Wednesday, April 11, 2012

Artemis On Volatility At World's End: Deflation, Hyperinflation And The Alchemy Of Risk

For nearly 3 years our underlying thesis in viewing artificial capital markets (because what we have today are not normal markets) and the increasing central banker intervention therein, has been that, just as Robert Frost suggested, we will eventually have an ending of either fire or ice, or in practical terms: hyperinflation or hyperdeflation, since what relentless intervention does is accelerate the amplitude of cyclical swingsm, while decreasing the frequency, until one day the market may have swings as great as 100% within minutes. And because the fiery outcome is much easier to achieve (all it takes is a stick CTRL and P key and the rest is silence... and printer toner) for central bankers, we have no doubt which of the two terminal states the game will end in. That said we are delighted to not be the only people who view the end of the current status quo world in such a Hegelian dynamic: another firm whose opinion we greatly respect is Artemis Capital Management, whose latest epic letter is an absolute must read for all.
From Volatility at World's End: Deflation, Hyperinflation and the Alchemy of Risk
Imagine the world economy as an armada of ships passing through a narrow and dangerous strait leading to the sea of prosperity. Navigating the channel is treacherous for to err too far to one side and your ship plunges off the waterfall of deflation but too close to the other and it burns in the hellfire of inflation. The global fleet is tethered by chains of trade and investment so if one ship veers perilously off course it pulls the others with it. Our only salvation is to hoist our economic sails and harness the winds of innovation and productivity. It is said that de-leveraging is a perilous journey and beneath these dark waters are many a sunken economy of lore. Print too little money and we cascade off the waterfall like the Great Depression of the 1930s... print too much and we burn like the Weimar Republic Germany in the 1920s... fail to harness the trade winds and we sink like Japan in the 1990s. On cold nights when the moon is full you can watch these ghost ships making their journey back to hell... they appear to warn us that our resolution to avoid one fate may damn us to the other.

Volatility at World's End symbolizes a new paradigm for pricing risk that emerged after the 2008 financial crash and is related to our collective fear of deflation. The metaphor encapsulates the unyielding sense of dread that the global economy will plunge into the dark abyss and is the source of major changes in volatility markets. Today the existential fear of world's end deflation is so powerful investors are willing to pay the highest prices for portfolio insurance in nearly two decades. The market for forward volatility has become unhinged as the SPX variance and VIX futures curves sustain historically high premiums over low spot vol. My argument is not that this extreme fear is misplaced but that it is mispriced. Like Odysseus in the epic poem the global economy is trapped between the monsters of Scylla and Charybdis. We risk one to avoid the other. From one world's end to the next sometimes I wonder if decades from now we will look back with the hindsight that we were all hedging the wrong tail.

In the face of foreboding undercurrents our US-economic ship seems to have turned course toward calmer waters. The S&P 500 index had its best first quarter in 14 years, volatility fell to a 5 year low, and bond yields rose sharply on the trade winds of better than expected economic and jobs data. Risk assets were buoyed by an orderly Greek default with the ECB's three year bank lending program (LTRO) succeeding in reducing dangerously high sovereign yields in the Euro-zone. While I admit I don't understand why further leveraging the Euro-banking system to the same sovereign debt that caused the crisis will fix anything in the long-run it definitely has succeeded in calming markets in the short-term. Unfortunately this has been a recurring theme and once again there is no shortage of eager financial and political middle-men cheering that the worst is now over. The conventional wisdom says "do not fight the Fed" so by extension of that logic it is madness to fight every central bank in the world by fading this rally. The pace of global monetary stimulus has been astounding reaching almost $9 trillion in total expansion over the past three and a half years in the greatest period of fiat money creation in human history(1). Let me put these numbers into perspective. Collectively global central banks have created enough fiat money to buy every person on earth a 55'' wide-screen 3D television (do the math).

The effect of coordinated global monetary easing on the performance of risk assets and volatility cannot be underestimated. A total of 16 central banks have eased since the fourth quarter of last year alone providing ample support for risk markets(2). The ECB has allocated more than €1 trillion in Euros ($1.34 trillion in USD) since December as part of its three year lending program. The total ECB balance sheet is now an astounding 30% of euro-zone GDP. In addition the Fed has left the door open to a third round of quantitative easing and currently carries a $2.9 trillion dollar balance sheet that represents 19% of US GDP. Emerging economies continue to add stimulus too with China lowering its bank reserve requirement ratio 100 basis points since last November and Brazil easing rates into the high single digits.

In our postmodern economy it is very difficult to separate the reality of fundamental economic growth from the illusion of central bank backed-prosperity. Today's markets are trapped in an Orwellian world of financial repression whereby equity and bond markets are not up, not down, but merely where ever central banks want them to be. When the monetary gods want you to buy risk assets, like it or not, you will be punished for not doing so in the form of ZIRP and lagging performance. What concerns me most is not how markets perform during monetary expansion but what occurs immediately thereafter. For the investor the equation is simple: when central banks are printing money volatility declines and risk assets increase, but when the printing stops... get the hell out of the way.
On practical implications of the realization that central planners run it all, and will ultimately fail:
Today traders are irrationally exuberant for fear.

The VIX futures curve (a rough proxy for SPX forward volatility markets) has become unhinged breaking new boundaries in the price of fear. The cynicism of retail investors burned by a decade of phony bull-markets is driving the popularity of VIX exchange traded notes and introducing retail demand for vega on the front of the term structure. The largely retail buyer base of VIX ETNs seems to follow a one-dimensional playbook for purchasing vol based on anchoring biases with little regard for the intricacies of the asset class (e.g. "buy VXX when the VIX is low"). Farther out on the curve institutional investors are driving up the price of forward volatility by purchasing tail risk insurance even as investment banks have pulled back the supply of short vega due to reduced demand for structured products. Below is visual breakdown of different regimes in VIX futures and options from 2004 to 2012. The steepening of the VIX futures curve and higher volatility-of-volatility ("VOV") skew for VIX options demonstrates the rise of investor fear in the post-crash environment. VIX skew measures the volatility-of-volatility (VOV on y-axis) investors are willing to pay per given level of spot-VIX (on x-axis). The steeper the VIX skew the more premium it costs to hedge against a crash using VIX options. The chart that looks like it was drawn by a first grader (bottom left) shows raw VIX skew data and is hard to interpret. The chart to the bottom right uses a smoothing technique to show the rise in fear and sharply steeper VIX skews whether volatility is at 14 or 40.

The punchline:
Our fear of deflation may damn us to hyperinflation. Even if we fall over the waterfall of deflation first at the very bottom of that abyss may be the fire. It is not currently fashionable to talk about the risks of hyperinflation in modern developed economies. If you merely mention the concept you are quickly relegated to being an apocalyspe junkie, gold bug, or someone who spends too much time looking at the Mayan calender. The Fed and financial establishment seem to be on a public relations campaign to debunk the risks of inflation (I presume as a precursor to QEIII). Remember that psychological bias whereby our minds either completely ignore or exaggerate the probability of rare events based on an emotional connection? It works both ways. We have 100+ years of deflationary fear imprinting. The last Americans to experience hyperinflation on our soil were in the Confederate South during the Civil War. Very few investors or policy makers today have any direct professional and more importantly emotional experience in a hyperinflationary reality.

The financial and monetary establishment currently ridicules those concerned with hyperinflation as being naive ... ironically that is exactly why we should be afraid. During this period of unprecedented fiat money creation a devastating period of long-term inflation is worth serious reflection. The role of a successful trader is not so much to predict the future but to find mispricings in risk. To be clear I am not predicting hyperinflation will occur today, tomorrow, or even in the next ten years... but what I am saying is that the risk in the right tail is not priced into the options market and this is remarkable given a careful study of economic world history.

For a generation of traders (including the author of this paper) the intellectual implausibility of rampant inflation is compounded by spending our entire lives in a cycle of declining interest rates. I remember that while in training at an investment bank they ran us through an incredibly stupid trading simulation using actual market data between 1980 and 2000 condensed into one hour. The team with the most profits by the end earned a $300 bounty. The winning team (wink wink) leveraged their portfolio to the max with long-duration zero coupon bonds and then took an hour long happy hour before coming back to claim their well-deserved prize. If only real trading were that easy! So goes the power of decades of declining rates condensed into one hour. To understand what rampant inflation would mean to our world look at the last few decades in the mirror. and this is remarkable given a careful study of economic world history.

The conventional thinking is that hyperinflation in the developed world is impossible because the velocity of money is close to zero. I find this argument flawed because #1) it ignores economic history and #2) it forgets velocity of money is a psychological concept first and an economic concept second. In other words money velocity is volatile and can reappear just as quickly as it vanishes in a crash. The Fed's thesis that "too much stimulus can be taken back later through a corrective tightening of policies" (Ahearne et al, 2002) is a classic cognitive bias that is at best arrogant and at worst dangerous. Many hyperinflationary episodes in history began with a period of very low velocity of money. In Weimar Germany there was no surface inflation and prices were remarkably stable between 1920 and 1921 as the government doubled the money supply. In that same period Germany had one of the healthiest economies in post-WWI Europe (on the surface) with a booming stock market and for a brief time the mark was even the strongest currency in the world.

There is no historical precedent to understand how modern derivatives market would perform in the hell of destructive inflation. Weimar Republic Germany did not have a market for options, CDS, or variance swaps for us to study. For me it is valuable to theorize how that reality may unfold in volatility markets and to do so we need to think creatively.

In hyperinflation everything we think we know about volatility will be backwards... literally it will be like watching options markets through the mirror. The traditional rule is that volatility will spike when the market crashes and vice versa. This is a rule of markets but not a law. In reality volatility is only a statistic indifferent to the direction of price movement. Volatility increases when an asset declines only because prices fall faster than they rise (the old adage that markets take the stairs up and the elevator down). To illustrate this concept the graphic below shows the 1-month realized volatility of the S&P 500 index deconstructed according to the percentage of variance derived from increases or decreases in the index price. On average 54% of SPX 1-month volatility comes from increases in stock prices but during crashes downside movements may comprise up to 99% of variance (thus far in 2012 increases in the SPX contributed between 80-90% of variance). The market for implied volatility anticipates the fat downside tails associated with market crashes. Since 1987 out-of-the-money put options have traded at a higher volatility level than out-of-the-money call options, a phenomenon otherwise known as negative volatility skew. The VIX index moves up and down the SPX volatility skew on the assumption that higher local volatility will result from a decline in the underlying index (see charts). The negative skew for SPX options became even more pronounced after the 2008 crash as tail risk hedging became fashionable. The problem is that this volatility paradigm, entirely valid in today's deflation fearing market, is completely wrong in a world where prices rise faster than they fall... like in hyperinflation.

The conclusion:
What do we fear more... the evil that we know or the evil that we don't know? The market is clearly fearful of the phantom of our recent economic past and rightfully so. It is not the fear that is the problem but how we respond to it. We fear deflation so much that we have complete faith in the same institutions that failed to foresee it and their judgment in scaling back an unprecedented monetary experiment before we veer into hell. The truth is that pure intellect, even with the best of intentions, can lead us to tragedy if not tempered by common sense. Our real peril is that we value willful ignorance over knowledge and stability over free will. It is not farfetched that one day we will knowingly give up our freedoms to stop an economic terror. In fact many European sovereigns are doing this today. Whether we plunge off the waterfall of deflation or burn in the hell of inflation may matter less than if we recognize ourselves in the mirror when it is all finished.


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