Knee Jerk Vol & the Fed


The Fed is now shrinking its balance sheet; they are no longer buying new securities as they mature. Below is a bit of analysis on if the Fed’s recent activities in shrinking its balance sheet is the cause of the recent rise in volatility.

Quick note: Data is at a weekly tenor, from Jan. 8, 2014 to April 4, 2018.


The thinner vertical line denotes when the Fed began to shrink their balance sheet last October; the thicker vertical line denotes when we had that massive vol spike in February of this year.

On the surface, the Fed’s action doesn’t appear to be the cause of all the hullabaloo, i.e. the shift from risky assets to safer assets.

If we turn to bonds, we see the following.


Rates on 10-Year Treasurys have moved higher since the Fed began shrinking it’s holdings of US Treasurys. Recall, bond prices fall as rates rise. Less buyers = lower prices = higher rates.

It appears these movements aren’t directly related to the recent rise in volatility.

However, there appears to be an inverse relationship between bond rates and the VIX Index.

A simple linear regression would see if the markets follow each other and if there was any preditcability between the markets. The equation is as follows:


Regression Summary:

reg summary apr6.JPG

We see a significant coefficient, with a value of -8.545, and an insignificant alpha. Therefore your new equations is:


If you predict a 25 bps rise in bond rates, we would expect to see a 2.3136% fall in the VIX Index, with 95% confidence:


The VIX is crazy volitile and the regression has a small R squared, so take the results with a grain of salt.


Thanks for reading,



  4. Yahoo Finance
  5. Bloomberg


Note: The VIX and the 10-Yr are already percentages, so they’re calculated in absolute terms.

Delta VIX = VIX Value Today – VIX Value Yesterday

Delta 10-Yr = 10-Yr Today – 10-Yr Yesterday


Bogus Tweet Risk


Most financial media is focused on “tweet risk” or “trade wars”. To me, these seem like water under the bridge. It’s in China’s interest politically to retaliate to trade sanctions, but not in their interest to crash US markets. They hold a massive amount of US Treasurys, if they stop buying US bonds, rates will shoot through the roof and China loses. The following analysis attempts to succinctly summize the economic situation.

Tempered Expectations of Future Growth

We’ve crossed the 50 bps level in the 2 to 10 year US Treasury Spread, signaling lower expecations of future growth prospects, strengthening the late stage economic growth narrative.



US Dollar Slides


The DXY Index represents the US Dollar vs a basket of major currencies. Yields in the above chart are represented by the Generic 10-Year US Treasury yield. Higher yields depreciate a currency, as stated by Interest Rate Parity.

A weaker dollar allows foreign investors more buying power in US markets.

Resilience of US Goverment Capital Markets

The 10-Year Treasury rate now sits at around 2.75% following last week’s sale of a LOT of Treasurys. The market is handling this flood of supply well (nearly $300bil last week), as bonds have rallied in the face of rising interest rates. The US Treasury Department will auction off $48bil of 3-month T-bills and $42bil of 6-month T-bills this week.

Rates on the short end are slightly higher following a Fed funds rate hike in March, but longer term yields have fallen since last month signaling strong demand for US debt.


Higher Volatility but Lower Tail Risk

We’ve seen elevated levels of stock market volatility since the beginning of the year. However, since last month we’ve seen less tail risk, i.e. a flatter Volatility Skew.

  1. Elevated levels of Volatility overall
  2. Lower levels of Vol Skew


Tail Risk is the risk of a Black Swan event. This is measured by the relative demand of out of the money calls and puts. As the volatility smile flattens, the market is pricing in less tail risk, albeit at an elevated level of overall volatility.

Higher vol means more trading, which is good for financial services, as are higher rates. A trade war will be bad for industrials. I’ll be watching financials (XLF), and industrials (XLI).

Thanks for reading,


What I’m Reading: Lords of Finance: Bankers Who Broke the World




Disclaimer: The opinions above are my own and are for information purposes only.  This post is not intended to be investment advice.  Seek a duly licensed professional for investment advice.


FX Dynamics

Two competing forces in FX markets: Interest Rate Parity and Hot Money

Interest Rate Parity states that a lower yielding currency should appreciate relative to a higher yielding currency. According to the International Fischer Relationship, higher yielding currencies have higher inflation domestically. This inflation difference causes the high yielding currency to depreciate relative to a lower yielding currency.

An alternative force is hot money.

  • Hot Money = Change in foreign exchange reserves – Net exports – Net foreign direct investment

These are the yield chasers. Higher yield means higher returns, so the high yielding currency apprciates. Investors who chase yield invest so called “hot money”, that will vamoose once yields elsewhere are higher. A country heavily dependent on Hot Money (see: Germany 1928-9) may see wild fluctations in capital flows. See the following excerpt from Lords of Finance…:


Hot money is tough to measure, but it is considered a yield seeking activity. If yields start to rise, money will flood from US equities to bonds, depressing equities. For now, a glut in supply stemming from a fiscal expansion is keeping US yields low.




Gotta Pay the Debt Collector

This entire rally is being fueled by credit, not real gains in productivity. A tweet:

Screen Shot 2018-01-15 at 8.49.57 PM

Let’s investigate. See: Three body problem. Tl;dr Good companies make good stocks, and high quality, trustworthy governments issue to low yielding, safe bonds. There is correlation, but as an investment strategy the relationship seems to be working less and less. Ben Hunt doesn’t dismiss the corollary, he merely introduces a third party in the market. He believes the third body to be central banks and their whopping balance sheets. Hold that thought…

See: Economic Machine, Ray Dalio. In order for there to be growth in an economy, there must be more transactions. A transaction is exchange of cash or credit for goods or services. More cash and credit available in markets means more transactions. One (wo)man’s spending is another (wo)man’s income. FYI: American’s on average spend $97.10 of all every $100 earned.

Credit cards fuel spending; consumers borrow from their future selves to spend today, in the hopes of having a higher income in the future. If rates on credit are low, the cost (interest) to the consumer to borrow today is less than if rates are high. This encourages borrowing. More borrowing, more spending, more transactions, more “growth”.

Below is a graphical representation of the relationship between interest rates and outstanding credit:

Screen Shot 2018-01-15 at 9.50.15 PM.png

M2 is the amount of liquid money available in financial markets, it’s clear that the government is printing more, and at a faster rate, than they used to. The best fit line is polynomial, not linear (with an explainability of 98.7%). Also, note the trend of the yellow data set. That’s consumer debt (boat loans, car loans, RV loans, credit card debt) owned by the US Federal Government.

Here’s that same graph less M2 and the Fed Funds Rate since 2007:

Screen Shot 2018-01-15 at 9.58.01 PM.png


Here’s who owns all outstanding consumer debt:

Screen Shot 2018-01-15 at 10.02.22 PM.png

Check the rift in 2010. This is the government absorbing the blow from 2007-08, through foreclosures. Notice how the US Govt’s share of the pie gets exponentially bigger every year since 2008.

The Federal Reserve of the US, a government sponsored enterprise, has the power to print money and buy securities (bonds) in the open market. The Fed prints money and lends it to the US Government through the purchase of US Treasuries. The government then takes said cash and buys your debt from the banks who lend you money; the banks receive a lower rate of interest than they would from you, but they also receive a guarantee from the US Government they they’ll get their money back. Your payments pass through your bank and onto the US Government’s bottom line. Theres a quasi-governmental agency that does this with Mortgages called Freddie Mac. And we all know how that worked out.

I posit that the growth realized by the US Stock market is fueled by debt, not “…profitability and growth”. There’s a storm coming, and we best be ready when she does.

Best of luck. Thanks for reading,

– Tommander

What I’m reading: The Money Game – Adam Smith


  2. Economic Machine – Ray Dalio –
  8. FRED –

So let me get this straight…


US Government Treasury bonds are the safest asset in the world today. They are implicitly guaranteed to get you your principal back at the maturity of your bond. Economists and investors commonly consider yields on Treasuries to be the ‘risk-free’ rate; meaning rates on Treasuries are the smallest amount of return an investment should provide.

Higher expected growth in the future means longer term bonds will have higher rates. Similarly, if lower growth is expected in the future, longer term bonds will have lower rates relative to shorter term bonds. A common metric quoted in financial news is the “ten to two”, i.e. the yield on a ten year US Government bond minus the yield on a two year US government bond. The ten to two measures the steepness, or slope of the yield curve. Note: slope is also used as a rate of change, i.e. velocity, in calculus (think, economic growth).

Here’s the yield curve today versus a year ago:

Screen Shot 2017-11-21 at 10.11.33 AM.png

The yield curve was steeper last year than it is today. We’ve realized some massive growth over the last year (see table below), and the Treasury market is beginning to temper it’s enthusiasm on future growth.

Screen Shot 2017-11-21 at 10.44.26 AM.png

Note that as home prices rise and wages do not, they’re financed with debt not cash. *cough* 2007 *cough*.

The 10-year Treasury yield minus the 2-year Treasury yield is at it’s lowest level in 10 years. That includes November 2007, right before the market went nose-fuckin-down.

Screen Shot 2017-11-21 at 10.47.17 AM.png

Disclaimer: the ten to two was already on its way up in November ’07, after inverting in March ’07.

It’s pretty much written in stone that money follows performance. Top performing Morningstar funds are given five star ratings. According to this WSJ article, five star rated funds attract massive amounts of assets, only to underperform their past performance: “Only 58, or 14%, of the 403 funds that had five stars in July 2004 carried the same rating through July 2014…”

So let me get this straight, we’ve seen massive performance in the last year. We’ve seen the ten to two at its lowest level in ten years. Why are equities still going up?


  1. The cost of money, i.e. interest rate on loans, is so low that arbitrageurs are borrowing to buy stock, because stock market returns are stable and greater than interest rates on loans. This is called leverage, and is a product of financial engineering. This could be huge once stocks start to fall. (Note: Check leverage levels in the market, thoughts on where to look readers?) Housing growth is also being fueled by easy money, just like last time.
  2. Quantitative easing loaded banks with cash and they’re using it to purchase assets, like money market accounts. Note: I’d like some clarity here, not sure if this is even fundamentally correct. Banks are paid for their excess and required reserves at 1.25%, which is about the same as a 5-year US Treasury bond (1.30%). Why would they get rid of their cash if they’re making 1.25% on every dollar per year; IT’S FREE MONEY FROM THE FED?
  3. We’re hitting the euphoria stage of markets. (See: This is Your Brain on Investing). Markets continue to push all time highs, and the financial media is eating it up. If markets continued at this clip for the next 3 years, both the Nasdaq and the Dow Jones would DOUBLE again (Sauce: Rule of 72). If yearly performance of the Nasdaq and DJIA continued, this is how it would look in November of 2020, does that look right to you?


Good luck, thanks for reading,

– tommander-in-chief

What I’m reading? Wealth, War & Wisdom – Barton Biggs



Discretionary Recessionary Signals

Do you feel more optimistic than a year ago? Despite more negative headlines and political turmoil, bond markets are signaling more optimism surrounding future growth than a year ago.


Nominal yields around the world are much much lower than their historical averages. We actually see negative rates in some European nations. That being said, things are improving. Long-term growth expectations are heating up:


Since a year ago (See: Column “Delta One Year”), all yield curves have steepened, with the Italian yield curve steepening the most severely. In all cases, the 10-year yield rose/fell faster/slower than the 2-year yield. This signals more demand for short term bonds compared to a year ago. Since a month ago (See: “Delta One Month”), all yield curves, save for Italy, have flattened. This signifies more demand for long term debt than short term debt. See Table 1:


It seems sentiment has changed since a year ago. Within the last month, more investors have loaded into longer-term fixed income securities. This is a yield-seeking activity. There has been a global flight to longer term, higher yielding fixed income securities within the last month. This point of view describes investors preference for more yield (less long-term risk).

As yields rise, the opportunity cost of owning stocks rises. More investors will flock to bonds as yields become more attractive. This dynamic causes equity markets to follow bond markets. This point of view describes investors preference for more return i.e. more yield.


Dueling Pianos:

As the yield curve steepens, expectations of future long-term growth have risen relative to short-term growth expectations. As investors become more optimistic on the economy, more money will pile into riskier assets, i.e. stocks. I call this the Future Expectations argument. Under this argument, a yield curve steepening results in higher stock prices. This argument describes an investors preference for risk. More expected growth = more willingness to accept risk. Under this argument, bonds and stocks are inversely correlated.

As the yield curve steepens, yields rise and prices fall on the long end of the curve. As yields rise, equity investors looking for yield will sell equities in favor of bonds. As long term yields rise, equities will fall. This is the Opportunity Cost argument. Under this argument, a steepening yield curve will result in lower stock prices. This argument describes an investors preference for yield. Under this argument, bonds and stocks are positively correlated. (For more on Stock/Bond Correlation, see PIMCO).

Given today’s nominal yields & equity values:

Investors are yield-seeking at current nominal yields, thus the Opportunity Cost argument dominates the Future Expectations argument. When the yield curve flattens today, equities will rise tomorrow and when the yield curve steepens today, equities will fall tomorrow. As nominal yields rise, I believe the relationship will flip, and the Future Expectations argument will dominate.

In 12 out of those same 12 markets, yield curves have steepened over the last year. In 11 out of 12 markets in our sample, yield curves have flattened within the last month. Should this change of sentiment continue, yield curves will flatten and equities will continue to rise. However, I expect the long-term trend to prevail, with yield curves continuing to steepen throughout the next year.

When the ECB and BoE decide to stop QE and raise short term rates, I expect yield curves to steepen. As yield curves steepen, equity markets will fall as investors switch to bonds from stocks. Investors will flock to safety, rallying bond markets.

Watch the ECB and BoE for signals on bond markets. See German Bund Yields.

Thanks for reading,

– Tommander-in-Chief


Further: “What the hell are you talking about?”

A common measure of bond market sentiment is the different between the yield on a 10-year government bond and a 2-year government bond. For example, the spread below is 1.25%. (Note: not the actual yield curve below.)


Review: There are two types of yield curve steepeners: Bull and Bear. A bull steepener short term rates are falling faster than long term rates. This means the 2-year fell faster than the 10-year (and both rates fell); recall, prices rise as yields fall. A bond bull market is one where yields fall. A bear steepener is one where the 2-year rises less than the 10-year, and both rates rise. Prices on bonds fall as yields rise.


Why are Markets so Calm?

Valuations are stretched and economic data is cooling, yet markets are complacent. Why? The following are rationalizations of current market values.

1.) Massive movement from active management into passive strategies. Why pay someone to under-perform the S&P 500? Passive investing implies no trading, which means less volatility.

2.) Increased regulation has permanently caused a decline in the riskiness of markets. Insurance companies and financial institutions no longer have autonomy over what they can invest in. With more oversight comes less risk…

3.) Lower interest rates globally have caused investors to flood into riskier assets. With more investors seeking risk, demand is high, creating inflated but stable asset prices. Argentina, who has defaulted on Government debt SEVEN TIMES, just issued a 100-year bond at a 7.9% yield. Demand for the high yielding asset was strong.

4.) JPMorgan estimates that stock pickers account for just 10% of trading volumes, with 60% done by quantitative trading strategies and passive investing. With more trading done by ’emotionless’ quantitative algorithms rather than hot-blooded traders, market risk has declined permanently. We’re in a “new normal” of low volatility and interest rates. Sounds firmiliar… *cough* Tech bubble in 2000 *cough*

5.) “Stocks always go up.” 😉

6.) Quantitative Easing in Europe and Japan cause inflows to higher yielding assets. The Bank of Japan (BOJ) or the European Central Bank (ECB) pumps liquidity into markets through open market operations (bond buying initiatives). Sellers of the bonds use the Yen or Euros to buy US Dollars. They use the Dollars to buy equities and debt. QE by foreign governments is inflating assets prices. As they continue to ease, i.e. flood markets with liquidity, we should see the trend continue. However, we have seen the USD decline since December ’16. Keep an eye on foreign monetary policy moves. A sudden move by the ECB or BOJ might cause fluctuation in US asset prices.


Thanks for reading.

– Tommander-in-Chief