Mystery lingers about the causes of the 'fall fall'

Whether you call it the "fall fall", the "autumn apocalypse" or just another flash crash, all agree that last month's market ructions really hurt. There is little agreement, though, on what caused the plunge in equities, bond yields and the dollar.

The question might seem academic, with US stocks making new highs last week and the dollar surging close to its 2010 peak. Yet the outlook for the market and in particular for volatility depends a lot on what the explanation was for the scale of the unrest in October.

Consider first what happened. Equities had been falling since mid-September. In early October the dollar and bond yields joined in, with the falls becoming precipitous over the next fortnight. Then on October 15 the most liquid market in the world went haywire.

Treasury bonds had already been in strong demand that morning - with prices rising and yields falling - after a poor set of retail sales figures and a much lower than expected New York manufacturing report. But shortly after 9.30am on Wall Street, with the yield on the 10-year bond already whacked by 20 basis points by the economic data, yields went into freefall. In just six minutes they plummeted from above 2 per cent to 1.86 per cent.

Minutes later prices had rebounded. A trader who had nipped out for a cigarette would have missed the whole thing.

This looks to many like a "flash crash", when a sudden unwillingness to trade combined with structural problems in the market dries up liquidity and leads to unreasonable price swings.

The 10-year Treasury future leapt 2.5 per cent, the biggest rise in price within a day since 2009. The dollar followed, with the second-biggest drop in five years. Equities came within a fraction of completing a 10 per cent correction from their peak, the first in several years.

Trading volumes exploded, with record turnover in Treasuries and Treasury futures, suggesting little shortage of liquidity, even as some of the primary dealers turned off their quote machines. On the other hand, trades had much more impact on the price than usual, with much less "depth" of liquidity - a measure of the size of trades that can be executed easily - according to Nanex, the market technology company.

Unlike in the equity flash crash of May 2010, there were no gaps in pricing: the market continued to function smoothly, even amid drastic moves.

My favourite theory for the scale of the move was that it was mainly due to the capitulation of hedge funds and other speculators who had been betting on yields and the dollar rising. As bond prices rose, it became too painful to hold their short positions, which were the highest since 2006 in 10-year bond futures and just off all-time highs in two-year futures. The rush to close positions became self-fulfilling as rising prices squeezed the shorts, but once shorts were covered, the market rebounded.

Others put more weight on other "technical" factors, and the broader context. The Federal Reserve had surprised markets a week earlier by sounding more dovish than expected, disrupting the consensus view of a rate rise in the middle of next year, or perhaps even earlier. Hedge funds holding stock in Fannie Mae and Freddie Mac, the mortgage facilitators, had been burnt by a court decision in favour of the government.

Worse, those who wanted to dump assets such as corporate bonds and junk bonds knew there was little ability to sell in these markets, so may have sold Treasuries instead.

David Kostin, US equity strategist at Goldman Sachs, points to calendar effects, too. The US equity market has been supported for several years by companies buying back their own shares. But buybacks stop five weeks or so before financial results, coinciding with the pullback in equities. They restart soon after, with a quarter of annual buybacks in November and December in recent years, suggesting hope for the rest of the year.

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Clearly more than one, perhaps all, of these explanations can be true. Hopefully delving by the Fed and other US watchdogs will provide a clearer picture.

Each possible explanation is a lesson. Avoid excessively crowded trades, as they usually end badly.

Plan to hold assets for the long run, as regulatory changes mean it is harder to buy or sell in a hurry.

And the broader context warns once again about the dangers of reading too much into the details of every central bank utterance. Fed officials are smart, but not omniscient.

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