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!

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. 

This is NOT Nuts, Where is the Crash? (II)

With dollar index on record highs, emerging market equities (except, of course, China!) getting bullied around on fed hike scare, and as the Greek saga continues, investors around the world are beginning to worry about risk trades. Especially equities and high yields. IF I am not mistaken, the latest Bloomberg investors survey points to that direction. Well, it seems we need not worry, not as yet! The Risk-On is going still very much strong.

I take the major equity indices around the world along with treasuries and internal sovereign ETFs (iShares) as well as high yields, and run some PCAs. The correlations as below.

The first one is obviously the risk-off/ risk-on factor. The second one is more like a fixed income allocation factor. The last one is domestic (US) vs international factor. We pick up the first factor and run it through a regime switch model (a Hidden Markov Model). The results below. The figure shows S&P Performance (orange) vs. the probabilities of different states we may be in. State 3 (bottom-most in black) represent Risk-On, state 2 (middle in black) is the Risk-Off state, and state 1 (top most in black) can be construed as Risk-Moderation state for lack of better words. As we can see, we are very much in Risk-On (click image for bigger picture).

Given the general nature of flows, esp smart money flows, chasing asset price momentum, we can say that much touted crash/ correction is a bit further away in to the future. Interestingly, similar analysis for other factors along with the assumption above means, for domestic investors, US fixed income is becoming increasingly less attractive, and foreign FIs more so.

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1. if you are wondering about the title, part I is here)

2. data from 2010 onward, analysis and plots by depmixS4 and Quantmod package on R 

ECB: Negative Rates Strikes Again!

On the occasion of 3 month euribor turning negative for the first time in history, here is a quick look at the policy rate corridor in Euro Area

What you see before the 2008 crisis is the original intention. The eonia and euribor tracking each other and the policy rate (refi rate) closely. The deposit rate and and the marginal lending facilities are uncollateralize lending and borrowing rates for bank with ECB. So naturally they straddle the other market and policy rates.

Then something changed after the crisis. Immediately after, and more emphatically in later half of 2012, the market rates (euribor and eonia) decoupled from the policy rate (refi). Finally ECB caught up in 2013. But eonia still trades below zero consistently. And today 3m euribor fixes below zero for the first time. Germany is negative till 8 year. 10y bunds on its way to trade below zero. Investors are ready to lend money to Germany for a meager 50bps for 30 year!

And we have quite a few months of QE left for ECB! A few more possibly if the inflation remains stubbornly moribund beyond 2016. Draghi categorically mentioned no further cut in depo. ECB under Draghi has been less prone to make statements in advance, or as Mr Draghi says, "pre-commit", without solid reason. So we can, for the moment, assume depo stays at negative 20bps.

The success of ECB QE is ultimately measured in inflation and inflation expectation. On this measure so far it has been moderate (see here). It remains to be seen if the bonds shortage issue come up in near future how ECB is going to handle that, without further cutting depo rate. 

Meanwhile we can assume they will not, and paying eonia on that assumption is the natural trade.

Widow Maker : The Latest Avatar?

Ever since Draghi declared "whatever it takes" in 2012, traders have constantly put their bets on euro rates long end normalization. The arguments were many - take your picks from below 

1) a pick up in credit situation (touted since 2012, there are early signs appearing this year)

2) resolution of debt crisis (it is perhaps not a "crisis" any more, but certainly not resolved either)

3) pick up in growth (we have seen consumption recovered a bit, but not enough) and general good feeling/ green shoots

4) add your custom reason here ... (bond vigilantes, anyone?)

Since then, the euro long end rallied a 170-180bps (swaps and Germany long dated papers). To be fair the rally started in full throttle in 2014. But even then, the euro long end normalization trades have hardly paid off. This year itself, the euro long end rallied another 70+ bps, with no sign of a reversal. The question is will the inflation and QE chase each other out and make the long end "normalized" sometimes in near future, or are the long ends already normalized at current levels and we do not know it yet.

In Japan the 30y swap trades around 1.3% area, whereas in Europe it is down to around 0.70%. The 5s30s yield curve spread at 110bps for Japan vs a meager 55bps for Euro. And the reason is as below

Japan and Euro area has similar amount around 10y and more, but Euro area is more skewed towards long dated. On top, ECB QE has had a much stronger impact than BoJ, partly because initial BoJ QEs were weak in comparison. In a yield chasing environment, 10y point on JPY curve sounds a more suitable comparison point for 30y euro swaps. And to get there, we have some ways to go. The JPY 10y swaps trade at 0.50%, and the JPY 5s10s at 25bps. To do a Euro long end normalization trade two things are required. A stop loss large enough to see the bottom, and patience. 

So the message is simple: if you are not in a downside protected positive carry trade with a longer term trading horizon, you probably should not be in it.

And for this same reason (economies aside), UK long end is more vulnerable to further rally than the US.

ECB Dictatorship!!

What on earth was that!!

Contrarian: Short EUR to hedge Grexit! Are You Sure?

Sounds rhetorical indeed. But does it? 

Two charts below on EUR/USD vs Italy benchmark 10y yield below. The first one shows YTD move, the second shows the relationship back in 2011-12, during the height of European debt crisis. 

It is true the general yield compression and euro sell off is driven by the same force, i.e. QE. However that does not explain the sustained correlation on the other side as well, i.e. periphery sell off along with euro rally. 

This puts a question-mark to the theory that a Grexit will result in a large euro sell off. It depends what safe assets you buy when you panic. But whatever it is, we will see a large move for sure.