Every quarter, as part of the Treasury's refunding announcement, the TBAC, aka the Treasury Borrowing Advisory Committee (aka the Supercommittee that Really Runs America [14]), which is the committee that until recently was chaired by JPM and Goldman and which in 2014 handed over mock leadership roles to Dodge & Cox and BNY [15], shares some critical insight into what Wall Street's banks are really thinking in a private head to head with the US Treasury. As a reminder, it was this same TBAC which, several months after we warned about plunging asset liquidity [16], issued a warning about just this issue [17], something which even the Fed, whose QE is the primary culprit for the disappearance of high quality collateral, is now actively worried about.
So what did the TBAC hint at as one of the biggest concerns currently on the Treasury's mind? As it turns out, the primary charge (the secondary was even more interesting and we will discuss it in a post shortly) of the TBAC was to come up with its views on plunging, and until recently, record low market volatility, or as it also defines it: "Market Complacency And Excessive Risk Taking." To wit:
Asset price volatility has declined over the past two years both in the United States and globally. At the same time, forward-looking measures of market uncertainty across a range of fixed income, equity, and foreign exchange markets have also declined.
What are the Committee’s views on these developments and the factors that have contributed to the current environment of low volatility globally?
Remember, that it is not just the Treasury that is worried about plunging Vol. Ironically, so is the Fed (why it's ironic? read on).
Here is what the TBAC had to say on the topic of plunging volatility, market complacency and where we go from here (link [18]):
Current State of Volatility
Monthly count of Bloomberg articles that contain the phrase “low volatility”.
Credit Suisse Interest Rate Volatility Estimate: yield curve weighted index of normalized implied volatility on a rolling series of constant at-the-money one-month expiry swaptions weighted across benchmark maturities 2yr, 5yr, 10yr and 30yr.
[19]
And for the irony: the bankers find, as we do, know that primary culprit for record low volatility is none other than the Fed itself with its vol-suppression policies (and Kevin Henry selling Vol futures). To wit:
Factors contributing to low volatility
- Actions by the Fed and ECB have significantly clipped the left tail risk, in terms of both economic outcomes and market outcomes (QE I)
- As interest rates approached the zero lower bound, rate vol is lower by construction which leads to maturity extensions, lower term premia and declining volatility across other asset classes through a lower and more certain discount rate (QE II)
* * *
But that's not all: here is what the all too clear punchline: "Suppression of yield and vol induces investors to take on more risk (QE III). The market clings to perception of certainty regarding outcomes, despite the Fed shifting commitment modes from time or level-based to data dependent. This stage of policy should eventually lead to increased uncertainty and risk."
[20]
Translation: the TBAC itself, whose summary assessment this is, is now actively derisiking!
* * *
For the VIX addicts and all those curious for more, here are some other key observations that substantiate the TBAC's view that now is the time to head for the exits.
Supply / demand factors in the options markets
Tail hedgers have decreased as evidenced by
- Falling prices of downside puts on the S&P
- Shrinking fund size of VIX ETF
[21]
Convexity hedging by mortgage accounts has gone down significantly after the crisis because of lower issuance and the Fed’s QE purchases. QE mortgage purchases remove both duration and convexity from the market, making it one of the most powerful policy tools.
[22]
QE mortgage purchases remove both duration and convexity from the market, making it one of the most powerful policy tools.
[23]
Market complacency and excessive risk taking
Interest rate volatility can be viewed as a proxy for the corporate bond market and the interest rate at which people and companies borrow money.
Shown below is 1y10y interest rate vol with 5yr spreads of the credit default index of investment grade on the left and high yield on the left
[24]
Note the lack of 10% corrections during the past hiking cycles in 2004 and 1994
[25]
Against environment of low vol and low returns, the only way to achieve the same return targets is to take on more risk
- Ballooning AUM invested in hedge funds, now $2.7 trillion
- VAR-based risk management frameworks and risk-parity investment models in which volatility is an input that determines the amount of risk to take
[26]
Mostly unchanged target for investment returns from the pension community. Latest data from November 2013 shows the median target shifted to just under 8% in 2012, despite the yield on Moody’s AA index having fallen to 4.2%.
[27]
Equity vol term structure has held up against complacency in the market place
[28]
FX vol term structure is also near the steepest level in the last 5 years.
[29]
Rate vol term structure is off the highs despite the Fed being closer to tightening than at any other point in the last 5 years
Equity volatility term structures
[30]
Interest rate volatility term structures
[31]
Conclusions
- Monetary policy and regulatory changes have contributed to the decline in volatility.
- Less demand for volatility across asset classes naturally lowers the price for such insurance.
- VAR-based analysis leads to self-reinforcing loops as low volatility causes models to recommend scaling up risk.
- The term structure of volatility is a powerful indicator; flatter vol curves would suggest excessive complacency and presage increasing risk.
- Volatility tends to rise mid-to-late stage of the business cycle as expansive endeavors increase through the system.
- An unexpected increase in volatility might come from broad-based selling of assets wanting to de-risk in front of a turn in policy.
- With liquidity providers having declined in number and capacity, the system is less able to deal with such episodes of higher volatility. Institutions which deliver absolute returns or provide liquidity to the system would be most at risk.
* * *
It couldn't be said any clearer.
