From Citi's Steven Englander
Black Swan Fatigue and Under-Provisioning for Fat Tails
Tomorrow is the second anniversary of the S&P having begun its rebound from its cycle low (see the figure below)
We also see historical (and in some cases implied) volatility in many currency pairs at post-crisis lows (see chart below). We plot 1-month realized AUDJPY vol below because it is typically a metaphor for high volatility, but even this cross appears tame. A similar pattern is reflected in many G10 currency crosses.
Where do the Black Swans comes in? For much of this two year period of S&P recovery, the clever thinking among investors has been to fade the rebound. This is as much true of FX investors as in other classes. Generically, the arguments have been that the forces driving the recovery are fragile, that many fundamental issues in global financial markets are unresolved, and that policymakers have deferred rather than resolved problems.
It's hard to argue with this line of analysis except that it has been dead wrong in market terms. Our conjecture is that investors are tired of being told to hedge against risks that have not emerged, and where the positions end up as costly in terms of premium paid out. (And it is an obvious truth that the kids outside playing in the snow without sweaters and scarves seemed to have much more fun than those of us who were bundled up.) Indeed the downward trend in vol may reflect that too much optionality was bought to hedge risks that didn't happen and now it is being disgorged back into the market.
In recent weeks we have been arguing that tail risk remains and is unusually realistic given the potential sources of shocks. We have also found that in many cases clients are reluctant to buy into these fat tail scenarios (actually 'reject' may more accurate than ' are reluctant' ). The argument is basically that they have heard it many times before in the last two years and asset markets have continued to flourish.
We would argue that the correct approach is to ask whether the macro risks looking ahead are those that can be dealt with using the policy tools at hand. If not, the tail risk scenarios are more concrete. Conversely if the asset market bounce and rebound in high-beta currencies over the last two years can be explained largely as the result of massive liquidity injections globally and significant fiscal policy ease, the question looking ahead is whether these policy tools will be equally effective in dealing with the future shocks.
Consider the obvious potential risks: an oil shock, commodity prices and advancing headline inflation in the context of growing concerns about social and political disruption. We would make the case that the risk is high that if any of these shocks were to move to centre stage, it would be harder for policy makers to deal with them because printing and spending money is not quite the solution to these problems that it was to the financial shock of late 2008 and early 2009.
… which brings us back to Black Swan fatigue. When we see currency vols so cheap in a world that appears to be so risky and in which policymakers do not hold a terribly strong hand, it makes a strong case for hedging tail risk, even if FX price action is apparently indicating otherwise.