The Fed and the May 6 'Flash Crash'

The Wall Street Journal

Near-zero interest rates have made investors susceptible to the same stresses at the same time.

Regulators have been busy searching for the cause of the May 6 "flash crash" when the market dropped by 9.3% and then recovered within minutes. I think it's a good bet no cause will be found; there is still no consensus on what triggered the one-day 20% stock market crash of 1987. But even if there was no trigger, market conditions created by the Federal Reserve's easy money policy definitely made the crash more likely.

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The market is a critical system. To illustrate, let's consider another fragile system: the earth's crust. Imagine geologists scouring through the debris of a big earthquake in search of its trigger—as in, "Let's investigate anyone jack hammering in the minutes leading up to the quake." It is intuitively obvious that earthquakes don't have identifiable triggers. We know that big earthquakes, which happen very rarely, are nothing more than many little earthquakes piled on top of each other due to stresses built up within intricate networks of faults. These little fissures cascade into enormous ruptures. The more correlated the fissures, the more delicate the system.

Back to markets. Think of every investor holding a risky position. Then think of all of these investors together in a big herd. Each member of the herd focuses on what the others will do next, since the only reason anyone takes a position is because others are initiating like-minded ones.

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When imitative behavior starts happening in markets en masse, expect funny things to happen to liquidity. All you need to know about market dynamics—as I learned as a Chicago pit trader—is that market prices always adjust to the level where market-makers see balanced two-way order flow between buyers and sellers. All market-makers want to do is buy at the bid price, sell at the offer price, and at the end of the day go home unscathed. When there are only buy orders, for instance, expect market-makers to be unwilling to sell to those buyers until the price has adjusted to the point where they see roughly equal buyers and sellers again. To expect them to do anything else is to imagine them as charities.

So when you combine imitative behavior with noncharitable market-makers, there will be seismic waves from time to time. What makes our current system particularly prone to global ruptures is that hair-trigger traders have crowded into exceedingly risky bets. Why would that be, with the crash of 2008 so fresh in traders' minds?

This type of alignment among investors in risky positions is precisely what the central economic planners at the Federal Reserve intended when, in response to the historic credit collapse, they commanded interest rates to zero and signaled that they would prop up all risky assets.

The profitability of an investment is simply its return on capital beyond the cost of that capital. It is against this spread that investors must assess risk. So when the Fed distorted the cost of capital following the 2008 collapse by lowering it for many by roughly 2% (to about 0% for banks), it had the same effect as the 2% higher aggregate dividend yield for stocks or higher credit spreads for investment grade bonds. Suddenly what was toxic looked cheap.

The Fed lured everyone to buy everything and anything that was risky—and did so itself with outright purchases of risky assets like mortgage-backed bonds. Anyone eager for easy profits fell right in line, bidding up dangerous assets like clockwork. Sensing safety in numbers, the herd quickly followed, and in no time the market had consumed the Fed's gifted 2% profit spread and then some.

All in all, it seemed like an impressively engineered recovery. In reality, it was an ephemeral illusion caused by distorting investors' assessment of risk. Despite what zero interest rates were signaling, savers flush with cash weren't flooding the capital markets and credit wasn't expanding.

The Fed has managed to align every little market fault right with each other such that they all succumb to the very same stresses at the very same time. Meanwhile—no surprise—the world remains a very seismically active place. What's extraordinary is that the Fed continues this intentional deception about the real cost of credit, even as we've repeatedly witnessed the consequences of this policy.

Left alone, the market works naturally, with waves of buy-order ruptures and waves of sell-order ruptures. Sometimes mini-ruptures coincide to form much larger ones, such as on May 6. But searching for a discreet trigger for such events is futile. To find the real source of the system's excessive fragility, the regulators will need to look much closer to home.

Mr. Spitznagel is the founder and chief investment officer of the hedge fund Universa Investments LP, based in Santa Monica, Calif.

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