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JM
April 30, 2010
The boom and bust cycles of the new normal (as it wishes to be called) can be characterized. This characterization
provides clues about the nature of its endgame and progress toward that end.
Economic growth fueled by easy monetary policy leads to excessive investment in specific assets
(bubbles), resulting in more extreme boom and bust cycles.
Government policies to regulate the cycles lead to further crises that impact higher levels of capital
structure.
In particular, very steep yield curves result in a generalized carry trade.
Equity valuations always get smashed in a crash. However, in the new normal the top of the corporate
capital structure is not as immunized as it has been.
The next to get smashed? Sovereign credit.
The Endgame? The United States lives within their means, or U.S. t-bills get hammered.
The typical stuff you often read is that “averaging these losses out, optimal return is obtained with the following
asset class allocation… blah, blah, blah...” The real point is quite different. Observe that the boom-bust cycles
exhibit a tendency toward greater losses at the top the capital structure. This is not just in corporate names. If
you permit the analogy, sovereigns were marginally affected in the latest bust (see above). You can see it written
all over SovX quotes. It will get worse until policymakers stop rewarding failure.
My conjecture is simple: more and more capital structure senior assets are synchronized to a measure of
disruption in the subordinate capital structure: VIX. This instability is the new normal until another new normal
comes along.
Focus on 2008
A closer look at those capital structure losses in the last bust gives a feel for the cloth. That Spoos vaporize is
nothing new. CDX.IG is an index of big liquid CDS names. There was a tremendous amount of stress on cash
markets, shown by the IG bond index blow-out, and that the term structure of SP500 vol was inverted for a good
chunk of Q4 2009.
Imagine a financial experiment across a spectrum. At one extreme are very solid senior credits, at the other
extreme are residual securities, subordinate in terms of capital structure. Shocks to one extreme manifest in
higher credit spreads to the “risk-free” reference rate; the other extreme results in selling. I use daily bond
spreads and VIX quotes for this. VIX is good for this purpose because it is traded and thus demonstrates extreme
effects better. And yes… I too am stunned, benumbed, and burned by the hateful chasm between ratings and
reality. The agencies themselves engage in at best pro-cyclical cheerleading. At worst they are... pathetic. Close
eyes, think of England.
t = daily quotes
AAA, Baa spreads = ratings based on Moody’s seasoned bonds, daily quotes.
2
From 1990 to 1999, the fit was near perfection (R ), and Baa spreads were dominated by AAA spreads (t-value).
From 2000 to 2005, the model says essentially the same thing, though the overall fit is marginally diminished.
From 2006 to April 2009, the situation is different. The overall fit now admits specification issues (it’s still real
good fit), but more to the point, VIX now has more explanatory power over Baa spreads than AAA spreads (bold t-
value).
Regression: Jan 2006 - Apr 2010
Parameter
Variable N Estimate t Value Pr > |t| R2
Intercept 2.28122 11.96 <.0001
0.8183
VIX 1149 0.05061 66.36 <.0001
In these regressions I lagged VIX as well. There was no appreciable difference in fit are parameter estimates. This
implies that either the relationship between VIX and Baa spreads is simultaneous or the effect in time is somewhat
complex.
The correlation function is a way to determine how the relationship of VIX and Baa spread evolves in time. The
correlation function is a mapping that measures the correlation of changes in one time series to changes in the
other time series.
The analysis below uses daily quotes; back-testing on intraday quotes shows evidence of a power-law relationship.
Simulations haven’t performed as well on single reference entities as it has on indexes for a high-frequency cap
structure trading strategy.
The chart below takes a given Baa spread in time and measures the strength of correlation to the closing price of
VIX from 24 days before to 24 days after. The closer a line is 0 on the horizontal axis, the less relationship there is
between Baa spreads and VIX. The more positive or negative the line becomes shows how positively or negatively
correlated Baa spreads and VIX are to each other when looking at Baa spreads on, say, Jan 1 and at VIX 24 days in
the past and 24 days in the future.
Changes in the Baa spread is negatively correlated to the closing price of VIX on the same day. However, Baa
spread rises made VIX more likely to rise then next two days afterward. Note also that the correlation between
Baa spreads and VIX has more extreme positive and negative correlations in the 2006-2010 period. These
extremes seem to characterize the new normal.