Friday, December 25, 2015

Macro : The Year of Volatility (That Was Not)

2015 was supposedly the year of the comeback year of the volatility.

And no it did not, we had some occasional jitters, but mostly volatility in most asset classes, measured in standard manner, are in line with long dated averages, realized, as well as implied (say for example VIX for equity, Deutsche Bank CVIX for currencies and BoAML MOVE for treasuries).

But what we did see was a comeback of vol of vol instead. See the charts below. They plot rolling averages of number of weeks with 1.5x move (compared to recent weekly realized vols), on a longer range (2000 till date, left hand side) and a zoomed in version (2010 till date, right hand side).

What we have seen in 2015 is a definitive spike in days with large moves, in almost all asset classes, but with average volatility in line with long-run history.

Additionally there is a large divergence in this pattern across asset classes. Historically volatility tends to spike (following major events) across asset classes simultaneously. The current divergence we observed beginning in 2015 is unprecedented in terms of the degree.

This is quite different than the last hike cycle of 2004, perhaps driven by diverging monetary policies. Alternatively vol as an asset class no longer captures a single risk factor and relates to asset specific risks. Liquidity in rates? re-balancing in commodities? may be even HFTs in equities? - at this stage, we can only guess.

This means if this continues, those risk-factor based investors are going to find it difficult to generate consistent and commensurate returns as pricing gamma becomes more difficult. The upshot is for tactical and discretionary asset agnostic investors, who will have it easier to insure short gamma strategies (by selling the richest gamma and buying the cheapest in another asset class).

Monday, December 14, 2015

December Fed: A Study in Ornithology

That time when you can't really tell a dove from a hawk!

December Fed is mostly settled, with a good old 25bps rate hike priced in. However, the real question will be then what!

If it is just a 25bps hike, market will perhaps focus mostly on the subsequent press conference - for clues on future rate hike path. And I am certain the Fed chairman will make an extra effort to explain that bit. And if there is a hike, the press conference will be certainly dovish. I think the primary motivation for any hike at this point in time is more an effort to return to a resemblance of normality, than inflation worries. The Fed will definitely maintain that policy action works with a lag and this hike is just being on the cautious side. While that is true and the labor market is definitely showing early signs, the split in goods and services inflation across the globe makes it difficult for central banks, including Fed. And I doubt they have a very strong conviction on that.

We have no comparable history of this potential first rate hike in almost a decade. But we do have something close. The taper of QE program was announced in 2013, in a very similar manner. The market was mightily perturbed mid year, then the Fed backed off in September. Finally it went ahead with cautious taper in December and life went on (deja vu?). Below are some charts that capture how asset classes reacted during entire 2013 and especially around December 17-18 FOMC in 2013, compared to this year's move (click to enlarge).

The points to note here: the rates moved a lot more in 2013, and after taper tantrum, again sold off after the actual taper, till market realized around late January 2014 that taper is NOT tightening. Compared to that, we had quite feeble move in rates this year, despite it being possibly the actual tightening year! On equities again, the taper in December was quite a good risk-on move, but of course on P/E basis, S&P was much cheaper back then. And dollar, well, dollar sold off, mostly, in 2013 or in 2015. Note, this is Bloomberg DXY index, which given the correlations (CHF, SEK etc), is almost 65% Euro!

Now let's take a look at the same thing, in relative value terms (again, click to enlarge).

Well, now things do look a bit different. For one, in terms of excess yield (inverse of forward P/E less 5y yields), the S&P now and then are more or less in the same territory. Yes S&P was much cheaper in P/E terms then, but we also have to remember how much the rates rallied since. On the dollar chart, well it is more or less similar, except the recent sell-off looks a bit too sharp. This perhaps got little to do with dollar itself and mostly re-pricing of Euro after the Dec ECB. And finally, rates! Yes in general a start of the hiking cycle puts flattening pressure on the curve, but see the difference then and now. In fact the USD curve is so flat (despite the solid commodities thump) that some complain the risk premium (like calculated by the ACM method) is historically low compared to any other hiking cycle in history.

The key here is less about predicting what the FOMC will decide, and more about how the market will react to different outcomes.
  • A no hike will be quite surprising and will almost surely have a negative outcome ("they know something we do not") - unless it is properly explained in the subsequent press conference. Risk-off rally in rates and sell-off in equities.
  • The other outcome of 25bps hike will hardly be surprising. As mentioned earlier, then the entire focus will be on the press conference, which is most likely to be quite dovish on the future rate hike path. And overall this should mean a relief rally for equities. Mild risk-on for equities and rates will have limited response. Given the recent flattening, a very dovish press meeting will also mean some asymmetric positioning in steepener in USD rates makes sense.
  • And another outcome, something in between - say a 15 bps hike. That will be really interesting. Given the charts above, it is highly likely the market will really understand and trust the Fed's point on slow pace of rate hike much easily with this outcome. And with a proper press conference it will be nowhere near "what do they know that we do not" risk-off argument. In a word, it will accentuate the risk asset reaction from the second point above. And a possible steepening in rates as well.
Trades Here: So overall looking from above, the probability weighted tactical positioning is:
  • long equity (perhaps Dec expiry calls to leverage gamma to optimize payout ratio)
  • convex steepening in USD rates in limited size (and/ or against Euro)
  • long dollar to hedge above

Friday, December 11, 2015

Note to Self: December Fed

If you are looking for tactical positioning around Fed decision day, the major question you should ask yourself is what if they hike by less than 25bps which has been the standard. The market prices in a full hike. How it will react to a "half-hike" is what the most asymmetric positioning will be about.
More on it later.