Last September, JPM's Quant guru Marko Kolanovic forecasted a short-term increase of market volatility and equity outflows at a time when volatility was "unsustainably low", and pointed to catalysts that would trigger de-risking by systematic investors. In a just released note, he warns that "a similar set-up is developing now, this time driven by extremely low levels of market correlations."
First question: what has driven the recent collapse in vol?
The JPM quant answers that one of the main drivers of the recent collapse of volatility (and hence high leverage of systematic and fundamental investors) is the record decline in market correlations. Not just that the sector, stock, and country correlations are at all-time lows, but the recent change (drop) is the largest on record.
Next question: what has led to this decline in correlation, and a follow up: is this a sign of more calm, fundamentally driven markets ahead or just a temporary dislocation?
Kolanovic responds that the collapse of correlations is temporary, and was driven by violent re-pricing of market segments in relationship to recent macro developments. These were primarily sector and style rotations at the back of Trump’s election and the prospect of higher rates (e.g. think of Banks vs. Utilities).
In addition, strong seasonal effects temporarily pushed correlations lower. In a turn of the year effect, investors rotated from e.g. large to small, momentum to value, etc. which pushes correlation lower. The impact of the US earnings season in late January / early February is also highly significant. Indeed, correlations tend to reach their lowest point during the Q1 earnings season, which is typically followed by a sharp increase into March quarterly options and futures expiry. Quarterly expiry cycles (March, June, Sep, Dec) are dominated by index trading activity and sparse flow of stock specific news. Figure 4 shows the seasonality of correlations, as well the trend towards more pronounced seasonality, likely driven by the increase in passive assets. We believe correlation will start rising going into March.
And with rising correlations, the market will once again see rising volatility. How much more? Kolanovic again:
Given that the average volatility of individual stocks and sectors has been remarkably stable (at ~20%, and 13% respectively), an increase of correlations would drive market volatility higher. Correlations will likely increase from these levels, which will likely push short term S&P 500 realized volatility up to ~4% higher (i.e. from 6% to 10%, assuming single stock volatility stays constant at ~20% and correlations increase from ~15% to 35%).
This type of volatility increase would cause a meaningful de-leveraging of strategies such as volatility targeting and risk parity. For instance one could see ~$40-50bn equity outflows from volatility targeting strategies, ~$20-30bn from risk parity strategies, and additional outflows from other strategies on account of increased levels of market risk. While this on its own may not cause a market correction, it represents a significant risk that is building up.
Another topic Kolanovic touches on, appropriately in the wake of the Catalyst fund implosion, is gamma exposure, which as we first reported yesterday was the main reason for the market's relentless ramp over the past few days as the Catalyst fund was caught short the S&P in gamma, forcing it to chase the S&P higher to cover. More from Kolanovic: "If the overhang of market makers’ long gamma positions wears off, this his could add an additional ~2% volatility points (for this to materialize investors would need to add / roll protection higher, or the market would need to slide lower by 1-2%)."
Here is the quant's take on the Catalyst blow up, and why such events could lead to "potential accidents" in the market:
Indeed, many investors watched the past few days how the S&P 500 was squeezed higher, and there was frenzied buying of upside call options. This was not as much a bullish sign, but in part caused by closing of large option positions that were supplying upside S&P 500 volatility and gamma. As was the case with other systematic strategies (volatility targeting, CTAs, etc.), low market volatility forced investors to increase leverage in short volatility systematic strategies as well (which results in either selling more options, or selling riskier, closer to the money options, leading to potential accidents).
One final risk mention by Kolanovic, and one that is a function of Trump's policies, is the potential for an unwind of short bond positions.
In the aftermath of Trump’s election, trend-followers (e.g. CTAs) reversed bond positions from a record long to record short. Figure 5 shows that speculative bond futures positions are currently near all-time lows. Figure 6 shows the exposure (beta) of CTA funds to 10Y bonds, and the net speculative bond futures positions over the past year. As we pointed out shortly after the US elections, we think that market participants embraced an oversimplified fundamental narrative on Trump’s impact on financial markets. In particular we think that a stronger dollar and significantly higher rates were in part driven by carry and momentum trades, rather than just a change in fundamental outlook. The fundamental narrative has been unraveling recently and may further come under pressure if bond shorts and USD longs continue to get unwound. Investors may again interpret some of these systematic flows as a fundamental signal (this time bearish, i.e. risk-off). This could in turn negatively impact e.g. financial stocks, or lead to broader equity weakness.