Price swings in financial markets have become increasingly muted as investors mull the outlook for monetary policy in the world’s biggest economies, but with a little turbulence starting to creep into markets, this record-breaking collapse in risk perceptions (and record levels of leveraged speculation) is a recipe for disaster.
As Bloomberg details, The Bank of America Merrill Lynch GFSI Market Risk Index, a measure of future price swings implied by options trading on global equities, interest rates, currencies and commodities, fell this week to its lowest level since Dec 2015...
Different asset classes are influencing one another by the most since at least 2008, according to a Credit Suisse Group AG gauge known as the cross-market contagion indicator that tracks price relationships in equities, credit, currencies and commodities.
“With the Federal Reserve and Bank of Japan meetings ahead of us, investors can’t make any out-sized moves before the major events are over,” said Takashi Hiroki, chief strategist at Monex Securities in Tokyo. “We have a lack of reasons to move, and have been seeing a directionless market for some time.”
The torpor in stock markets is going global. A gauge of volatility in global equities has dropped to levels last seen two years ago..
China is the most prominent example of risk collapse. As Bloomberg notes, the Shanghai Composite Index has swung less than 1% on a daily closing basis for 17 days in a row, first time since 2001.
Turnover is down 76% from last year’s peak, and a measure of volatility has dwindled to a two-year low
“It’s becoming difficult for us to play in the market now,” said Wang Zheng, Shanghai-based chief investment officer at Jingxi Investment Management.
“The ‘national team’ is very deeply involved, and its main purpose is to prevent the market from moving up or down too extremely. Sometimes when the market looks set to break out and you buy shares to wait for them to rise, the good momentum would suddenly stop.”
And realized vol has plunged...
But US equity markets have not been this 'quiet' since 1994...
It's not just stocks. Yields on Treasuries due in a decade have largely been stuck in a range between 1.5 percent and 1.6 percent since the start of August. The Bank of America Merrill Lynch MOVE Index, which measures price swings in U.S. debt, is close to the lowest level since December 2014, reached Aug. 10.
And JPMorgan's Global FX volatility index has collapsed...
And as all this exuberant complacency happens, hedge funds have never been more bullish in Dow, Nasdaq, and VIX futures...
But as we noted previously JPMorgan's Quant head Marko Kolanovic has some concerning thoughts on the endgame from the collapse in global risk:
As market volatility plummeted, investors added to option protection and moved (struck) it closer to current price level. The market would need to move only 1-2% lower for option hedging to push volatility higher (as opposed to suppressing it, which was the case past 2 months). Given the low levels of volatility, leverage in systematic strategies such as Volatility Targeting and Risk Parity is now near all-time highs. The same is true for CTA funds who run near-record levels of equity exposure. Our estimate of equity exposure for these strategies is shown in Figure 1.
Record leverage in these strategies and option hedging could push the market lower and volatility higher, if there is an initial catalyst to increase volatility. In fact, we may not even need a specific catalyst, apart from the seasonal increase in market volatility which is typical for September and October. Figure 2 above shows that equity volatility tends to increase by ~20-30% in September and October (September also tends to be the worst performing month, with an average -1% return). This seasonality is also present after removing prominent outliers (e.g. 2001, 2008, 2011, and 2015). When it comes to deleveraging of systematic strategies, even this seasonal increase in realized volatility would produce outflows of ~$100bn, which could push the market lower.
It seems that equity long-short investors are already anticipating a potential weak September, as their equity exposure (equity beta) declined over the past month. The low exposure of long-short hedge funds, and the fact that equity momentum would only turn fully negative below ~2000 on the S&P 500, are the only two positives we see for the market going into September.
It's not just the threat of a quant-deleveraging, noted recently by Bank of America, that keeps Kolanovic on his toes. He says that "a more troubling development would be if data from central banks (ECB, BOJ and Fed) signal monetary policy tightening" noting that "this could result in a significant selloff across asset classes."
We believe that CBs will stay accommodative (e.g. no September Fed hike, accommodative ECB/BOJ) and hence this negative scenario will likely not materialize. To look for indications of such negative developments, many investors started monitoring cross-asset correlations. These correlations recently increased to near-record levels (Figure 3, and for a primer please see our report Rise of Cross-Asset Correlations). We want to make few observations about cross-asset correlations that perhaps make this recent rise less alarming. First, most cross-asset correlation measures incorporate bond-equity correlation with a negative sign (equivalently, rate-equity correlation has a positive sign, i.e. correlation spikes in risk-off events when bonds and equities move in opposite direction). A potential tail event driven by central banks would happen if bonds and equities drop together. Also, cross-asset correlation measures are backward looking – the current near-record level of cross-asset correlation can in part be explained by a sharp move of risk assets (and bond rally) during Brexit. Indeed, over the past few weeks, cross-asset correlations have started declining.
The risk of risk-parity deleveraging as a result of a spike in cross-asset corrlations was discussed one month ago by BofA, in an article we wrote explaining "What Would Prompt Another "Risk-Parity" Blow Up" with Kolanovic piggybacking on this theme. But there's more:
More concerning than the level of cross-asset correlations, is how quickly they have been changing over recent past months. This large instability of correlations makes it harder to forecast and hedge risk for a multi-asset portfolio and strategies such as risk parity. For example, rate-equity correlation spiked on Brexit to +90%, and then dropped below 0 (with resurfacing fears of CB normalization). High levels of rate equity correlation help strategies like risk parity and volatility targeting, and negative correlation is harmful. Similarly, correlation of FX to equities (e.g. EUR/USD vs. S&P 500) spiked to +75% on Brexit and then quickly dropped to -60%. Average stock correlation spiked to +70% on Brexit and then declined to only 10% in August. These record swings in the levels of cross-asset correlation point to a high level of macro uncertainty which makes asset allocation difficult.
So, buckle up and watch the yield curves steepening...
As Risk-Parity funds run of gains has not ended well in the past few years - staircase up, elevator down...