Where next for vol.?
Nowhere. Unless it’s lower. Of course. That’s how things work. That’s how things have to work. That’s how things must work.
Because as Citi recently put it, “trades and strategies which explicitly or implicitly rely on the low-vol environment continuing are becoming more and more ubiquitous.” That ubiquity begets feedback loops – i.e. self-feeding dynamics that, when underwritten by radical central bank transparency, optimize around themselves. They work because they have to. Rebelling against the prevailing system entails foregone carry, underperformance, and to quote Deutsche Bank’s Aleksandar Kocic, “a high probability of gradually losing small amounts over an indefinitely long period of time, keeping in mind that persistent small losses over an indefinite time period could lead to large cumulative losses.”
What happens in the interim? What are the “trades and strategies” that Citi refers to? What comprises the feedback loops? You know the answer – or at least you should. Here’s JPMorgan’s Marko Kolanovic to remind you:
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.
As Deutsche Bank notes to start the week, five-decade lows in realized vol. are not entirely a mystery. “Together the unemployment rate and the ISM explain the bulk (68%) of the variation in realized volatility,” the bank writes, in an asset allocation piece dated Monday. But while low realized vol. may not be a complete conundrum, the confluence of factors operating here is rare. “Since the 1960s, there are only 19 months when the ISM was 58 or higher and the unemployment rate was less than 4.5%. That is only 2.7% of the time,” Deutsche continues.
Additionally, it’s worth noting that for the bank’s Binky Chadha and Parag Thatte, a quick look is all you need to know that record lows on the VIX are not necessarily indicative of complacency, but are rather just a product of low realized. To wit:
Indeed the equity vol spot risk premium has been well above its historical average since the Q1 2016 growth scare and the 3mma is currently at the top of its historical distribution (99th percentile). Similarly, the term structure of implied vol has been rising since Q1 2016 and is very steep. The 3mma of the 3m-1m slope of implied vol for example is also at the top of its historical distribution (100th percentile).
Ok, so given that, maybe rampant complacency isn’t the best way to describe record lows on the VIX, but the question still remains: What can break the low vol. spell? The answer is the same as it ever was: a sudden upturn in inflation that catches central banks behind the curve and forces them to effectively revoke the market’s license to co-author the policy script.
As alluded to above, lurking in the background is a significant amount of technical risk. For that technical risk to “trigger” (as it were), a vol. spike needs to be some semblance of steep and also sustained. Paradoxically, the tendency for investors to “sell the rip” (the vol.-selling, ex-Target manager equivalent of “buying the dip” in equities) helps to keep spikes short-lived. Here’s Deutsche again:
Shares outstanding in the short vol ETPs tend to increase following a volatility spike as investors rush to capitalize on the increase in vol. These positions are subsequently unwound when implied volatility reverts back. An initial spike in volatility will see short vol traders reengage and unless the vol spike ‘sticks’ we can expect the old behavior to continue. A sustained period high vol that sees vol keep jumping higher is the most likely scenario when short vol traders will finally disengage from this trade.
Have a look at this annotated chart of 2017 VIX spikes:
To reiterate, a combination of supportive econ, dispersion (low correlation), BTFD, central bank transparency, and indiscriminate flows (e.g. buybacks and passive) are responsible.
Oh, and don’t forget about outright QE. How much does that still matter? The short answer is probably: a lot. “Over the past year, Central Banks added over $2 trillion to their balance sheets even in the absence of market stress,” Deutsche reminds you.
Have a look at this rather telling chart that plots the annual change in central bank assets with 12m realized vol. on the MSCI world:
What then, outside of an inflation shock that forces an abrupt policy shift, could alter the dynamic? Well, in the presence of synchronized global growth and subdued macro volatility, perhaps nothing.
But again, the technicals mentioned above cut both ways. They optimize around the prevailing dynamic, but if an exogenous shock were to come calling and break the spell, they will be self-feeding during the unwind as well. Here are four factors as delineated by DB that suggest a greater potential for volatility spikes in 2018:
- A greater risk of 5% pullbacks for the SPX, which can be intensified by crowded carry trade unwinds.
- Short volatility positioning has grown and rapid de-risking will exacerbate a downturn.
- Leverage continues to build in the long-running bull market with low levels of cash in retail accounts
- Investors may have less portfolio protection on to limit losses, after the frustration of burning any sort of options premium in the undisturbed rally
There you go. And on that note, we’ll leave you with one final chart which should serve as a rather poignant reminder of just how infrequent the type of large drawdowns that typically accompany sustained vol. spikes have become…