Goldman: ‘Market Depth Has Stopped Improving’, Stocks Still ‘Vulnerable To Sudden Volatility Shifts’

On Monday afternoon, we noted that Goldman is sticking with a generally cautious approach as risk assets continue to rally on the back of dovish central banks and ostensible “green shoots” for the global economy.

Tuesday brought more dovishness (albeit of a retroactive sort, in the RBA minutes) and a bit of incrementally good news on the economic front in Europe (ZEW expectations beat, even as current conditions missed). Here’s a good chart from Bloomberg’s Luke Kawa which shows bund yields lagged by five months versus ZEW expectations:

(Bloomberg)

If you were looking for some confirmation bias for a view that the nascent cyclical reflation story has legs, you could do worse than that.

Although equities faded a bit during the US morning, stocks were strong overseas and in a testament to some of the credit dynamics we’ve been talking about over the past several days, it’s worth noting that through Monday, BBBs had tightened for nine straight sessions.

Anyway, amid the rally and as central banks pound the table on “patience”, cross-asset volatility has collapsed and if you ask Goldman, that means “options are becoming more attractive both as a hedge or as a cash replacement strategy.”

Again, that’s from a Monday afternoon note. Fast forward to Tuesday, and the bank’s Rocky Fishman (regular readers will recall that when Rocky was a Deutsche, he spent quite a bit of time warning about the dynamics that would eventually lead to the collapse of the short VIX products) is out with the latest edition of “Vol Vitals”. These are fun little notes that make for great FinTwit fodder as everyone races to post the most colorful visuals.

Fishman starts by reiterating the idea that with hedges cheap, it may be time to… well, to hedge. Here’s Rocky:

The combination of improving economic data, a Fed that appears to be on hold for an increasingly long period, low volatility in rates and FX, and single-digit SPX realized vol are all consistent with the VIX’s fall toward a six-month low of 12 if not even somewhat lower. The key takeaway from this low in implied volatility is that hedges may be close to their most affordable point of the year, particularly longer-dated hedges.

As we’ve documented exhaustively (literally – I’m actually exhausted with it), equity vol., despite trending back lower, still looks high by comparison. Fishman uses FX vol. as an example.

“As one concrete example of low macro volatility, the euro has been in a 3.5-cent range since mid-October, its tightest six-month trading range since the currency was created”, he writes, adding that by contrast, “the SPX’s 22% range over the same period was its highest since 2011-2).”

(Goldman)

Of course the rates space is the poster child for indefinite vol. suppression. To illustrate, just try plotting cross-asset vol. in units of 3M10Y for 2018 – you’ll see huge spikes in, for instance, VIX/3M10Y and crude implied vol./3M10Y. In any event, here’s a bar chart from Fishman which puts things in historical perspective – note FX and rates vol. at the bottom.

(Goldman)

Ultimately, Fishman’s “Vol Vitals” notes are a kind of “choose your own adventure” type deal, comprised of a series of bullet points containing various “observations” and accompanying trades, but you could plausibly suggest that the main takeaway from Tuesday’s piece is the following, which comes after Rocky reiterates that given the likelihood of things remaining calm in the near-term, longer-dated hedges are preferable and cheap:

9M-6M put price differential is its lowest since pre-GFC. The 0.8% of spot price difference between a 9-month 95% SPX put and a 6-month 95% put can be thought of as a rough three-month carry cost of an SPX longer-term hedge. That cost is now the lowest it has been since 2007.

So, there’s that in terms of specifics.

More broadly – and this is the set of visuals that folks are busy tweeting on Tuesday – Fishman notes that while market depth has improved over the course of this year’s dramatic rally, liquidity provision remains impaired. The chart headers say it all:

(Goldman)

I generally despise the phrase “this is what’s keeping people up at night”, but it’s somewhat apt here, at least as far as conveying the extent to which this backdrop is what makes it possible for bad situations to get worse in a hurry.

“The recent uptick in VIX options’ implied volatility is one reminder that conditions can change quickly, especially with diminished liquidity”, Fishman cautions, adding that while he “sees no key imminent catalysts, low-vol periods are a good time to accumulate mildly-carrying, longer-dated protection.”