Only A “Black Swan” Can Stop Me Now!

Right, so nothing matters anymore.

Not the fact that a reality TV show host and government neophyte occupies the White House. Not the fact that there’s a Nazi on the ballot (again) in France. Not the prospect of a nuclear war on the Korean peninsula. Not the fact that the EU is on the verge of dissolution. Not the fact that there at least three Sunni/Shiite proxy wars raging across the Mideast. Etc. Etc.

By all accounts, any one of those of those things should be sufficient to drive volatility up across markets but as you can see from the following handy table from Goldman, there basically is no volatility – anywhere.

That of course helps to explain why equities and credit have remained absurdly buoyant. This has become a demon market possessed by central bank liquidity and dip-buyers. “Offered” is no longer allowed. “There is no ‘offered’ only ‘bid'”…

Anyway, this is a self-fulfilling prophecy as outlined earlier in “A ‘Useful Maxim’ Before ‘It All Goes Horribly Wrong.‘”

The question becomes: if none of the crazy shit outlined here at the outset can lift volatility, then what can?

Apparently “known unknowns” are woefully inadequate. In Taleb parlance, “gray swans” don’t stand a chance in hell of making anyone nervous anymore. Recall Taleb’s definition of a “gray swan”:

They are somewhat tractable – knowing about their incidence should lower your surprise; these events are rare but expected.

That said, it follows that the only thing capable of derailing this train is a true “black swan.” 

Here’s Deutsche Bank with more…

Via Deutsche Bank

Credit market snapped back over the past two weeks as a perfect combination of higher equities coupled with a collapse in volatility at a cost of only modestly higher rates all contributed to strong spread performance. HY OAS now finds itself at 387bps, roughly in the middle of its recent range between the 418bps peak registered in mid-April and 368bps low from early March. Its YTD total return of 3.8% is now dominated by excess return contribution of 2.9%, even though just two weeks ago the contribution between rates and credit was roughly equal. Naturally, CCCs have shown some outperformance in this perfect risk-on environment.

A move higher in rates — at +12bps on the US 10yr Trsry over the past two weeks — represents a partial giveback in the context of a broader move lower in this benchmark over the past two months (-45bps). It is too early to tell whether we are looking at a genuine change in direction, or just a temporary reversal in this recent trend. We are inclined to think that rates are headed higher over the course of the balance of 2017, although we do not have a particularly strong view on their near-term direction.

The collapse in implied volatilities — visible particularly well in equities, where VIX touched on its all-time lows in recent sessions — but also evident across asset classes in rates, FX, and credit, represents perhaps the most interesting piece of the puzzle here. After all, how could it be that with all the uncertainty around us, ranging from the unorthodox US administration to unfolding Brexit drama to EU elections to rising geopolitical tensions to central bank policy normalization, investors somehow find reasons to price future volatility as if the environment has rarely been more predictable?

Running a risk of over-rationalizing the market’s behavior, we would venture to say that all these risks, as meaningful as they are, are known-unknowns. The market is well aware of them, has been dealing with them for some time, and has [what it believes to be] a pretty good handle on how to manage them. This observation coupled with a recent reprieve in some of these risks have contributed to a formula that pushed implied vols to their recent lows, we believe.

So what would it take to upset this perfect equilibrium? Something the market is not expecting, something completely out of left field, an unknown unknown, a black swan.