What Can Stop This Party?

There’s a pretty strong argument to be made that once vol. spikes sustainably, the biggest risk to markets is what JPMorgan’s Marko Kolanovic is calling “quantitative exuberance.”

That’s a little bit of an eye-roller. Apparently, everyone had the same idea for their year ahead previews. “Let’s do a riff on ‘irrational exuberance.'” Someone was first with “rational exuberance” (Barclays maybe), then Goldman picked it up, so I suppose it was only right that the Street’s most famous quant put his spin on it which, naturally, turned into “quantitative exuberance.”

If you missed it, here’s the quote:

We think that for the next market crisis, irrational exuberance in the ‘tech bubble’ sense is not needed. The reason is the prevalence of quantitative and passive strategies that don’t decide based on emotions, but rather based on measures such as the level of interest rates, volatility, price momentum, or bond-equity correlation. Examples of these strategies include Volatility Targeting, Low Volatility strategies, Trend Following strategies, Risk Parity strategies, Dynamical hedging strategies, Volatility selling strategies, and others. In addition, there are relative value strategies that transmit risk premia compression across asset classes and strategies. With volatility at record lows and central bank balance sheet inflows peaking this year, these strategies currently experience ‘quantitative exuberance’ that poses risk when monetary policies start normalizing in a meaningful way next year.

It’s the same story: what happens if vol. spikes for whatever reason and the rebalance risk in levered and inverse VIX ETPs exacerbates things thus forcing the systematic crowd to deleverage into a falling market? BofAML’s Michael Hartnett seemed to hint at this:

50-year low in stock volatility, 30-year low in bond volatility likely to be followed by flash crash (à la ’87/’94/’98) in H1.

Deutsche has been tracking the risk with their “feedback loop dashboard” and even Albert Edwards is talking about it:

Of course the machines took over the selling in the form of Portfolio Insurance programmes, but speaking to my colleague Andrew Lapthorne, he reminds me we also have similarly pro-cyclical ‘doomsday’ vehicles today with so much money being run by volatility targeting, risk parity and CTA/trend following quant funds.

Of course something has to tip the first domino there or, put differently, vol. has to spike first in order to light the fuse. The consensus is that there are two things that could serve as the catalyst: geopolitical risk (ever present) and a sudden pickup in inflation that catches central banks woefully behind the curve and forces them to move aggressively without “consulting” the market via forward guidance.

Well, BofAML’s Ioannis Angelakis is out with his year ahead credit derivatives outlook and he’s saying the same thing. To wit:

Reasons to stop this party – geopolitics and inflation

Geopolitical risks and inflation pick-up are our key concerns for the year ahead and beyond. The former has always negatively impacted spreads and vols. But against the new backdrop of dovish and most importantly predictable central banks, we feel less concerned. The CB put has lower strike but is still there. The latter is the single most important factor to be worried about for the future in risk assets and most importantly for rate-sensitive assets. What if this output gap finally closes and inflation finally picks up?

Geopolitical risk has always been important for risk assets, feeding into wider spreads and higher volatility. The chart below shows that the majority of vol spikes over the past few years have taken place during periods of geopolitical uncertainty.

GeoVsVol

Inflation could be the single most important reason to change the route of this rally. As inflation risks have abated and inflation has been range-bound for the past few years, our economics team feels less concerned about a sustainable move higher and a break of the 2% target level. The recent wage data have been pointing to the upside; but the team attributes this to one-offs and thinks it will eventually fade.

This is why the prospect of introducing deficit spending and aggressive deregulation is so dangerous. If it turns out that the “transitory” factors are indeed “transitory,” well then we’ve been laying trillions in highly combustible inflationary kindling all over the ground for nearly a decade. So if for some reason the disinflationary impulse created by tech, demographics, and a positive oil supply shock should evaporate all at once against a backdrop of deficit spending and regulatory rollbacks, well then that “missing” inflation might come beating down the goddamn door.

But assuming it doesn’t, central banks will be free to keep the communication loop open with markets – i.e. they can remain predictable and can continue to telegraph policy moves well in advance. In that environment what’s an investor to do? Spoiler alert!

“As central banks fear introducing volatility to the system, we think the reach for yield trade could remain in vogue next year,” Angelakis goes on to write, adding that “with still ~25% of global fixed income assets in negative-yielding territory, fixed income investors reached for yield in the highest beta pockets of credit.” See right pane below:

BofAVol

So there you go. And in case that’s not clear enough for you, allow BofAML to spell it out: bank capital, XO CDS index, HY, single-Bs, sub-insurers and corporate hybrids.

BofAMLVol2

Obviously, nothing could go wrong there.

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