Exactly a week from today, the FOMC will meet on September 21, to decide whether or not to go from QE Lite to a full-blown QE 2 regime. And while most pundits had previously lost hope that the Fed will go full retard in its dollar destruction ways as early as next week, instead opting for the November 2 meeting if not wait for 2011 entirely, Morgan Stanley (specifically Jim Caron) came along: "We see considerable risk that the Fed may open the door to QE2 at this September 21 meeting despite the stronger-than-expected August payroll results and even if upcoming economic data stabilize. We believe that QE2 may come in the form of a vague outline for a plan to buy assets, expand its balance sheet and keep interest rates low conditioned upon economic data." Why the sudden change in opinion? "We believe that the Fed may be reluctant to act aggressively after September 21 so as not to influence the election outcome. However, if deterioration in economic conditions warranted it, then the Fed may uncharacteristically act close to the election date. Acting sooner rather than later would be consistent with Bernanke’s plan to stave off deflation risks before they arise." Right or wrong about the Fed's choice (and with Caron's recent track record, one may be tempted to choose the latter), Morgan Stanley does correctly observe that volatility will likely jump in the weeks and months ahead, even as its has been moving progressively higher lately: "Interest rates have been subject to big daily swings." Curiously, as a hedge to surging rates vol, Morgan Stanley proposes the opposite Variance Swap trade that caused a massive loss for Goldman in Q2, and was Goldman's Top trade of 2010. Let's see who blows up first: Goldman, which still expects a decline in vol, or Morgan Stanley who is on the other side. Perhaps the two firms can just trade with each other (that wouldn't be that much of a change from the current regime).
Rising Volatility in the Months Ahead – Consider the Source
Let's start with policy and economic uncertainty – the Fed may open the door to QE2 at the September 21 FOMC meeting. The September 21 FOMC meeting will be the last Fed meeting until the next meeting on November 3 after the mid-term elections on November 2. Based on Bernanke’s Jackson Hole speech, many investors thought this would be the opportune time for the Fed to introduce QE2, a proposition for the Fed to buy more assets and drive interest rates lower. That is until the stronger-than-expected release of the August payrolls caused investors to reassess their thinking and postpone their expectations for QE2 until a later date. We see considerable risk that the Fed may open the door to QE2 at this September 21 meeting despite the stronger-than-expected August payroll results and even if upcoming economic data stabilize. We believe that QE2 may come in the form of a vague outline for a plan to buy assets, expand its balance sheet and keep interest rates low conditioned upon economic data. Why the rush? We believe that the Fed may be reluctant to act aggressively after September 21 so as not to influence the election outcome. However, if deterioration in economic conditions warranted it, then the Fed may uncharacteristically act close to the election date. Acting sooner rather than later would be consistent with Bernanke’s plan to stave off deflation risks before they arise. We believe this to be a considerable risk which supports our view for higher volatility in the weeks and months ahead.
Finally, political uncertainty. The gridlock in Washington over the appropriate fiscal response and stimulus to boost the economy creates a wide range of outcomes for the path of interest rates. For example, our economics team has a bimodal and asymmetric outlook for yields (see Will 'Sunset' Darken the Outlook, September 3, 2010, Berner and Greenlaw). Specifically, if the Bush tax cuts are not extended, then it would cause a fiscal drag on growth that could shave off 3/4% of 2011 growth, according to our US economists. Under such circumstances, we could see UST 10y yields falling to 2% or lower. However, if the tax cuts are extended and there is a break in the fiscal policy logjam, as our base case suggests, then this may encourage economic stability that could push UST 10y yields well north of 3%. As a result, we expect many wide swings in interest rates as we head into the politically charged period of mid-term elections on November 2 and the December 31 sunset of the Bush tax cuts. In our view, the wide bimodal path of rates, due to political and economic uncertainty, is the reason for vol to move higher in the months ahead.
Here is how MS suggests positioning for the gradual increase in Vol.
Expressing a Long Volatility Position
Thus, we expect volatility to rise during this period and recommend that investors manage their volatility exposure while investing in carry products. We re-iterate our favored ways to own volatility is through variance swaps and forward-volatility agreements (FVAs). The risk to these trades is that vol remains low.
Variance swap: A variance swap gives investors exposure to realized volatility over the life of the swap. Investors are taking a view on current implied volatility versus future realized volatility. As Exhibit 1 illustrates, the low level of rates does not tell the whole story; the market is rife with debate that is producing a high frequency of double-digit basis point moves in 10y rates, which is contributing to the rise in volatility. In a variance swap one gets the square of the move in rates, which is beneficial when the market is frequently having big swings.
- Buy 3-month variance swap on 10y CMS struck at 131 variance points. This is equivalent to 114bp normal vol, or 7.2bp/day breakeven. Over the past month, realized vol has outperformed implied vol, and we believe that may be the case going forward, given the policy, economic and political uncertainty.
Forward-volatility agreement (FVA): An FVA gives investors exposure to the level of implied volatility at a set forward date. Investors are taking a view on future implied volatility versus what is priced in by the market. We expect realized volatility to rise over the coming months as it typically leads implied vol, which we think is at an attractive entry point. An FVA enables one to cleanly express a rise in implied volatility that is independent of the level of rates and strike.
- Our preferred expression of this trade is to buy a 3-month forward 3m10y FVA for 380bp. This means that the investor has agreed to buy an ATM 3m10y straddle in 3 months for 107bp (see Exhibit 2, LHS).
Heavy Supply and High Correlations to Interest Rates May Increase Volatility in the Rates Market
The heavy supply calendar for September may act to exacerbate movements in the interest rate markets. In addition to the $127 billion UST supply, we also have estimated investment grade corporate issuance at close to $100 billion this month with only about $25 billion maturing, which puts net issuance at ~$75 billion for IG corporates (see Exhibit 2, RHS). Issuance matters more in terms of interest rate risk because the duration of issuance has been increasingly making the heavy bond supply more sensitive to changes in the level of interest rates. This is a point we have made in the past, but the interest rate risk is exacerbated today due to the spike in issuance. For example, in August, 39% of corporate issuance had maturities greater than 10 years, the most since December 2007 based on Bloomberg data. Also, Bank of America Merrill Lynch indices show that the duration of corporate bonds reached a record high of 5.69 years. As investors reach for yield further out the yield curve, they are also upping the ante on their interest rate risk exposure. It seems that many asset classes, whether bonds or stocks, are highly correlated to the level of interest rates. This makes the volatility we expect in the interest rate markets in the next few months all the more worrisome.
Conclusion: Policy, economic and political uncertainty may cause rate volatility to rise in the months ahead. Much hinges upon the extension of the Bush tax cuts by the end of the year. Failure to extend these tax cuts might shave ¾% off of 2011 growth and alter its path (see Exhibit 3). This will have a meaningful impact on the path of interest rates as well. A failure to extend the Bush tax cuts could create fiscal drag and cause UST 10y yields to drop below 2%, while an extension of the tax cuts could push yields well north of 3%. This produces a bimodal distribution of rates that is causing interest rates to fluctuate greatly in the interim period. Managing this rise in volatility while earning carry will be the key to adding alpha. In this report we will discuss various ways to gain exposure to volatility.