China Shuts Down Its VIX To Halt Market Turbulence

While most of the world saw regional equity markets covered in red overnight, China's Shanghai Composite rebounded, rising 2.2% for two reasons: i) a delayed reaction to global equity prices after the country's 5-day Lunar New Year holiday and ii) China's latest crackdown on anything that can precipitate a selloff, like a high VIX for example.

And so, just like on August 24, 2015 when the US market crashed so hard in the pre-market, the VIX briefly "went offline" as input signals went haywire, China also decided to stop updating its local version of the VIX Index, taking its latest step to discourage speculation in equity-linked options after authorities tightened trading restrictions last week.

As Bloomberg first reported, China's state-run Securities Index Co. didn't publish a value for the SSE 50 ETF Volatility Index on its website Thursday. An employee who answered a Bloomberg phone call said the company stopped updating the measure to work on an upgrade, however according to "people familiar", the move was designed to curb activity in the options market. 

It's unclear when the index will resume.

Just like the US VIX, the SSE 50 volatility index is the most widely-followed indicator of Chinese investor anxiety. Which is a problem because also just like the VIX, the index doubled in the span of a few days earlier this month. And the last thing Beijing wants is nervous investors thinking that other investors are nervous... and selling in a blind panic. 

So what to do? Why shut it down of course, just like all global equity markets will be shut down once the real selling begins.

According to Bloomberg, the decision to stop publishing the index forms part of a broad effort by Chinese officials to contain market turbulence. 

Other measures this month have included volume limits on active options traders and informal directives encouraging some major stockholders to purchase more shares. Chinese leaders have in the past faced criticism for meddling too much in markets, particularly during the nation's 2015 equity crash.

The VIX blackout follows tighter curbs on options traders unveiled from Feb. 12, people familiar with the matter said last week, in part because they were alarmed by a gain of as much as 2,250 percent in the price of one bearish contract on the SSE 50 ETF (also known as the China 50 ETF). The fund is China's only equity-linked product with options.

Demonstrating surprising wisdom, unlike the U.S., China has avoided approving derivatives and funds tied to its volatility gauge. And while it won't have its own homegrown XIV collapse, China has more than enough potential candidates that will unleash the next crisis: just last night we reported that while China may not have inverse VIX ETFs, it has another, far more serious problem - pervasive stock loans, hundreds of which have seen margin calls in recent days, forcing dozens of companies to simply halt trading.

In fact, a pattern is emerging in China: any time there is a problem with any one asset, or any one indicator... why, just turn it off.

For now these "solutions" are working: volume in the SSE 50 ETF options was about 40% lower than the 20-day average on Thursday, according to data compiled by Bloomberg. What traders are more interested in is what happens when the volume hits 0% and nobody trades anymore, and - tied to that - what happens when China's creeping admission that its capital markets are broken finally seeps through.

Who Will Buy Trillions Of US Treasuries???

As of the latest Treasury update showing federal debt as of Wednesday, February 15...federal debt (red line below) jumped by an additional $50 billion from the previous day to $20.76 trillion. This is an increase of $266 billion essentially since the most recent debt ceiling passage. Of course, this isn't helping the debt to GDP ratio (blue line below) at 105%.

But here's the problem. In order for the American economy to register growth, as measured by GDP (the annual change in total value of all goods produced and services provided in the US), that growth is now based solely upon the growth in federal debt. Without the federal deficit spending, the economy would be shrinking.

The chart below shows the annual change in GDP minus the annual federal deficit incurred. Since 2008, the annual deficit spending has been far greater than the economic activity that deficit spending has produced. The net difference is shown below from 1950 through 2017...plus estimated through 2025 based on 2.5% average annual GDP growth and $1.2 trillion annual deficits. It is not a pretty picture and it isn't getting better.

Even if we assume an average of 3.5% GDP growth (that the US will not have a recession(s) over a 15 year period) and "only" $1 trillion annual deficits from 2018 through 2025, the US still continues to move backward indefinitely.

The cumulative impact of all those deficits is shown in the chart below. Federal debt (red line) is at $20.8 trillion and the annual interest expense on that debt (blue line) is jumping, now over a half trillion. Also shown in the chart is the likely debt creation through 2025 and interest expense assuming a very modest 4% blended rate on all that debt.

So, for America to appear as if it is moving forward, it has to go backward into greater debt?!? If you weren't troubled so far, here is where the stuff starts to hit the fan.

With the change to the Unified budget, effective as of 1969, the Social Security surplus was "unified" into the federal budget. The government gave themselves a ready buyer for US debt while simultaneously allowing the SS surplus to be spent in "the present". Congressionally mandated to buy US debt, from 1970 to 2008, the Intra-Governmental Holdings (over half from the Social Security surplus) purchased over 45% of all federal debt issued. This meant "only" 55% of US debt was auctioned into the market, or "marketable debt".

But the annual SS surplus has declined by 90% (from over $200 billion a year at the peak in 2007 to perhaps $20 billion this year) and, according to the SS trust fund, the last surplus will be recorded in 2020 or 2021. After that (or essentially now), the Congressionally mandated buyer (which consumed almost half of all US federal debt for 4 decades) will cease. Not only will the IG Holdings no longer be a buyer, they will need additional debt created to make good on those $2.9 trillion in SS "reserves"...and all the debt issued will be "marketable".

The chart below shows the "marketable" debt vs. IG Holdings from 1970 through 2025. As noted above, IG consumed nearly half of all US debt up to 2008...but since '08, IG has consumed just over 10% of all the new issuance and nearly 90% of new debt been auctioned into the market. IG has essentially ceased to be a buyer...meaning that marketable debt will continue to soar.

So who is a buyer of US Treasury debt? 

Only three possible groups remaining; "foreigners", the Federal Reserve, and private domestic sources (pensions, banks, mutual funds, individuals).

I will show that foreigners have essentially ceased buying, that the Federal Reserve isn't a buyer and in fact is reducing it's balance sheet...and this means there is only one buyer remaining to soak up the surging marketable debt.

But before I detail these...I want you to remember Harry Markopolos. Markopolos is a financial investigator and he gave clear evidence of Bernie Madoff's Ponzi to the SEC as early as 2000, again in 2001, and again in 2005. The SEC did not see what they didn't want to see and it wasn't until the great financial crisis of '08 that Madoff's fraud was exposed and the loss of approximately $65 billion realized (below, from Wikipedia).

When Markopolos obtained a copy of Madoff's revenue stream, he spotted problems right away. Madoff's strategy was so poorly designed that Markopolos didn't see how it could make money. The biggest red flag, however, was that the return stream rose steadily with only a few downticks—represented graphically by a nearly perfect 45-degree angle. According to Markopolos, anyone who understood the underlying math of the markets would have known they were too volatile even in the best conditions for this to be possible.

As he later put it, a return stream like the one Madoff claimed to generate "simply doesn't exist in finance." He eventually concluded that there was no legal way for Madoff to deliver his purported returns using the strategies he claimed to use.

As he saw it, there were only two ways to explain the figures—either Madoff was running a Ponzi scheme (by paying established clients with newer clients' money) or front running (buying stock for his own account, based on knowledge about his clients' orders).

With that in mind and the largest single buyer (IG) now a seller, let's look at the remaining "buyers" and consider the nearly $21 trillion US Treasury market:

BUYERS -

Federal Reserve...presently allowing Treasury bonds and MBS (mortgage backed securities) to mature, reducing it's balance sheet on a monthly basis. The Fed plans to roughly halve its balance sheet from $4.5 to $2.2 trillion between now and 2022 (a $250 billion annual reduction in Treasury holdings). That is a net increase of available Treasury debt of $250 billion annually above and beyond the trillion plus in new issuance and trillions being rolled over every year.

Foreigners...foreigners presently hold $6.3 trillion in US Treasury debt but since QE ended in late 2014, foreigners have essentially gone on strike, adding just $150 billion in a little over three years (chart below).

Foreigners added an average: 

'00-->'07 +$160 billion annually 

'08-->'14 +$540 billion annually 

'15-->'18 +$50 billion annually 

The current pace of foreign Treasury buying is less than 1/3 the pace of the early '00's and a 90% reduction from the pace of '08 through '14, when QE was in effect.

Just three buyers hold over half (55%) of all debt held by foreigners; China, Japan, and what I call the BLICS (Belgium, Luxembourg, Ireland, Cayman Island, Switzerland). The chart below shows each nations/groups US Treasury holdings from '00 through December of '17. Entirely noteworthy: 

China '00-->'11 +$1.2 trillion...but China has been a net seller of Treasury's since the July of 2011 debt ceiling debate 

Japan '00-->'11 +$600 billion...Japan's holdings did rise after the July 2011 debate but are fast declining now toward the same quantity it held in July of 2011 

BLICS '00-->'11 +$300 billion...It has been the $800 billion surge in BLICS buying since July 2011 that has kept foreign demand alive. 

As for the BLICS, their buying patterns since '07 have grown increasingly bizarre, as if profit isn't their motive? However, if maintaining a bid for US debt is the motive, the massive surges in buying at the worst of times makes sense.

So, I've shown US federal debt is surging but the only thing keeping the US economy "growing" is the size of the deficit and debt incurred. I've shown the traditional sources of net Treasury buying have ceased except for the domestic public. That the Intra-Governmental holdings are essentially peaking and will be a net seller within a couple years and all new debt issued will be "marketable". I've shown the Federal Reserve plans to "roll off" approximately $250 billion a year for up to four years. I've shown that China ceased net buying Treasury debt in 2011 and foreigners have essentially gone on strike since QE ended. The only real foreign bid remaining is from some pretty shady demand that looks an awful lot like it could be central bank buying, but regardless the BLICS, foreign demand for Treasury's (on a net basis) has essentially stopped.

This leaves the domestic public to purchase all the surging new issuance, plus the portion the Fed (and soon enough, the IG) is rolling off, and with little to no assistance from foreigners (even the possibility the strike turns into an outright selloff!?!). The domestic public currently holds about $6 trillion in Treasury debt and will need to buy in excess of $1.5 trillion annually (indefinitely) between picking up the roll off and the new issuance. If the public "willingly" do this at low interest rates, it will represent 7.5% of GDP going toward Treasury purchases that yield well below needed returns. If the Public don't do this "willingly", interest rates will soar far more than shown above and the US will be overwhelmed by debt service. The only other option is that the Federal Reserve makes a U-turn to re-start QE and openly engage in endless monetization.

Why China’s Return May Be Last Straw for Global Rebound

China's Return May Be Last Straw for Global Rebound

China will return from the Lunar New Year holiday to reinforce the gloom that's seeping through global equities. The five-day break came with global equities scrambling to rebound from the collapse of early February. That bounce has looked fragile.

Bulls need the world's second-biggest market to come roaring back refreshed but such a positive outcome looks unlikely.

China is key because it's the only major market that hasn't yet seriously bought into the fantastical stock rallies that got going once the ashes of Brexit had settled.

Over the past 1 1/2 years, record highs were set for all three major U.S. indexes, along with the benchmarks for Canada, Hong Kong, South Korea, India, the U.K., Germany and Switzerland. Stocks in Japan and Taiwan hit the highest since the early 1990s. Australia's benchmark index reached a decade-high, as did France's.

China was the only $1 trillion-plus national stock market missing out on the party -- the Shanghai Composite only reached a two-year peak and its 6.6% advance in 2017 was in the bottom third of performances among 96 primary indexes tracked by Bloomberg.

This matters because the narrative drummed into everyone's consciousness during the most-recent leg of the global rally was that a synchronized pickup in growth was the reason to relentlessly bid up stocks and sell down volatility.

The underperformance of China -- the world's biggest exporter and the largest market of consumers -- casts doubt over that optimistic story.

Through the start of 2018, it looked as if the country's shares were playing catch-up to validate the global meltup, only to start dropping well before the Feb. 2 U.S. wages print supposedly let the inflation genie out of the bottle. Looking forward, there are even fewer reasons for optimism: the lack of obvious organic Chinese drivers means any rallies can be viewed as merely aping global trends, making them just as vulnerable as last time.

China's Communist Party made it clear that it's determined to shift to a more stable, steady growth profile; a direct contradiction of the frenzied global stock rally that was pricing in perfect outcomes and was turbo- charged by the short-term sugar hit of deficit-fueled U.S. tax cuts.

The deleveraging that's central to China's plans has to entail a slower growth profile. It's also delivered the highest nominal 10-year yields since 2014 and brought real yields close to the highest since 2009. All three of those factors undermine the case for strong equity gains from here.

Fed President Sounds Panic Over Level Of US Debt

Nearly a decade after the US unleashed its biggest debt-issuance binge in history, doubling the US debt from $10 trillion to $20 trillion under president Obama, which was only made possible thanks to the Fed's monetization of $4 trillion in deficits (and debt issuance), the Fed is starting to get nervous about the (un)sustainability of the US debt.

The Federal Reserve should continue to raise U.S. interest rates this year in response to faster economic growth fueled by recent tax cuts as well as a stronger global economy, Dallas Federal Reserve Bank President Robert Kaplan said on Wednesday.

"I believe the Federal Reserve should be gradually and patiently raising the federal funds rate during 2018," Kaplan said in an essay updating his views on the economic and policy outlook.

"History suggests that if the Fed waits too long to remove accommodation at this stage in the economic cycle, excesses and imbalances begin to build, and the Fed ultimately has to play catch-up." The Fed is widely expected to raise rates three times this year, starting next month.

Kaplan, who does not vote on Fed policy this year but does participate in its regular rate-setting meetings, did not specify his preferred number of rate hikes for this year. But he warned Wednesday that falling behind the curve on rate hikes could make a recession more likely.

Echoing the recent Goldman analysis, which warned that the recently implemented Republican spending plan could lead to an "unsustainable" debt load, Kaplan - who previously worked for Goldman - also had some cautionary words about the Trump administration's recent tax overhaul, which he said would help lift U.S. economic growth to 2.5% to 2.75% this year, pushing the U.S. unemployment rate, now at 4.1% down to 3.6% by the end of 2018, but not for long.

On the all important issue of inflation, he projected it would firm this year on route to the Fed's 2-percent goal.

The most ironic warning, however, came when Kaplan predicted the US fiscal future beyond 2 years: he said that while the corporate tax cuts and other reforms may boost productivity and lift economic potential, most of the stimulative effects will fade in 2019 and 2020, leaving behind an economy with a higher debt burden than before.

"This projected increase in government debt to GDP comes at a point in the economic cycle when it would be preferable to be moderating the rate of debt growth at the government level," Kaplan said.

He was referring, indirectly, to the following chart from Goldman which we showed previously, and which suggests the US will become a banana republic in just a few years.

A higher debt burden will make it less likely the federal government will be able to deliver fiscal stimulus to offset any future economic downturn, he said, and unwinding it could slow economic growth.

"While addressing this issue involves difficult political considerations and policy choices, the U.S. may need to more actively consider policy actions that would moderate the path of projected U.S. government debt growth," he said.

So to summarize: when US debt doubled in the past decade the Fed had no problems, and in fact enabled it. And now, it's time to panic...

Finally, going back to Kaplan's point that fiscal stimulus may no longer work during the next downturn covered by a record mountain of debt (which according to Trump's budget will hit $30 trillion by 2028), we agree, and is why we suggested a few days ago that the next crisis will lead to - what else - even more QE, which also explains why Goldman has been so desperate to get its clients to sell all the Treasurys they have now, as Goldman's prop desk keeps adding to its inventory...

A 58% Wipeout Is "Best Case"!

Two of of the best "tried and tested" ways to rapidly grow your wealth are to:

Use leverage in a rising market and 

Flog equity at ever rising prices (à la Tesla) 

Both methods work, but leverage is not unlike that smoking hot girlfriend you used to have who was, let's admit it, pretty unhinged.

Hanging about too long was always going to get you into trouble — serious, call-the-police-NOW trouble. But the allure was so strong and kept pulling you back. The decision was really tough. Not because it didn't make sense, but because you weren't really thinking with you brain.

Enter the Allure of Ever-Rising Prices (and the Debt That Fuels It)

That debt, like the smoking hot but unhinged girlfriend, may be about to do what it always promised to do — damage!

Australia's household debt-to-income level has reached a spectacular new high, hitting 200% for the first time. Total household debt now stands at an eye-watering record $2.47 trillion... or nearly $100,000 for every man, woman, and child in the lucky country.

Even after debt-free households are factored in, the average Aussie household now owes twice the amount they bring in annually from wages, welfare, and other sources of income.

I get it — Joe Sixpack isn't skilled in managing money. Hell, he's a plumber, or a lawyer, or works in IT, or maybe he makes overpriced lattes for soccer moms. Whatever it is he does, he's not the time to think about (or even know about) the eurodollar market or global capital flows, let alone price to income ratios.

What's more, Joe's got 2 and a half kids, a wife with a shoe fetish, and all these things take up a lot of his time.

What he does know is that he needs somewhere to kip at night and so do his family. So he needs a house. But he figures this is an investment (poor sod) and so he understandably makes it as BIG as he possibly can.

For many folks it's the only time in their life they actually think about making a capital allocation to literally anything other than weekend beer and the odd family holiday to Fiji. And maybe it's a good thing as it is the only asset that may actually leave him with something when the nurse wheels him around with tubes up his nose feeding him mushy peas.

Gasoline on the Fire

Now, the Aussies realised a long time ago that actually the government were and are completely isht at managing pensions, and unless they did something and did it quickly, they were all going to end up like all the other Western economies. Screwed and pretending they have pensions when their own balance sheets make the assertion completely laughable. And so they instituted something called "self-managed super".

This meant that individuals would manage their own superannuation funds where they'd contribute money and towards that the government would assist via multiple ways including tax breaks and various other incentives.

The mechanics don't matter for the purposes of this article. What matters is that over 600,000 self-managed super funds (SMSFs) are now in operation, managing over $7 billion in assets.

So, in that respect the Aussies are waaaay better off than many of their Western counterparts. But just when you thought, hooray for them, they went and doubled down on that one bet they'd already made: Australian housing.

You see, there has been an explosion in SMSF borrowing to buy into the property market amid surging house prices earlier this decade.

How bad?

Well, borrowing by SMSFs has grown from $2.5bn in 2012 to more than $24bn today.

This is like having the crazy girlfriend, marrying her, and then — in what can only be described as a period of deranged insanity — going out and getting a couple (yes, two more) mistresses who make her look positively boring and sane.

Now, if this all sounds crazy, it's because it is.

The sheer odds of something going wrong are right up there with patting your head and rubbing your tummy while trying to defuse a bomb with your teeth. Try it.

An Interesting Number

3.5, that is.

All (yes, all) property bubbles that have exceeded 3.5x GDP have subsequently fallen by at the smallest 58%.

The reasons are as simple as Paris Hilton.

Joey with negative equity is no longer a buyer. The only way this entire squadron of buyers remain buyers is when property prices go up.

When they begin to go down, however, they completely vaporise from the market. Perhaps this is why property prices rarely fall by 15% or even 25% at the end of a spectacular boom. They go down hard.

Some other interesting numbers for you to consider.

35.4% of home loans are interest-only. This figure has already dropped from above 40% following APRA's cap on the amount of new interest-only loans. As one professor at the University of New South Wales recently pointed out:

"Interest-only loans in Australia typically have a five-year horizon and to date have often been refinanced. If this stops then repayments will soar, adding to mortgage stress, delinquencies, and eventually foreclosures,

Even if that is true, we are still left with highly indebted households who have nearly $2 of debt for every $1 of GDP, a raft of interest-only loans that will soon involve principal repayments, and stagnant wage growth."

What to Watch

Given that Sydney property prices have enjoyed their fifth straight month of price declines, clocking in a 3% slide over the last quarter, it's reasonable to ask ourselves the question: Is this it?

What is really interesting to note is that all of this is happening while rates have not yet moved for mortgage holders.

I wrote extensively before about how the Aussie banks are subject to international funding markets, and as such the RBA's power to re-inflate the market when the rates are effectively set in the eurodollar market will work with the power of an asthmatic in Bangladesh blowing at you through a straw.

And then here's what LIBOR looks like (LIBOR being a rough measure of that interbank lending market I wrote about):

Source: http://www.macrotrends.net/1433/historical-libor-rates-chart

To understand how important the eurodollar market is to this whole "fustercluck" of financial puzzlement, feel free to read the free report I wrote on the importance of the eurodollar market.

Failure to Make New Highs

Now, I'm fully aware many of you look at squiggly lines the same way you look at that bloke with his bum cleavage showing, but there looks like a fairly significant head and shoulders formation on ALL of the major Australian banks.

Westpac Banking Corp (orange); ANZ Banking Group (purple); Commonwealth Bank (green)

These are the folks who actually own the vast majority of both residential and commercial housing stock in the country.

People mistakenly think they own their own home even when they have mortgages on the place. Silly, I know, but we, humans can imagine the darnedest things when it suits us.

And one more thing: I — along with every other investor, money manager, hedgie, banker, and of course let's not forget home owner — don't know for sure what comes next. Those who profess they do know are to be trusted in the same way you'd trust gas station sushi or a prostate exam from Captain Hook.

What we do know are only probabilities, how those are priced, and that is, in fact, all we need to know in order to make rational calculated asymmetric investments.