Bonds haven’t been the best hedge for your equities over the past two years. Maybe you noticed.
Not only have bonds failed to diversify, they’ve actually been a source of portfolio volatility — indeed, they’ve been the sponsor of various market “events,” including the near implosion of the UK LDI complex and a handful of US bank failures. Suffice to say the correlation an entire generation of investors was brought up to regard as sacrosanct was in fact the product of recency bias.
As noted here on Tuesday, the world’s largest Treasury ETF, which is mired in a 50% drawdown, is now more volatile than the S&P after recent fireworks.
So, how are folks hedging the myriad risks around both the economy and the fraught geopolitical environment? Or, “Where has the market been hedging ‘tail-y’ war escalation scenarios in light of duration’s current inability to hedge for structural reasons?” as Nomura’s Charlie McElligott phrased the question on Wednesday.
Three places, according to Charlie. The market is hedging in three places.
First, there’s VIX upside. “After some relaxation off the back of VIX upside call monetization from clients, we’ve seen another escalation in VIX upside demand in recent days around the Middle East tinderbox, which along with dealer legacy short strikes, risks creating more short gamma accelerant flows on an upside move,” he wrote.
The VIX is the preferred hedge because it’s non-linear, Charlie said. It’s a convex instrument which is going to offer greater protection in a tail event.”
The other two hedges: Crude and gold, of course.
Charlie said you have to trade crude upside “tactically and locally with a calendar twist.” “The assumption from speaking to clients is that you sell this week’s upside to fund purchases of next week calls [on] the view that Israel can’t move on the Gaza attack until Biden is out of the country.” That’s a good point, and it’s worth mentioning even if you don’t intend to tactically trade crude options.
As for gold, it’s “the classic hard asset risk-off beneficiary,” McElligott said. The shiny yellow stuff is up 7% in two weeks. “Legacy systematic gamma sellers in the space have gotten absolutely roasted the past month, as 20-day rVol exploded from 6.3 to 17.6 and 10-day rVol mov[ed] from 7.3 to 20.0!” Charlie exclaimed.
