Over the weekend, Bank of America's volatility experts Jason Galazidis and his team, pointed out that while US equity vol remains at historic low levels, it is not just equities where market participants are remarkably complacent, and write that both US credit & Chinese equity hedges "are pricing a world almost free of risk."
To Galazidis this is perplexing as "there appear to be abundant potential sources of global market uncertainty: a CB policy miscalculation, the propensity for political surprises, unanticipated consequences of the first US rate hike cycle in over a decade and the feasibility of Trump’s economic growth agenda, to name a few."
And as Goldman pointed out recently when it demonstrated that the cost of liquid long-dated hedges in equity and credit has collectively reached its lowest level in six years...
... BofA agrees that risky assets for the most part remain euphoric, exhibiting what the bank's Michael Hartnett has famously termed an "Icarus" moment before "hubristic positioning, complacent profit expectations, and hawkish policy signal a reflection point."
Notably, Galazidis adds, cross-asset vols (baring a few isolated assets such GBP and JPY) have declined to very low levels (Table 1 and Table 2) making select hedges relatively cheap to own.
How to capitalize on this? Simple: buy those puts which are pricing in a world of "absolute perfection" and no uncertainty as far as the eye can see. BofA has the following suggestions on how to identify value in puts across asset classes
Chart 1 shows crash returns of different assets during historical tail events per unit of current OTM option implied volatility. We measure tail events by the 10 largest 3M drops since Jan-06. Ranked by the average, the screen shows that the hedges which are most underpricing historical drawdowns are: US (IG & HY) Credit payers, GLD (Gold ETF) calls and HSCEI (Chinese equity) puts:
- US (IG & HY) Credit payers – which we are reintroducing to our universe of assets - screen as the best value hedges across asset classes owing to historically low credit volatility (Chart 2). European credit and HYG (US HY Credit ETF) puts also screen high, ranking immediately after Asian equity puts.
- GLD calls are the 3rd top ranking hedge as current options costs are discounting the historical propensity for Gold to rally strongly during risk-off episodes.
- HSCEI puts continue to screen as best value within equities. In contrast, ESTX50 puts are near the bottom of our screen (most expensive) as 3M option prices now embed French election risk premium (voting takes place on 23-Apr and 7-May).
And, as a reference, the following table shows the largest drops within 3M in each asset class between ‘06 and ‘16, ranked in the same order as the assets in Chart 1. For those who believe that the period of low volatility is ending, this is the best reference to find the derivatives that are "coiled" the most.
Who knows: maybe this time those willing to fight the central banks, and betting on a rebound on volatility, will finally be right.