Volatility

Daily news.

In 20 minutes we will get the only market moving piece of news, which many hope will bring back volatility to the market. Or it might not. As Goldman says, 'nonfarm payroll growth should slow on seasonal and weather-related factors'

It seems like last Friday we were waiting for details of the latest Greek plan – PSI and Troika.  We are still waiting.  Details are starting to come out.  We should know what the bonds investors are expected to exchange into will look like.  The ECB sounds like it may use the interest they have earned on SMP to reduce the amount Greece has to pay back.  The Jobs data gives us an additional twist to today’s Euro watching.  How many of the courier jobs will disappear?  My guess is the data will be okay, but nothing special, just like the rest of the data.  The courier jobs are interesting, not just from what happens this month, but will they come back next year?  Amazon has been beaten up over the Kindle, but one of the benefits of the Kindle is that Amazon doesn’t have to deliver e-books.  I think we will all forget that by next December when everyone’s payroll estimate will include a bump for couriers, but maybe we won’t.

Just when it seemed that nothing could possibly surprise about adverse Greek bank exposure, as these are beyond insolvent already relying on the ECB for day to day operations as is, here comes one more development, this time courtesy of the one index that has been in literal freefall in the past two months, and recently hit a 20+ year low - the Baltic Dry. OpenEurope explains: "An interesting but niche issue has come to our attention recently in relation to the on-going troubles in Greece. The 'Baltic Dry Index' (a measure of global shipping demand/prices) has fallen for a month straight to record lows. When this index falls it suggests that there is trouble in the shipping industry, raising questions over the stability of shipping firms. As it turns out many of these firms have secured their financing from Greek and other European banks – meaning if they start defaulting on their loans these banks could take losses. This raise further questions over the bank recapitalisation plans and whether such contingencies have been thought of in the second Greek bailout (which sets aside €20bn for Greek banks)."

Smart money selling again.

All you need to read.

There are two pillars that have supported the recent cross-asset class rally: 'improving' macro news and a reduction in concerns about European and financial risks. While this pattern is not new, as the interplay between the two has been a key focus for some time, Goldman manages to differentiate the impact of both and quantifies which assets have more sensitivity to each pillar. Unsurprisingly, European assets have been driven more by Euro area risks than non-European assets, equities (even in Europe) have been driven more by growth views, and credit spreads (including in the US) have been more responsive to Euro area risks. A number of other assets are much more closely to the market's view of growth than to the Euro are risk perceptions and global FX ranges from highly cyclical to highly Euro-sensitive while many of the major EM currencies are stuck in the middle. Overall they find that the market has more confidence in global growth (with markets pricing little more than +1.75% US growth for instance so not over-confident) but that Euro-area risk has been discounted excessively given the nature of the ECB's actions relative to the underlying problems (as we discussed this morning). Goldman provides a good starting point for consideration of which risks (and how much is priced in) across global asset classes.

VIX continues to remain low, but intraday (or intranight) volatility appears to be making a comeback.  That is volatility in the true sense of moves up and down (I'm not sure when volatility came to mean 'stocks went down'). Chinese PMI is supposedly one of the reasons that futures are up, yet, that seems to be a bad explanation, since futures went from an Amazon induced low of 1306, up to 1311 on the PMI news, but then drifted lower and were at 1304 by the time Europe got up and running.  It has been a relentless march higher since then as it went to 1320. Volumes remain low.  Street liquidity remains very low.  I don't see any reason for this trend to reverse itself, and think higher levels of intraday volatility are on the way.  Is it time to buy some options to capture this? Long or short, it looks like trading some options could make sense as some timely 'delta' rebalancing could be very effective and the implied volatility you are paying seems reasonable.

All you need to read.

• China’s factories in strong start to 2012 (FT)
• Merkel to court Chinese investors (FT)
• States to decide this week on mortgage deal (Reuters)
• Europe is stuck on life support (FT)
• IMF's Thomsen Says Greece Must Step Up Reform (Reuters)
• Tax cuts expiry to slow US growth (FT)
• Government health spending seen hitting $1.8 trillion (Reuters)
• Romney Win in Florida Primary Shows Strength (Bloomberg)
• EU regulator blocks D.Boerse-NYSE merger (Reuters)
• Greek Bondholders said to get GDP Sweetener in Debt Swap Agreement (Bloomberg)
• S. Korea Plans to Buy China Shares (Bloomberg)

The post-hoc (correlation implies causation) reasons for why the initial LTRO spurred bond buying are many-fold but as Nomura points out in a recent note (confirming our thoughts from last week) investors (especially bank stock and bondholders) should be very nervous at the size of the next LTRO. Whether it was anticipation of carry trades becoming self-reinforcing, bank liquidity shock buffering, or pre-funding private debt market needs, financials and sovereigns have rallied handsomely, squeezing new liquidity realities into a still-insolvent (and no-growth / austerity-driven) region. Concerns about the durability of the rally are already appearing as Greek PSI shocks, Portugal contagion, mark-to-market risks impacting repo and margin call event risk, increased dispersion among European (core and peripheral) curves, and the dramatic rise in ECB Deposits (or negative carry and entirely unproductive liquidity use) show all is not Utopian. However, the largest concern, specifically for bondholders of the now sacrosanct European financials, is if LTRO 2.0 sees heavy demand (EUR200-300bn expected, EUR500bn would be an approximate trigger for 'outsize' concerns) since, as we pointed out previously, this ECB-provided liquidity is effectively senior to all other unsecured claims on the banks' balance sheets and so implicitly subordinates all existing unsecured senior and subordinated debt holders dramatically (and could potentially reduce any future willingness of private investors to take up demand from capital markets issuance - another unintended consequence). We have long suggested that with the stigma gone and markets remaining mostly closed, banks will see this as their all-in moment and grab any and every ounce of LTRO they can muster (which again will implicitly reduce all the collateral that was supporting the rest of their balance sheets even more). Perhaps the hope of ECB implicit QE in the trillions is not the medicine that so many money-printing-addicts will crave and a well-placed hedge (Senior-Sub decompression or 3s5s10s butterfly on financials) or simple underweight to the equity most exposed to the capital structure (and collateral constrained) impact of LTRO will prove fruitful.

The so-called January-Effect is almost at an end and if the market closes near these levels, the S&P 500 will have managed a 4.4% gain or its 20th best January since 1928 (84 years) and best since 1997. The outperformance of banks and sovereigns (LTRO) and the worst-of-the-worst quality names (most-shorted Russell 3000 stocks +9% YTD vs Russell 3000 +5.2%), as Morgan Stanley noted recently, is not entirely surprising since the January effect is considerably larger in mid-cap and junk quality names than any other size or quality cohorts. We have pointed to the seasonal positives in high-yield credit and volatility and along with the obvious short squeeze in S&P futures (which has seen net spec shorts come back to balance recently), we, like MS, are concerned that the tailwinds of exuberance that virtuously reflect from seemingly pivotal securities (such as short-dated BTPs now or Greek Cash-CDS basis previously) very quickly revert to a sense of reality (earnings and outlook changes) and perhaps the slowing rally and rising volatility of the last few days is the start of that turbulence.

Growth. It's what every economist and politician wants. If we get 'back to growth', servicing debts both private and sovereign become much easier. And life will return to normal (for a few more years). There is growing evidence that a major US policy shift is underway to boost growth. Growth that will create millions of new jobs and raise real GDP. While that's welcome news to just about everyone, the story is much less appealing when one understands the cost at which such growth comes. Are we better off if a near-term recovery comes at the expense of our future security? The prudent among us would disagree.

Since the spike in VIX in October of last year, short-dated volatility (and correlation) has dropped significantly, but the vol term-structure has steepened, and long-dated volatility remains stubbornly high. Goldman Sachs updates their volatility debt cycle thesis today and so far we are following the typical cycle post-volatility-spike - realized vols drop, short-term implied vols drop, term structure steepens, long-term vols drop - leaving them focused on both the implications of the current low levels of short-term vol and the high-levels of long-term vol. In brief, short-term volatility reflects very closely the current macro environment (GDP growth, ISM, high-yield, and Goldman's models) but longer-dated volatility trades significantly worse. The volatility (variance swaps) market is expecting realized volatility to be very high over the next 5-10 years - the only time this has happened was during The Great Depression. Professionals remain anxiously aware that the global debt super-cycle has ended and that we face deleveraging and deflationary pressures for years to come, short-dated vol will continue to ebb and flow with each band-aid and risk flare but investors deep-down know that the 'big one' remains around the corner. Although markets are in a healthy state at the moment it would only take a relatively mild cross-wind to expose the problems again and vol markets reflect this despite what the mainstream media's view of the fear index tells us.

The Treasury complex is seeing yields (and curves) compress dramatically today. With 5Y at all-time low yields and 30Y rallying the most in three months, the divergence between stocks and bonds appears ever more glaring. 30Y (which just went positive YTD in price) has traded around the 3% yield mark for much of the last 4 months (around 120bps lower than its average in Q2 2011 - pre-US downgrade) and most notably curve movements (as the short-end becomes more and more anchored to zero) have been dramatic. 2s10s30s is now at almost four-year lows and the last four times we saw equities diverge (up) from bonds' sense of reality, it has been stocks that have awoken. Back of the envelope, 2s10s30s suggests that the S&P should trade around 1100 (as we test 1300 in cash today).