Last year now-former FOMC Chair Janet Yellen downplayed the possibility of another financial crisis.  In her hubris she believes the central banks have walled off the financial system from ‘contagion risks’ brought on by over-investment in synthetic derivative market products.

Like generals, however, central planners are always fighting the last war.

We’re experiencing a major correction in the equity markets brought on in a mean-reversion exercise thanks to central banks trying to shore up their defenses around the last battle they lost, namely off-exchange, unregulated CDOs — synthetic debt-based investment products.

Humans are clever and will always find a way around a problem. The problem is incentives.  The banks created CDO’s because there was a demand for investment returns far above what the central banks were allowing the market to pay, by setting interest rates well below the real risk profile of the investment community.

In other words, government bonds were over-priced and investors went looking for better returns.  Now that Yellen have stamped out most of that market investors still need yield.

And that’s where the equity markets and the VIX come in.

VIX-ing the Markets

The response to the 2008 financial crisis was zero-bound interest rates and trillions in liquidity created by the central banks sitting around looking for yield.  It found its way into the equity markets which over the past six plus years been on an historic rally off the October 2011 low.

During that time the VIX became more important.   What was once only discussed by the real pros was now in the hands of everyone.  Contagion risks jumped asset classes.

For the uninitiated the VIX — or volatilty index — is a bet about the behavior of the S&P 500, itself an index of stocks.  Higher VIX values equal higher implied future volatility in the S&P 500 and vice versa.

In mathematical terms the S&P 500 is the first derivative of any single stock.  Stocks in the index trade in sympathy with it regardless of their current business.  The VIX is then the 2nd derivative of any stock in your portfolio.

During a rally the VIX falls.  But, now with so many products out there, ETNs — Exchange Traded Notes — both leveraged and un-leveraged — to speculate in the VIX it became easier and more profitable to trade it than the S&P 500 or individual stocks.

Trading volumes in these products have soared.  The tail didn’t just wag the dog, it became the dog.

Now these ETN’s are another derivative of the equity markets. And if they are leveraged, i.e. the note trades with twice or three times the volatility of the VIX itself (volatility of volatility), then options on these ETNs is the fourth derivative of the underlying stock.

Volatilty of volatility of volatility.

Look, fourth derivatives are noise. These computers are trading the VIX and the hedge funds are trading the noise.   Who do you think is going to win?

And they tell me that the Bitcoin markets aren’t real.  All the complaining about Tether ain’t got nothing on the fourth-derivative VIX trades out there.

You Can’t VIX this

So, thanks to Janet Yellen, the VIX kept rising in importance.  Yield-chasing momentum monkeys kept the one-way trade buoyant because the central banks had their back, same as quantitative easing has the bond traders’ backs.

And because it was a one-way bet thanks to the central banks pushing trillions into the stock market it was easy for them to multiply gains by factors of five or ten over that of the S&P 500.

And they call Bitcoin a bubble?

Add in the dominance of computer algorithm-based high frequency trading and the story pretty much writes itself.

The markets broke over the past two days because of the VIX finally became so over-valued and so many people had piled on thinking it would continue to go down forever, that when it snapped higher on Friday they were all caught short and had to liquidate.

This is a crowded trade that is so much more important than any cryptocurrency.

animal house

This manifests then in the stock indexes selling off, which, in turn, moves the bond markets, which affects gold and currencies which saw liquidity drain out of the crypto-markets.

So much for there not being any contagion risk anymore.

Contagion, Contagion, Contagion

As I pointed out last week, the sovereign bond markets were reaching panic levels in yield for European safe-haven issues as well as U.S. treasuries.  This is expected when the stock market is galloping to all-time highs.

But, it’s deeper than that.  The dollar is beginning to firm, the euro is in danger of breaking down.  Bond yields have not been stuffed back into their long-term downtrends.

This VIX explosion is a simple short-covering rally that will take a few weeks to sort out.  It will lop a 10-15% off the Dow Jones and the S&P 500.  They needed it.  The markets also needed a reminder that the central banks will not be there to save the equity markets in the future.

Their primary focus is the currency and the bond markets.

But there is a lesson here for the central banks and the bond markets.  If they think they have everything under control now, just wait until the interest-rate swap and derivatives markets blow up like the VIX just did.

Powell isn’t going to stop raising rates.  The equity markets will absorb this correction and move higher as government stability is questioned in Europe and Trump’s opponents press on to try and take him down for not playing by their rules.

Europe is teetering on the verge of political insanity (see here and here) with Italy’s election in 26 days, Hungary’s right after and the potential for Germany’s Grand Coalition to fail muster with the Social Democrats.

This correction will make stocks look attractive, further putting pressure on sovereign bond yields suppressed by central bank policy.  And once this correction reverses without any technical damage to the indexes (possibly today), the Fed will raise rates sooner than later.

I wouldn’t be surprised if Powell raised rates in March if the data was good, the Dow was back above 25,000 and Merkel forms a government in Germany.

And then all the pressure will shift to the European Central Bank.  Oh, and the VIX will go back to the zero-bound, but for completely different reasons.

In my newsletter I teach you how to build a portfolio that both insulates you and takes advantage of this kind of central bank-induced insanity.  You can sign up for the Gold Goats ‘n Guns Investment Newsletter for just $12/month at my Patreon Page.