Monday, May 25, 2015

Volatility: The Force Awakens

My best guess is this year will be remembered for the end of the volatility comatose we witnessed ever since the global QEs flushed the financial markets and beat the life out of vol across asset classes.

With this perspective we take a look at long term and more recent history of vols across asset classes. Volatility itself is a bit hard to define. On top given the differences among asset classes it is quite an effort to compare vols across asset classes. Here we take a simple approach to work around. Below figures show the running count (i.e. cumulative count) of number of times an asset class has moved 2.5 times of it's half yearly weekly volatility in a given week. This simple measure standardizes all volatility to a simple number, irrespective of how volatile the asset class is or how you measure the volatility itself.

A long term look at asset classes shows some interesting things - like how oil (on a longer horizon) has been much less volatile than rest of the commodities (which incidentally show most volatility). If you take S&P as the benchmark, only commodities (ex oil) come on top. The second chart shows a closer look, since 2010 (after the initial impact of the financial crisis). We see a long period of subdued volatility. With S&P as the benchmark again, till early last year, only commodities (ex oil) was beating it, as before. Then something happened. Later in 2014, first the dollar picked up in vol, followed closely by Euro, and then oil, and finally Bunds. Only treasury remains below S&P in terms of vol. As of now that is.

This clearly shows the trend, and we will definitely see more uptick in vol for the rest of this year. Perhaps driven by the much anticipated Fed rate hike. But more fundamentally, vol can happen without any reason, because high vol just happens sometimes!

Monday, May 4, 2015

Inflation: It is Still a Long and Winding Road Ahead

With the commodities seemingly bottoming out, we have quite a strong reversal of moods in the market about deflation. Suddenly there is lot less worry about disinflation and lot more chatter about rate hikes. It is true since the bottom in Jan, Brent is up 42%, WTI  36% and the broader CRB commodity index is up `9% since the troughs around middle March. And breakeven inflation market followed the suit across markets, in EUR, USD and GBP. 

However, we are perhaps far from writing off the disinflation fears. The goods prices, including energy prices, have bounced back from the bottoms, but the services shows a very different story. And I believe this is the story of the underlying inflation pressure once the base effects and transitory effects settle down.

The Euro area is really really far from coming out of dis-inflationary pressure. The MUICP service YoY prints has been, and still is, steadily going down in a trend that started mid 2011. There was an interesting article from the excellent IMFDirect blog about the NPA dead-weight on the banking sector. This is definitely NOT helping. As mentioned earlier, the QE impact in Euro has been less successful in terms of inflation and real rates, spectacular as it was in terms of nominal levels and exchange rate.

And as expected, UK services are quite in sync with the Euro area following the downward trend. The only one robust among this is US. 

Last week's large sell off in rates was triggered by Euro zone rates (perhaps supported by the M3 and the ECI prints from the US). However, this is no repricing of economic outlook. The sell off has been entirely in real rates, with breakeven hardly moving much. This shows the sell off was definitely driven by QE positioning. Most likely the players front running ECB has a sudden change in mind and scampering to get out, triggering lots of stop losses. 

And as Goldman Sachs explains, this can definitely be a self-fulfilling cycle. ECB pledge to buy papers floored at negative 20 bps means players can push the price of any papers subject to that floor (unlike long term investors who will abhor the negative yields). So as more and more bonds get in to negative zone, less and less papers are available for ECB to buy. So this will push down the prices of longer and longer dated papers down without any concern about fundamentals. And unfortunately it works in the other direction as well. A significant sell off can trigger further sell offs.

And this makes taking directional views on euro rates very hard. 30y swaps moved from a bottom of 72 bps to current 113 bps in merely a week! This makes the whole market very sensitive to issuance calendar determining supply.