Bond and Stock Market Volatility Is Collapsing Post-QE3
If history is any guide, investors getting long that trade are flirting with disaster.
I was attributing the 2008 financial meltdown not to the real estate bubble was crashing but to a spike in inflation from aggressive Fed easing.
The 2008 crash didn't happen because people quit paying their mortgages. It happened because of a rapid repricing of risk premiums in highly leveraged (short volatility/short gamma) positions due to a spike in inflation discounts that drove an eventual spike in implied volatility. The correlations between the dollar, commodity prices, the yield curve, and the risk curve are undeniable.
So in reality, what is causing these perma bears to flinch and go long is actually the biggest risk in the market. Yet both equity and bond investors are now sitting comfortably long, thinking they have the wind of the Bernanke put at their backs. But it is this put or the inflation he is trying to engineer that could cause market risk premiums to spike just like in 2008.
I think investors are making a dangerous mistake in extrapolating the cause and effect of QE I and QE II on asset prices and thus the effect of QE III. I addressed this last week in Analyzing the QE Meltdown, Ex Ante:
However, one of the biggest mistakes investors make is interpreting cause and effect in the market. It's easy to draw correlations to explain market behavior, but just because something appears to be related or was in the past does not mean that it is or will be in the future. Correlation does not imply causation.
The best advice I ever received was in 2006 when I was trying to short the market due to the housing market topping and a mentor told me sentiment is still too bearish, and there will be no bears left when this market tops. Well, today the bears are dropping like flies. QE III isn't causing risk assets to rise; it is simply the catalyst to bring in the last holdout market skeptics to finally capitulate and jump aboard the rally train.
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