a result of stock market declines, financial conditions have tightened considerably in recent days.

In the medium term, the answer is almost certainly yes. The main concern is of a cash-crunch that affects the real (as opposed to the financial) economy. The CPFF (Commercial Paper Funding Facility) should help US Corporations weather the short-term liquidity crisis as they can clearly not rely on banks to fund their operations, whilst the US Dollar short squeeze should also alleviate as a result of the swap lines the Fed has arranged with various foreign central banks. The delayed reaction may be at least partly due to the requirement by Risk-Parity (RP) funds and other volatility targeting trading systems [2] to sell almost everything to respond to the huge jump in volatility. According to Nomura’s quantitative analyst, Charlie McElligott, RP funds saw a 15.5% drawdown (i.e. price fall in their assets) in just 18 days- an 8 standard deviation event and an all-time record. RP trading systems are just not able to handle that sort of price change and neither is market liquidity. The selling has hit “safe havens” such as US T-bonds and Gold too, because, if one is losing large sums of money quickly, the natural reaction is to sell other holdings to try to offset the losses- one sells what one can, not what one wants to.

For now, the analogue with the year 2000 has broken down, (as the next chart shows) but in the wrong way, with NASDAQ prices massively undershooting. This will inevitably reverse itself as investors look to take profits on their short positions – and they will be substantial.

Today (20/03/2020) US markets have a “Quadruple-witching” options day, with Index futures, options and Individual stock futures and options all expiring simultaneously. As noted, profits will be substantial and, given the very high pricing of options for April (in line with the rise in the VIX Index to the 60-70 range) it is unlikely that many investors will want to pay the prohibitively high prices for new options contracts for April or May for example.

Thus, dealers, who have sold Index futures and Individual stocks short to hedge their options exposures, will have to buy back to cover those positions. As the next chart shows, the value of options tied to the S&P 500 expiring on 20/3/20 comes to around $1.5 trillion, a third of the total outstanding options. In addition, as time passes, volatility may start to drop off from the hugely elevated levels that pertain currently, leading investors to look to sell the VIX Index, again triggering buying from trend-following investors, such as Commodity Trading Advisors (CTA’s) and computer algorithms.

That is lot of potential buying pressure – as of mid-morning Friday, the S&P 500 is up 3.5%, so this buying may have already started.

Longer term, it is harder to judge – it takes a long time for markets to gain confidence, but that confidence can be (and has been) lost in a matter of days. A lot of the price action in the next few days and weeks will be dependent on Corona-virus-related sentiment swings, which no-one can predict. But how much worse can it get? Most trend following funds are now short equities AND oil, whilst being aggressively long bonds, so the market impact of a further spread of the virus may be limited.

At the Davos Meeting in January, Ray Dalio proclaimed that “cash is trash”, which may go down as an epic mis-judgement, but with cash interest rates this low, there does not appear to be any investment merit in owning it, so investors have few viable options to equities, bonds and property to go to. The most likely scenario remains that shares will be the best option available to investors. We may look back at these events on the months and years to come as just another mini panic that shakes out investors of their positions, setting the stage for a resumption of the bull trend. Best not to be one of those that succumbs….

[1] Basis Swaps reflect the cost of swapping overseas currencies for US Dollars. As US interest rates were (until recently) higher than those of Euros, Yen Sterling etc. in theory, the swap rate should be positive (i.e. a premium would be payable to swap Euros for example to US Dollars), to reflect the interest rate differentials between the Dollar and other nations’ currencies. As the chart shows, it is sharply negative, implying investors willingness to pay almost anything to get US Dollars…

[2] Volatility targeting trading systems apportion trading sizes according to market measures of volatility (such as the VIX Index). As volatility rises, position sizes get reduced, forcing many to sell at the same time as each other-and vice versa, leading to a pro-cyclical approach to market moves – the more prices fall (and thus volatility rises) the more these systems trigger sell orders- and vice versa of course.

At present though, it appears that volatility-targeting funds have little left to sell.