From $500,000 To $170 Million In A Few Months: The Next “Subprime Trade” Emerges

Ever since a few far-sighted, contrarian traders made a killing by betting on the collapse of subprime in 2005 and 2006 – and by implication on the implosion of the capital markets – a trade famously resurrected in the latest Wall Street movie The Big Short (whose Michael Burry recently warned that “The Little Guy Will Pay” For The Next Crisis, again) everyone has been dreaming to uncover the next “subprime” – a trade that has a 20-to-1 upside to downside ratio, which can be put on in massive size, and which would lead to a quick and lucrative retirement.

So far the next “subprime trade” remains elusive, with global capital markets continuing to grind ever higher thanks to constant central bank manipulation, as first called out on this website many years ago, and as admitted recently even by such “serious” legacy institutions banks as Bank of America which in an attempt to explain market instability

Central bank’s risk manipulation well explains local tails

A good way to explain why we have seen local tail risks arise so frequently since central banks began to heavily manipulate asset prices is with the following analogy, illustrated in Exhibit 1. Essentially central banks, by unfairly inflating asset prices have compressed risk like a spring to unfairly tight levels. Unfortunately, the market is aware the price of risk is not correct, but they can’t fight it, and everyone is forced to crowd into the same trade. By manipulating markets they have also reduced investors’ inherent conviction by rendering fundamentals less relevant.

This then creates a highly unstable (fragile) situation that breaks violently when a sufficient catalyst causes risk to rise – overly crowded positioning meets a market with little conviction.

The above explanation leads to a critical line of thought:perhaps the next “subprime” trade is not shorting a mispriced asset at all?

After all, all assets are mispriced as a result of central bank intervention.

As BofA admits “the market is aware the price of risk is not correctbut they can’t fight it, and everyone is forced to crowd into the same trade“, which is logical: after all why should one fight the Fed when any time there is even a 5% drop in the S&P500, the Fed can and will either jawbone and threaten to cut rates or launch QE4 or NIRP, or just do it? In doing so, of course, the Fed merely “kicks the can” and with every failed attempt at reprice risk and bring back some trace of price discovery, guarantees that the next market crash will be the most epic ever, one which will wipe out not only the Fed’s credibility but the bedrock of the modern financial and economic system, a monetarist system based on neo-Keynesian rules. Frankly, the devastation can not come fast enough.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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