Diary of a Financier

The Market Returns to Some Familiar Norms; Preparing for the Government’s Exit

In Capital Markets, Economics on Fri 28 Jan 2011 at 08:28
  • Volatility has returned and correlations have eroded in the past weeks.
  • If the government’s divesting of Citi is responsible, watch for the market reaction to the upcoming AIG offering; derivative activity will be prescient.
  • As POMOs/QE2 & other stimulus programs wind down, fiscal consolidation must be accompanied by monetary support to uphold demand through a recovery.

It’s not so much that the VIX is slightly off its lows; it’s not so much the wider intraday trading ranges for securities; it’s not even so much that US markets are back to leading [instead of following] activity in international markets.  It’s more the fact that within asset classes and between asset classes, correlations have finally shattered their lockstep.  Further, I’m noticing that earnings reports are triggering huge reactions in associated single names–something that was largely muted in the past two quarters.  These are difficult attributes to substantiate, but being in the market day after day, I’ve sensed a different jive.  These may be the first effects of the US government withdrawing its capital and running low on liquidity resources/will.  If government intervention is waning, fiscal consolidation should begin, and its deflationary effects must be offset by continued monetary support.

On one hand, earnings surprises are triggering big swings, a return to a norm we’re familiar with from 2009.  On the other hand, I have to return to 2007 before I can remember a time when assets moved with such independence from one another.  I can’t help but consider the effect of the US government, having hoarded assets over the past two years–like TARP equity, MBS, Citigroup (C), AIG (AIG)–now cutting loose some of its holdings on the secondary market.  The Treasury and the Fed (and certain extensions like Maiden Lane) injected liquidity into troubled institutions to bolster capital ratios. With those liquidity injections comes dilution and oversupply in secondary markets (i.e. downward price pressure), so the government had little choice but to retain its new investments (preferred stock & equity warrants) from the open market to prop-up prices.

As aforementioned, the Treasury reluctantly gifted & retained [$45bn worth] of Citi equity.  By December 23, 2009, Citi had repaid the $20bn portion of that which was issued as preferred stock.  In the beginning of December 2010, the Treasury unloaded the last of its Citi investment, $25bn denominated in common stock, unto the market.  That added 7.7bn shares or 26% of the free float for traders to chase.

Imagine that you’re in an open-air fish market haggling with vendors over the price of Cod.  There’s only 4 pieces of fish, which is perfect since you’re one of only 4 other shoppers looking to take home Cod for dinner.   So all the shoppers agree on a price with all of the vendors, but right before you exchange your cash for the Cod, another vendor comes running in with a 5th piece of Cod.  Now the balance of pricing power shifts into the favor of you & your fellow shoppers.  In returning this Citigroup free float to the marketplace, the Treasury took the available supply of Citi shares from a relative balance to a relative excess.  (Do consider that Citi has the most liquid stock on the NYSE in terms of volume.)  The last slug of that 7.7bn shares was 2.4bn shares sold after December 6.  Throughout the subsequent trading days, this action had to have been met by a substantial counterbalance; something with the ability to stoke demand enough to meet that outward shift in supply.  I’m sure QE2 went into overdrive to accomplish just that… and it did, hitting full stride with ~$50bn in incremental Treasury purchases between December 1-15.  In addition, excess reserves on deposit at the Fed dropped by an unusual $64bn in that second week; as Tyler Durden indicated:

The decline in excess reserves was substantial, amounting to $64 billion in the week. This is liquidity that Primary Dealers could use in addition to POMO liquidity to goose up markets. In other words, there was about an incremental $100 billion in additional liquidity made available to prop desks to buy risky assets.

That extra bit of demand is exactly what the government needed to service the Citi shares and then some.  In fact, if you understand the mechanics of the VIX, the fact that this volatility index fell out of bed in the beginning of December suggests that institutions were unwinding single-name volatility and option hedges to increase long bets:

VIX dives in advance of the Treasury's divesting of Citi stock.

Yet, the interesting note is that volume in Citigroup stock didn’t explode as much as you’d expect (outside of a few blips around the 12/6/2010 announcement of the Treasury’s exit):

Citi- note the insignificant volume increase, even after a 50% increase in the free float

Volume across the NYSE also felt nothing more than a quick shudder:

NYSE Total Volume daily- a short-lived bump up in December...

...NYSE Total Monthly Volume- but in the grand scheme, it wasn't a big bump.

Often the heaviest traded stock on the NYSE, Citi added around 25% more shares to its free float, but NYSE volume didn’t ferociously react?  Strange.

In contrast, AIG’s volume pumped-up in the aftermath, reacting as I would have expected Citi’s to have:

AIG- compared to Citi, there's a significant volume increase here.

While an 8K was filed on December 7 to disclose the intention to repay FRBNY loans, the big news hit AIG on December 8, when trading was halted amid a flurry of selling volume.  AIG & the Treasury had released a revised plan to convert the Treasury’s preferred shares to common, then sell them to the public.

Today, AIG is preparing that public offering to tender the government’s equity stake.  As of January 20, the Treasury owns 92% of AIG, so a lot of private demand needs to be gathered for the offering.  It would take a ROIC miracle to justify the valuation on AIG as of today’s price.

So what will happen when AIG’s shares come online?  Will we have a reoccurrence of the Citi 12/6/2010 stake sale?  That would indicate a heap of liquidity to drown a dollop of new issuance.  That would indicate another leg to this bull rally, with perceived risk dissolving.

I’m happy to fade the VIX, because like I said before, present volatility is real.  (I’m watching premarket reactions to yesterday’s NFLX & CAT earnings, or even prior BA earnings, AAPL, etc., etc.)  Future volatility–at least as measured by the VIX using put/call premiums–is apparently not real, since derivative hedges were unwound in December like Tyler Durden relates above.  But, as evidenced in Implied Correlation’s (index volatility expectations) spike through December, the slide in the VIX (single-name volatility expectations) doesn’t tell the whole volatility story.  KCJ represents an Implied Correlation index:

VIX v KCJ relative performance (December 2010-present): here, we see that while traders were closing single-name hedges, INDEX hedges stayed relatively stable.

VIX v KCJ absolute performance (6 months)- here you can see a recovery in KCJ in December, while VIX kept crashing lower.

I think liquidity is running dry (on schedule I suppose), and the government is having to focus its resources on supporting individual names like Citi or AIG in a triage to recoup taxpayer investments & stabilize the companies they set free… which takes precedence over supporting broad indices.  During stretches of this government preoccupation, Primary Dealers are a proxy, making coordinated moves to go head-long into risk and provide support where the government cannot.

Therefore, when the AIG offering approaches, I’ll be watching single name hedging activity (VIX) relative to broad index hedging (KCJ).  A further reduction in either index would tell me that the smart money has gone long to support the system.  A reduction in both means the smart money has gone all-in, which leaves little upside.

This is a prescient warning, and I’m even more intrigued after hearing Bill Gross on CNBC yesterday: he balked in answering the question, ‘when should normal investors position themselves for the government withdrawal from markets?’  My answer would have been: you don’t fight the Fed or the Treasury.  If you’re feeling contrarian, sit in cash, but don’t bet against the will of sovereigns.

A while ago, I posted a VoxEU research piece in my Bookshelf.  Entitled “A recession to remember: Lessons from the US, 1937-1938,” the column communicates the importance of complementing fiscal consolidation with monetary support for aggregate demand.  Authors Nicholas Crafts & Peter Fearon survey the Great Depression and the government’s missteps, and they arrive at that Bernankian conclusion:

In early 1937, there was still an output gap, estimated by Balke and Gordon (1986) to be around 15% of GNP, but there was a widespread feeling that the depression was over. The focus of policymakers was shifting to concerns about future inflation and a return to a balanced budget. The Federal Reserve was worried by the build up of substantial excess reserves in the banking system while on the fiscal side the ratio of the national debt to GDP had risen from 16% in 1929 to 40% by 1937…

The implication was a discretionary fiscal tightening amounting to over 3% of GDP, according to estimates by Larry Peppers (1973). On the monetary side, a new policy of sterilising gold inflows was adopted in December 1936 and reserve requirements for the banks were doubled in three stages from August 1936 through May 1937… Inflation ceased and prices started to fall again. This was a big reversal and the contraction in economic activity was at similar rates to the early 1930s. The recession ended when reserve requirements were eased, gold sterilisation ceased, and the balanced-budget policy was dropped as government spending was increased by $2 billion…

The key message here for policymaking in the current situation is not that fiscal consolidation should be postponed. Rather, it is that exit strategy needs to focus on providing monetary support for aggregate demand as fiscal stimulus is withdrawn.

Word to the wise.


  1. In that vein, a big move today: DJIA +150 pts.

  2. […] since the inflation that exists doesn’t relatively trounce my disposable income. ) From a diary entry of mine a few weeks ago: I posted a VoxEU research piece in my Bookshelf.  Entitled “A recession […]

  3. […] and pursued fiscal consolidation without the accompaniment of monetary support.  I can’t repeat that enough, especially with Americans asking US policymakers to take their foot off the gas when […]

  4. […] can’t emphasize enough the need for Monetary stimulus to support fiscal […]


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