“Recessions used to be exciting”, Deutsche Bank’s Aleksandar Kocic writes, kicking off his latest note which finds Wall Street’s deepest thinker asking what there is to do “when volatility hits rock bottom.”
Moribund rates vol. is a topic that’s come up in these pages on so many occasions over the past six months that I’m getting manifestly tired of writing the words “moribund rates vol. is a topic that’s come up often in these pages over the past six months.” It seems like I use that intro (or some derivation thereof) at least once every three or four days to kick off a post.
By now, you know the story. Volatility has migrated away from rates. Rates vol. has been the outlier during periodic bouts of market tumult, leading, at various intervals, to sharp spikes in vol. ratios (e.g., equities versus rates, crude versus rates). This state of affairs has sparked discussions about the extent to which central banks are still having a lot of success when it comes to using forward guidance and an implicit convexity management strategy to keep tail risks from materializing.
Last week, Kocic explained the apparent paradox in rates vol. legging lower at the very time when “things started to become interesting”. Long story short, it’s not all that hard to explain if you take a step back and think about what the recent policy bent means in the context of constrained monetary policy and a macro backdrop where growth risks are proliferating. Here’s Kocic, from earlier this month:
Despite years of accommodation, things don’t look great, but not very bad either. There does not appear to be any major economic imbalances or runaway inflation on the horizon that could trigger a dramatic economic downturn. Even if we are recession-bound, given stricter regulatory constraints and years of considerable deleveraging of the private sector, the recession is likely to be a shallow one without massive and/or very aggressive deleveraging. However, given the expansion of the public balance sheet and still relatively low rates, we are less prepared to combat recessions, even if they are shallow. This means that, in addition to rate cuts, the Fed would need to grow its balance sheet again, which takes us back to financial repression, low yields and range bound rates, which implies another wave of protracted supply of convexity to rates and transfer of uncertainty from rates to other markets. With that outlook, it is difficult to build a case for owning rates volatility over any horizon.
In his latest piece, Kocic notes that in the old days, “any hint of economic downturn, rough patch, or political event used to send volatility into overdrive”. Further, vol. never used to collapse completely because, after all, you can always find something to worry about, even after whatever the risk du jour happens to be fades away.
Now, though, the game has changed thanks to the evolution of monetary policy and the necessity of keeping rates vol. suppressed in the interest of avoiding the tail risks that would accompany a spike. No matter how myriad the risks and how seemingly fraught the environment, “gamma can’t find a bottom”, Kocic writes, in a note dated Monday.
“3M10Y is dancing at historical lows, only a half of a bp from the lowest level it has ever been at”, he continues.
After reiterating that volatility is concentrated at the short end of the curve, he notes that outside of that, “vol remains low and the market expects it to stay that way.” The rationale for the market’s conviction is the same – it’s the legacy of the post-crisis policy response and the inherent difficulties in unwinding those policies. To wit, from Kocic:
This is the overhang of the new paradigm of post-2008 monetary policy, which had been forced to work in overdrive to compensate for secular economic trends — despite years of unprecedented stimulus, productivity growth is still near 1%. By growing their balance sheet, central banks have effectively been offsetting the effects of forced deleveraging in the private sector. Inability to raise rates significantly above zero and reduce meaningfully their balance sheet before the next recession would leave little choice but to repeat the same pattern in the future. This would imply further compression of risk premia and little reason for vol to rise.
At this point, though, one is left to wonder whether this is a scenario where vol. just can’t go any lower. That appears to be Kocic’s message.
“In our view, these are attractive levels to own volatility [as] at 2.65bp/day breakevens on 3M10Y straddles, it is less uncomfortable to hold a long gamma position”, he writes, adding that “in the face of ongoing political and global economic tensions and implied latent risks, nothing unforeseen that happens is likely to be good any time soon.”
You’ve got to love that latter bit – “nothing unforeseen that happens is likely to be good any time soon” is a uniquely Aleks-ish way of communicating the idea that any surprises from here are likely to be unpleasant.
The bottom line – i.e., spelling this out – is that even if you assume nothing goes haywire, it’s hard to see realized not beating breakevens.
Kocic – and his colleague Stuart Sparks – go on to document the pension rebalancing story, which is pretty straightforward (i.e., the higher equities go, the more of a re-balancing bid there would be for fixed income, pressuring yields at the long end).
“During the first three quarters of 2018, private sector pensions bought $66 billion of fixed income, while state and local public sector pension investors bought $81 billion”, they write, on the way to concluding that “because equities are now well above Q2 2018 levels, we anticipate that further gains in the equity market will drive new rebalancing on the margin.”
The general takeaway from all of this is simply that we’ve reached a point where even if the monotony continues and nothing comes along to shake things up, with 3M10Y sitting near record lows, we may have finally reached a point where owning volatility is attractive despite the dynamics that have served to keep rates vol. suppressed.