I want to explore a theory that the recent unprecedented marketvolatility is actually explainable. The theory seems to come downto leverage - one of the two reasons why everything blew apart,especially when coupled with mark-to-market rules.
Consider this: Many financial institutions had exposure todifferent assets at leveraged amounts of between 20:1 to 40:1 -numbers that were commonly used in looking at Lehman Brosexposures. Then would it not follow that positions were unwound ashedge funds and other investors became, at a best case risk averse,and at a worse case desperate for cash to meet margin calls andother obligations associated with their exposures? The gross amountthat had to be transacted would be 20 to 40 times the amountactually used to create the exposure. This is a situation where themultiplier effect would cause massive swings in the markets of allasset classes when those transactions are unwound and add to thisthe fact that normally, these transactions would have occurred overa span of time. However, due to the urgency caused by investorsneeding to get the principle invested back as markets declined andthe time compression effect caused by panic and driven by riskaversion, the transaction volume of unwound positions would notonly be very high, but those amounts would be traded over a muchshorter time span than usual.
When considering these factors, it becomes more obvious thefollowing can all be viewed as results of a now common event, oftenreferred to as the new normal , due to these marketdrivers: one-day, 800 and 900 point swings in the Dow,three-percent to five-percent moves in currencies, $15 per barrelmoves in oil prices and 50 basis point moves in three-monthTreasuries.
Is there any real evidence to prove the theory? I think there isand it can be found in the relationship between commodities and theU.S. dollar. Everyone has heard the argument that the relationshipbetween these two asset classes is strongly linked. From amacro-economic stance, the U.S. dollar is typically considered thecurrency used to price commodities, and it was devalued in theincrease in oil. If the dollar lost value in Euro terms, thecommodity price should be at least partially offset by the fact thedollar is weak, and therefore, it should not cost any more in Euroterms. The other factor that must be included in the equation isthat the actual demand for oil might have also gone up at the sametime. So, for example, if the EUR/USD rate moved from 1.30 to 1.35and oil went from $100 to $125 per barrel, then for each one-Euromove, there was a $2.50-move caused by the currency strengtheningand another $2.5-move caused by the investment (speculative) demandfor the commodity (which is also aided by the currencystrengthening - a true chicken or the egg scenario.) It is easy tomake what seem like rational observations in similar situations,but there must be some underlying proof, whether it is by cause andeffect or correlation.
Referring back to an article I wrote for the ISOnewsletter, the correlation as both the Euro and oil rose; $5 inoil was about equal to one Euro. A reasonable theory. Theinteresting thing was that when both oil and the Euro fell, closeto a $2.5-decline in oil was equal to one Euro, which supports theidea of how much value was driven by demand and how much was drivenby currency strength.
To get back to what this has to do with volatility. In hindsight,commodities seemed to become the most attractive asset class toinvestors as a way to speculate and make money quickly to offsetthe debt instrument losses incurred by the subprime mess. Not justoil, but also agricultural products - mainly grains more than meat,even though the roll on effect of escalating feed cost eventuallypushed meat prices higher - and metals. The Commodity ResearchBureau (CRB) Index rose from 300 in mid-July last year to 473.5,its highest level ever, by the beginning of July this year. It hassubsequently fallen to 256, which we are close to today.
The speculative commodity bubble caused by a search for returnsafter the subprime debt cash cow died pushed the U.S. dollar down.Commodities, currencies, debt and probably some equities were alltraded at leverage to the underlying amount invested. So, once themargin calls started coming in, the unwinding accelerated and thevolatility went through the roof. As can be seen on the CRB indexchart we seem to have bottomed and are moving sideways just as thevolatility in all markets has subsided. This could mean a goodpercentage of the unwinding of the speculative positions isover.
If this is correct, then historical data on the CRB Index chartshows that the 300- to 325-range is normal on average. The 5-dayagainst 20-day moving average lines on the chart are set to cross,indicating a bottom and a change in direction back up.
The markets now appear to be returning to being driven by economicfundamentals. If the CRB index rebounds back to 300- to 325-range,the dollar should give back a small proportion of its recent gains,but this would have to be demand driven. Given the slowdown, suchdemand is less likely to materialize. Further strengthening shouldagain take over as the rest of the world seems to be lagging theU.S. in this downturn and the interest rate cycle. The Bank ofEngland dropped their benchmark rate 1.5 percent from 4.5 percentto 3 percent last week. The European Central Bank dropped ½ percentas expected, missing an opportunity to surprise the market. Alarger decrease at a time when bolstering the market and consumerpsychology is just as, if not more, important as economic(inflation/growth) reasons. This was an opportunity lost. The SwissNational Bank also dropped their 3-month target LIBOR rate to 2percent from 2.5 percent.
Dare I venture that the volatility we have experienced in the lastthree months is nearing an end? It was a wild ride, but I think itwill be another year before all markets return to "normal". In themeantime, after a little consolidation look for the dollar tocontinue its current trend albeit at a slower pace.