“Equity basking in gamma”, reads the headline on the first slide of a new presentation from SocGen.
The deck is comprised of 10 charts which together summarize the bank’s thoughts on volatility in the new year.
Beneath the headline is a cartoon of a bull reclining blissfully in what looks like a pool of mud. Why mud? We’ll never know, but that’s not really the point.
“Last year saw a decent number of potential triggers for more volatility”, the bank says, in the full outlook piece, dated January 9.
They cite the usual suspects: weakness in leading indicators, plunging breakevens, curve inversion, rising recession probabilities, sluggish corporate profit growth and lingering doubts about the viability of the trade truce.
Things obviously turned around in the fourth quarter, but through August, 2019 was a year defined by growth jitters, which eventually morphed into an outright recession scare.
Fortunately, those same worries prodded central banks into action, supporting risk assets of all stripes as the promise of abundant liquidity and the idea that assets were “on sale” following the Q4 2018 rout, helped spark a rally that ended up persisting for the entire year.
And yet, even as some 90% of global assets posted positive returns (a complete flip-flop from 2018, when USD “cash” outperformed almost everything), equity implied vol. generally trended higher, something SocGen points out.
That trend notwithstanding, it would be strange to characterize volatility has anything other than benign. How to explain that in the face of so many geopolitical flash points and persistent worries about secular stagnation?
SocGen flags four controlling factors, starting with central bank largesse.
“The fact that most of the gains in the S&P 500 in 2019 came via a rise in valuation points to the significant role that lower rates have played in lifting equities and suppressing volatility”, the bank notes, adding that “lower discount factors increase the present value of future earnings [and] the housing sector has benefitted from lower rates, which has arguably held up consumer sentiment and spending, offsetting some of the weakness in manufacturing”.
We doubt you need this chart again, but just in case, note that 2019 was all about investors paying more for a dollar of earnings.
SocGen goes on to document the Q4 “reflationary wave”, which you can see clearly in the first visual above, as breakevens rose and the curve widened out beyond 30bps (even as ISM refused to cooperate).
The bank cites the Chinese credit impulse in explaining reflation optimism. “While weaker in magnitude than the previous instances, the reflationary wave is likely to continue to support themes such as value over quality, and is likely to continue to suppress volatility, perhaps more in geographies outside the US”, they note.
But the crucial bit comes when SocGen documents the effect of the gamma “pin”, a theme so pervasive that it comes up virtually every, single day (regular readers are well-versed). Here’s SocGen:
Against the backdrop of very low (and often negative) fixed-income yields, volatility (or option) selling is becoming a staple of institutional investors’ portfolios as a yield-generating strategy. Overwriting calls on cash holdings (and cash covered put underwriting to some extent) is becoming increasingly popular among investors. Dealer-hedging of these option flows overwhelm[s] other cash activity and are often responsible for the seemingly asymmetric and fragile nature of volatility markets. These long gamma positions dampen realized volatility, thereby pulling the short-end at-the-money implied volatility down with it. As a result, we get a combination of high skew, high vol-of-vol, steep term-structure and low short-term at-the-money volatility.
The visual below shows the change in the S&P vol. surface from April to December. As the bank explains, “the noticeable increase in the overall volatility surface presents a sharp contrast to the heavy pressure on the front-end at-the-money volatility”.
We often talk of “gamma gravity” in these pages. SocGen employs the same language. “The persistent weight of gamma positioning while in positive territory keeps this part of the vol-surface pinned, just as a heavy object warps spacetime”, they write.
This dynamic helps to explain both the persistence of stability over long periods and the sudden downdrafts when dealer gamma positioning flips, ushering in a selling-begets-selling environment that can push spot through key levels associated with CTA trend de-leveraging and other systematic selling. Here’s SocGen again:
As large and positive aggregate gamma impacts the realized volatility directly (dealer need to buy when the spot falls and sell when the spot rises, thereby dampening the potential spot moves on either side), persistence of long gamma positioning can lead to low volatility over extended periods of time. As per our estimates, aggregate gamma on the S&P 500 was positive for more than three-fourths of 2019, and hence we believe this to be a significant cause of lower than expected volatility last year. Heavy gamma positioning was also among the main reasons why the S&P 500 escaped any drawdowns amidst all the US-Iran newsflow in the first week of 2020.
To that latter point, note that on the bank’s estimates, January found the market in the longest stretch of persistently positive gamma on listed options since the third quarter of 2018.
“The current 96th %ile aggregate Dealer ‘Long $Gamma’ position continues to act as a ‘gravitational force’ for the S&P”, Nomura’s Charlie McElligott wrote Thursday, on the way to suggesting that if many of the options aren’t rolled out and up, the “pin” could become less effective – the gravitational pull less powerful.
“Per our estimates, nearly 36% of the total $Gamma across strikes is set to drop-off following Friday’s expiry, which should then allow us greater freedom to move in either direction”, he said.
Of course, when you’re looking to explain suppressed vol. and what amounts to systematic stabilizer flows, don’t forget that while understanding everything described above is absolutely crucial, you needn’t be a derivatives strategist to know that two additional factors continue to play an important role too.
“Corporate buybacks are partly responsible for reducing volatility on the margin”, SocGen goes on to say, a half-dozen pages into their 2020 vol. outlook piece, adding that “the BoJ buying of ETFs likely depresses volatility by more than 1% annually on the Nikkei 225 index, and we expect a similar effect on US equities from the corporate purchases amidst an increasingly passive market that trades ever lower volumes”.