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

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

Macro | 2017 - The Year Ahead

2016 has been the year of surprises - The Brexit, the US Presidential election, the Italian referendum, the massive de-monitization in India, the Nobel prize in literature - you name it. But perhaps the real surprise was how the markets shrugged off each of these supposedly to catastrophic events.

As discussed earlier, this year has been the year of the dollar. The chart below on the left compares volatilities across asset classes in terms of cumulative daily moves greater than 1.5x the daily standard deviation. The dollar has been the clear winner. But also notice the sharp pick up in rates (US 30y here) late this year, reflecting the sell-off after the US election. The chart on the right shows the reversal and continuation of trends across asset classes during the year. The solid performance of risk assets after the sell-off early in the year, in spite of the dollar rally, increase in yields and continued weakness in the Chinese Yuan, has been nothing short of unexpected.

Going in to the next year, however, much of it depends on the performance of the US economy - more specifically the continued strength of the private consumption components and the much expected revival of the investment expenditure. The charts below show what to expect in each of these going in to 2017. A simple linear model points to the strong dependence of the house prices, real rate and labor productivity. The biggest risk to this component of GDP from rising rate is the house price, which has been strong in 2016. The upside risk is of course a much awaited improvement of the productivity (without a runway inflationary pressure).

The investment expenditure, on the other hand, is largely driven by the inflation (NOT real rate, based on this empirical AR(1) model) and expectation about the economy (here represented by the Conference Board leading Index for the US). This part will be crucially determined by the policies of the new administration. The built-up expectation about fiscal spending and its impact on keeping the US growth engine running I think is a bit over-rated. In fact fiscal stimulus in an economy with tight labor market can be more inflationary than expected. The biggest upside may possibly be in the private investments front, which has been running remarkably low for a recovery compared to past episodes. A judicious mix of policy can change this. An improvement in tax regime and infrastructure spending may make US assets attractive not only for domestic, but also for overseas investors. On the other hand, the storm kicked up over trades and foreign policies can be unsettling for long term investments. This is too early to conclude in either way - but this will definitely be the major source of risks, either good or bad. And if this hypothesis is true, this will mean a decoupling of the movement of rates, risk assets and dollars, conditional on no extraordinary increase in inflation or inflation expectation.

The last bit about contained inflation is the base case scenario. Over-all 2016 has seen global inflation picking up in the second half of the year. This to a large extent is driven by the recovery in energy prices and commodities in general. We are still to see any thing on the core inflation that will be any cause of concern. In fact global core inflation is down marginally in the second half in 2016, with notable exception of China. The medium to long term inflation forecast remains stable. The recent rally in inflation break-even markets, while impressive, is coming off from a very low level. We have discussed before the weakening relationship of wage pressure and headline inflation. Nevertheless wage growth is least of any concerns. We do have decent growth in wages in the US, but they are hardly extraordinary compared to pre-crisis periods, and elsewhere globally it remains subdued.

2016 has also been remarkable in at least two other aspects. First, we have seen a definite improvement in global PMI, not only limited to the US anymore. And also the significant contraction in US (negative) current account balance since the post-crisis QE world has now turned a corner and we have a marginal expansion in US current account deficit again. This is all the while with an expansion of Chinese current account surplus along with strong Euro area balance and contraction in current account surplus in petro-dollars economies. If the recent recovery of oil prices sustain, we will see the last bit changing in to positive territories again. That leaves the post-crisis anomaly of the very large Euro area surplus. The global imbalance in trade (and alternatively net savings) is shown the chart below on the left. During the 2000s, the US consistently ran an increasing current account deficit and a shrinking interest rate differential (see the right hand chart below, weighted rates differential to Euro and Japan economies). The dollar more or less followed the suit, weakening during most part of early 2000s. If we assume the QE is more or less done for the ECB and in 2017 we will focus back on tapering in the base case scenario, then it is hard to see that rates differential widening any further. Add to this the massive current account imbalance of the Euro area, and 2017 might as well be the turn-around year for the Euro, instead of the consensus long dollar trade (barring political accidents).

Finally, one of the biggest anticipation in 2017 is the great asset rotation, investors fleeing the bonds universe from the rising rate fear and piling in to equities. Again, there is hardly a strong case for that. Firstly, the demographics in the developed world does not allow a strong return to equities. Secondly, the fear about overseas official accounts dumping treasuries is largely unfounded - primarily most of them have been snapped up by the private sectors, and if we have steady energy prices we will see a lot less selling of treasuries by the petro-dollar economies. China, of course remains vulnerable with a steady outflow, but the outcome is unexpected here. A large dumping of treasuries by China, driven by PBoC's need to supply dollar demand in the domestic economy, will mostly be a risk-averse move and will have the opposite effect on US yields than what a large sell-off might suggest (i.e. a flight-to-safety rally instead of a bonds sell-off). As far as the US households are concerned, they started the great rotation a while back already - as the chart below show.

Overall, we can conclude from above that the major macro drivers for 2017 will be 1) US house prices and US fiscal and trade policies 2) Euro area economic indicators, especially credit impulse 3) The uncertain role of the emerging market economies in face of rising rates and dollars and finally 4) The re-balancing of global excess savings. We should expect a limited rise of rates and inflation (and inflation expectation). Also risk assets face no immediate strong head-winds yet as we expect the upside risk to bond yields and inflation limited. Finally, as we near the end of monetary activism and divergence, going forward we will see a higher de-correlation among asset classes. The major tail risks remain the Chinese economy - where expected risks of accident are low (but with a large impact of course). Among idiosyncratic risks, the UK economy may be vulnerable to a dragged-on negotiation on Brexit, which also potentially may have some mirror impact on the Euro area.

Given this, here we list the top macro trades for the coming year. Note these are the major themes and ways to express them, not a fire-and-forget strategy to be executed on the first trading day of the year.

Economic Theme	Market Impact	Trade
US Policy Regime Shift – pro-business (tax friendly), pro-fiscal (infra spending) with a risk of foreign confrontation	Macro: Consumption (and employment) has limited upside, the main upside lies in investment pick-up. Downside for house prices and trades Market: Selectively positive for equities, negative for rates, Limited upside for dollars.	Pay USD rates against GBP Long equity options with knock-out on lower rates Forward vol around (1y5y5y or similar) through vol-triangle, or simply 1y5y vs. 1y10y vol spread to protect against unexpected inflation/ sharp bear flattening. Rates receivers with lower rates knock-in for hedging economic shocks (long equities hedge, positive carry on upper left on forwards levels)
European/ Global   Recovery	Macro: higher rates, higher Euro (against USD and GBP) and higher inflation – with political surprise downside for Euro Area. Normalization of EU trade balance.	Long Euro FX calls with knock-in on higher rates GBP vs. EUR inflation breakeven tightener (pay GBP breakeven) Opportunistic rates steepener convergence
Brexit Implication	Unsustainably high priced-in inflation in UK. Equities so far priced-in only sterling weakness (FTSE in dollar terms sold off same as GBP since Brexit, this does not incorporate any weakening of the economy)	Short FTSE 100 quantoed in euro vs. SX5E or beta-weighted SX7E (highly correlated to Euro rates) GBP vs. EUR inflation breakeven tightener (pay GBP breakeven)
China Put	A flare up of Chinese crisis. Chinese market prices more controlled, than dependent countries	China rates payer vs AUD Short EM bonds (especially if you see a strong dollar rally ahead of us)
EM underperformance	Dollar strengthening, and economies closely linked to dollar following the rates moves	Buy dollar against EM CCY basket Short EM bonds (especially if you see a strong dollar rally ahead of us)
Euro Area Crisis Hedge	Reversal of peripheral spread tightening	Long Germany break-even vs. Italy (follows  closely the CDS spread)
Run-away inflation cheap hedge	The (unlikely) scenario of central banks losing control or way behind the curve. The idea is while normal inflationary pressure will push real yields, runaway inflation will force monetization, given the debt-to-GDP ratios of major economies.	near-OTM rates payers vs. inflation, against far-OTM inflation caps against rates.

Have a great year ahead!

Macro: The Quiet Riot - Continental Version

For the past few weeks, the fixed income market has seen a significant change in moods.

The earliest trigger was in the JGBs market in late July, then it was the Gilts in late September following a pause from BoE. This week it definitely felt like the Bunds. Treasuries are down too from July highs, but in a much gradual fashion compared to the rest.

Now while we do have individual explanation (with the 20/20 hindsight) for all these (BoJ steepening chatter, Brexit, ECB QE rumors and, of course, Fed hike expectation), these moves signals some fundamental changes common across the markets as well. For one, this sell-off in rates is markedly different that recent large moves or the 2013 taper tantrum in terms of the accompanying movement of the inflation expectation. This is the first large sell-off in rates where the real rates (I used 10y yield less the 5y swap breakeven rate) were stable. Clearly the common thread has been inflation expectation - led by the Sterling inflation market, in response to a weakening currencies. But this was not limited only to GBP. Backed by the strong recovery of the commodity prices and oil, inflation markets across regions rallied, recovering from the bottom in Q1 this year. Even the Euro inflation is  flat on YTD basis after this recent move.

However, it is still too early to say if this points to an inflation scare. We are far off from seeing the white of the eyes of inflation. Large part of the recovery in inflation is driven by commodity prices which just came off multi-year lows. With over-capacity in many sectors, and a new cost/ supply equation for oil (see here too), there is no strong case for the commodity rally to overshoot substantially from here. On the demand side, apart from the healthy wage growth in the US, things are not significantly better. UK is still trying to figure out the consequences of Brexit. The collapse of the credit impulse in the Euro area late last year is yet to recover and Japan seems increasingly stuck.

The suddenness of the move suggests a large driver of the sell-off may be positioning, especially in Euro and GBP. Bunds open interest on Eurex were near historical high since 2008 before the selloff. This was definitely not helped by a rather tight-lipped Draghi on the last ECB. ICE Gilt positioning also indicated asymmetry with position build-up after Brexit. For core rates, this means the recent sell-off will stabilize as the pressure from positioning is diffused eventually. However, it is clear that we are approaching near the end of the era of quantitative easing. The next big move in rates will not be triggered by Fed. It will be the policy announcement from BoJ in Nov, followed by ECB's decision on QE in Q1 next year. Fed is priced in, and with all probabilities, will carry out a measured hike in December. It will be mostly a non-event.

What is rather interesting is how the current monetary policy plays out for the curve. It is clear we are increasingly approaching the end of QE-topia, with some central banks moving to normalize, and some still leaving considerable liquidity in the system and trying to lean on the next lever. This apparent divergence in the first order (the level of rates) is leading a convergence drive in the second order (the yield curve slope). BoJ is actively seeking to steepen the curve to alleviate concerns of the banking sectors, among other things. ECB will be glad to have the Euro area curve steepen back. The Fed is allegedly getting in the same business. The latest round of rates sell-off, unlike most before in recent time, was mostly a bear steepening move. Unfortunately, steepeners are not as juicy as they used to be in terms of carry a couple of years back, but still this is the trade to be in for the medium term - either in absolute term or cross-markets.

On the equity side, contrary to general view, this is not at all negative. Inflation recovering from current levels shows strength of the macro drivers. In fact in recent years, S&P 500 has shown more asymmetric correlation to inflation expectation than outright rates itself (see chart below). The thick tail on the right hand side has been dominated by inflation downside (i.e. correlated sell-off in equities with collapse in inflation expectation). A recovery in inflation expectation should be positive, at least initially, and ultimately uncorrelated to equity performance (runaway inflation is still a distance myth). This is especially true given the strong commitment from the Fed on its intention of slow paced hikes.

The S&P appears to be in a consolidation state - in a typical triangle formation, before the next leg (usually up from here).

The downside for equities from here is in fact event risks, and not macro. The US presidential election is one -although apparently the market does not care. Italian referendum is another - and again the history does not make a strong case for it either, if you go by the off-hand manner in which market digested the outcome of recent southern European election outcome.

Markets: Volatility Ahead

Finally we had a little bit of excitement back in the markets, and a vindication of sort for the numerous bears. Analysts from Citi confirm the macro drivers to blame. Indeed the cross market correlation has been on the rise. Below table shows the current cross market correlation¹. As it shows, rates and inflation still remain the major drivers, along with a very high level of correlation between commodities and currencies.

The chart below shows average correlation across asset classes. The recent spike is still far away from the levels around August 2015, but clearly captures the market sentiment.

And this sentiment is what is reflected in the latest AAII release last week. The market neutrals and bears remain significantly above the historical average as we have during most of this post-crisis bull runs. The change to highlight is an increase in bears at the expense of mostly the neutrals. 

For a contrarian, this would signal a limited scope of continued sell-off. However the other factor is positioning on the derivatives side. I have written about this before, but you must have already observed the change in the intraday price patterns in S&P. During much of last few months, it showed a strong mean-reverting characteristics (opening price shocks reversed during the day). For last few session starting from the 9th sell off, it seems the intraday trends are self sustaining now. That is confirmed on more quantitative measures as well. The chart ² below shows two approximate indications of short gamma positioning of the dealers. The idea behind this is in a market where the dealers (i.e. the hedgers, as opposed to players who hold options positions unhedged) are short gamma (net sellers of options), the natural hedging activity will create price pressure that will tend to amplify a price move (a up move in to a sustained rally and vice versa). On the other hand, when the dealers are net long, this will tend to stabilize price moves. Much of the stability in S&P intraday move for past few months can, at least partially, be attributed to net long position from the dealers, which appears changing now, as the short term intraday trends get stronger and sustain longer.

On the valuation side, however, S&P is still not screaming over-valued. Below chart shows world equity markets valuation vs trends (past 1-year returns) in two measures. The left one is the regular P/E measure, on which S&P is quite in the red zone, along with India and only second to Mexico. However, just going by historical P/E in a world of zero rates can be highly misleading. In terms relative valuation to bonds, S&P is quite in the middle.

If you followed the trades from my last post, it would have been a good couple of weeks capturing most of the major moves in the markets in the right direction. Looking ahead, if you are a bear, the investor sentiments and the valuation is not at a very helpful support to go big short at current levels. On the other hand the change in the gamma signature of the markets tells us unless something changed after Friday's expiry, we will continue to see decent swings and volatility will pick up. Although vols are not particularly cheap (relative to realized, yet), and I think given the reasons discussed before, it still makes more sense to buy options than to buy VIX here.

A traders' market after a long time. Brace for the upcoming Fed, but more for the BoJ. Going beyond equities, the major moves in rates (one of the major driers across asset classes now) has been set in motion by BoJ arguably. The recent bout of steepening in fixed income started with a bout of sell-off in JPY rates markets. This transmitted to rest of the world following ECB, with sharp steepening across EUR, USD, and GBP. The built up to the month end BoJ is almost palpable, and if not FOMC, at least this is almost certain to be an interesting event.

---

1. This is based on smoothed data (Gaussian kernel smoothed with 5-day bandwidth) to capture medium-term correlation.

2. The left chart is based on identifying trends quantitatively using change point techniques. The idea is as trends become more sustaining the ratio of max to median trends will increase, as shown in the chart. The right hand chart shows absolute value of beta in a simple regression of intraday price to time, capturing the strength of the trend (if any) irrespective of its direction (rally or sell-off).
3. Data from Bloomberg and Google Finance

Markets: The Rise of The Vol Tourists

Since the Great Financial Crisis, the volatility market has undergone some significant changes. One major driver was an increased awareness about tail risk hedging. This was further aided by increasing acceptance of volatility as an asset class. Following the correlation one period during the crisis, the trend among asset managers has been risk factors based investment, moving away from traditional asset class diversification. This, along with the rising popularity of exchange traded funds and exchange traded notes, has given rise to a whole new set of demands for volatility products as an asset class.

Another impact came via the central bank reaction function route. The profound changes and the new normal condition following the crisis brought in a new set of players ready to supply (short) volatility - including those so called "vol tourists". But the appeal of systematic short volatility strategy has been strong following the crisis. As the unprecedented monetary stimulus created a huge yield chasing pressure, shorting volatility has become an important source. I have written about this quite a while back from rates perspective, but this is generally applicable to any asset class.

The left hand side chart below shows why shorting volatility systematically has been so popular. This tracks performance of a strategy that shorts the nearest IMM VIX futures and rolls just before expiry. The size is determined to match a margin of 10% of the invested capital (the approximate worst case loss). After the crisis, apart from a few hiccups (notably during the 2011 US debt ceiling crisis), the performance has been quite impressive. 

The result has been a discernible dynamics in the VIX futures market. The right hand side chart above shows the typical nature of VIX positioning that we have seen in recent time.

On one hand we have the asset managers managing the various ETNs linked to VIX. The left hand chart below shows the flows in to such ETNs (the short VIX ones are added with sign, reflecting net flow in to equivalent long VIX funds). These flows have typically been negatively correlated with VIX level itself. And the positions of these asset managers in the futures market have pretty much followed these flows - as shown in the right hand chart.

This has led to a situation where dominant players are the swap dealers (large banks) and leveraged money managers - the hedge funds - either discretionary or systematic short vol players. In fact, given the fact that after the introduction of tighter regulations since the crisis, most of the swap dealers positioning will be driven by hedges. So this leaves the leveraged managers as the only discretionary players in the VIX markets. 

This particular development in volatility markets - fundamentally driven by ZIRP policy of central banks, new regulations and the paradigm of risk factor investing - has resulted in an overall low volatility and high contago environment, even over and above what one can expect with a central bank puts. Apart from the China fear back in Aug 2015, the VIX level has remained remarkably tamed - below 25 almost always. Also the spread between front month VIX futures and the VIX levels itself has widened significantly since the crisis, as the most discretionary players have been systematically short in futures. The futures curve has been so steep that it is now very costly for long players to systematically roll macro hedges in VIX futures. In a normal market in a mean-reverting asset class like volatility, you would expect just the reverse.

The second impact, arguably, has been the feedback loop to S&P itself. As we have seen above, the VIX funds are flow driven. This means the leveraged managers are short against the large banks. The fact that most banks will have a hedged position, especially after the new regulations, make this positioning quite asymmetric. For the short VIX players, it is a linear position in volatility. However for the swap dealers - the opposite long VIX position will also mean a short option position as hedge. It is not important whether the short option position is the trade and long VIX is the hedge or vice versa. What is important that, a long VIX positioning will also mean a short gamma position. And the act of delta hedging will feed this into the underlying, i.e. S&P. If most hedgers are short gamma, as the underlying moves and the hedgers buy or sell to re-balance delta, they will tend to amplify the move. On the other hand, if most of the hedgers are long gamma, their delta hedging will introduce a stabilizing effect on the underlying. And this is captured in the following chart.

The chart shows the 20 day correlation (kernel-smoothed to capture the trend) of S&P 500 opening moves vs trading hours moves. This can be treated as a measure of the gamma effect above. We can treat the opening move as an impulse from overnight news. If the day move tends to counter that systematically, it is highly probable that the long gamma dealers are introducing a stabilizing effect. This means you would expect to show this up as an accompanying short VIX position for the swap dealers under such condition. Whereas if the day move amplify the open, this points to a short gamma position of the street (long VIX). So this correlation measure should move in steps with swap dealers positioning if we are right. And as we can see this is indeed the case, especially since 2014.

For a few days prior-to UK referendum, you must have noticed this phenomenon in practice. Taking a cue from the European markets, the S&P would open down more often than not, only to recover and more almost with statistical consistency during the trading hours. 

The rise of the vol tourists (and the short vol players in general) means watching VIX positioning and tallying it with the underlying moves has now become an important input for investors, even if you have nothing to do with VIX itself.

---

all data from CFTC reports and Bloomberg

Trade Ideas: Cheap Brexit Hedges

The Brexit noise and fear in the markets are getting ever louder. Handful of opinion poll results have led to extreme volatilities in currency and equities markets. It is something that no longer can be written off and hoped against. Unfortunately for investors, hedging such a macro event is neither easy nor cheap.

 

This blog discussed about a cheap Brexit hedge previously, here we take a more systematic approach.
 

Hedging macro event such as Brexit involves defining scenarios and associated outcomes in terms of market variables in each scenarios, and then picking the outcomes we want to hedge against. Then it becomes an exercise in balance between the cost of hedges and the residual risks (including basis between investor portfolio and hedge as well as the risk of the particular scenario/outcome assumed not realizing). Defining expectations about scenarios and outcomes of a such an uncertain event is not straightforward. Beyond economic analysis, what matters most in near terms is what market participants perceive as the possible impact, and also what they expect others to expect as possibilities - and make the most out of it. The resulting outcome can turn out to be quite different than what is based on pure economic outcome. However, at present, it is generally agreed that in the event of a Brexit, sterling pound will sell off considerably.

 

Taking this as an anchor, we analyze cross asset markets for their correlation (rolling weekly) to sterling pound. The figure below shows the outcome. On vertical axis, we have the correlation to sterling pound (GBP) in percentage point. On horizontal axis we have the relative rich/cheap position of each asset (z-score since 2014 beginning). If our assumption is right about a GBP sell-off and if these correlations hold, to hedge positions one would short the assets on the top half and go long on the bottom half. Also from relative value point of view, you want to short assets as far to the right as possible (rich) and reverse for longs. Hence the ideal hedging assets will be diagonal from top-right to bottom-left.

 

The motion chart captures time evolutions of these correlations. Drag the slider to the latest date. As we can see the most effective hedges (apart from shorting GBP/USD of course) is shorting GBP/EUR. However, in terms of cheapness the GBP 5y cross-currency basis swaps fares much better. In equity space, shorting FTSE vs. EM is attractive too. In rates space the best is shorting USD vs. EUR  10y swap rates (pay EUR swaps). On the bottom half, the best hedge is long euro FX volatility.

 

Looking around, to position for upside, shorting FTSE vs. Euro Stoxx looks quite attractive.

 

The trades here:

 

#1: long calendar spread in Euro FX straddle: discussed in more details here.

#2: short EUR 10y vs. USD in swaps: With Germany 10y hitting negative for the first time, there is very little scope of move further down here. On the other hand, in the event of an actual Brexit happening, any substantial margin calls can transmit risks asset selling pressure to safe assets. This appears more true as it does not look like there is a high amount of defensive positioning around the event. And given the expected tight liquidity in such a scenario, this can very quickly lead to a significant sell-off in euro rates. On the monetary policy side, a Brexit will definitely push down US yields further, pricing out any Fed hike (or even active easing). ECB, on the other hand has little traditional room to push rates down. My theory here is that a policy rate cuts has much less latency in market reaction than asset purchase can ever achieve in a stressed situation.

#3: short GBP short term (2y or 5y) cross currency basis swaps. In  the event of a Brexit, potentially we will have a significant demand in USD funding from UK players. In fact a more risky version of this trade is to short GBP basis vs. EUR. The former is trading far richer compared the later. And presumably given the cross-border exposures of UK to Europe, we may see a significant spike in euro demand as well to fulfill near term obligations of UK financials institutions.

Equities do not offer much attractive hedges after the recent sell-off (although shorting FTSE vs. EM equities can be considered). Equities however offer more attractive upside positioningfrom these levels (see above).

 

---

1. All data from FRED database/ Bloomberg
2. Symbols Key in the Chart - GBP10Y: GBP 10y Swaps, GBP5S30S: GBP swaps 5s30s slope, GBPBS5Y: GBP 5y cross currency basis, EURBS5Y: EUR 5y cross currency basis, GBPMMSPREAD: GBP 1y1y money market vs. libor spread, FTSE: FTSE100, VIX: CBOE VIX, GBPEUR: GBP/EUR cross, GBPJPY: GBP/Yen Cross, PERIPHERAL: Germany/Italy 10y bond spread, INFLATION: GBP 5y breakeven inflation, EURVOL: EURUSD 3M Vol, USDEUR10Y: USD/EUR 10y swap spread, GBPEUR10Y: USD/EUR 10y swap spread, USDGBP10Y: USD/EUR 10y swap spread, USDGBP5S30S: USD/GBP 5s30s Spread, USDEUR5S30S: USD/GBP 5s30s Spread, FTSEEU: Long FTSE vs. Euro Stoxx, FTSEUS: Long FTSE vs. S&P500, FTSEEM: Long FTSE vs. MSCI EM Index.