The Death of the “Death of Contagion” Central Bank Meme
The Death of the “Death of Contagion” Central Bank Meme by TOM LUONGO
Last year now-former FOMC Chair Janet Yellen downplayed the possibility of another financial crisis. In her hubris she believes the central banks have walled off the financial system from ‘contagion risks’ brought on by over-investment in synthetic derivative market products.
Like generals, however, central planners are always fighting the last war.
We’re experiencing a major correction in the equity markets brought on in a mean-reversion exercise thanks to central banks trying to shore up their defenses around the last battle they lost, namely off-exchange, unregulated CDOs — synthetic debt-based investment products.
Humans are clever and will always find a way around a problem. The problem is incentives. The banks created CDO’s because there was a demand for investment returns far above what the central banks were allowing the market to pay, by setting interest rates well below the real risk profile of the investment community.
In other words, government bonds were over-priced and investors went looking for better returns. Now that Yellen et.al. have stamped out most of that market investors still need yield.
And that’s where the equity markets and the VIX come in.
VIX-ing the Markets
The response to the 2008 financial crisis was zero-bound interest rates and trillions in liquidity created by the central banks sitting around looking for yield. It found its way into the equity markets which over the past six plus years been on an historic rally off the October 2011 low.
During that time the VIX became more important. What was once only discussed by the real pros was now in the hands of everyone. Contagion risks jumped asset classes.
For the uninitiated the VIX — or volatilty index — is a bet about the behavior of the S&P 500, itself an index of stocks. Higher VIX values equal higher implied future volatility in the S&P 500 and vice versa.
In mathematical terms the S&P 500 is the first derivative of any single stock. Stocks in the index trade in sympathy with it regardless of their current business. The VIX is then the 2nd derivative of any stock in your portfolio.