Saturday, May 6, 2017

Markets | VIX - Waiting For Godot

By now everyone and their cats are aware that volatility across markets and asset classes are low, been so for a long time, and shows no signs of reversal. VIX, the US market benchmark vol index is around it's historic lows. The MOVE Index - the bond markets benchmark from BofA/ML - is no better. CVIX - an FX benchmark from Deutsche - is doing a bit better but nothing assuring. People have punted, hoped and feared a come back of volatility, but so far we have not seen any sustained sign of it.

The reasons and the expectations from analysts come under mainly two flavours. The first narrative is that volatility is artificially suppressed by big league volatility sellers (speculators, but more importantly those ETFs folks and systematic risk factors people). The second narrative is market in general is going through a hopeful optimistic patch supported by central bank puts. Both groups believe volatility is going to explode sooner or later. According to the first narrative, a potential driver is a random shock, that will force re-balance in ETFs and risk factors strategies and will amplify the move. The second version is we are just a few bad economic prints or some geo-political mis-steps away from a runaway volatility.

While both of these narratives have some merits, none of them is either sufficient or complete. Or even useful for any practical purpose. There are different opinions, but I tend to side with the arguments from risk factors people (like AQR) that this line of arguments vastly over-estimates the impact of risk factors portfolios. And it is hardly fair to blame some folks for selling vols in a steep roll-down scenario as we have these days (we have written about it before). On top there is certainly some influence from street positioning. As we have written about before, for a long time now, the dominant positions of the big hedgers (read big banks and market making houses) in the markets have been long gamma, putting a stabilizing effect and pinning the vol down. The second "complacency" narrative appears less plausible, but of course cannot be ruled out.

But irrespective of which one (or may be even both) you believe in, none is useful to take a position in volatility. Essentially the argument is: volatility is trading in a distorted way and we need an external event to set it right. It is cheap since such an event will surely come some time in future. Unfortunately, by definition, we cannot predict much about the timing of an unexpected external event. And presumably you do not have the luxury of an infinite stop-loss on the bleeding you will have while you wait for that vol exploding event to materialize.

In fact the only predictable statement to make about the direction of volatility is: when the rates go up, VIX will follow. And here is why.

To start, note that although the VIX is near historical lows, it is not cheap. The realized has been lower. And the second fundamental thing to note that in the post-crisis world, the volatility has transcended its status as just a "fear gauge" and has become an asset class in its own right. And in this world of unconventional monetary policy and low rates, volatility has become intrinsically tied to the level of rates. The chart below captures this point.

We talked about this point way back in 2012 (from bonds markets point of view). When you treat volatility as an asset class (where selling volatility is a surrogate carry strategy) it becomes clear to see the connection. Consider an asset allocator who has an option to either sell volatility and collect the premiums, or buy some equivalently risky carry product, e.g. a high yield corporate bonds portfolio.

To make apple-to-apple comparison, we can think of a hypothetical "volatility bond". Given the existing spread of risky (BBB) bonds to treasury, we can deduce the probability of default of such an investment. From this, we can hypothesize a volatility bond, which consists of selling an out-of-the-money (OTM) call spread and put spread on S&P 500, each 100 point wide. The strike of the short options are such that the probability (implied from volatility) of them ending up in the money is equal to the probability of default of the high yield portfolio above (worth 100 in notional). In both cases the maximum we can lose is $100 (note in the case of short vol strategy, only one of the call or put spread can be in the money and exercised against us). So the yield from the high yield portfolio, and the premium collected (let's call that volatility yield) are comparable returns from portfolios with comparable risks. The chart above shows the yields from these two roughly equivalent portfolios. As we can see, in this rough approximation, the vol yield has in fact been higher than comparable BBB yield through out the post-crisis period, and moved in steps. The relative value before the crisis was unbalanced. It would have paid to buy OTM options spreads, funded by a high yield portfolio (anecdotally, there was an equivalent popular trade there during that time, but in the wrong market - the infamous Japanese widow maker). But at present the markets are pretty much in sync with each other and appear efficient. Far from the "distortion" argument in the narratives above.

The only way the vol can rationally go up from here is if the general risk portfolio yields also go up. That can happen in two ways. Either spread to risk-less rates (like treasury) increases (signifying a risk-off event like in the narratives above). Or through a secular rise in rates - which basically takes us back to Fed and inflation. As argued in the last post, pretty much everything we can expect now hangs on future inflation path.

The results are outcome of an approximate analysis. We obviously ignored some important issues (like skew and convexity of these deep OTM strikes) and made some shortcuts (a digital set-up is more appropriate than a options spreads as in here). We also missed a bit more fundamental point here, which is correlation. S&P 500 is a much broader index than the high yield universe, and the comparison above is more appropriate as the market-wide correlation goes up. As the correlation goes lower, we can afford to sale closer to the money options spread in S&P to retain the same riskiness in the portfolio, thus making the volatility yield even higher. And as we have it, the correlation (again see the last post) is down off late. But the main point remains unchanged - Vol is low but NOT cheap (although last few points in recent time in 2017 points to some relative cheapness).

Perhaps it is a good time to stop complaining about low VIX prints and watch those HY spreads and inflation development carefully instead.

All data from CBOE website/ Yahoo Finance/ Bloomberg

Monday, May 1, 2017

Macro | Cross Asset Correlation Update

The markets seem to slowly leave behind the massive focus on fiscal impulse following the US presidential election, and the inordinate amount of stress and optimism about the US dollar rally. This is already reflected at least in terms of asset price behaviours, if not media and analysts focus yet.

Cross asset macro drivers for 2017 YTD (based on first factors extracted from principle component analysis for each asset class) looks much like H1 of 2016, which saw a cautious rally in risk assets following the early stress period - albeit now it comes with reduced influence of oil prices and volatility on risk asset prices. This stands markedly different from the H2 of either 2015 or 2016 - which saw a pick up cross asset correlation (with very different outcome, a risk-off move in H2 2015 and a risk-on rally in H2 2016). The MST charts below captures this dynamics pictorially.

Among the risk assets, DM equity factor shows increased positive sentiments to rates (i.e. increased yields leading to rally). Inflation has become more important for DM equities as well, while FX has virtually no influence. For EM equities, the latest trends has been a slight de-sensitization to rates and FX movement, although they remain significant. The credit factor also picked up its correlation to rates (and FX, which is mostly influenced by EM credits part), while retaining correlation to inflation.

This makes the rates and inflation path the most important determinants for risk assets at present - at least from Developed Markets equity investors' point of view. Markets will always react (or over-react) to tax cuts expectations and presidential elections. But we are now, it appears, back to the basics.

On this fundamental note, we have seen some recent encouragement in global inflation space. The left chart below shows GDP weighted CPI inflation (global top 20 economies as well as Developed Markets within that). Since the recent bottoming out at start of 2016, we have seen a secular rise in inflation, which is more pronounced for the DM case. However, the core inflation scenario (not presented here) is far from running hot. Core inflation in the US and China have improved from 2015 lows, but much less dramatically. Only in the case of Euro area this has been solid (from very low levels). One the other hand, global credit growth (right chart below) appears to have topped out in a secular manner. On the positive sides, the wage growth in the US (not shown here) has been encouraging and sustained.

If we consider these points, in the context of extraordinary monetary accommodation that exists across the globe today, we should be more hesitant to conclude we are heading towards a definite normalization anytime soon, in spite of strong sentiments. The rates market seems to agree. We have seen inflation recoveries in 2011 (remember the ECB hike mistakes) and also in early 2014. It was a misfire in both cases. A weakening credit impulse and barely normal inflation in the face of extraordinary monetary stimulus represents a global demand which is far from recovered. This makes the case for removal of these extraordinary monetary measures very difficult - most policy makers are still biased to err on the upside inflation naturally. That is unless we see the whites in the eyes of inflation - in which case, it either may be too late, or have to be too harsh and steep. For now, the forward looking inflation measures (both market based like break-even inflation and model based like Cleveland Fed now-cast) remain stable without any sign of worrisome upward pressure. This means the risk assets will largely avoid negative reaction by a possible June Fed hike (market probability of 67% as of date priced in). The key risk in this regard remains any (mis-)communication or premature taper on the central bank balance sheets.

All data from St Louis Fred Database