“From a Vol market perspective, the issue is that the VIX is broken — again,” Nomura’s Charlie McElligott said Monday, in one section of a sweeping note documenting recent dynamics and detailing what a trio of backtests might foretell for markets on the heels of last week’s somewhat deranged developments.
It’s “all demand” for implied, but no supply, Charlie wrote. He described a “near-endless need for skew/ forward vol/ convexity from hedgers,” in an environment where dealers are unable to supply it.
In case you haven’t noticed, markets are increasingly susceptible to the self-referential, flows-volatility-liquidity feedback loop (colloquially: the “doom loop”) and other manifestations of VaR shocks. Long periods of apparent calm hide an underlying fragility in true “stability breeds instability” fashion.
Deutsche Bank’s Aleksandar Kocic touched on this years ago. To wit, from a 2017 note:
Excessive determinism is almost always the biggest enemy of stability. This seeming contradiction is behind the concept of metastability which captures the mode of market functioning in the last years. Metastability is what seems stable, but is not — a stable waiting for something to happen. [An] avalanche is a good example of metastability to keep in mind — a totally innocuous event can trigger a cataclysmic event (e.g., a skier’s scream, or simply continued snowfall until the snow cover is so massive that its own weight triggers an avalanche).
The frequency of “avalanches” in equities limits vol supply. “Dealers simply cannot be short crash and/or tails in any sort of size, across any look-back period from a regulatory stress test/risk management perspective,” McElligott wrote Monday, on the way to delivering the following more granular color:
This steepness / carry in the VIX futs curve (until last week) had recently seen vol and systematic investors pile into roll-down trades, as evidenced by CFTC data into start of last wk showed Non-Comm VIX futs Vega the most “net short” in a year, as 12th%ile since 2011…while conversely, the stickiness of long-dated VIX showed up in the VIX ETN Vega at 1 year highs and 81st %ile, with retail getting LONG VOL, with the ETNs adding like $5mm-10mm of Vega each day…just bidding up fwd vol—but got hard stopped-out last week, as evidenced by the crazy move in VIX +64% lo-to-hi last week, vs the “just” -1.5SD move in SPX.
The interesting bit — from a macro/portfolio management perspective — comes when he ties this into expectations for higher bond yields and the prospect of bear-steepening in the curve predicated on, of course, the reflation narrative in all its various manifestations, whether you want to cite Democratic control of government, fiscal-monetary coordination, vaccine rollout, or all of the above.
I’ve talked at length in these pages over the past year about the prospect that bonds may no longer serve as an effective hedge for equities. This is not a new argument. Although it’s obviously true that policy rates are not a lower-bound for bond yields (10-year bunds, for example, are still some 30bps rich to where they “should” trade thanks to the ECB’s influence), there’s a very real sense in which buying government bonds is just tantamount to speculation these days. As Paul Singer put it last month, “When you buy something with no yield, where you can only make money if the yield goes from zero to [negative five or negative 10 basis points], you’re engaged in speculation, you’re not engaged in investing.”
Throw in the distinct possibility that bonds are vulnerable to “tantrum” events, and you’re left to ponder whether 60/40 (or, more to the point, the reliably negative stock-bond correlation that underpins it), is still viable. I personally think it is, but that’s another story.
The connection to the points made above is straightforward.
“Many who previously relied on the ‘bonds as your hedge/min vol asset’ correlation off the 35-year bond bull market backtest in that generic risk parity/balanced 60/40 fund way, are reconsidering their core assumptions on USTs/Equities correlation,” McElligott said.
That, “reconsideration” is feeding into the dynamic described here at the outset. “The narrative concern about the potential for regime change within [US Treasurys] on account of the ‘reflation renormalization + fiscal stimulus + blue wave, government deficit spending and issuance’ new world order, sees implied vol [as] the ‘trending’ hedge of choice,” Charlie went on to write.
Indeed, it’s possible that bonds become a source of risk and volatility rather than a stabilizer. Although certainly not anyone’s “base case,” it’s at least possible that some kind of vicious, vengeful bear steepener comes calling at some point due to, for instance, a “rogue” inflation print or a January 2018 NFP-style upside average hourly earnings beat.
Yes, the Fed has the capacity to bring something like that quickly under control, but perhaps not quickly enough to prevent a multi-session “diversification desperation” trade, where both bonds and stocks sell off simultaneously.
“Because bonds may no longer work as your idiosyncratic ‘accident’ hedge,” you have to find something else, McElligott remarked. Hence the implied vol connection.
“All of these dynamics show their face with [the] entire VIX futures strip ref 30+ out through July/Aug, while 50-day realized vol sits down scraping [the] bottom [of the] barrel at 12-13,” Charlie wrote.