CHAPTER 1

Bubbles and Anti-bubbles

The Greatest Bubble in History

On June 5, 2014, following in the footsteps of the Scandinavian Central Banks, the European Central Bank (ECB) became the first major monetary authority to introduce negative interest rates, smashing the limits of the almighty Zero Interest Rate Policy (ZIRP) and perpetuating the monetary snowball inflating the greatest financial bubble in history.

My head was spinning. A reduction from zero to −0.1 percent was arguably small, but for me was a game-changer, a quantum leap from the years of controversial unconventional monetary policies of zero interest rates. A step too far into the unchartered territory of monetary experiments without limits.

“Mario Draghi has broken the floor in interest rates. Time to rewrite the rules of finance and asset valuations” I told myself, as my engineering mind prompted nerdy analogies such as “Mario has just broken the upper boundary speed of light. Time to rewrite Einstein’s Relativity Theory” and “Mario has just broken the lower boundary of zero Kelvin. Time to rewrite the laws of Thermodynamics.”

To me, the implications were that enormous.

The ECB announcement was a “Fukushima moment” for me, a sudden realization that something truly major had just happened.

“At 2.46 pm on the 11th of March 2011, the largest earthquake in the history of Japan triggered a giant tsunami wave that would change the energy world forever” read the opening lines of my first book, The Energy World is Flat: Opportunities from the end of Peak Oil, which I had just finished cowriting at the time negative interest rates were introduced by the ECB announcement.

The parallel between both book openings is not a coincidence. Both books present contrarian frameworks inspired by game changers that challenge the status quo and complacency of the markets, at the time of writing.

The Energy World is Flat argued that “the collapse in crude oil prices was a matter of when, not a matter of if” and “the last barrel of oil won’t be worth millions, it will be worth zero,” ideas that were highly contrarian to the then prevailing beliefs, and sounded like science fiction at the time. Not anymore.

Some of the ideas of this book, such as “Lehman Squared,” the “Monetary supercycle,” or “Gold’s Perfect Storm” may sound as crazy as the ideas and coined concepts of the energy book—when we first published them.

I belong to the school of “no-free-lunch economics” and caution against the complacency of the markets. Time will tell if my fears are unjustified and we can solve all problems by simply printing more money and borrowing more money. Wishful thinking in my humble view. Time will tell.

Testing the Limits of Monetary Policy

The ECB rate cut into negative interest rates was not a first. The experiment of negative interest rates had been in place in Scandinavia since 2009, but most people, myself included, agreed that these relatively small economies did not pose a threat to the financial stability of global markets per se, at least directly.

It turned out that the Scandinavian experiment was considered a success by some influential Central Bankers, including the president of the ECB, who eventually decided to adopt it, turning a local experiment into a global risk.

The decision had been telegraphed to the market via the media and analysts, but was nevertheless very controversial. Mario Draghi delivered the announcement with his usual conviction and decisiveness, reminding the historic and overwhelming success of his famous “We will do whatever it takes to save the Euro… and believe me, it will be enough,” that earned him the nickname of “Super Mario” and the respect and fear of the markets. The motto “never fight the ECB” now carried as much weight and respect as the widely accepted “never fight the Fed.”

In turn, the European experiment of negative interest rates was considered a success by other influential global policymakers, including Haruhiko Kuroda, the Governor of the Central Bank of Japan, who on January 29, 2016 surprised the market with the introduction of nominal negative interest rates for the first time in the history of Japan, the country that had been pushing the boundaries of monetary policy for decades. The Japanese experiment is in my view, without any doubt, one of the greatest financial time-bombs in the making.

But it is important to note that the recent wave of monetary incentives and experiments originated in the United States in 2008 when, in response to the Global Financial Crisis, the U.S. Federal Reserve, led by Ben Bernanke, cut interest rates to zero and printed unprecedented amounts of money to buy government bonds via a process known as Quantitative Easing (QE), opening a new era of unconventional monetary policies.

QE, put simply, is a process whereby the left pocket (the Central Bank) lends money to the right pocket (the Government). QE was highly controversial at first, and questioned the principle of Central Bank Independence and risks to inflation and financial stability, but was gradually accepted and eventually embraced with full force.

QE was conveniently positioned by Central Bankers as a domestic policy, but it had a direct impact on devaluation of the USD (and therefore the CNY via the peg) against the EUR and the JPY.

QE became the latest weapon in the currency wars that export deflation and problems to other economies. Without any doubt, the QE program by the U.S. Federal Reserve, and the subsequent devaluation of the USD and the CNY, had a direct major impact in the European Government crisis of the following years, which put the Euro near the brink of collapse in the summer of 2012.

Europe and Japan were forced to defend themselves and adopt aggressive unconventional monetary measures that would help counteract the aggression from the U.S. Federal Reserve. A vicious cycle of monetary easing that pushed Europe and Japan to adopt monetary policy “without limits,” whereby the objective justified the means, sending interest rates into the unchartered territory of negative interest rates.

The implications were enormous. To start, negative interest rates broke the theoretical ceiling in bond prices, perpetuating the already exuberant bubble in fixed income.

Ever-increasing bond prices was a new paradigm that squeezed-out short speculative positions, squeezed-in underweight positions, and incentivized the speculation that is feeding the greatest bubble in government bonds in history, blessed by the complacency of the markets.

The epicenter of the problem is the artificial demand from Central Banks, which has incentivized—if not forced—investors to lend for longer and longer maturities in exchange of lower and lower yields, feeding the greatest bubble in duration in history.

Testing the Limits of Credit Markets

The duration bubble has created unprecedented problems for savers and investors, who in order to generate income, are incentivized—if not forced—to lend to weaker and weaker credits, and for longer and longer maturities, in exchange for lower and lower yields.

A “desperate search for yield” that behaves like a steamroller that crashes yields and inflates valuations across asset classes, starting by government bonds and spreading to risk assets such as credit markets.

The desperate search for yield applies to all borrowers. The demand for high-quality borrowers, known as high-grade, has pushed yields to historical low levels, which has once again incentivized—if not forced—investors to lend to weaker and weaker credits for longer and longer maturities.

The desperate search for yield has benefited the weakest borrowers the most, inflating parallel bubbles in high-yield credit and emerging markets, among others.

As a result, the desperate search for yield has inflated the entire capital structure, directly impacting not only the valuation of debt instruments, but also valuation of equity, adding yet another parallel bubble to the list.

The epicenter of all these parallel bubbles is the belief (in my view misconception) that Central Banks are infallible and in full control. The synchronous appreciation of all these markets creates a risk of synchronous depreciation as and when the belief is proven to be a misconception, which creates a risk of false diversification, as a portfolio composed of government bonds, high-grade credit, high-yield credit, emerging markets, and equities are just the exact same trade.

Testing the Limits of Fiat Currencies

Central Banks and Governments tend to respond to crisis with two simple and easy solutions: print more money and borrow more money.

These easy solutions seem to have worked well in previous crises, but the reality is that they do not resolve problems: they simply postpone and often enlarge them.

As a student of the school of “no free lunch economics,” I worry about the current path and try to understand how and when the consequences of these excesses will manifest themselves.

We need to be mindful that while Central Banks and Governments may have already gone too far with their policies, it can get much worse as they will do “whatever it takes” to keep the wheels spinning. A double-up, triple-up, and quadruple-up of bets that are enlarging, not resolving, the problems.

Monetary policy and fiat currencies are two sides of the same coin. As Central Bankers know well, during the gold standard they could not print gold to control the monetary base or interest rates. The global system was much more rigid, which has its pros and cons.

And with great power comes great responsibility, goes the saying, and why Voltaire claimed that “paper currencies eventually converge to their intrinsic value: paper.” A reflection that giving Central Banks and Government the power to “print their way out of a problem” is a slippery slope. A path that will ultimately result in a loss of confidence in the currencies and institutions that created them. A process of competitive devaluations that does not solve problems and that will conclude in a “monetary supercycle” leading major winners and losers in the process, as we will discuss later in the book.

Exuberance versus Complacency

Financial bubbles are often associated with exuberant market behavior, a sense of excess and market craze that drives a surge in asset prices unwarranted by the fundamentals.

As a corollary, any apparent lack of exuberance can be misunderstood as a new paradigm, as it gives the perception of stable equilibrium, instead of the unstable equilibrium that characterizes bubbles.

Indeed, I believe the most dangerous bubbles are driven by complacency, a sense of conformism that makes us believe that unstable equilibriums are stable.

The crude oil bubble, for example, was inflated by complacency that OPEC was in full control or that crude oil could maintain its monopoly in transportation unchallenged forever.

I believe the parallel monetary bubbles are being inflated by complacency too. Complacency with monetary policy without limits, complacency with credit expansion and fiscal policies without limits, complacency with the desperate search for yield, and the parallel bubbles in government bonds, duration, credit, equity, but also complacency that Central Banks can keep volatility artificially low, exposing hidden risks in correlation and liquidity. These dynamics are closely interlinked and could lead to a chain reaction where if any of the previous bubbles is exposed and bursts, it will most likely expose and burst the others too.

Central Banks are aware of these risks, which explains their obsession with stability and low realized volatility. A dynamic that feeds the beast called complacency, because it rewards bad behavior and encourages speculation. A dangerous unstable equilibrium.

Beliefs versus Misconceptions

As George Soros famously said:

In The Energy World is Flat, my co-author and I challenged a number of beliefs (in our view misconceptions) such as the Peak Oil theory, the belief that OPEC was infallible and in full control, or the belief that crude oil could maintain a monopoly in transportation demand unchallenged, among many others. Some of those beliefs are now confirmed as misconceptions. Some are still in the twilight zone.

Under the new regime, old beliefs become misconceptions. The Flattening of the Energy World described a new regime driven by transformational and disruptive technological processes, “game changers,” such as fracking, which set a before and after.

The process from belief to misconception tends to be gradual and creates a twilight period where beliefs and misconceptions coexist. Market opinions tend to be very divided and often give way to highly polarized views, as it is the case today.

This process tends to reach a tipping point when the rate of conversion accelerates, potentially quite drastically, leading to large sudden dislocations in the markets.

Stable, Unstable, and Metastable Equilibriums

The complacency of financial markets can also be explained in terms of physics.

In physics, we define stable equilibrium as “a state in which a body tends to return to its original position after being disturbed.” Visually, we can think of a marble inside a large bowl. Once displaced from its stable equilibrium at the bottom center, the marble will gyrate around the inside walls of the bowl but will eventually settle in the original position as illustrated in Figure 1.1.

The exact opposite dynamic is known as unstable equilibrium, “a state in which a body that is slightly displaced will depart further from the original position.” Visually, we can think of a marble on top of an upside-down bowl. Once displaced from its unstable equilibrium at the top, the marble will move down the outside surface of the bowl further and further away from the original position as illustrated in Figure 1.2.

Figure 1.1 Stable equilibrium

Figure 1.2 Unstable equilibrium

Figure 1.3 Metastable equilibrium

Somewhere in between, and very important in the real world, there is a dynamic known as metastable equilibrium, which is defined as “a state in which a body tends to return to its original position after being disturbed up to a break-even point, but that will move further away from the original position after being disturbed beyond that break-even point.” The marble inside the bowl looks like a stable equilibrium, but in practice is a metastable equilibrium, similar to a bowling pin, which will wobble back to equilibrium for small disturbances but will tip over for larger disturbances as illustrated in Figure 1.3.

Optically stable equilibriums may hide the danger of metastable equilibriums as illustrated in Figure 1.4. This is not only true in physicals but also in financial markets. The Energy World is Flat and the Anti-Bubbles challenge complacent beliefs in stable equilibriums, that in reality may turn out to be misconceptions, as the real market dynamics are governed by metastable equilibriums. There are two main reasons why our judgment may be blurred.

Figure 1.4 Unchartered territories. Optically stable, but may be metastable

First, we need to understand the physical limits of the bowl. They often tend to extrapolate the observed shape and material of the bowl beyond what we have observed. Empirically, we could “test the limits of our bowl” by gradually increasing the distortion to the marble. Our observations may show that the marble reverts to its original position, indicating a possible stable equilibrium. But as Karl Popper famously taught us, “one million positive observations do not prove a theory true, but one single negative observation proves a theory wrong.” We should be careful when extrapolating the results into the unknown. It would be naïve to assume the bowl—or monetary policy or credit markets, for that matter—have no limits.

Second, we need to understand that the bowl is dynamic. The assumption that the bowl is static over time is naïve. As Heraclitus taught us, “the only permanent thing in life is change.”

One of the key drivers of dynamic change is technology. Applied to financial markets, technology is proving to be a powerful deflationary force that allows us, not only to achieve “more with less,” but also leads to “quantum leaps” and “new paradigms.” In The Energy World is Flat, some of the beliefs widely held by the market such as “OPEC is in full control,” were challenged by technological changes such as shale and fracking. Those who push the marble ignoring the changes in the size of the bowl saw their marble crashing to the floor.

Another key driver of dynamic change is regulation, “the visible hand of the market.” Beyond the well-intended policy measures introduced by Governments and Central Banks, there are many more obscure unintended consequences of second and third order that may spin the marble out of control. In that sense, the Anti-Bubbles presents a framework where testing the limits of monetary policies and testing the limits of credit markets will eventually test the limits of fiat currencies. Indeed, the complacency of global markets and the desperate search for yield are testing the limits of a dynamic bowl into unchartered territory.

The OPEC Put

The belief that OPEC was in full control gave a false sense of security to many participants, who were counting on the ability and willingness of Saudi Arabia to cut production as and when necessary to preserve high oil prices. A dynamic known as the “OPEC floor” or the “OPEC put.”

The Energy World is Flat argued the transformational changes were creating a highly unstable equilibrium. From a fiscal perspective, at $100/ bbl producers needed 1 barrel of oil to generate $100 of revenue. At $50/ bbl they needed 2 barrels. And at $25/bbl they needed 4 barrels. That is, ceteris paribus, the lower the oil price the greater the volume they needed to produce. The exact opposite of what the markets believe at the time due to the complacency and misconception around OPEC’s ability and willingness to cut production. Lower production at lower prices is a “double whammy” and creates a highly unstable equilibrium, which can be maintained for a while, but not forever.

The relentless flattening power of technology and the battle for demand, we argued, would exacerbate the battle for supply, leading to more oil production, not less, to generate the revenues they needed.

The misconception around OPEC’s infallibility was debunked abruptly on November 29, 2014 when Saudi Arabia decided to “let the market forces decide the price.” The collapse in prices validated the views we had presented in a chapter titled “The Btu that broke OPEC’s back” (in clear reference to the straw that broke the camel’s back).

The complacency around high oil prices incentivized the development of high marginal cost fields, such as ultradeep oil in Brazil or heavy crude oils in Venezuela and Canada, projects that have become very challenged due to the threats from the battle for supply (civil war between oil producers) and the battle for demand (whereby crude oil is increasingly competing for transportation demand with other alternative fuels such as natural gas, electric cars, and many other challengers).

Misconceptions can last for a long time. And the longer they persist, the more entrenched they become, and the more complacent the market becomes about them. Very dangerous.

The Central Bank Put

There are clear parallelisms between the OPEC put and the Central Bank put, the current complacent belief that Central Banks are in full control and will continue to successfully step-in and stabilize the markets as and when required.

The belief that the U.S. Federal Reserve (Fed) is infallible has been strengthened with every successful intervention, and has led to the common saying “never fight the Fed.”

The ECB joined the monetary party somewhat late, but very decisively. Since his appointment, Mario Draghi has gained a status of invincibility. His “whatever it takes to save the Euro” will go down in history as one of the most epic battles won by a Central Banker.

The Bank of Japan (BOJ) enjoys mixed respect from the markets, and has seen some measures backfire spectacularly, such as the rally in the Yen after the introduction of negative interest rates. The BOJ has been forced to step into the markets and intervene on a regular basis, not only via the Foreign Exchange (FX) channel, but also buying equities and other asset classes. A very slippery slope.

The People’s Bank of China (PBOC) is in a similar situation to the BOJ, as they have been forced to intervene aggressively on numerous occasions. So far they have been able to contain the attacks, but the doubts are growing. The peg of the CNY to the USD has been a major source of imbalances, yet to be resolved.

The Swiss National Bank (SNB) went through one of the most spectacular fiascos in recent memory when on January 15, 2015 abandoned the 1.20 floor versus the Euro, creating mayhem in the currency markets. The shocking part of the SNB debacle was that they had—literally—infinite bullets in the form of printing their own currency.

The SNB fiasco is in stark contrast to other notorious Central Bank failures, such as the Bank of England (BOE), where interventions required selling of their finite foreign reserves. A lesson learnt by many investors, and a warning sign to those believing that the Central Banks are in full control.

The Anti-bubbles

I have coined the concept of anti-bubble with a double meaning and objective.

First, an anti-bubble describes the process by which asset valuations are artificially deflated, in stark contrast to traditional financial bubbles, the process by which asset valuations are artificially inflated. In other words, anti-bubbles described are the exact opposite, the inverse, of traditional financial bubbles.

Second, an anti-bubble describes a defense mechanism against bubbles, just like an antimissile may be a valuable defense against missiles.

Anti-bubbles are valued artificially low and will reflate—potentially quite suddenly and sharply—once the misconceptions that are artificially compressing them disappear.

Imagine, for example, a new treatment or medicine that is believed to dramatically improve the cure for a dangerous disease. The new treatment may not be totally proven yet, but the market tends to be quick and price-in higher valuations to the winners and price-in lower valuations to the losers.

There are two main scenarios here.

On the one hand, a scenario where the new treatment is proven true. it works and creates a new paradigm, a better world, where the old treatment is likely to become obsolete and eventually disappear.

On the other hand, a scenario where the new treatment does not work. The positive expectations that had been built-in in the winners turn out to be bubbles and quickly reprice lower, whilst—simultaneously—the negative expectations that had been built in the losers turn out to be anti-bubbles and quickly reprice higher.

There are several anti-bubbles in the current markets. The main three in my view are gold, volatility, and correlation, which can play an important dual role as “value investments” and portfolio diversifiers and portfolio insurance during “hostile markets,” when investors need those returns the most.

In that sense, the anti-bubbles can be viewed as antidotes to protect against the risks in other parts of the portfolio, such as fixed income, credit, or equities.

Gold, the Anti-Bubble

From the highs of 2012 to the lows of December 2015, gold collapsed by almost 50 percent and the gold miners by almost 80 percent, leaving a sour taste to investors. The collapse in gold prices coincided with the surge of other asset classes (government bonds, high yield, emerging markets, credit, and equity).

The massive divergence in prices was not a coincidence. It was the result of the exact same factors: deflationary forces, monetary policy without limits, yield-seeking strategies, the Central Bank put, speculative flows, are some of the factors that have simultaneously inflated the bubbles and deflated the anti-bubbles.

Many investors had bought gold as an inflation hedge. Why hold gold if there is no threat of inflation? Worse, why hold gold if the threat is deflation?

Many investors had bought gold as a safe haven. Why hold gold if the Central Banks are infallible and in full control? Indeed, the “risk on” mentality supported allocations to riskier asset classes, such as equities and bonds.

The perception of infallibility of Central Banks has been self-reinforced through the build up of the bubble, reinforcing a (false, in my view) sense of security to investors. Every time the Central Banks have successfully intervened (both quantitatively and qualitatively) to support the market, the belief is strengthened and the wrong behavior rewarded, and incentivized. The Central Bank Put incentivizes strategies that “buy the dip,” as any corrections are seen as opportunities to buy. In a way, “the Central Bank has my back,” they think. And it has worked very well for a long time.

It is ironic and illustrative how the markets reacted to economic data over the past few years. Bad economic data was interpreted by the markets as a clear indication that Central Banks would step-in to protect investors with additional monetary incentives and stimuli, whilst the inverse was also true. As a result, the markets rallied on bad data and sold-off on good economic data. An upside down world and not a very healthy market dynamic, in my view.

Many investors joined the duration bubble and desperate search for yield. Whey hold gold if gold pays no yield? Worse, it has a negative carry?

All these beliefs will eventually become misconceptions, in my view, and lead to a sharp increase in gold prices.

I don’t have a specific target for gold prices but like to say that the outlook is very asymmetric, offering “a few hundred dollars of downside and a few thousand dollars of upside.” Similar to my contrarian views in energy, I believe much higher gold prices are “a matter of when, not a matter of if.”

Volatility, the Anti-bubble

From the highs in implied and realized volatility during the Lehman crisis, implied volatility has been steadily trending lower and, at the time of writing, is trading at historical lows across many markets.

The ultra-low levels of implied volatility is consistent with the complacency and perception of low risk.

My view is totally the opposite and I believe the low levels of implied volatility not only hide huge risks but are also feeding even greater risks via dangerous structural leverage. A time bomb and the key Achilles’ heel of global markets,

There are two main processes feeding the collapse in implied volatility.

First, the Central Bank put, as described earlier.

Second, the complacent desperate search for yield, which incentivises investors to sell options and implied volatility. Indeed, investors have been large sellers of options in every shape and form. Investors that were long equities sold covered calls. Those who were not long, sold puts (so they could get long in case the puts were exercised).

And in large size and with significant leverage. Private banks have been offering structured products that monetize volatility and correlation plays, such as worst-of-baskets and other creative ideas that work very well… until they don’t. These structures tend to be very highly leveraged and have the potential to wipe out the entire investment.

The monetization of volatility pushed implieds lower and lower and lower as a result of imbalances in supply and demand, which contributed to the self-fulfilling prophecy. An unstable equilibrium, which can reverse quite suddenly and violently. Dangerous.

A normalization of volatility is likely to result in an overshooting to the upside. That is, implied volatility will go much higher than its fair value or equilibrium level, whichever it ends up being.

Many quantitative models, such as Value at Risk (V@R) use realized and implied volatility to measure risk. As a result, artificially low levels of volatility can give a perception that the risk is lower than it actually is, which is likely to result in larger positions than the real risk would warrant. A time bomb.

Correlation, the Anti-bubble

The parallel bubbles across government bonds, credit, and equity markets hide another important risk: what goes up together may also fall down together.

Indeed, I expect the correlation between asset classes to polarize during periods of stress: financial assets will either be strongly positively correlated (go up and down together) or be strongly negatively correlated (when one goes up the other one goes down, and vice-versa). Those investors who naively expect normal correlations to hold during periods of stress may be in for a nasty surprise.

The quantitative models, such as Value at Risk (V@R) that use realized correlations as inputs, contribute to this problem of overconfidence and false diversification as they give the perception that portfolios are more diversified than they actually are. False diversification is a major hidden risk and time bomb for global markets, but also a major source of opportunity for those who know how to monetize them.

The fundamentals behind these risks set the foundation to the “Lehman Squared” and the “Gold Perfect Storm” investment theses that I will discuss in full detail in the following chapters.

The last sections of the book provide a practical guide on how investors can avoid the bubbles and take advantage of the anti-bubbles (gold, volatility, and correlation) as both value investments and portfolio insurance.