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Yesterday I examined the possibility that unprecedented injections of liquidity by the Federal Reserve Board and other leading central banks had suppressed normal market volatility, potentially storing up bigger risks in the future (see “ How Low Can Volatility Go? Why Tranquility Keeps Traders Awake at Night”).

Liquidity may not be the whole story, though. A group of global macro traders that I gathered recently at Oxfordshire’s Ditchley Park estate to assess the outlook cited three other potential explanations for the extraordinarily low level of volatility in financial markets: a reduction in systemic risk as a result of postcrisis financial regulation and deleveraging, a sweet spot in the global economic cycle that is typically marked by low volatility, and a lack of geopolitical tensions to rile markets. These aren’t necessarily separate risks. In fact, they can amplify and interact with the tightening of central bank liquidity. Let’s examine these hypotheses in turn.

Systemic Risk Has Been Drained

There are three possible sources of systemic risk: the untested plumbing of the financial system, persistent high leverage and old-fashioned regional economic crises, akin to the one we have seen intermittently in the euro zone over the past five years — and ones we may well see in emerging markets over the next five.

“Our research suggests that the true underlying risk to portfolios is not accurately reflected in the implied market volatility indices,” said Mark Farrington, head of London-based Macro Currency Group, when I quizzed him on vol exactly a year ago. Surveying the steady implosion of volatility since then, he still believes systemic risk is being underpriced.

“If deleveraging at financial institutions was the petrol that fueled the fire of the global financial crisis volatility, the next crisis will draw fuel from insufficient secondary market liquidity to facilitate the real money position adjustment that will come with the start of Fed tightening,” says Farrington now. “A big vol event is coming, but its violence will be driven by poor market liquidity, not deleveraging. The Dodd-Frank regs and downsizing by banks have dangerously debased market-making balance sheets. In spite of politicians’ wanting fewer ‘ too big to fail’ banks, the global markets keep growing in size, and we need even larger financial institutions to handle the secondary liquidity needs.”

Consistent with this view, the Financial Times ran an alarming headline about the risk of a run on bond funds in its June 16 edition, suggesting that all that has been drained from the international financial system is liquidity, not risk. “In the wake of the financial crisis, tougher rules on capital and the abolition of in-house trading operations at major U.S. banks have resulted in Wall Street pulling back from helping big funds buy and sell corporate bonds,” the article claimed. “Bank inventories of bonds have fallen almost three-quarters from their pre-crisis peak of $235 billion, according to Fed data. At the same time, U.S. retail investors have pumped more than $1 trillion into bond funds since early 2009. This has created a boom environment for fixed income money managers, but raises the prospect of a massive disorganized flight of money out of the industry should interest rates rise sharply in the coming years.”

Incidentally, this type of flight by unlevered investors was cited as one of several possible triggers for a sharp decline in the markets by JPMorgan Chase & Co. chief U.S. economist Michael Feroli and his co-authors in their recent paper, “Market Tantrums and Monetary Policy.”

Liquidity Ebbs Away

Canny traders and analysts are already looking for early warning signs that tapering might stress the plumbing of the financial markets. “Where should we expect to see signs of stresses in the financial system when the Fed exits with a big balance sheet?” asks Torsten Slok, chief international economist at Deutsche Bank Securities. “One small sign of stress more recently is the spike we have seen in the number of fails.” (In Wall Street argot, a “fail” occurs when securities in a buy or sell transaction aren’t delivered by the settlement date, which often happens when traders put on a so-called naked short — selling a security short without any means of buying it back.) “If this is a reflection of lack of high-quality collateral to support a significant amount of shorts in the front end and belly of the curve, then I worry what could happen as we get closer to the Fed exit and even more investors want to be short rates.”

A Rising Tide of Treasury Fails
Source: FRBNY, Haver Analytics, DB Global Markets Research

As for the sustained leverage story, “The headline number out of the BIS is that nonfinancial public plus private debt is 20 percent larger than it was in 2007. So, on a global basis, there has been no deleveraging,” says William White, chairman of the Economic Development and Review Committee at the OECD in Paris and a former chief economist at the Bank for International Settlements, whose former colleagues at the Basel-based institution continue to track this carefully. “Public debt has increased because of the action of normal countercyclical policy through automatic stabilizers. However, the big problem has been that private sector debt, with the important exception of the U.S., has not gone down. The developed markets have reached 100 percent debt-to-GDP levels, which are well above a reasonable comfort zone, especially in Europe.”

How about an old-fashioned balance of payments and currency crisis, either within the euro zone periphery or by an emerging-markets sovereign?

Despite the failure of Europe (ex-U.K.) to delever, a semiannual poll of global macro traders that I conduct for Institutional Investor continues to assign a shrinking probability of default by any euro zone periphery state. In June just 1 out of 10 respondents thought there would be a euro zone default by the end of 2014, down from 13 percent in December 2013. Interesting, they also foresee only a 1 in 3 chance that the European Central Bank will begin its own version of quantitative expansion before the year is out.

“Courtesy of [president] Mario Draghi, the ECB’s intervention has been effective in addressing the stability of the banking system,” agrees Michael Hintze, founder and CEO of CQS. “One could argue that there was a significant amount of ‘kicking the can down the road.’ This breathing space, together with the markets’ faith in Draghi, has enabled banks to supplement their reserves through retained earnings as well as through issuance of equity and tier-1 debt to strengthen their capital structures. Capital ratios are stronger; inflation of asset prices, thanks to the liquidity created by central banks, has reduced the probability of default.”

Several of the Ditchley participants thought that there was still ample trouble brewing in emerging markets, which could lead to episodic volatility in foreign exchange markets and EM sovereign debt markets, with several candidates in the wings beyond the so-called Fragile Five of Brazil, India, Indonesia, South Africa and Turkey. “The EM countries have undergone enormous credit expansion,” says White. “Significant amounts of foreign currency and especially dollar-denominated debt are laying the structural groundwork for the same kind of problems that caused the 1990s Asian financial crisis.”

This is the “déjà vu all over again” story, expressed elegantly by Michael Pettis in his dissection of the Asian financial crisis in the book The Volatility Machine, echoing the late economist Hyman Minsky’s classic argument that long periods of stability are ultimately destabilizing. “Risky structures are usually built up by risky financial practices during periods of financial tranquility,” writes Pettis, a senior associate at the Carnegie Endowment for International Peace’s Asia Program in Beijing. “As asset prices rise and expected returns on safe assets decline, investors begin to widen their horizons in search of higher returns — they become ‘yield hogs,’ in Wall Street lingo.”

Then comes an exogenous shock. What determines whether the shock becomes an irritant or a calamity? “The virulence of the crisis is largely a factor of capital structure vulnerability,” writes Pettis. High levels of foreign currency debt by many EM countries, both corporates and sovereigns, keep that vulnerability high — if and when the shock occurs. The sharper the devaluation of a country’s currency in a crisis, the higher the foreign currency debt burden becomes.

Our traders’ survey forecasts an average 30 percent probability of a balance of payments crisis this year in one or more of the Fragile Five, with South Africa and Turkey the most vulnerable. This is down from a 43 percent probability assessed in December 2013. The traders perceive both Brazil and India as being largely out of the woods, at least for the rest of this year.

The continuing miners’ strike in South Africa and the nasty infighting between Prime Minister Recep Tayyip Erdogan’s ruling Justice and Development Party and the Gulenists in Turkey kept those countries at the top of the Fragile Five list. In contrast, the absence of social strife around the World Cup in Brazil and the landslide election victory of Prime Minister Narendra Modi’s Bharatiya Janata Party in India dispelled some of the perceived risk of a crisis in those nations.

So could systemic risk rise up again and trigger a revival of vol? Perhaps, but the potential appears less acute today than in the past. No one really knows about the hidden pressures inside the financial plumbing, leverage hasn’t declined outside the U.S., and the currency crisis potential is down in both Europe and most emerging markets.

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