Chaos.

On Monday, all eyes were on oil as the world’s most financialized commodity collapsed more than 30% after the Saudis fired the opening shot in an all-out price war with the Russians.

Then, in the blink of an eye, the market’s attention pivoted to credit, which was already showing signs of distress prior to the collapse in crude. Not only did CDX high yield witness a six standard deviation move, CDX IG widened by the most since Lehman, a 12-sigma event.

Then it was bonds, as 30-year yields in the US careened as much as 59bps lower intraday. By the closing bell, all eyes were on stocks, if for no other reason than it’s exceedingly difficult not to rubberneck a horrific car accident as you drive past one on the interstate.

As spectacular as Monday’s moves were, they now seem a distant memory. And certainly not because things have gotten better. Rather, because things have gotten so much worse that by Thursday, the Fed felt compelled to step in with super-sized repos to head off a burgeoning cash crunch and announce that going forward, it will buy coupons (i.e., “real” QE) in order to restore proper functioning in the Treasury market (which, by any number of accounts, was all but broken).

How to make sense of the chaos? Well, Deutsche Bank’s Aleksandar Kocic reminds you that “chaos (not the metaphor, but its actual realization) is not randomness run amok, but an essential instability to changes in initial conditions”.

“Chaotic movements in the market undermine our intuition and heuristics about the interaction between the cause and effect”, he writes, in a new note. “Even the tinniest disturbance can have profound consequences”.

To help you visualize, he asks you to think about the difference between standing at the other end of the room from someone who is either tossing a ball your way, or, alternatively, releasing a previously blown-up balloon. In the case of the ball, you can still generally catch it or anticipate where it will end up even if you make a minor misjudgment about its trajectory. However, with the balloon, its trajectory will be impossible for a human to prejudge, and even the smallest errors are likely to lead to gross miscalculations.

“In chaotic systems (balloons) everything is moving away from everything else [and] if we try to predict the future (range, level, risk,…), errors in initial measurements/judgement become overwhelming as time progresses and our long-term predictions will be extremely wrong”, Kocic goes on to write. Consider that in the context of the current market environment. Here’s Kocic:

As such, chaos reflects disregard for the long-term effects of the present actions — last week’s becomes irrelevant/inconsequential in light of yesterday’s headlines. Chaos is destruction of the future — only what’s simultaneous counts. It promotes shortsightedness and fosters arbitrariness. Markets lose sight of the future: The range has no meaning, there is no RV, and there is no V, only a squeeze in short-dated protection and relative indifference to what happens beyond the near term.

He puts this in the context of what happened in credit on Monday.

Market participants are fixated on BBB risk. Whenever there’s stress in the market, the issue comes up (it was all over the place during the Q4 2018 rout, for example). It’s the “BBB apocalypse” story. Or, “fallen angel risk”, if you like.

To be sure, there is cause for concern, although until now, fears seemed overblown for a variety of reasons. When you think about Monday’s anomalous widening in CDX.IG (shown below) and the generalized widening in credit this week, you have to consider the BBB story.

(BBG)

Kocic explains this in straightforward fashion, for anyone who needs a refresher.

“Behind this reaction of credit lies the decomposition of the IG sector”, he writes, before capturing one of the main sources of consternation in credit as follows:

In terms of its size, BBB is the largest tranche accounting for about 40% of the entire investment grade universe and sitting at the cusp between IG and HY (Figure). It is the lowest tranche of IG with highest sensitivity to oil prices. Any downgrade in BBB removes it from the investment grade and requires IG funds to sell it. In that context, BBB (and indirectly, oil prices) are the biggest source of negative convexity in the present constellation of risks. The unprecedented widening of the IG sector is a function of these forces.

The collapsing of horizons and markets’ tendency to lose sight of the future in a chaotic system is exemplified in the term structure of volatility. Kocic contrasts the adjustment from last Friday to Monday inside the 3M horizon with virtually no adjustment beyond that horizon to illustrate the point.

When overlaid with CDX.IG, you can see that the two are correlated. That makes sense. “The two are logically interconnected: Inversion of the surface as a measure of market anxiety is correlated with credit spreads — both represent a measure of risk premium in the market”, Kocic writes.

But, beginning last year, surface inversion began to decouple. That decoupling reached extremes earlier this week. The scatterplot shows this. The grey circles are the six sessions through Monday.

(Deutsche Bank)

The gist of that visual is that anxiety as expressed in vol. surface inversion may not just be excessive, but could be “a massive overreaction”, Kocic says. That’s a huge sample, by the way, spanning nearly 14 years.

There are a couple of paths to convergence and then a kind of offshoot of the second path. If things calm down in relatively short order, “risk should rebound followed by a collapse in gamma”, Kocic writes. On the other hand, if the crisis gets worse, long-dated vol. moves higher and credit widens out more, closing the divergence.

The offshoot from that second path is a scenario wherein the Fed exhausts its ammo, rates go to zero, and rates vol. moves lower, but the crisis persists. At that point, Kocic writes, “further market turbulence would catalyze transfer of volatility to risk assets while credit continues to widen [marking] a structural break in the link between rates vol and credit and risk market convexity”.

For what it’s worth, on Thursday the market was pricing in nearly 100bps of rate cuts from the Fed next week.

Finally, when you think about the various anecdotes about Treasurys being sold and gold positions getting liquidated to raise cash and cover losses in other assets, consider one last quote from Kocic:

Everything is moving chaotically and everything appears to be coordinated