I was going to write a post outlining the inexplicably popular theory that the recent drama on Wall Street was caused by strong wage growth in the latest jobs report. Then I was going to explain why this theory is, in fact, nonsense. Matthew Klein at the FT Alphaville, however, saves me the time:

Average hourly pay was reported to have grown by 2.9 per cent over the previous year — the fastest pace since June 2009. The thinking is that this will necessarily lead to faster consumer price inflation, or at least to Federal Reserve tightening in response to the fear of faster inflation.

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Leaving aside the historically weak linkages between changes in nominal wage growth and changes in the rate of consumer price inflation, the bigger problem is that the latest figures do not actually validate what traders are thinking.

Klein has some nice charts and a good follow through on the debate.

So what did happen you ask? My take remains, as I noted yesterday, that this is all the result of what are best thought of as technical issues with the market’s measures of volatility. A lot of trading is strictly automated. That trading that is not is nonetheless heavily influenced by the mechanical or semi-mechanical operations of market participants.

For example, suppose you are running a small hedge fund which is betting heavily on low volatility. Suddenly measures of expected volatility spike higher. You can bet, and at minimum, you have to be prepared, for a number of clients attempting to cash out. To handle that you must unwind your bets. In doing so you are reducing the number of traders actively betting on low volatility.

This action itself will raise measure of expected volatility. Not only that buy all your peers are doing the same thing. Not only that but knowing all of your peers are doing the same thing means that you best do it and do it now before expected volatility really hits the roof.

These incentive cascades ripple like falling dominos. Even though actors in the middle know that the prices are artificially low, they still face enormous incentives to sell.

The mediating force, such as there is one, is deep and liquid markets. This means that despite this cascade of destruction going on in the volatility trade there will be a large number of traders who have nothing to do with volatility. They will notice the bargain prices, jump in with orders to buy and stabilize the market. Indeed, that’s more or less what happened. It is simply that there were so many volatility traders it took nearly an hour to pare the worst losses and days to get on track towards normal.