‘Rolling Minsky Moments’ And ‘Pseudo-Stability’: Revisiting The Avalanche

That relationship is what allowed the low vol. regime to optimize around itself; it is also what killed off “choice” and replaced it with “selection”.

Market participants could not rebel against the prevailing order unless they intended to burn premium waiting for something (i.e., a sustained move higher in volatility) that was not only unlikely to happen, but in fact could not happen in the absence of other market participants joining in and agreeing to stage a coup.

Theoretically, one could “choose” to rebel, but that would entail underperformance as everyone else rode the carry gravy train. Are you really “free to choose” if rebellion assures your destruction? Not really, because at that point, exercising your freedom is tantamount to suicide.

And so, “choice” became “selection”. Something like this: “Here are some ostensibly different options for expressing the carry trade, and you can select from this list.”

At that point, there was no conceptual difference between trades. It’s all one trade, and each option is distinguished only by the amount of carry on offer. Here’s Kocic from a January note:

Through their communication with the markets Central banks, and the Fed in particular, have become “good listeners” with their decisions and actions made with markets’ consent. After years of this dialogue, the markets have gradually surrendered to the ever shrinking menu of selections that converged to a binary option of either harvesting the carry or running a risk of gradually going out of business by resisting. Not much of a choice, really. In this process, Central banks have reached a point of enormous power and control where market dissent is practically impossible. We believe that such levels of market control remain uncontested with anything we have seen in recent history and that the markets’ dynamics have never been further from that of the free-markets. Low volatility is a perfect testimony of that.

That state of affairs creates an environment that seems stable, but in fact is not. Here again, Deutsche’s Kocic offers the best exposition. This is from a June 2017 note (more here):

In general, there are three types of equilibria to distinguish: stable, unstable and metastable. The bottom of the valley is stable; top of the hill is unstable; a dimple at the top of the hill is metastable (Fig). Metastability is what seems stable, but is not — a stable waiting for something to happen. [An] avalanche is a good example of metastability to keep in mind — a totally innocuous event can trigger a cataclysmic event (e.g. a skier’s scream, or simply continued snowfall until the snow cover is so massive that its own weight triggers an avalanche).

Kocic0

That is how this situation has evolved.

Why trace it in such painstaking detail? Well, because you need that frame of reference to understand what the above-mentioned Charlie McElligott meant on Thursday when he said this in the same note cited here at the outset:

As higher real interest rates reset term-premia, the cost of leverage, cross-asset correlations and asset price valuation across this post-GFC era market structure, Minsky Moments are a simple fact of nature—STABILITY BREEDING INSTABILITY.

In the hours after Charlie’s Thursday missive made the rounds, U.S. equities of course suffered another harrowing bout of selling and later that day, he made a cameo on Erik Townsend’s MacroVoices podcast. Unsurprisingly, all of the above came up.

“If I’m really stepping back and talking almost more philosophically, it’s the bigger picture here is that a higher real interest rate environment is resetting term premiums and, with that, the cost of leverage, cross-asset correlations, asset price valuation – all of these constructs built into the post-crisis quantitative easing era are now ripe to tip over,” McElligott said, responding to Erik’s question about a prospective shift in the landscape.

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Disclosure: None of what I write here is to be construed as advice to buy or sell any kind of asset. It is merely my personal and not my professional opinion. Any asset can go to zero.

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