Heisenberg Report

What Could Go Wrong? ‘Tis The Season To Be Vol-ly

On Thursday, we went back over just why it is that volatility can’t get off the mat.

To be clear, this is no longer a mystery. We know why market-based measures of vol. are disconnected from the best available means we have of quantifying policy/political uncertainty. You can read five reasons here.

But although the reasons for this disconnect have been documented, discussed, and otherwise debated ad nauseam, you can believe the fixation will continue right up until there’s a vol. spike that proves sustainable enough to satisfy those who spend their days decrying markets’ apparent complacency.

As a reminder, the controlling factor here is the communication loop between markets and central banks. The removal of the “fourth wall” and the radical transparency that comes with allowing markets to essentially co-write the policy script have made it impossible for anyone to take a long-term view. Only the rebuilding of that wall will be sufficient to break the spell – as it were.

That said, here are Deutsche Bank’s four arguments for why vol. could be “very near” its lower limit:

  1. Can the real growth and inflation trends remain any more compliant? After all US and global measures are both in the perfect “not too hot not too cold zone”. We may have already past the point where inflation is at its most vol depressant, and US inflation is seen being more supportive of vol in H2 next year;
  2. Central banks if anything are likely to be wary of lower vol, that was seen as a potential catalyst for excessive risk taking before the 2008 crisis. Similarly Central Banks will avail themselves of the lower volatility that is associated with strong risky asset performance and easier financial conditions by continuing the process of policy normalisation that will support vol. Yes normalization will be done at a “gradual” pace that precludes persistent disruptive spikes in vol, but only as long inflation remains reasonably quiescent.
  3. We only have only limited experience with the ‘stock versus flow’ effects of QE. 2018 will see the world’s most important Central Bank balance sheets shift from a 12 month expansion of more than $2 trillion, to a broadly flat position by the end of 2018, assuming the Fed and ECB act according to expectations. The QT that was feared surrounding the taper tantrum never happened in 2014/15, but will very likely occur in 2018/19.
  4. Will the Fed’s balance sheet exit work as smoothly as the econometric work equating the Fed’s 2018 balance sheet reduction to a 15bp increase in the 10y yield? Coefficients tend to change over time, not least if there are other forces pushing in the same direction, leading to a compounding effect. Higher inflation and/or other Central Bank QE tapering from the likes of the ECB could compound the expected small negative bond influence from the Fed balance sheet adjustment

Good points, all. And indeed, the “stock versus flow” effect argument may be one of the most important considerations for markets in the months ahead, especially in light of news that the ECB is set to cut QE in half starting in just a few months.

But for those who prefer a far simpler rationale when it comes to justifying a penchant for lighting money on fire by going long vol., October seasonality is on your side. Except when it’s not. Although it’s difficult to decide if Goldman has actually said anything worth saying in their latest note on vol., I suppose it’s fine to give them the benefit of the doubt. Here’s an excerpt from a note out this morning:

Historically, October has been the most volatile month of the year for the S&P 500. This seasonal patterns remains consistent over time since 1928 but also across equity markets, although the seasonality is boosted by some outliers that happen to be in October (1929, 1987, 2008). In addition, we see even less evidence of this pattern in years that fall into low vol regimes (Exhibit 1). As we discussed recently, low vol periods can last a long time if growth remains strong and there is little upward pressure from rates and inflation: since 1928, S&P 500 low vol regimes on average lasted 22 months (median 16 months) and since the 1990s they have often lasted in excess of 3 years.

So again, it wouldn’t be entirely accurate to say that they’ve said nothing, but it wouldn’t be entirely inaccurate either. Basically, the seasonality of vol. disappears during periods when volatility is low. 

What are the risks to the low vol. regime as far as Goldman is concerned? Let them tell you:

Rates and rates volatility are likely to pick up into year-end, supported by Fed QT and ECB tapering, just as growth and US policy optimism could reach a peak. The dispersion of 1-year-ahead GDP growth and inflation at all-time lows has helped anchor rate volatility, but uncertainty over inflation in particular could pick up in Q4 (Exhibit 2).

Our Macro Rates team have highlighted that low dispersion of consensus GDP and inflation forecasts helps explain current low term premia. Last week’s payrolls confirmed a strong labour market, with a large increase in average hourly earnings pointing to a pick-up in wage inflation, and today’s US CPI print and the Q3 earnings season will be important to assess the trend in inflation. Also, the hurricane reconstruction efforts in the US could provide a near-term boost to inflation. Volatility of shorter rates has also declined, alongside lower disagreement on 1-year- forward 3-month rates. That said, market pricing for 2018/19 remains too dovish in our economists’ view, and there is uncertainty on the future Fed chair.

Higher rates volatility and inflation weighing on risky assets is particularly concerning for asset allocators owing to lack of diversification. Multi-asset balanced portfolios have delivered strong Sharpe ratios as a result of the Goldilocks backdrop YTD, with risky assets rallying alongside safe havens; this has made ‘barbell strategies’ popular, where for every unit of risk a ‘safe haven’ is added to keep portfolio risk stable. There is also bullish positioning in short vol strategies and by systematic investors, such as vol target and risk parity funds, which have added risk YTD. Those strategies are particularly vulnerable to higher volatility with positive equity/bond correlations, and unwinds could add to volatility in the near term. Also, our Rates team has highlighted the increasing lack of diversification in bond markets, which could push investors to manage duration risk more aggressively in a bond sell-off.

Just to be clear, Goldman doesn’t think anything too bad is likely to happen, but the overarching point of everything said above is that if the question you want to ask is “what could go wrong?” the answer is: “a lot.”