There’s been no shortage of discussion about what could break the low vol. spell.
Allow us to reprint what we said months ago about how there is now a cottage industry for missives on volatility:
Volatility has become the market’s perpetual topic du jour (does it make sense to use “perpetual” and “du jour” in the same sentence? Not sure on that).
Suppressed vol has become ubiquitous. And the amusing thing about ubiquity is that it has a way of making everyone think they’re entitled to have an opinion on whatever it is that’s ubiquitous. That’s certainly the case with volatility.
That’s the (black) magic of VIX ETPs. Hordes of retail investors have been transformed virtually overnight into futures traders much the same way as the rampant proliferation of margin debt in early 2015 helped turn every bored housewife in China into a leveraged Shenzhen day trader.
This dynamic has created a veritable cacophony of explanations as to why vol. is suppressed and as to what could change the dynamic.
To be sure, the question as to what’s behind suppressed vol. has been answered as definitively as it can be answered. Part and parcel of this discussion is the glaring disconnect between market-based measures of vol. and the best tools we have for quantifying geopolitical/policy uncertainty. For a recap on this, see “The Great Disconnect: 5 Reasons Why Volatility Is Detached From ‘Chaotic Uncertainty’.”
And so, the conversation has come to center on what the catalyst will be for the next sustainable spike in volatility – we know that low vol. regimes can endure and the historically unique characteristics of the current regime (innovations in market microstructure and unprecedented central bank accommodation) cast doubt upon the usefulness of precedent.
For Deutsche Bank’s Aleksandar Kocic, the communication loop between the Fed and markets – i.e. the transparency that comes with the removal of the fourth wall – effectively makes a vol. spike impossible. Recall this from a recent note:
Post FOMC excitement has proven to be short lived. The market has reverted again to what appears to be a familiar pattern, whereby gamma becomes a way of event trading. It is difficult to see anything in the near term that can provide a sustained support for vol. As long as there is no structural shift – and it is becoming increasingly clear that such a shift is not on the horizon — regardless of the content of the event, volatility is unlikely to sustain a bid.
In our view, primary reason for persistence of bearish pressures on gamma is excessive liquidity on the exchanges and transparency of the Fed. As much as transparency has been elevated as a tool intended to inspire trust, it inherently creates blind spots and residual risks that in the long run become difficult to manage. Transparency forces everything inward and numbs the awareness of anything that resides outside of the existing channels of informational exchange, making it difficult to have a non-consensus view against the background of total transparency. In this way, transparency becomes a method of control.
In the environment of abundant information, everything becomes short term. A long term vision becomes progressively more difficult to construct and things that take more time to mature receive less and less attention. Given the magnitude and severity of policy response during the financial crisis, Fed has been running significant addiction liability in the context of stimulus unwind. The communication loop between the Fed and the markets has become a way of controlling the residual risks associated with their exit. Excessive transparency has been perceived as the most effective way to stabilize the system. When used in this context, it confirms and optimizes only what already exists. The markets remain blind to what lies outside of the context of informational exchange.
The only thing that can change this – i.e. the Fed becomes less transparent, less concerned about the market reaction, and thereby rebuilds the fourth wall – is if the committee’s hand is forced by deficit spending or inflation – i.e. things that would bear steepen the curve.
That brings us to Kocic’s latest note, out Monday morning, which finds him reiterating that “for anything to happen, the long rate has to move higher.” Here’s Kocic:
With abundant liquidity, Fed transparency, and “predictable” political shocks, we have entered a regime of noisy status quo whereby the only temporary source of transient bid for gamma could be triggered by possible missteps in monetary policy unwind. However, even that seems to be relatively unlikely and, even if it happens, episodic at best. The largest, and possibly, the only risk capable of resetting the vol higher is the tail risk associated with bear steepening of the curve and disorderly unwind of the bond trade. This is the risk that would be probably impossible to control, its trigger being either excessive deficit spending or inflation.
It is precisely the severity of this problem that prevents return of volatility. Current monetary policy is focused on the management of the underlying tail risk and the Fed transparency and gradual hikes are all about the reduced maneuvering space that has remained after almost a decade of stimulus. Fed has an uncomfortable (and complicated) task in this context: Fed needs to raise rates in order to prevent rates rise.
What must not be, cannot be: Inflation cannot be allowed to develop because it would be no way of avoiding dramatic rise in rates. If the Fed embarks on aggressive hikes in order to fight inflation, rates would rise. If the Fed stays behind the curve, the market would bear steepen the curve. Either way, the long rates go up.
This suggests that the market’s sandbox is small – the “playground” is constrained. Here’s Kocic again:
The gap between the Short term rate expectations and the Long rate represents the remaining maneuvering space that the Fed has left. This gap defines the playground for the markets — everything that can happen, has to happen inside that space. This gap is narrow, currently at 60bp . Given where long rates are, Fed appears as overly hawkish – it has only two more hikes to go and, for volatility and risk premia to reprice higher, the gap has to widen. As is appears unlikely that the Fed will be cutting rates any time soon, the gap could widen only if the Long rates sell off. For anything to happen, 5Y5Y sector has to move higher. This is the catalyst for everything.
So to the long vol. crowd, now you know what matters. Adjust your positions accordingly. Or keep lighting money on fire. Either or.