June 17, 2015

The Escalator

As the US investor-relations profession’s annual confabulation concludes in the Windy City, we wonder how the week will end.

The problem is risk. Or rather, the cost of transferring it to somebody else. Today the Federal Reserve’s Open Market Committee Meeting adjourns with Janet Yellen at the microphone offering views on what’s ahead. The Fed routinely misses the economic mark by 50%, meaning our central bank’s legions of number crunchers, colossal budget and balance sheet and twelve regional outposts supporting the globe’s reserve currency offer no more certainty about the future than a coin flip.  That adds risk.

The Fed sets interest rates – not by ordering banks to charge a certain amount for borrowing but through setting the cost at which the Fed itself lends to banks. Higher rates paradoxically present lower risk because money can generate a return by doing nothing.  Idle money now wastes away so it’s getting deployed in ways it wouldn’t otherwise.

If you’re about to heave this edition of the Market Structure Map in the digital dump, thinking, “There goes Quast again, yammering about monetary policy,” you need to know what happens to your stock when this behavior stops. And it will stop.

When the dollar increases in value, it buys more stuff. Things heretofore made larger in price by smaller dollars can reverse course, like earnings and stock-prices.  As the dollar puts downward pressure on share-prices, derivatives like options into which risk has been transferred become valuable. Options are then converted into shares, reversing pressure for a period. This becomes a pattern as investors profit on range-bound equities by trading in and out of derivatives.

Since Sept 2014 when we first warned of the Great Revaluation, the apex of a currency driven thunderhead in things like stocks and bonds, major US equity measures have not moved materially outside a range. Despite periodic bouts of extreme volatility around options-expirations, we’re locked in historic stasis, unmatched in modern times.

The reason is that investors have profited without actually buying or selling real assets. This week all the instruments underpinning leverage and risk-transfer expire, with VIX volatility expirations Wednesday as the Fed speaks. The lack of volatility itself has been an asset class to own like an insurance policy.

Thursday, index futures preferred by Europeans lapse. There’s been colossal volatility in continental stock and bond markets and counterparties will charge more to absorb that risk now, especially with a sharpening Greek crisis that edges nearer default at the end of June. Higher insurance costs put downward pressure on assets like stock-prices.

Then quad-witching arrives Friday when index and stock futures and options lapse along with swap contracts predicated on these derivatives, and the latter is hundreds of trillions of notional-value dollars. On top of all that, there are rebalances for S&P and Nasdaq indices, and the continued gradual rebalancing of the Russell indexes.

Expirations like these revisit us monthly, quad-witching quarterly. That’s not new. But investors have grown wary of trading in and out of derivatives. Falling volumes in equities and options point to rising attention on swaps – the way money transfers risk. We see it in a trend-reversal in the share of volume driven by active investment and risk-management. The latter has been leading the former by market-share for 200 days. Now it’s not. Money is trying to sell but struggling to find an exit.

Here at the Chicago Hyatt Regency on Wacker Drive, when a NIRI General Session ends, the escalators clog with masses of IROs and vendors exiting. Index-investing, a uniform behavior, dominates markets and there is clogged-escalator risk in equities.

It may be nothing.  Money changes directions today with staccato variability. But our job as ever is to watch the data and tell you what we see.  We’ve long been skeptics of the structure wrought by uniform rules, and this is why.  It’s fine so long as the escalator is going up.  When the ride ends, it won’t impact all stocks the same way, however, because leverage through indexes, ETFs and derivatives – the power of the crowd – has not been applied evenly.

This year’s annual lesson then is no new one but a big one nonetheless. Investor-relations professionals must beware more than at any other time of the monumental uniformity-risk in markets now, wrought not by story but macroeconomics and structure.

So, we’re watching the escalator.

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