In Shifting Vol Landscape, One Thing Never Changes

A persistent theme in these pages is the notion that monetary policy can never be truly “normalized.”

The best expression of that idea and how it relates to fiscal policy was probably last year’s “Yen And The Art Of Bridge Maintenance,” but I’ve written almost ceaselessly about it since.

In “The Lollipop Emoji,” I wrote that,

At every turn, serious investors are compelled to consider the price of money, the risk-free rate and liquidity when assessing valuations, the relative attractiveness of equities and market conditions. Money has been free, risk-free rates have been zero and liquidity has been (more than) abundant for so long that I doubt it’s possible to revert to a policy conjuncture that’s materially different without everything falling apart.

A companion article (“Too Far Gone“) noted that,

After more than a decade, it feels like everything now runs on the assumption of zero (or near-zero) policy rates and, at the least, the persistence of the QE “stock effect,” whereby even if the monthly “flow” of asset purchases is reduced, trillions in safe assets remain sequestered away on central bank balance sheets, creating artificial scarcity which, in turn, serves to keep yields low. The events of September of 2019 suggested that attempts to shrink those balance sheets are almost guaranteed to dead end in funding squeezes.

The “addiction” analogy is overused (to the point of being a cliché), but I think it can be taken almost literally now. It isn’t clear that markets (any of them) can function outside of a global regime characterized by rock-bottom policy rates and bloated central bank balance sheets. A testament to that is the extent to which the idea of central banks becoming active sellers of the assets they hold is generally seen as a total non-starter.

2018 was a case study in addiction liability. That year, Jerome Powell received a crash course he shouldn’t have needed. Transcripts of historical Fed meetings made it abundantly clear that Powell knew how addicted the “patient” was, but he nevertheless pushed the envelope while trying to detox markets.

The result of Powell’s efforts, recounted at some length in “Jay Powell: Unlikely ‘Victim’,” is shown in the figure (below).

Anything beyond 1% on 10-year US reals was a non-starter. And not just for equities. 2018 featured myriad instances of acute indigestion triggered by tighter Fed policy. For example, there were EM tremors over the summer and credit jitters in Q4, when stocks fell into a fleeting, mini-bear market.

In their latest equity volatility outlook, SocGen’s Vincent Cassot and Jitesh Kumar alluded to that episode, placing it in historical context. “Since the early 80s, the Fed has managed to keep policy tight for less and less time,” they wrote. “In fact, in late 2018, as per our calculations, the Fed barely managed to raise the policy rate above the neutral rate before having to ease again.”

The figure (below, from SocGen) shows just how ephemeral the 2018 trip to neutral really was — you can see the gray line poke its head above ground only to quickly retreat and then plunge as the Fed embarked on the most aggressive easing campaign in history to combat the pandemic.

Real policy rates have now fallen so far thanks to QE and inflation that the spread to neutral is the second-widest on record. “In short, US monetary policy is currently at its loosest level ever as per multiple metrics,” Cassot and Kumar remarked.

What does that mean for volatility? Well, that’s debatable, but for SocGen, monetary policy will likely be a (if not the) key determinant for broad index vol going forward. Their previous research indicates a lead of between two and three years.

The bank’s estimate for annual realized volatility in Q4 2023 is now below 10% (figure above).

In the introductory remarks to the full piece (which is some 30 pages long, complete with all manner of trade recommendations and additional color), Cassot and Kumar recapped how quickly the volatility landscape has evolved, touching on dynamics that will be familiar to many regular readers.

“The retrenchment of bank balance sheet available for volatility warehousing as well as the rise of algorithmic market makers paints a very different picture from a decade ago,” they wrote, adding that “while some market participants are looking for a lack of diversification from bonds to lead to higher demand for equity volatility” their work “suggests long vol trades will need to be timed even better than before to be profitable given the high skew/convexity cost.”

Although market microstructure is rapidly evolving (challenging market participants to keep up, and effectively antiquating attempts at regulation in real time), one thing hasn’t changed very much, according to SocGen.

“The one constant is the impact of monetary policy on average stock volatility,” Cassot and Kumar wrote. “That hasn’t changed for the past 50 years.”