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This was truly big week news wise, for the most part the markets have just yawned widely and not moved far from where they began.  First and most important, Russia and China announced their Holy Grail energy deal that could be as big as $400 billion.  In other news that is just as big if you think of the ramifications, China has arrested the ex-head of JP Morgan Asia.  I guess the Chinese missed the memo that the big banks and especially Morgan are “too big to jail.”

We also found out the results of the vote in India, the winner is pro gold and it looks like the tariffs may be lifted.  If this were to occur, India will be back in the race with China importing over 1,000 tons annually of the yellow metal.  Speaking of gold, Russia sold $26 billion worth of U.S. Treasuries in March and apparently bought just over $1 billion in gold or 28 tons.  Interesting that also this week, a German TV station released a documentary on you guessed it, “the manipulation of gold.”  This will reach the German, Swiss and Austrian people.  I guess this station also did not receive the memo that gold and silver are the ONLY “non manipulated” markets on the planet.

To finish out the list, Barclays head of gold trading resigned, Russia tested another ICBM, the Fed released their minutes telling of no fear of inflation (that’s a good one), numerous individual Fed member statements, Deutsche Bank is raising over $10 billion of new equity at up to a 30% discount under market (maybe infinity over true value), the U.S. indicted 5 Chinese military officials for espionage followed by the Chinese “re” sanctioning the U.S. by no longer using Windows 8, China is also lining up against Vietnam while Russia sits back to watch Ukraine vote parts of their body to Moscow, martial law was imposed in Thailand, and let’s not forget the scandal du jour at the VA or President Obama “readying” us for a bailout of the insurance industry should (when) losses from Obamacare begin to bite.

Was this not enough news for a week (actually just 4 days)?  Maybe I am just really old but I can still remember the days when just one of these pieces of news would set markets on fire one way or the other.  Oil hasn’t moved much, nor the dollar, stocks, bonds, gold or silver.  In fact, the VIX (volatility index) traded to 14 month lows and May so far is the least volatile (for stocks) in over a year.  But why?

I could use the old term “this is the calm before the storm,” this would just be opinion but my guess is that it’s probably correct.  I think that out of necessity, the markets are being locked down …because “movement” would be a problem.  Why is this?  Beneath the surface are $1.4 quadrillion worth of derivatives.  When markets move (especially interest rates) there are gains and losses that ultimately net out to zero.  The “netting out” part is what the “spin” is all about whereas the individual “gains and losses” are what the reality is all about, let me explain.

As volatility occurs, these derivatives get marked to market which is something that our banks stopped doing 4 or 5 years ago.  It is this “marking to market” which is the problem.  Were our banks to do this with their bond inventories then the losses would be greater than the equity and we would find out that the banks collectively were insolvent.  (Don’t get me wrong, just because an institution reports asset values that are inflated …doesn’t change the fact that they are not insolvent).  This is the same situation in derivatives.  Volatility creates a winner and a loser, the problem today is that there just cannot be any losers …or at least none that have losses big enough to “break the bank.”

You see, no link in the chain can break otherwise the “chain” is no longer a chain.  In other words, once there is an entity (think Lehman Bros.) that goes belly up, the entire system goes belly up.  This is why there can be no volatility …because there can be no losers.  Think about it, if you have two behemoths on different sides of a trade, what happens when one loses?  No, don’t tell me “they are all strong enough” because they are not.  Deutsche Bank I believe is the second largest player on the planet in the derivatives cesspool and they are raising over $10 billion …at up to a 30% discount under current market prices.  Is this “strong?”  No, this is DESPERATE!

Let us for a moment think about the word “strong.”  This is certainly a “relative” term, but relative to what?  Think about Bear Stearns or Lehman Bros., they went from nearly all time high stock prices to insolvent in what 3-6 months?  What I am saying is that they were “perceived” to be strong and solid as a rock …right up until they were not.  Once the perception changed, it took less than a week for them to completely drown.  I bring this up because you could look at Goldman or JP Morgan (the latter claims a “fortress” balance sheet) or any other large “rock solid” firm and think to yourself “it could never happen to them.”  Well, please understand that many of these firms employ leverage of 25 to 1 or more (the Fed is over 70 to 1) a mere 4% misstep with their investments would mean a complete wipeout of their equity.  Also, the above “leverage number” is to assets, NOT total exposure which is exactly what derivatives provide… lots and lots of exposure with very little “money down” or behind it.

I know that you must be wondering what my point is exactly.  I believe that the volatility has dropped dramatically because it HAD to.  Do you remember how still methodical and quiet you had to be carrying a completely full glass so that you didn’t spill any?  Even more so if it was hot coffee or tea because it would burn you?  This is what I think we have today; I think we have banks that are so levered and “full” with derivatives that any volatility will make the cup spill.  The problem is that the cup is filled with the stuff that if spilled will blow up like nitroglycerin.

There is one more aspect to this that I would be remiss if I didn’t mention.  This aspect is “fraud.”  Fraud is prevalent everywhere and has been used to “get us to where we are now.”  Volatility will not only create losses, it will expose fraud.  Just like the “chain breaking” I spoke of above, the discovery of one fraud will lead to another and another and another … what happens when “trust meets fraud?  This is why I believe the volatility has dropped, because it had to and has been “made” to!