The U.S. Dollar Replaces a Broken VIX Index

The VIX Index is broken. It no longer provides an accurate measure of the amount of leverage in the financial system. This poses a problem because central bankers, regulators, policy makers and economic forecasters all use the VIX as a the central measure of leverage. This is the conclusion of Hyun Song Shin of the Bank for International Settlements (BIS) in a speech presented on November 15, 2016. This speech is one of the most important insights into the global financial system since people began to warn of the coming sub-prime crisis in 2005-2007. BK encourages everyone to read and re-read this speech...it's that important.

To be sure, the subject matter is dense and requires the reader to understand things like interbank lending, covered interest parity and cross currency basis swaps. But BK assures you that understanding these concepts and reading this speech will provide an asymmetric return on time invested.

BK also understands that we are all time-challenged so here are the highlights of the speech and BK's bullet points for understanding:

From the speech:

Given this close association between the VIX index and leverage, a generation of researchers grew up with the VIX as a "wonder variable" in empirical research. The VIX was like the secret sauce that livened up an ordinary dish. The VIX was able to capture the way that risk appetite fluctuated in the financial system. Risk-taking depends on leverage, and if the financial system as a whole goes through a period of ample funding liquidity, even thinly capitalised banks can borrow on easy terms. Since banks borrow in order to lend, easier borrowing conditions translate into easier lending conditions, reinforcing the already easy financial conditions. By the nature of the interactions between liquidity conditions and leverage, the boom phase rides an apparent virtuous circle of greater leverage and easier liquidity. The VIX index was capable of capturing such shifts in sentiment.

However, something has changed in recent months, and the VIX no longer works as a barometer of the appetite for leverage. We can see this from the centre and right-hand panels of Graph 1. The middle panel of Graph 1 shows that in the years after the crisis, the VIX index has been subdued, easing to levels close to the lows seen in the years before the crisis. Despite this, leverage has continued to fall. Leverage of the broker-dealers is now around 18, lower than at any time in the last 25 years.

And BK Bullets

* The US dollar is used as the base currency in international lending.

* In order to operate long supply chains (i.e. iPhones made in China and shipped to US) working capital is needed.

* This working capital is financed by the banks and denominated in US dollars.

* Since manufacturers (like Foxconn) finance in US dollars but pay salaries in local currency (Yuan), when the dollar rises profit margins decrease.

* The declining profit margins cause the banks to lend less.

* This creates a forced deleveraging that is NOT captured by a rising VIX.

* Therefore the higher the dollar rises, the greater the probability of a forced deleveraging similar to 2008.

Bottom Line: The rising US dollar could be the biggest Black Swan that everyone can see, but no one thinks is a problem.