Expect more flash crashes.
It’s not us saying it, but Professor Joachim Wuermeling, from the Deutsche Bundesbank.
As he said in Brussels last Tuesday:
‘Looking at the recent turbulence in equities and the market for VIX related financial products, it can be concluded that the events of February 5 share many similarities with a ‘flash crash’.
‘The rise in volatility in the S&P 500 then nearly instantly affected the VIX industry, making it not the cause but more the first victim of this market event, with losses up to 95% on assets. We do not expect this phenomenon to disappear in the future. On the contrary, more of these flash events are to come.’
Stock markets across the globe went through a sharp correction on Monday 5 February.
US markets plunged, then rebounded, and then dropped again.
The Dow Jones industrial average, the S&P 500, and the NASDAQ plummeted over 8% in that period.
And losses were not limited to the US. Asian and European equity markets also dropped as investors around the world panicked.
Why did the stock market crash on 5 February?
It was a result of the US jobs report coming in above expectations. While unemployment stayed put at 4.1%, the economy created 200,000 jobs, 20,000 more than thought.
Yet the big surprise was in wages.
Average hourly earnings rose by 2.9% over the year. This is the best year on year wage increase since 2009.
Higher wages mean higher inflation…which sparked a fear of more tightening by the Fed.
After the 2008 crisis, central bankers around the world experimented with Quantitative Easing (QE) to jump-start the economy. They lowered interest rates and increased the money supply.
Years of low interest rates and cheap money have pushed up asset prices and debt.
Now, central bankers are looking to reverse this trend with Quantitative Tightening (QT). That is, increasing interest rates and reducing the money supply.
The Fed wants to bring interest rates up to what they consider ‘normal’ levels before the next crisis. If we hit a recession before they are ready, they fear they will have no tools to fight against it.
Investors expect the Fed to raise rates three times this year. Yet a return of inflation could mean they tighten faster.
But if they tighten too fast they could trigger a recession.
On that Monday 5 February, the CBOE Volatility Index (VIX) also jumped up 20 points.
The VIX, or ‘fear index’, is a good way to measure where investors stand on risk. Low volatility means that they are willing to pay low fees to protect their portfolios. In other words, investors are confident that stocks won’t fall.
A higher VIX means investors are starting to worry.
But volatility is not a bad thing. It simply means investors have different views on market values and the future.
With volatility at historic lows all throughout 2017, traders had taken to shorting the VIX. That is, they were expecting volatility to continue to stay low or even drop.
And the trade was profitable…for a while.
Check out the chart below on VelocityShares Daily Inverse VIX short-term ETN [NASDAQ:XIV]. The XIV — VIX backwards — was one of the popular tools used by investors to bet against volatility.
[Click to enlarge]
Why did the XIV crash?
As reported by Forbes, the XIV and SVXY — two inverse VIX exchange traded products — had US$3.5 billion assets under management at their peak.
Yet betting that volatility will not ever come back is madness…
When wages came in above expectations in February, investors took it as a sign that the Fed could be tightening faster.
So the XIV crashed down by 96%. Yep, 96%. That’s not a typo.
Source: Yahoo Finance
[Click to enlarge]
The XIV no longer exists…
Check out Wuermeling’s quote above again:
‘The rise in volatility in the S&P 500 then nearly instantly affected the VIX industry, making it not the cause but more the first victim of this market event, with losses up to 95% on assets.’
Using the VIX on these trades has turned it from a ‘fear indicator’ of where investors stand on risks, to a contributor of volatility.
As Sandy Rattray, one of the co-founders of the VIX formula told the Financial Times:
‘The Vix has moved from being a measure of something to being something that influences this thing it is trying to observe.’
This drop was most likely made worse by the use of algorithms and automation. Large banks and hedge funds are increasing their use of High Frequency Trading (HFT). That is, an automated trading platform that use computers to analyse markets and carry out trades at high speeds.
According to Wuermeling, since 2011 HFT has accounted for about 45–50% of all trading in US equities. In Australia, they account for about one third of all equity trading in 2015.
As he continued:
‘A single normal trading day generates about 3-6 million data points about prices, order deletions and modifications in DAX futures alone. No human can analyse these amounts of data simply by looking at them in an Excel spreadsheet. More sophisticated and sometimes also AI-driven techniques are necessary to do the job.
‘With the help of AI, various human shortcomings in dealing with finance can be mitigated. As behavioural finance has taught us, biases, inertia and ignorance lead to the malfunctioning of markets. AI allows humans to reach out beyond their intellectual limits or simply avoid mistakes.’
But, these automated systems come with a lot of risks to financial market stability. As Wuermeling continued:
‘The workings of AI can be a mystery; it can trigger loss of control, make fatal errors, and have a procyclical effect due to its mechanistic functions. Pattern recognition has its limits. This can be dangerous particularly in crisis scenarios. An autopilot would never have been able to land a jet on the Hudson River. Nor can algorithms stabilise in periods of financial stress.’
Markets are supposed to be about human interaction. About gathering and exchanging goods and services for a price that we are willing to pay. What’s at stake is our financial future.
Yet to computers, these are only numbers.
And this is turning the markets into a very risky place to be…especially if there is a panic.
Editor, Markets & Money
PS: After years of low interest rates and increasing debt, editor Vern Gowdie thinks we are heading for a ‘big one’. That is why he has created a survival guide to protect investors from a massive crash. For more information on his step-by-step guide, click here.