“The truth is simple”, Deutsche Bank’s Aleksandar Kocic writes, in a note dated Friday. “A surprisingly large segment of the population is practically one paycheck away from some kind of insolvency”.
It’s a grim revelation, but one America has been forced to confront over the last two months, as businesses large and small closed their doors amid an engineered shutdown (an “induced coma”, as JPMorgan puts it) of the largest economy on the planet.
But that economy – the “envy” of the world, according to the president – appears now as something of a castle in the sky, just as it did in 2008. It’s a mirage built on what, at best, is the flimsy foundation of late stage capitalism. Kocic calls it “intrinsically unstable”, based as it is on inherent massive negative convexity.
When precarity becomes everyone’s prospect
“In the absence of a major disruption, the system is capable of moving along by collecting small installments of rent (‘clipping the coupons’) from a large segment of the population”, he writes. “However, if an exogenous shock disrupts the fragile order of these cashflows, there is a chain reaction of collective insolvency ready to sink the entire system”.
That is not hyperbole – Kocic doesn’t traffic in hyperbole, and has no interest in bombast for bombast’s sake. Rather, that is the cold, hard truth. And, if we’re all being honest, we’ve known it for years.
He describes the chain reaction as the paycheck-to-paycheck contingent of society (a massive percentage of the overall population) “exercises their option” to simply stop paying rent, stop consuming and stop funding education for their children, certainly not because they want to, but because they are suddenly broke, jobless and thereby cut off from consumer credit.
That’s when the dominos fall. That’s when the Jenga tower collapses. The sheer size of the financially vulnerable portion of the populace means that without their participation, employees of the sectors they effectively sponsor are left staring into the abyss.
“As precarity becomes everyone’s prospect, the consumers from a wider sector of the population withdraw and the rest of the economy gradually has to contract or shut down”, Kocic writes.
Convexity’s travel plans
Kocic proceeds to outline “how convexity travels”, noting that “crises generally erupt when significant negative convexity buildup is exposed”.
He characterizes the ensuing policy response as “a generalized, last-moment insurance maneuver of short covering of the inherent negative convexity of the system… designed to smooth out the effect of the initial shock of convexity exposure”.
[It would be useful, but not necessary, for readers to review my summary of Kocic’s conceptualization of policy as “convexity management” in the post-crisis world. It helps to inform and frame this entire discussion and can be found here: “‘Through The Looking Glass’: Aleksandar Kocic And The Fed In Convexity Wonderland“]
When it comes to parallels with previous crises, Kocic says this time “is both the same and different”. Once again, “it’s all about negative convexity”, he says, and yet, the nature of the shock is wholly exogenous.
It is a social shock with economic consequences, which necessitates a more coordinated, multi-tiered response involving both monetary and fiscal policymakers.
Monetary policy in this crisis plays a supporting role. If that’s not quite right, it is conceptually the “second act” (as Kocic puts it), even if it was technically the first mover by virtue of not being subject to the same type of partisan gridlock and laborious consensus building that characterizes decision-making inside the Beltway.
The Fed is providing leverage for the fiscal impulse, both figuratively and literally – Treasury provides the first-loss buffer for some of the Fed’s myriad backstops, which allows the central bank to lever up its support for various corners of the markets.
As Kocic goes on to say, “since the essence of the rescue revolves around recapitalizing the temporarily dislocated consumer, short covering of the negative convexity is performed through fiscal injection, but coordination of monetary policy plays an essential part in smoothing the functioning of the markets and providing conditions for optimal leverage for the government package in order to insure its effectiveness”.
Like stale cigarette smoke
When it comes to volatility, the immediate effect of monetary policy is to tamp down rates vol., but Kocic reminds you that risk never disappears – it just “shifts around”. We are, of course, still in the early innings of the crisis, pretensions to “opening up” parts of the economy notwithstanding.
In these early stages, volatility transfer has been from rates to equities, which, Kocic notes, “generally [see] the same economic and event risks [even as] their response to these is manifested with different intensity and on a different time scale”. That leaves the ratio of the two rangebound and admitting of what Aleks calls “a certain structure that outlines the differences in the reaction function of the two markets”.
In the present, we’ve seen rapid transfer of volatility from rates to equities. The ratio has plunged to record lows in the short space of a single month.
(BBG)
“Monetary policy is supplying convexity through rates and credit, but uncertainty is pushed out elsewhere where vol continues to linger due to delayed reaction and the uncertainties regarding the effectiveness of the policy response”, Kocic says.
He contrasts the current episode with the financial crisis for context. The chart in the left pane below is just a two-decade history of the interaction between the VIX and equities. The GFC is denoted with the black, dashed line. On the right is, to quote Kocic’s description, “the hysteresis that captures the 2008 crisis and recovery to initial configuration (with same values of both observables) in subsequent years”.
(Deutsche Bank)
What will things look like this time? That is, what path will the recovery to the original configuration take?
For Kocic, that path is likely to be different, and he says market participants are already seeing a preview of it.
During the GFC, the recovery was characterized by a fairly “coordinated” (if you will) retracement that mirrored the trajectory of the selloff/VIX spike. You can see that in the left pane below.
(Deutsche Bank)
On a cursory visual inspection (that is, imagine you had no conception whatsoever of what it is this discussion is about) the left pane looks far less threatening than the visual on the right. Even to the totally uninitiated, the right pane appears to represent a more perilous dynamic.
Describing Figure 5, Kocic notes that “in 2020, however, we are already seeing an indication of structural shift”. Over the past month, the relationship between the S&P and the VIX is split into what appear to be two distinct regimes. As Kocic writes, “selloffs have led to much more reactive VIX, with its practical refusal to decline in recoveries”.
This suggests volatility in equities could linger, like stale cigarette smoke in a bar that’s been closed for a month.
The post-COVID reality
To the extent the vestiges of March’s tumult persist in the form of stubbornly elevated equity volatility, it’s at least partially attributable to the uncertainty surrounding the post-COVID reality.
Even with state support, some companies may not make it. Many small businesses almost surely won’t. Some iconic local establishments are already closing their doors permanently. For many industries which accept bailouts and taxpayer money, the future is wholly indeterminate due to potentially onerous operational restrictions. Kocic puts it as follows:
The underlying uncertainties that this crisis has opened. Certain sectors of stock market might not be able to recover (in terms of their prices) even with the help of the rescue package and a comprehensive stimulus. For many corporations, the rescue could come with various provisions that inhibit or temporarily restrict certain corporate practices (like stock buybacks) or force more prudent risk management practices, which could adversely affect stock prices.
By contrast, the government sector cannot be allowed to malfunction. Trouble in dollar-funding markets (i.e., the “plumbing”) simply isn’t tenable as it could effectively freeze the entire global financial system, cementing the transformation of COVID-19 from a public health crisis to a financial crisis.
More broadly, Kocic writes that “unconditional and comprehensive support” for Treasurys and the rates space is intended to “maintain price stability and eliminate any disruption that increasing issuance and changing economic factors might cause”. After all, we need monetary policy to ensure stability in the Treasury market as long as we insist on the notion that bonds must be issued to finance fiscal stimulus.
For these reasons, Kocic says, “the distribution of risk could tip towards equities and the low vol ratio could persist for longer”.
The picture in credit is broadly similar. Kocic recaps the aftermath of 2008, noting that monetary policy clearly created a bullish backdrop for credit “by crowding out the UST and supplying convexity to the rest of the markets” which made corporate bonds desirable in classic hunt-for-yield/ positive carry fashion. Stocks too enjoyed the effects of easier policy, but in lagged fashion, through the “positive externalities of low real rates and explicit efforts to reflate the economy”, as Kocic puts it.
This time around, the Fed’s support for credit markets is direct – the Fed is buying investment grade bonds and ETFs, is also supporting fallen angels and will provide a limited bid for high yield ETFs.
Equities, by contrast, “are not a priori insulated from bearing some burden of recovery”, Kocic notes.
Or at least not yet. But, I suppose nothing can be ruled out given the Fed’s (not to mention lawmakers’) express intent to “make everyone whole”.
There’s little in the way of appetite at the Fed for the direct purchase of equities, but if it becomes apparent (for example, in a hypothetical retest of the local lows) that the crisis is being amplified via an unacceptably large reversal of the vaunted “wealth effect” (whereby rising stock prices buoy household balance sheets and thereby boost consumption), it’s not entirely far-fetched to suggest that officials would consider some support for stocks. Just ask Janet Yellen.
Ultimately, the most searing lines from Kocic’s latest are found in the opening paragraphs, as excerpted sparingly above. I’ll leave you with the full quote from Kocic:
The events of the last two months have brought into the open how many people, and to what degree, are hurting financially after one missed paycheck. The truth is simple: A surprisingly large segment of population is practically one paycheck away from (some kind of) insolvency when they will be unable to service their obligations of rent, consumption, childrens’ education or healthcare. Due to their size, this group of people is an enormously important part of the normal socioeconomic functioning. These revelations underscore the extent of fragility of what, until very recently, could have been identified as a booming economy. This reflects the intrinsic instability inherent in massive negative convexity of the entire economic system.
Carl Spackler trying to rid Bushwood of gophers. . .
In systems theory there is a concept known as the “Law of Requisite Variety.” Simply stated, a system is said to have requisite (resource) variety when no matter what shock the system is subjected to, it has enough of the correct resources available to respond in a timely manner to restore system stability. A system without requisite variety will face an inevitable risk of being shocked by its environment to such a degree that it cannot recover. If a human falls into the ocean at 35 degrees with no clothing s/he will die of hypothermia because the human system cannot produce enough energy to overcome the loss of body heat through the skin and organs will shut down leading to death. A system that lacks requisite variety is said to be “open.” Essentially, all biological systems are open.
Since it is uneconomical for social and economic systems to maintain a stock of resources ready made to counter each and every shock to which the system can be subjected, the next best solution to respond to critical negative shocks is to maintain a stock of flexible resources that can be used for more than one countermove to help to restore an unstable system. The most flexible resources, in order, are money, skilled people, and information. Keeping a safety stock of money, the right kind of people and stores of relevant information can prepare a social or economic system to respond to major shocks that threaten its stability, or even its survival. We used to believe in keeping those kinds of resources around in-house in various parts of our system but today, not so much.
The reason for our short-sighted lack of resources which can enhance our ability to control system shocks stems most from the fact that idle resources, even flexible ones that could save us, carry an opportunity cost that people would rather not pay if they can’t see an immediate need. So to maximize profits, keep down our taxes, and avoid being subjected to various sacrifices that reduce our well-being in the short run, while protecting us from harm in the long run, society has dropped its guard. The average family in America can’t respond to a shock that requires even a couple week’s pay. We are told from elementary school we can “have it all” and right now… Well we can’t have it all and being grasshoppers instead of ants and failing to heed the Bible’s exhortation to put away resources in the seven fat years so we can eat in the seven lean years is suddenly somehow “boring” or “stupid,” what losers do. So we are short of money and faced with relying on deficits, we are short of emergency medical facilities and must rely on tents in the park, we are faced with unreliable data that keeps us from even knowing our true situation. Businesses have reduced their safety net cash reserves to buyback stock and generate grasshopper returns. Our systems are out of balance and we no longer are a society that has the requisite resource variety of face a serious shock of any kind. It’s a universal law we can’t ignore whether we like it or not. If we survive, and many of us won’t, either because of the disease or our attempt at a “cure,” we won’t be ready for another such shock unless we forget about normal and go back to a more sensible system. I , for one, am not optimistic. Real sacrifice seems to have left our DNA and all anyone seems to want is to finish the NBA season somehow, start the NFL on time and get back to “normal.” Sure doesn’t look like this has been any kind of a learning experience.
This is a fantastic commentary. Should be a separate post.
Thank you, sir. I read you regularly and really respect your thinking.
+1
+!
That the evangelicals are supporting the right who are principally responsible for the lack of slack in our systems, in order to fund tax cuts, is a testament to the theory that Conservatives are closet radicals and evangelicals are not willing to follow any biblical principles in real life.
@Mr. Lucky a large and prosperous middle class provides precisely the shock absorption that our society needs. Unfortunately… our neo-feudalistic system ensures that the lords continue strip mining the debt serfs ever more efficiently.
But what is money when they are printing it at will.
If you let your imagination take over you can see The Nomura system Charlie has popularized intertwined in the negative convexity that Kocic talks about,,, Gotta concentrate to see it though……Really good post H………
Yeah I thought the same as I read this. Somehow Nomura’s macro analysis described over the last year or so here then is a micro version of what Kocic is, in part, describing above, no?
Separately, I’m also trying to sort out in my head the corollary, if any, between the descriptions H has repeatedly laid out for how the hunt for yield has pushed out the quality ladder based on all the macro moves made by central banks post-GFC, and this attempt by the Fed right now to push risk out the structurally necessary ladder (from most existentially critical to less so)…
The science of Economics is rooted in simplicity and often a version that is understandable can be distilled out of the complex muddle that appears to never have an actionable alternative ..In Kocic…. simplicity can be logical the Nomura system as quantified by Charlie M.. makes it potentially actionable but of course not for the little guys……None the less at some point one has to feel that there is a measure as to whether one got it right (sometimes) … Never committing a guess makes you loose your bearings .
Maybe printing money to devalue wages and annihilate savings might have a downside after all…oh, I forgot the experts say Quantitative Easing is something more complicated and theoretical
Mr. Lucky- I like your post.
My parents, born in 1933, taught me to – spend less than I make, save from my first paycheck, not borrow money (other than for a house I can afford), learn a skill that someone will pay you for and make my own coffee. I married a man with the same principles and we showed our children the power of living that way. So far, so good with them.
Americans need to embrace this philosophy as Germany has done. Short term sacrifice for long term gain.
I have often read that corporations are/were irresponsible for buying back shares and raising dividends rather than putting capital to productive use. But what if there was/is nothing more productive to do with the money? Let’s say you are the CFO of Acme Airlines. The COO and analytics people are telling you that the Acme really has no markets to grow into –gates are scarce, marginal routes are too dicey a proposition, costs have cut as much as possible via low cost puddle jumping subsidiaries, narrower seats, better reservations and pricing systems just about every fee imaginable. M & A has been taken to the limit (United Continental deal anyone?) Fixed costs are, well, fixed. But we have all this free money from the Fed –how can we not take it? The most responsible thing for the CFO dedicated to fulfilling his fiduciary responsibilities is to maximize shareholder value. In absence of operationally or strategically viable uses of the money, issuing bonds at a suppressed interest rate and using the money to buy back (and so retire shares) that permits either sustaining an inflated dividend seems like the sensible thing to do. This is a classics case of “unintended consequences” of which Robert Merton wrote so insightfully (and so well –about as good as it gets as far as academic writing goes) in 1936.
Wouldn’t want to invest in your labor force…..that wouldn’t maximize shareholder value.
And…..we wonder why Americans have so little ability to weather a financial shock.
Is there no responsibility to employees, customers, society?
“There is a common belief that corporate directors have a legal duty to maximize corporate profits and “shareholder value” – even if this means skirting ethical rules, damaging the environment or harming employees. But this belief is utterly false. To quote the U.S. Supreme Court opinion in the recent Hobby Lobby case: “Modern corporate law does not require for-profit corporations to pursue profit at the expense of everything else, and many do not.” ”
source: https://www.nytimes.com/roomfordebate/2015/04/16/what-are-corporations-obligations-to-shareholders/corporations-dont-have-to-maximize-profits
The ghost of Milton Friedman stalks our nightmares.
Great piece, H
It’s true that people need to learn to save for a rainy day, as a poster above admonishes. We’ve also known for a long time that a good economy is dependent on a robust middle class. And yet those who should know this second truism (corporations & politicians) continually fed themselves first and most rather than supporting the truth of the matter and shifted all America’s wealth to the few at the top.
In the old days, religion was the opiate of the masses. It still is but to a lesser degree. Today it seems the continuous flow of sparkly technology has become the new opiate. Combine that with poor education and we have a real mess.
How else can we understand the phenomenon of the protesters in Michigan and elsewhere demanding their right to go back to living paycheck to paycheck all the while waving signs and guns supporting Trump and all those who would continue to take from them? They also famously vote against their own self-interest. That is one powerful drug, and it’s causing the protesters’ anger to be misdirected.
We are witnessing the consequences of massive inequality in wealth distribution politely called here “negative convexity”
These concepts are new to me… and I’ve been trying to get up to speed, but after hours of reading up, I’m still at sea. This subtitle of this post is “The truth is simple.” Evidently, not to me.
I can grasp negative convexity as it applies to MBS. Separately, I understand the vulnerability that “A surprisingly large segment of the population is practically one paycheck away from some kind of insolvency” implies for the economy,- and why Kocic calls that “intrinsically unstable.” But what I can’t seem to grasp is exactly how the concept of negative convexity applies to this vulnerability. I’m not able to transfer what I do understand about negative convexity in relation to MBS to the chain reaction enabled by the desperate plight of the many who are so near insolvency. I certainly get it that it is terrifying, despairing, and potentially deflationary,- I feel the awfulness in my stomach,- I just don’t understand why all that is, to quote the top of the piece “based as it is on inherent massive negative convexity.” I’m missing something simple conceptually. And if someone would be kind enough to explain it, I’d by truly grateful.
With mortgages, the homeowner has an option to refinance. Therefore, the issuer or the owner of the mortgage bond is short an option. That is why mbs have higher yields than treasuries.
Similarly with credit: if a corporation issues a (defaultable) bond, they have a right to default (stop paying coupons or prIncipal if their business doesn’t work out). So, the owner of a corporate bond has sold an option to the issuer and has a higher yield in return.
So, both mbs and credit markets are negatively convex because they have an embeded short option.
At the point of issuance, both refinancing options and default options are far out of the money, so that convexity is small. But if the market moves towards the strike, that negative convexity becomes substantial. This is a problem if the move is systemic because everyone wants excercise their option at the same time.
This is really not much different than selling insurance and then everyone who owns the policy comes to collect it at the same time. this is clearly an unstable point of the market.
For a consumer in question, if they have a job, they will continue to pay their obligations-in principle, they can decide not to, they are always long that option, but are unlikely to, at least not all of them. But if a large number of them loses job, their option not to pay, will be forced. That triggers the chain reaction
This has been a bonus article for me. A good article by H, a good post by Mr Lucky, and a very nice explanation by Mr. Knausgard. Thanks to all of you.
Thank you kindly Mr. Knausgard. Now I see it. Though it’s a grim picture, it’s a relief to be able to see the negative convexity come out of my blind spot.
Great post. Clear explanation. Thanks.