In a now legendary interview given almost exactly one year ago, Chris Cole of Artemis Capital appeared on the MacroVoices podcast to develop an article he had written titled "Volatility and Alchemy of Risk", in which Cole set out the risks associated with what's going on. 39, he believed to be an explicit and implicit global exposure to short volatility. and how the resolution of this massive position could usher in an era of instability for all asset classes, as markets were forced to reassess systemic risks in a devastating manner.

And, as fate had announced, just a week later, on February 5, the markets exploded into a massive short-term compression that justified Cole's warnings and resulted in the death of one of the most popular FTE in the short term – erosion of profits made by amateur day traders who had reaped millions of dollars in profits from short-term trading.


Fortunately for legions of US retirees and private investors, the February blast came to be an isolated incident. The markets experienced a surprisingly rapid recovery and in the summer they had reached unprecedented highs. But Cole persisted in his warnings that what we saw in February is only the weaker hands that were driven out of trade in the short term and that there would be more chaos.

And so, with the markets losing a brutal fourth quarter, which prompted some members of the financial press to speculate on if the bulls are back in charge, Cole makes his triumphant return to MacroVoices presents its perspective on the volatility that gripped the markets during the fourth quarter, as well as a word for the advisor: The slowdown in the massive bird-flying trade that Cole predicts more than a year ago, is not over.

On the contrary, it is only beginning.

But first, let's remember it quickly: in Cole's opinion, traders have grossly underestimated the risks associated with short-volatility transactions by using them as a source of return and as a risk-taking factor. Counter-intuitively, the lower the volatility, the higher the risk. The higher the volatility, the lower the risk. This introduces a self-reflexive regime that creates massive systemic risk.

I think what we saw last February actually comes from being the weak hand of the table eliminated by short-term trading. Many people read my newspaper. They came to see me and were happy to have it well developed because there was this explosion of short VIX ETP products that occurred, literally, a few days after the interview.

And I said, you know what, that's not what I was referring to. These low-flying products, those VIX ETPs, the weak hands of the table, were only the first phase of what will be a multi-year cycle and a rebalancing of the flight regime while a large number of these strategies of institutional volatility are resolved.

Referring to the beginning of last year, Cole tackles an aspect of public opinion that has been largely misunderstood: that is, it is not an explosion of volatility " volatility as measured by the absolute movement of fixed-rate volatility options on the S & P 500, the rise was stronger in January than in February, suggesting that rumblings of the February explosion could have been felt weeks before.

Cole then analyzed step by step how an adjustment in interest rates had led to a liquidity crisis that had led to soaring stocks.

Yes, I think 99% of people would say February's volatility has gone up more. In fact, if you look at the S & P 500's absolute flying speed, the flight actually moved more in January than it moved in February of last year. Much of this was actually a right-wing move in volatility. I think it's quite shocking to most people. The surge in bonds in February was largely misunderstood. The media has spoken of it as an event of volatility. But it was not a real flight event.

It was a liquidity crisis resulting from a rapid revaluation of prices and extreme risk. You had a lot of very weak hands at the table that reduced volatility in the form of these VIX FTEs in the hope of continued stability. And it's just that there was a moment when many of these strategies had never been tested in a truly unstable environment.

And when we had a revaluation, the volatility higher. Those weak hands at the table were out. And what we saw, in fact, was not a fundamental overhaul of the volume dictated by the credit cycle or fundamentals, but by the weaker hands at the table struggling to buy extreme risk insurance. . Do not cover their portfolios. To cover their career. They were forced to take out risk insurance or deal with insolvency. This situation is similar to that of some of the subprime lenders that exploded at the end of 2006-07, mute, dumb, dumb money that was over-indebted and out of control and was released earlier. Of course, this stupid money is withdrawn first.

There is an initial panic. And then we begin to see a fundamental regime shift in the volatility that occurs later, after the release of that stupid money. This is what we started to see in the fourth quarter of 2018 at the beginning of the year. And what I mean is that in February, traders were not buying options because they thought volatility would rise. They were buying options because they were facing insolvency. And it is this offer on extreme risk insurance that blew up the volume of the VIX.

In the end, the chaos of February was largely contained in the VIX FTE space, accounting for only a fraction of the $ 2 trillion of short-term trading monsters. .. which means that there is still $ 1.95 trillion that, according to Cole, will shrink to 1 to 3 billion dollars here. years.

In other words, "the Big One" – an explosion tied with Black Monday – could be in sight,

And it was an explosion of this tiny portion of world trade in short volumes. I'm talking about this Ouroborus, worth $ 2 trillion in short-term exposure. These VIX FTEs accounted for only about $ 5 billion, or $ 5 billion out of $ 2 trillion. The much larger $ 2 trillion world trade liquidation short-term that is just starting. And this is a fundamental change in volatility regime that, if one believes the story, will last between one and three years and offers enormous opportunities for different strategies that take advantage of change and coincide not only with a quantitative tightening but also with the evolution of the debt. and lever cycle.

Especially if the rise in inflation forces the Federal Reserve to continue raising interest rates. Cole argues that signs of these stressors are already appearing in the form of rising interbank lending rates and widening credit spreads. These risks have been magnified by record levels of corporate debt, which is only a step above the speculative rating, creating potential for a wave of newly fallen fallen angels produce a reaction that explodes the entire market …

Indeed, on Black Monday 1987, most people think of the day the stock market fell by 20%. They do not think that at the beginning of 1987, inflation was actually lower than it is today and rates went up 300 basis points.

And this caused a cash-grab that was initially starting to be felt in interbank lending and a higher credit spread, and then down to 20% in equity markets, all before Black Monday.

… a process that Cole compared to a fire causing the appearance of a barrel of nitroglycerin …

So I want to emphasize the idea that these short-term strategies and these institutional strategies – many institutions seeking to use financial engineering to gain leverage in order to obtain additional returns because they do not get it in their fixed income portfolio – these strategies are a bit like a barrel of nitroglycerin sitting in the office.

I could go to your office – I do not know where you are – but I could sit and say that, oh, what's in this barrel?

They are beautiful offices, but what's in this barrel? And you are, oh, it's a barrel of nitroglycerin. I'm like, oh my god, what's he doing here? It could blow up three blocks!

And you would be like, oh, it does not matter. The bank pays me to keep it here. And I'm like, it's terrifying. All it takes is a small fire for this thing to explode.

We could not have said it better ourselves.

Listen to the full interview below: