Yesterday's Event is a VIX Event, Curnutt Says

it's a short volatility products. So basically Credit Suite has two of these exchange traded notes that basically mirror the inverse performance of the of the volatility index what we call the VIX TOMPs. So quite clearly, as the VIX has exploded from like eight in January to fifty on the screen at the moment, these exchange traded notes have been absolutely hammered. The big question now is whether they

actually consider a redemption of the volatility note. And what we understand, according to a person familiar with the situation, is that Credit Swa are indeed doing that, which is why I'm really happy to say that din Kerne is with us credit sway to stock down like almost four percent on my screen was as low as eight and a half percent. There is some sixth serious concern out there about what this means. So let's drain some of the drama, Dean, and help us understand what a redemption

of this volatility note actually means. The mechanics of it. Well, I think the first thing to note is that the losses that people experienced in being let's say long the x I V at a price of a hundred and ten, whether the note is redeemed or not, those losses nearly a percent will be materialized. So again, if it if the note goes away and it effectively is unwounded zero or close to zero, obviously you have a hundred percent loss.

But whether or not the note hangs on and they choose not to redeem it, you're going to have a price that is so low in a exposure to volatility that is so small that the losses are going to be near Anyway, Dan, if we got an idea of the size of the short vaald trade, how big it actually got through last year, it rewarded you handsomely like returns north of a hundred percent, and the flows into

these exchange traded notes even through January were huge. They were record months for some of these individuals, particular funds. How big is this trade? Yeah? This is the thing about markets is that winning trades attract sponsorship, they attract attention, uh, and they get crowded. Uh and Uh. No trade has delivered a better sharp ratio in previous periods than the short vall trade. Uh. And so I think a lot

of folks got involved the the the vega. So the exposure to volatility that the x I, V and the other product s v x Y had was on the order of two million UH dollars. So to just to put that in context, when when long term capital blew up in we learned after the fact that it had a short volatility position that was equivalent to eighty million dollars of exposure per volatility point um. This one right

now had exposure of two million dollars per points. So when when the VIX spikes fifteen points or so, um it you lose three But I translate that that not inflation adjusted, it's three times bigger than the size of the LTC. I'm compare. You're doing right, And I think, what's again, what's so prominent about this particular blow up is that the the selling of volatility was very very

much concentrated in very short term selling. So they were selling one month options which can be very profitable when realized volatilities very low, but also, as we have seen, can be unwound in violent fashion repair. And maybe Bruce, you could help out here as well, but didn't heard it. Compare the drug of the new product, the short vault trade with a drug of portfolio insurance, which we all studied or lived in seven Is it just, you know,

different products, same dynamics. I would just say that there's a lot of similarity. Uh. The portfolio insurance was marketed as a product in which you could effectively ensure UH stocks, but you didn't have to pay a premium UH for doing so. UH. And what was portfolio insurance was a dynamic strategy where folks convinced investors that they could sell futures as the market fell in order to get a

larger and larger short position to hedge the portfolio. And so what that does is it creates a pile on effect as the market falls. This is back to the portfolio insurers found themselves selling more and more UM. In this case, As the VIX rose, the VIX E TPS the x I V for example, had to buy more and more vixed futures to deliver this inverse daily return.

And so it was a spiraling effect, more rising volatility to beget more demand for vixed futures, which further increased the level of the VIX, which further created more demand for vixed futures. It was a spiral higher, higher evolve begets higher evolved futures coming off the lows. It's worth pointing out down futures now down one seventy sp futures negative nine. So a couple of questions I've got for your Dean. One, can we officially say that the short

vault trade has blown up? And two? And this is terribly difficult to get your hands around at this point. It could take months, even years to understand what's happening in the cash open this morning and through the equity market session yesterday. But how much of what we're seeing on the screen is forced selling from a short vault trade blowing up a tremendous amount. I think this yesterday's event is truly a VIX event. Uh. It is a

very very specific technical unwind of something that was vastly crowded. Uh, pretty misunderstood by a lot of retail investors unfortunately. So so it is pretty concentrated. So so the VIX event has occurred. Um. I think a big question Jonathan is um there are many other trades that have characteristics similar to the VIX. They make money in stable, quiet markets. Right. There are effect strategies their bonds strategy like this. Uh. And so the VIX event has occurred, but there could

be larger market implications. Dean Karnitt will stay with us. Bruce Casmin, thank you so much, thanks to JP Morgan for letting you free for two hours. To Bruce Casmin is the chief economist of JP Morgan. If you believe, as you have heard every interview this morning, that the pros are watching bonds, this is, without question the interview of the day. Stephen Major is an HSBC. He has been brilliant on saying no, rates aren't going up, aren't

going up? Aren't going up? Yes, sometimes he's perfect, sometimes he's almost perfect. But he's been dead and about the rates lower call he joins us down from London with hs BC. Stephen, wonderful to have you earned away from your clients and his two mild Do you have any

sense of adjustment where you would suggest rates could move higher. Well, I'm following the forward rates, Tom, and I think the US five year rate in five years time got above three percent recently, which is basically saying the bond market was pricing the FED going all the way to its long term dot of two sev. So bonds have got

cheap at the end of last week. UM, So that was the time to start considering bonds as an insurance policy against something going wrong, and something went wrong this week. We're seeing risk assets free price. And you've mentioned the vix. I mean for me, the shoe is on the other foot.

What does that mean a couple of months, Well, we've had a couple of months of people in the equity markets and credit markets looking at rates and saying that rates are higher and they're going to keep going higher. Um And actually I'm wondering what happens when equities go down two sovereign bonds and we're seeing that now, we're actually seeing risk gus that's repriced something more reasonable, having been overboard for some time, and I think bonds get bid.

So we probably have seen the near term highs the bond yields. Now, I know it's not very fashionable to say, but you're supposed to own bonds, especially long term bonds. I can't imagine that the thirty year bond is going to sustain a move above three pc. And like I said, when you look at the forwards, the five year, five year forward, anything near to three percent for that one is a bye. So there's two things going on here, Stephen.

You mentioned the FED ability to get to its long term dot one and then two you talk about this safety bid that comes back into Treasury. So let's talk about the second point first, and then we'll get to the federal reserve point. On the second point, we've had this regime where bonds and equity have moved simultaneously, yields lower, equity prices up. Are you saying that regime is done

and we're moving to something else. Well, it looks like we're going to have to go through a period of transition, John, And it's it's not obvious to me that we have to have any kind of correlation because why why should it be so easy? It's it seems to me that we've had several months of a one way street. So bond deals going up and equity is rallying, But of course something is broken here, and I think that we are seeing a repricing of risk conversus risk free. People

talk about the risk parity trade, et cetera. For me, it makes sense to own some bonds as an insurance against something going wrong, as we have just seen. So so I think the correlations are breaking down, and what's happening to the VIX must be quite scary because that has to be input into all the models. People now have to reappraise their assumptions about credit. For example, what

does this mean for high yield credit? I wonder, And we'll start asking questions about some of the emerging markets as well. So so it's the read across to other athletic classes that really matter from the move in the bond yield. So let's talk about that reevaluation of risk assets versus the risk free asset, Steve. So far, the only risk asset that's repriced dramatically is equity. We haven't seen it a high yield credit. We've seen it a little bit spread a wider, but not in a significant way.

Are you suggesting that we can see in the coming days, the coming weeks. It started in European high yield this morning. Obviously, investment grade is protected by a central bank buying in the euro Zone, so it's it's difficult for I G. Credit to set off aggressively when you've got central bank buying. But it's the high yield part that isn't so well protected.

So let's watch what happens when we endured higher volatility to spread markets where the spreads too tied steven the time that we have with you this morning, I want to get to something as basic, as basic as we can get. You're suggesting that we can have stable yields or even lower yields with higher full faith and credit prices and still have risk assets like stocks go down. They can be that separate. Well, yes, I think that

we could go through a period of decorelation. And and to me, we're probably over simplifying if we think that there has to be a stable correlation between his passes. I mean, if it was so easy, we'll be making loads of money, wouldn't we There have to be harder and and I'll come back to the first point I made today about the FED. The FED is at one point five on io E R. They're telling us that they're going to go to two point seven five over the next few years. That's a long way from here. Well,

but critically, Steve, this is critical. You have been more than anyone I know you and Gary Shilling, I'll give doctor Shilling good morning, doctor Shilling as well. You more than anyone at any major house. Steve Major have said that path of the FED is a difficult assumption. You stand by that, right, Yeah. I've taken a lot of heat for that in the last few months, and and and the point the point is is that people don't

want to believe it. But I think we're oversimplifying if we think that the FED just carries on with its eyes closed and arrived at two seventy five. Because you've got this huge debt overhang, and with with this massive debt, each basis point means much more than it did in the past. I mean, I would estimate that one hundred basis points increase on the ten year today like we have seen since last summer, is worth about three hundred basis points in the in the regime of twenty years ago.

So the point is, with this very high duration and highest stock of private sector debt around the world, by the way, not just in the US. Stuff happens. Stuff happens because people can fall to service the debt and it affects their consumption and investment. So, you know, the assumptions about g d P based on some kind of model that set the path of rates seemed to be

missing the overhang of debt. And I think that the FEDS models have historically been a fault there because they haven't they haven't taken accounts of the debt, and then we would overlay the impact of demographics and technology, all of which are weighing down on inflation. That's why bonds

are in better shape. So, Steve, your essential point here is that this economy, the global economy for that matter, just does not have the tolerance for the kind of rates that some people are suggesting will get to the Federal Reserve. My basic question at this point is the feder is carried on hiking even though inflation through much of last year trended lower. So what's the bite point for the Federal Reserve to sit back and say we're doing too much. Well, that's the interesting one. We're sort

of finding out, aren't we um. The debt servicing costs that we look at are based on the forwards and some assumption on the credit spreads. It strikes me that credit spreads have been very tired, so it would be dangerous to assume that they're going to stay there. If you if you look at an average, which will be credit spreads, they're much wider. Can we afford the debt servicing costs that a mean version of credit spreads would imply?

And the answer I think I probably no. Steve. We've got to leave it there for you to get under your busy Dyer the just BC. We greatly appreciate the time this morning, Mr Major, first head of all of strategy with HSBC, and of course he is someone who has adamantly said higher interest rates will be a challenge to get to. Last night, my world stopped at seven thirty while I wait it on the Bloomberg terminal for exclusive use by our terminal customers of a Ponza Kawa jewel.

On all that David Wilson has just talked about, Sarah Ponzac summarized perfectly what's going on in this vixed derivative market. Sarah, our our E t F team this morning, says it's a value of two to three billion. Let's take the top ticks three billion dollars x number of weeks ago and all this short volatility stuff. Do you and Luke Kawa just assume that's all evaporated in the space of

three or four days? Sadly yes. I mean there's someone who's at Macro Risk Advisors, is an analyst, and he says that pretty much everything in these funds is blown up. There's maybe five per cent of it left. Who takes that loss? Who takes that loss? Well, the investors are going to take the loss, but it also depends on what happens with the redemption. So right now credit sue. So we don't have the final answer, but we're trying to figure out if they're going to take on the

risk um. So right now they're saying that this is what happened, and this isn't too much of an implication for them, But I mean, they haven't come out with the statement. It seems a little bit dodgy. We're trying to figure out exactly what's going to happen here damage wise. Sarah I wondering if you could just define for people exactly what these products are supposed to do and how new are they in terms of their availability to investors.

So think about these products. In the past couple of years, we've had crazy calm in the market. So what these products do is you can bet on that train quility staying prevailing. So if you believe that markets are going to stay calm, they're not going to bounce around a lot, then you would you would buy these products, and you meant money along the way, right, Like, how much along the way? If it's a so called carry trade, did you beautifully describe what's the lay up amount you make

every year? Given? I love the word train quility. So the the x I V actually returned a hundred eight seven percent in the past year. So depending on how much money you put into that product, you return to hunt. Right. It's absolutely astounding. But also something that's so amazing is how much new money is in these products that had

to experience this since the beginning of the year. Actually over two billion dollars has been put into x I V. And then also the pro shares UH retail or is it institutionally it's it's a combination of both, but it is a lot of retail money because a lot of people have just been told that if you put money into these shares it's free money, you're you're going to make money, and people have bought it, and people have

thought it's a really easy trade. I actually spoke to an investor I remember a couple of months ago, and he said that how he loved the trade and he would never let go of it. PIM yields up the new high six basis points in the tenure yield two point seven six. SMP futures have improved negative eight. Down

futures have improved negative one seventy three. Right now, Sarah, when you talk about volatility, just explain how it works in terms of how volatility can be get more volatility, because when you have market turbulence, you're describing a whole set of investors who have been betting against that happening exactly. So what happens is when you explain the volatility or explain the vix it's basically the amount of movement that's

going on up or down within the stock market. So what happens is when the SMP five hundreds starts selling off, people start realizing, Okay, there's more volatility coming into the market, people start selling more of their shares in the SMP five hundred or as we saw yesterday, people were talking

about a flash crash. Algorithms start sharing sharing, there's more movement, Volatility goes up, people want to unwind their short volatility trades, and it just becomes a completely exacerbated and then there's no one on the other side of the trade, at least on the price that you would like to get out, just as it creates a negative feedback loop because you keep trying to find the price that someone else will pay for your at least at that moment. Poor investment exactly,

there aren't many people on the other side of the trade. So, like I said, said they were about two billion dollars that went into the store volatility trades just this year. If you compare that to how many people went long volatility towards the start of the year, that was just about a million, So that's a huge difference. And it's also sometimes sold as a way to mitigate risk, right, so it can be sold in a fashion that makes sense when markets are complacent, but when they turn the

other way, not so much. We gotta leave it there Sarah Pounds, Thank you so much, greatly appreciate, thank you this morning and congratulations look forward to your next work. We are speaking with Alberto Gallo. He is the head of macro Strategies at Algebras. Alberto as one of the managers of the Algebras Macro Credit Fund. Wanting if there is an opportunity for you in terms of what you might be looking to purchase as a result of all

of this dis location. What kinds of investments would you be looking to to add or even to sell from the fund. Well, I would say that the biggest dislocation is in volatility. So of the funds that have been selling volatily betting on the world would stay the same, have been um compressing bulletically to really really low levels in the last few months. Today what we saw as an unwind of these strategies today and yesterday, bringing volletic

levels to record highest. So this is an opportunity. Obviously one has to be careful because we don't know how much of the of these strategies are still still need to be unmound um Across the rest of the space, we saw some declining equities, some declining corporate bonds, but we're not at levels where one wants to spend all the ammunition. We have a small correction, UM, but you know, we could see more, especially the corporate bond world has

been extremely stable this time around. Well, just looking at the VIX right now, thank you John Tucker. The VIX is a lower thirty five. It's down thirteen point one eighteen. Alberto. If you look across Europe, what has been the response in Europe, at least in investors terms, to what has happened in the United States, I would say the European market is more stable. UM. This is perhaps one of the few times where Europe is not as volatile, and I think the reason is that much of this financial

leverage UM was absent from European markets. The the presence of leverage strategies of on vix, on on other types of short buttive it is much lower here in Europe UM, and therefore the unlined effect, this self fulfilling feedback loop, we haven't seen it as much. And as far as specific country debt, I noticed in the fun big holdings in the Kingdom of Spain is that for any specific reason other than this was what was available at the yield that you could get, or what was the reason

for adding so much from Spain. Well, we're still positive on UM. We're being positive on the European perry free Spain, Italy, Greece, Portugal. I would say that UM today we are most positive on Greece. We continue to see a path to upgrades when it comes to Spain and Portugal, these are more established growth stories, you know, both growing over two percent this year, getting upgraded by rating agencies, but lower yields. The two allowed countries in Europe are Greece and Italy.

Uh and they are They've been lagging on reforms and growth, but this year Greece is growing over two point five percent real GDP and Italy is growing at over one point five UM. So with some reforms, with some fiscal stimulus with Marco and mccron and France and Germany, I think the backdrop is positive. These are one of some of the few places to hide in the debt market.

What are you doing this morning? I mean I've got yields round trip from lower yields by two or three basis points to now up a solid seven basis points higher yields. Lower note prices, the dollars stronger. Even gold is reversed and is lower by two dollars. I've got green on the screen. The Dow up a hundred and fifty smp up, the vix is down to an Alberto Gallo column of twenty two point six one. What is a guy like you do, Alberto? Did you just go

to lunch or you can actually do something? Now we are includes to our screens, and what we're focused on is the changing correlation across the market. What you're trying to understand, we're trying to understand if interest rates are stabilizing, this is a move. This is a repricing that started

with interest rates moving higher. You know, until the last few months, investors relied on a stable and low interest rate environment on the assumption that central banks would keep that environment, and therefore investors were buying bonds for capital gains and equities for yield. This has changed now we're close to normalization. We have inflation coming back in the US and Europe, and this means a lot of assumptions have to be revised across the equity and bond space,

and some investors have been two levered. So what we're trying to understand is um You know, in a risk of environment, normally rates rally, people buy treasuries, but actually today treasuries are widening, and this means that the risk of environment can continue, that the reprising can continue. So we're very careful about interest rates moves, especially in the long end of the curve, in the tent to thirty

year space. So you're bringing in your duration, you're shortening your bets because you're worried about volatile far out the curve. We are positioned. We're still position for rising in first rates. Yes, we're position for potential repricing in the long end of the curve, which would be great for fixed income investors, funds, insurance companies, but it also means that buy less stocks and buy more bonds. Okay, Alberta Gallo, thank you for

the briefing this morning. I'm great and short notice, I should say this is near four pm his time in Europe. Mr Gallo is with Algebras today. Thanks for listening to the Bloomberg Surveillance podcast. Subscribe and listen to interviews on Apple Podcasts, SoundCloud, or whichever podcast platform you prefer. I'm on Twitter at Tom Keane before the podcast. You can always catch us worldwide. I'm Bloomberg Radio s