Royal Bank of Scotland to investors: 'Sell everything'

As I said in the earlier post, the VIX is a measure of how much equity option protection costs. The greater the premium on the options, the more uncertainty there is about the direction of the market. ... and you get a higher VIX. As a measurement, it is supposed to give a sense of complacency or fear.

There are products (including leveraged futures, options on the VIX and leveraged and inverse leveraged ETNs) you can use to bet on the direction of the VIX -- as a trade. And what has happened the last several years, as volatility has gotten compressed (traders knew central banks have been in there supporting the markets -- essentially blowing bubbles, so it turned into a very popular trade to front run them.), the use of those products took off, but in one direction only. ... that being no fear of anything, because bond yields could only go down with central banks buying trillions of dollars of debt and suppressing nominal rates. And with rates suppressed, it keeps money flowing into the casino world they create. ... and that supports stock prices and blows bubbles.

There is a saying, "Don't fight the Fed." The extension of that is to jump aboard and front run them. If you know they are going to be buying bonds to suppress yields and that they will have no regard for price or value. ... you buy the bonds ahead of them and turn around and sell them to them for higher prices. It's "free money." And the central banks have acted like geniuses for suppressing yields that way. But it's a dangerous scheme that creates all kinds of mispricing of assets and capital being deployed in reckless ways.

The VIX trade has been similar. And it has been great for years. ... but now we finally get hints that the Fed (and ECB and BOJ) are pulling their support of the debt markets, just a little (a very little). The Fed built a huge balance sheet ($4.5 trillion of money they created out of thin air which they them used to buy our own debt) and they have been reinvesting the expiring bonds they bought (overpaid for) to keep support under markets. They recently started to allow a very small number of bonds each month to expire without buying debt to replace them. -- thinking there is a way out somehow. But yields started to rise (duh!). ... and we saw a small crack in the bubbled up markets they created. This happened a few years ago (what started this thread) when they wanted to get out of the problem they created and a credit mess spillover in China started to crack. But the ECB and BOJ panicked then, picked up the asset buying from the Fed, and their currencies became the funding currencies to be front run (and the bubbles that were starting to pop reinflated on the back of them buying trillions of dollars of assets).

As for the VIX, a lot of people have been on a naked swim. ... And as the VIX got lower and lower to levels we have never seen since its introduction in the early 90s, equity prices grinded higher. The bubble on the way up becomes a self fulfilling prophecy. Until it pops at some point and then on the way down, it is much more furious (and we still haven't seen the unwinding of all of the bad debt built up).

And the reason for that is all of the leverage behind it, which is what the central banks really have created. The trade itself isn't a problem. But the amount of leverage (it is always the same story) inherent in those trades is what created Friday and yesterday. And the reason all of that leverage is possible is because that is what Central Banks are really doing. ... this is the side effect of them destroying price discovery with regard to the price of money and entities being able to borrow it. They have destroyed the credit markets that are a natural regulator of things, and that means that credit flows too cheaply and it goes to hands it should never get anywhere near (just like in the mortgage mess they created last time around).

In any case, as long as the trade is working, you make money hand over fist. The minute it reverses the way we got a small taste of Friday and yesterday, the losses start to get magnified because of the overleverage -- selling begets more selling as there is forced unwinding. This is really kind of similar to the "portfolio insurance" / "program trading" that was a catalyst when the market bubble popped in 1987. But then too, the portfolio insurance wasn't the problem. It was the leverage due to the Federal Reserve having kept their overnight rate too low to try to monetize a burgeoning debt problem (remember Reagan cut taxes and started to run budget deficits). And the side effect -- all of that cheap money -- turned the stock market into a casino, albeit what they were doing with short-term rates to keep it cheap to borrow then (i.e. -- make it cheaper for the government to borrow too) was quaint compared to where we are today as they have now dug in deeper and deeper for several decades and with each credit crisis it requires them to intervene much more forcefully.

This is the story of every bubble in history. It always comes back to credit -- in the 1920s, for example, it was the margin (again on the back of a central bank that suppressed rates for a decade after WWI) that drove up prices. And it was the margin that created a panic eventually and made it so that selling begot more selling and ended with a crash.

In the era of central banking in the U.S. (1913 or so), all of those credit / margin / leverage problems directly trace them. They are not gods; they are political tools; politicians benefit in the short-term from loose "policy" because they can spend without having to make hard choices and the debt they run up gets monetized via monetary inflation. And it is all great until an inevitable credit crisis. We have put ourselves into a cycle of skating from one credit crisis to the next now (and answering each by trying to find ways to monetize more debt, rather than taking the medicine that is necessary for what we did) and in the process have sold out decades of the future.

We are now in a cycle where the world is way overleveraged yet again, but to a degree we have never seen (this goes way beyond the equity markets). Central banks have furiously been monetizing more and more debt for a decade now. These conversations. ... about a stock market bubble, the inverse VIX trade, even the thread about bitcoin. ... those are the symptoms of the mess they created, not the cause. If you want to cut to the chase, this all will end with a very serious deleveraging in the form of a credit crisis. Conversations about leveraged products and how they may act as a trigger that pricks a bubble are a sideshow, just as those conversations with regard to collateralized debt obligations the last time around were. The CDOs weren't the problem. The fact that they couldn't be priced honestly due to a bunch of clueless price administrators (central bankers) destroying price discovery in the debt markets was the problem. In any case, we need a serious very deleveraging. It should have happened in 2008. But instead, they answered a self-created debt problem by finding ways to rig the debt markets (with direct intervention this time turning themselves into hedge funds, except ones that don't care about making money, which should have been criminal) to create even more debt.

The answer to a debt problem is not more debt. And when the only thing enabling that debt is governments debasing their currencies and using the money they create out of thin air to buy the debt of various entities including their own government, to create a huge buyer that drives the prices of that debt up (and suppresses yields), you have really lost your way.