Volatility Observations: Can Rates Swing Without Pain
by Nic Lenoir of ICAP
Volatility Observations: Can Rates Swing Without Pain
For technical reasons already discussed, I am generally bearish on US Fixed Income for the near/medium term. What bothers me with the way we have traded is that since December we are essentially stuck in a range which is much more reminiscent of a bear flag than a bottom in the long end. Also, while implied volatility has come in a lot since the local lows of 12/15, realized volatility is actually very high in Fixed Income. As a matter of fact the spread between Fixed Income realized volatility and Equities realized volatility is at historical levels. Lastly, while in this ZIRP environment sell-offs have been associated with steepening of the curve, given the reflation arguments in vogue and all the hype about inflation, it would make sense to see this sell-of capped by some proper pressure in the short-end or at least the belly of the curve. We caught the bounce from 103 in 10s30s up to 120 but here I suspect pressure on the curve in the long end is about to return. To better illustrate these last 2 arguments, we were able to buy for our clients some 99.00 puts expiry February on EDH2 for only 5bps on Wednesday. Knowing that hardly 2 weeks ago the contract was trading at 98.85, it seems that implied volatility was quite shy of reflecting what is realized in the market. This is indicative of a quite high level of complacency despite high realized volatility. I have added charts for the 10Y US Treasury future. Targets indicate targets of 117-14 to the downside at the minimum. The support of the recent range is 119-20, this will be the acceleration level confirming the next leg lower is on its way. For the Bund I had already specified I was looking for a move towards 121.45 at least.
Another interesting development, very much relevant to my view for Fixed Income, is the blow out of the USA CDS to new highs. Charts of 5Y and 10Y CDS show that both have broken out of their range since the Fall of 2010, and in the case of the 10Y we actually blew past the tops of the Greek crisis. Even if the CPI does not reflect the real inflation felt by the consumer, we are going to get negative rates in the short-end just adjusting for default risk. With 2Y Treasury yieds around 62.5bps and the 2Y CDS trading around 35bps as of last night's close, owning the front of the US curve is not a very juicy proposition. As the widening of the CDS and hence the cost of insurance increases for US treasuries, yields should keep a bid.
One of the consequences is that equities should see a jump in volatility (unless Fixed Income realized volatility gets decimated, but the reasons mentioned above it is not my prefered scenario for now). We encouraged profit taking on VIX bearish structures Tuesday morning and I feel fortunate we did as volatility jumped quickly (I had anticipated a lower open on Tuesday, outside the lower bollinger band, setting up a key reversal, but we opened with a bid). Funny enough we posted the opposite signal yesterday: a bearish reversal for VIX after trading above the upper Bollinger band. Truth is volatility has been so low that the band for the VIX are at their narrowest since March 2010... Unless we manage to re-establish a trading regime like that of the "great moderation" (moderation in almost everything except real estate speculation and credit issuance), as we retest the lower end of the range around 15.50 one should be looking at buying protection. Looking at wave counts for both the S&B and the Nasdaq, I see two alternate scenarios: Either we had a bullish impulse from March 2009 to April 2010, followed by a consolidation and a bullish impulse of lower order which we are completing now, OR the rally since July 2010 is the last wave of the bullish impulse started in March 2009, in which case the upcoming correction will be of significant magnitude. The point is, either if you are extremely bullish one should expect a correction here of 100 points in th S&P at the minimum (that would be only 38.2% since July which is historically low if we just completed the first impulse of a bullish move of larger order). I expect us to retest the highs or slightly bypass them, flirting with the top of the ascending wedge before reversing sharply. This would make sense since topping processes always play out slower than people expect. One thing is for sure Fixed Income realized volatility cannot remain that elevated for an extended period of time without equities to be be affected: something has to give. I spent a decent amount of time talking about the markets with my friend Xavier Riera, who is in my opinion a brilliant capital structure arbitrageur, and analyzing the relationship between the price of debt, the probability of default, and volatility in the equity markets clearly reinforces my belief in the observations made above. Knowing that I will be on my honeymoon early in February, it would only be fitting that markets reprice then!
I will conclude by adding the 10s30s chart for Greece. A lot of people are wondering when we know it is too late to fix the deficit, what is the point of no return, and what to look for in the markets to signal that the game is over. Well in my opinion, this is exactly what the "oops" moment looks like: when people go from talking about the steep curve being an indicator of good things to come, and then all of a sudden we trade from +100bps down to -500bps as the Fixed Income curve morphs into a distressed high yield curve. It happens just as fast as a president can get kicked out of power like we saw in Tunisia. The general population has embraced the fear of inflation, the talk about austerity and need to fix the deficit, but none of the Republican politicians bringing it up of close to none really believes that it could be too late and we are done. Just think about how quickly the Soviet Union collapsed... those things happen very quickly, and can happen to everyone, not just tiny countries most people can't even place on a map. Does this mean it happens tomorrow? Probably not, but that is precisely the point: it can and most likely will happen quickly enough that almost everybody is caught pants down.
Good luck trading and have a great weekend,
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