Volatility Shocks & The Cheapest Hedge
Low volatility is being driven, in BofAML's view, by both fundamental and technical factors. Fundamentally, the volatility of real economic activity and inflation has fallen to near 20 year lows in what some are calling the Great Moderation 2.0. However, the recent further collapse in volatility is also explained by a feedback loop fueled by low conviction, low liquidity, low yields and low fear. Central bank policy has been the largest explanatory factor of both the fundamentals and technicals... and that has BofAML concerned about the risks of short-term volatility spikes exacerbated by market illiquidity.
Volatility across asset classes, including credit, rates, FX, commodity and equity has collectively hit its lowest level in recorded history, not only in terms of the volatility being realized by markets but also the volatility implied by options.
This is impressive given the fact that prior to this, the 2003-2007 period represented the biggest bubble recorded in volatility, driven by the liquidity produced through the excesses of the credit bubble and the exponential growth in hedge fund capital and leverage.
Volatility across asset classes has also become statistically more interlinked in recent years, being driven to a greater degree by a fewer number of factors.
This is most likely the increasing influence of central bank policy operating through multiple channels on the overall price of risk.
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What are the key drivers of today’s low volatility? While the factors impacting volatility across asset classes range from highly macro to idiosyncratic issues of a given asset class, we point to four factors impacting most assets globally:
1) Low economic volatility: This is one of the most striking long-term trends in the volatility landscape.
Chart 3 illustrates that since the mid-80s, during times of economic expansion, GDP growth has been very smooth compared to any other period post WWII. While many dismissed the “Great Moderation” of stable growth and low and stable inflation during the unwinding of the credit bubble, we are seeing clear evidence of a “Great Moderation 2.0” post GFC.
Chart 4 shows the realized volatility of economic activity indicators including Nonfarm Payrolls, Industrial Production and Personal Consumption, as well as volatility of realized inflation, which has recently hit 20 year lows. In our opinion, the primary drivers of this decline in fundamental volatility are A) more proactive and transparent central bank policy, and B) the difficulty of trying to lift a highly depressed global economy out of a deflationary spiral post the Great Financial Crisis (GFC).
2) Scarcity of yield: In research published in 2005 led by Arik Reiss, we noted that volatility (in equity) tends to rise and fall with the interest rate cycle, but with an approximate 2 year lag (Chart 5).
As interest rates decline and the supply of “safe yielding” assets falls, this encourages more risk taking by investors in the form of selling volatility, either directly through options (selling insurance) or indirectly through more aggressive arbitrage activity which is inherently short volatility (as most arb activity is). While real yields began to back up in April 2013 (Chart 5), the historical time lag would suggest 2015 as a potential turning point.
3) Psychology of hedging and the central bank put: Having lived through the most volatile period since the great depression in addition to what many thought could be the unravelling of Europe’s union, held together by central bank policy (or promise thereof), investors have become accustomed to not fear risk. Geopolitical risks that in the past would have most likely roiled markets today cause them to hardly flinch.
As one measure of this, Chart 6 illustrates that demand for S&P puts (among the most popular macro hedges) has fallen since early 2012 despite the intensity of negative newsflow remaining near long-term highs. The power of central bank policy on the pricing of risk is also evident in Europe, the region most recently bombarded with central bank liquidity, now has the most depressed risk of any region. While this does not seem to reflect true differentiation in regional risk, few have wanted to stand in front of the ECB liquidity train.
4) Falling market volumes/lack of activity: The linkages between market trading activity and volatility are strongly intertwined. Shrinking bank balance sheets due to regulation as well as a lack of risk appetite post-08 has helped reduce liquidity in many balance sheet intensive OTC markets.
As Chart 8 shows, US equity market volumes have also moved in-line with volatility in part due to longer-term trends including greater usage of index products, and high market correlations within equities. The tough trading environment in 2014 for many investors has also likely helped exacerbate the most recent leg down in volatility as lower conviction leads to low volume and lower volatility.
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The bottom line is that central bank policy, through both the fundamental economic volatility it drives, its control of the supply of “safe yielding assets” and the impact it has on the “psychology of hedging” is the single most important factor driving volatility across asset classes. Hence the outlook for central bank tightening and likewise inflation trends is key.
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Exogenous shocks and seasonal risks
It has primarily been this summer that volatility has taken a further leg lower to breach historical lows, owing to a feedback loop of low market conviction and falling volumes on top of the low volatility backdrop.
In addition, seasonally volatility is lowest in the summer and highest in the autumn (Chart 15), so simply based on historical trends, the likelihood of a shortterm rise in volatility as investors return from summer holidays and feel compelled to trade is present.
In addition, Michael Harnett, our Chief Investment Strategist recently noted three catalysts that he believes could cause a temporal shock to volatility in the next six months:
1) A macro event that causes a “rate shock” for example from a blowout US payrolls figure; he thinks a dollar rally could provide early warning
2) A financial event that causes a “credit shock”, in turn causing deleveraging and forced selling from a tightly wound credit market; which he believes is the most likely risk
3) A geopolitical event that causes a “growth shock” raising fears of a recession; the more unlikely risk unless it involves China and/or a Middle East conflict that causes a spike in oil prices
Hans Mikkelsen, head of US high grade credit strategy, also concurs that given how crowded the high grade credit trade has become on the back of record inflows, in particular through products like ETFs (which can demand liquidity) high grade credit volatility could increase upon the first signs of rate hikes or in anticipation of higher rates. With dealer balance sheets constrained due to capital regulations, “risk-off” periods could be met with an increase in volatility as the banks are less willing to act as a market buffer during a period of outflows.
Our high yield and credit derivative strategists, Michael Contopoulos and Rachna Ramachandran, believe that in high yield credit, though volatility is likely to increase upon a move higher in rates, fundamentals matter significantly more than in high grade. To see a meaningful sustained increase in high yield volatility, they believe a deterioration of balance sheets would need to exist, causing the default rate to rise and for the “reach for yield” trade to unwind.
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Cheapest ways to hedge...
To find the cheapest options-based tail risk hedges across asset classes, our cross asset tail risk hedging screen below compares current put option costs to the magnitude of historical tail events.
Hedges with the best potential value today are ones that are cheap to enter relative to the expected payoff in a tail event, assuming historical tail events characterize the potential magnitude of future sell-offs. Readings further to the right of the chart below represent assets that are most underpricing historical tail events currently.
Ranked by average benefit-to-cost ratio, Chart 21 shows that puts on TWSE (Taiwan equities), EURUSD and Crude Oil offer most value across asset classes:
TWSE puts screen most attractive overall as volatility on Taiwan equities is still in historically low territory despite a recent uptick
EURUSD puts at current pricing offer best value on average within FX and the second best across asset classes
Crude Oil puts offer the third best value overall as WTI Crude Oil was one of the few assets in our screen for which volatility dropped over the month of July
Finally, BofAML's equity derivatives strategists Benjamin Bowler and Nitin Saksena note that the average volatility of US large cap stocks has been trading near its lowest levels on record, unlike S&P 500 index volatility, which remains supported vs. 2005-07 lows. Hence they favor trades that buy record low US single stock volatility, funded by selling a conservative amount of index volatility to mitigate carry.
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