In Part 1 I described the effect on the financial markets of the Covid19 Crisis and called it the weirdest marginal liquidity shift I had ever seen. It was far more pronounced than the crisis itself warranted in economic terms and solicited unprecedented responses from nearly every Central Bank in the world to mitigate it.
We should examine why the crisis was as deep as it was and also whether the response by the Central Banks was warranted and appropriate.
In my opinion, there were several contributing factors, some specific to our times.
Why did the Spanish Flu of 1918 elicit a comparably mild set back in the markets (let us say 10-15% max) as opposed to the carnage of February and March 2020?
And do not forget that not a single Central Bank had to intervene at all to support the markets. They self-righted in no time.
Here are some factors that I see as relevant. Some are particularly relevant to this crisis, others are generally relevant to future ones as well.
The God Syndrome. As humans, in the developed world at the very least, we have grown over the past 50 years to see ourselves as almost immortal. As medicine has advanced by leaps and bounds, it has caused death to be marginalized. We no longer live with it on a daily basis. It is nowhere near as common a companion in our lives as it was 100 years ago and as for all of human history. Take my grandfather’s example. He was born in 1896. In childhood he saw 4 of his siblings die before they had reached the age of three and another at birth. Then he lost another brother in WW1 and saw thousands of his comrades killed in the same war. Just after he returned from the Great War, both his parents died within 6 months of each other. Nothing particularly out of the ordinary. Out of 16 siblings, only four remained alive by the time he was 40. How many of us have lived anything even remotely similar? Our response to the potential of death, facing our mortal reality, is much more extreme than in the past, simply because the unfamiliar is frightening.
The curse of Social Media coupled with the 24hr News Cycle. The God Syndrome feeds off the constant availability of “news”. While in 1918 the news came once a day in the daily paper (and was read in company, which is a form of therapy in itself), now there is a new piece of “news” or “analysis” available every second of every day. And every single one is designed to be more attention grabbing than the last. A guarantee of mass psychosis. Which is precisely what we saw. I doubt that even 1% of what we were fed as “news” was accurate or more importantly: necessary or useful for us to know or consume.
The Leverage Starting Point. The financial system we have today is nothing like that of the past. I won’t even mention the plethora of derivative instruments cascading volatility greeks from one instrument into its various components or second to “nth” tier derivatives. Today we have thousands of hedge funds and other “institutions” that trade everything on credit. A relatively small move has to be hedged or the margin gets called. You just can’t grin and bear it and look to the long term. The whole system is leveraged to the hilt. When, as in late 2019 and January 2020, everything is looking rosy, the economy is firing on all cylinders, the amount of leverage built up in both equity and credit markets can be (and obviously was) enormous. It is ironic that had Covid19 arrived in the middle of a recession, its effect on the markets would have been, in all probability, far less pronounced.
Technology killed “My Word is my Bond”. Today you know exactly your position, the margin needed and your account P/L every second of every day. There can be and there is no doubt. Rewind to 1992, which, in history, is a bat of an eyelid. During Black Wednesday, I had no idea whether I could cover my positions with the money which was in my hedge fund’s account. No idea at all. Did not even think about it too much. Neither did my brokers. We worked on trust. I had no idea what my P/L was. I continued giving buy orders, my brokers continued filling them. On trust. I amassed something like 5% of the total open interest in Gilt futures. I acted like a shock absorber. Which is what I had been trained to be in times of extreme stress: when things look cheap you step in and buy and hold and buy some more and hold for as long as necessary. I was by no means alone: a whole body of people stepped up and saved the system. People. We settled up at the end of the day. At about 2am, when finally we could reconcile trades and positions. I remember I was very slightly short margin overall but the market was called much higher next morning and the broker put up the difference to the exchange out of his reserves. On trust. Of course, none of this could happen today. Today I would be another lemming who had to liquidate, forced by a line of code. Pitiless, automatic, thoughtless. There is no latitude, no room for humans to come to honourable agreements. No TIME for anything to happen other than what is coded. Today’s trading technology is a fire accelerant. It exacerbates volatility at times of stress.
Dodd-Frank (or: the road to Hell is paved with good intentions and the plumbing there is pretty bad!). I am sure Mr. Dodd and Mr. Frank wanted to do the best by everyone and prevent public institutions from gambling with other people’s money in the financial markets, given the chaos that was caused during the Great Financial Crisis. While in the eighties and nineties we had dozens of banks and broker dealers and a handful of hedge funds, now we have thousands of hedge funds and only a handful of banks and broker dealers. Result: when all the hedge funds want (read: need) to deleverage, all at once, there is no one to take the other side. When you couple that with punitive capital restrictions on what positions the banks and broker dealers can run (pile on top political and social stigma if you lose shareholder money on “gambling”), it is a recipe for pronounced illiquidity at all inflection points. Show me a crisis that did not start at an inflection point! A guaranteed marginal liquidity shift generator. By Law.
I will not pretend that my list is exhaustive but I believe I have covered the most salient points.
You will have noticed that everything I have enumerated as a problem in today’s markets is actually in trend. It will all get worse: people will not suddenly be more accustomed to natural death or become less pusillanimous, social media and the news cycle will only want to spook us more, financial instruments will only get more complicated, hedge funds more numerous and leveraged, derivatives more volatile, technology faster and more pitiless and regulation on banks and brokers more onerous and restrictive. Having watched that travesty called the “House Hearings on Gamestop” this week, is there anyone who thinks that enlightened regulation is on the horizon?
Next week, in Part 3, I will examine the Central Bank response to the Covid19 Crisis, why I think it is wide of the mark (although I do agree with a lot of it) and my suggestions as to what The Federal Reserve (or any other enlightened Central Bank) could do instead to activate dampening mechanisms which lead to market solutions to crisis, as opposed to just piling risk onto Central Banks’ balance sheets.
It will take market understanding and enlightened legislation…so don’t hold your breath while you wait for someone in power to act on it.
Macro is the Weather. Part 2.
Even better than the last. You mention the social media 24hr news flow and old-time papers. I feel like waiting for this is waiting for the Sunday Times. Something to sit with over a cup of tea and take it. Thank you for writing these. I will share it and hope to get you a wider audience.
I really enjoyed this. The anecdotes on your grandfather and Black Wednesday are fascinating. I for one would love to read a longer account of the latter in a future article, as well as other major market events you traded through.