Two US Debt ETFs Odds on to Blow Up Tomorrow. Is this the Beginning of the Liquidation?

A near unprecedented crash in equities, oil smashed, 10Y Treasury futures soaring, and also for the first time in over a decade in that market, locked limit up for about an hour prompting a brief trading interruption. And,  the entire US Treasury curve - including the 30Y - trading not only below the effective fed funds rate, but also below 1.00% for the first time ever. Then, a flash crash in the Australian dollar, most likely the result of a macro fund being margined out and liquidating carry positions. All unleashing another bout of risk-off liquidation across asset classes. 

The big irony - unable to sell anything else, funds - facing historic margin calls on Monday (Northern hemisphere time)- are selling what they can... such as gold, which after hitting $1700 earlier in the session tumbled 0.7% as investors liquidate the safe asset to shore up liquidity ahead of a Monday (Tuesday Australia).

Worth watching this on Tuesday – three US ETFs – HYG, one of the largest HY bond ETFs globally, VelocityShares 3x Long Crude Oil ETN (Ticker: $UWT) and the 3x levered Direxon Daily S&P Oil & Gas Exploration & Production ETF (Ticker: GUSH . . . . .well, maybe not). 

The former – more than 10% exposure to energy HY bonds (and herein lies the risk of being index tracking - unless you're a distressed debt manager, you haven't touched the Oil & Energy sector. But index tracking mandates have no say). Looks like a re-run of the debt defaults in the sector the last time the Saudis / Russians tried to run US shale oil producers out of business (and the weekend move by Russia is a declaration of war on the US shale oil industry and a very targeted strategic move to use the 'opportunity' of Coronavirus to exacerbate financial market stress in the West).

The latter two – given their leverage – may well trip their trigger events tomorrow – liquidation, wind up, remaining cash paid out. Wind up of ETFs is not a good look - it spooks a retail market generally unfamiliar with concept of a lock up (or trading halt in the case of an ETF). More importantly, none of this is good for investor sentiment in vehicles that represent the liquidity mismatch in traded debt. As for oil price and US shale producers, the question is whether, wrongly or rightly, this is the event that spooks the rush to the doors. 

Seems crazy. Or, was that just the Central Banks that led us to this point. And those consequences aren't just here and now - they'll have persistent and undermining impacts from an inter-generational wealth perspective.

The markets can discuss V versus U shaped recovery, but the reality is no one knows with certainty when there are only bands of uncertainty. Trying to model supply chain shocks in today's "Just In Time" (zero supply chain redundancy) world is effectively impossible as such a simulation very quickly reaches impossible complexity. Contagion within supply chains is non-linear - one US company is severely disrupted by a Chinese provider and that disrupts 16 other companies the US company uses, and then those suppliers potentially, to differing degrees, disrupt XXX other supplying companies. Of course, the potential impact will nonlinearly increase as the duration of the disruption increases. Duration, path of infection, is key. 

Most debt managers (and the big debt ETFs anyway) prefer US exposure. Problem is, the US health system is flawed (probably costs a fortune just to get tested). But apparently authorities are about to get a little more proactive re testing - rapid increase?. New York has just declared a state of emergency. The largest metropolitan statistical areas (MSAs) collectively account for over 30% of U.S. GDP (source: PIMCO, Bureau of Economic Analysis). A U.S. virus outbreak that sharply disrupts activity in these areas could severely depress growth. 

That could be game over. But to paraphrase PJK - possibly the financial crisis we needed to have.