Less than a month after the latest forecast from JPM's Marko Kolanovic left something to be desired, when the famous quant said "it is no longer prudent to buy the dip" only for the dip to be furiously bought, whether by algos or ETFs, "Gandalf" is back with another discussion of his favorite topic, and an emphasis on a issue that is near to all traders' hearts, namely what could lead to a "volatility explosion."
Asking rhetorically "what will happen to Market Volatility", Kolanovic first observes what everyone knows, namely that "volatility is near all-time lows" and adds that "the main drivers of low volatility are the currently low level of correlations, supply of options through risk premia products, and impact of option (gamma) hedging that is suppressing realized volatility (see here). Following the March option expiry and ahead of French elections, positioning reversed leading to a short-lived increase of volatility. This has now fizzled out in the aftermath of the 1st round of elections. Selling of volatility is one of the key parts of risk premia/smart beta programs. Our estimate is that ~20% of risk premia strategies are allocated to selling volatility."
He goes on to note that selling of volatility is one of the key parts of risk premia/smart beta programs. One of the main reasons for the now daily EOD VIX slam is that a whopping ~20% of risk premia strategies are allocated to selling volatility across asset classes (and about half of volatility selling is via Equity options).
Why engage in such risky trading?
Selling of volatility is a yield-generating strategy that can be benchmarked against bond yields. Hence, declining bond yields invite more option selling activity. Increased supply of options also suppresses market realized volatility through hedging activity.
It goes without saying, the key risk of option selling programs is market crash risk. If one believes there’s a reduced probability of a market crash, volatility selling strategies look even more attractive, the JPM quant states.
The culprits encouraging such potentially destructive "investing" are familiar: "Global central banks have helped in both aspects by lowering yields and reducing tail risks. Indirectly, central banks have managed market volatility over the past decade."
Kolanovic then points out a chart that is familiar to regular ZH readers: "Figure 3 shows changes in global central banks’ assets (6-month change), and volatility of global equity markets (6-month volatility of MSCI World). One can see that in the 2007-13 period, central bank asset purchases closely followed market volatility (see crises in 2008-09, 2010 and 2011)." This is just another way of showing the famous "volatility suppression" regime implemented by central banks.
This level of correlation to market volatility gave confidence to volatility sellers. The large QE3 program (Sep 2012 – Oct 2014), was enacted during a period of improved macro outlook and declining volatility. This was the first disconnect between central bank purchases and market risk. QE3 coincided with a ~43% rally in the S&P 500. Due to declining volatility, the S&P 500 Sharpe ratio was above 2 in 2013 and 2014 (S&P 500 increased ten times more than the ~4.3% increase in hourly wages). As the Fed exited QE3, the BOJ and ECB stepped in aggressively in 2015. There were concerns about China, there was Brexit and the US elections, but the gap between macro risk (as measured by market volatility) and central bank purchases kept on widening. This brings us to the current wide gap – with a near-record pace of central bank balance sheet expansion (highest since 2011) and record-low levels of market volatility. This has further emboldened volatility sellers and other strategies that increase leverage based on market volatility (e.g., Volatility Targeting, Risk Parity, etc.).
Which brings us to the punchline:
"At this junction, the key question is when and how will this end. Will volatility just grind higher as the central banks start normalizing, or will it explode and wipe out some volatility sellers and levered strategies in the process."
The JPM strategist states that in his opinion, "volatility will not explode on its own. For instance, ~$50bn of potential outflows due to seasonality is likely not a match to the ~10 times higher ECB and BOJ bond inflows. A sharp increase of volatility will require stronger catalysts or a combination of few catalysts. Some thoughts on this are shared below."
And the "Near-term Catalysts" in question:
With the French election results almost certain, renewed dialogue between the US and Russia on Syria, and North Korea tensions elevated but steady, the short-term risks we highlighted last month are fading. The focus is now back on central banks, with the probability of a June 14th hike rising after the FOMC meeting yesterday (probability now at ~80%). A potential risk-off scenario could be a combination of macroeconomic data slowing, but the Fed proceeding with normalization. Neither a modest macro slowdown nor Fed tightening is likely to tip over the market on its own. However, if it happens in the seasonally weak time period, and if it trips up some of the volatility sensitive strategies (e.g., volatility selling, volatility targeting, etc.) the increase of volatility could be more substantial. For these reasons investors should closely monitor incoming macro data such as tomorrow’s payrolls.
There is of course an alternative scenario: one where volatility crashes even more:
There are also positive catalysts that could lead to the market moving higher. The US earnings season was positive, and the market currently prices in a very low probability of US tax reform. Many stocks that would benefit from the pro-business policies of the current administration (such as tax beneficiary stocks, deregulation beneficiaries, etc.) gave back almost all their post-election outperformance relative to the market. US tax reform is therefore an asymmetric catalyst with risk skewed to the upside.
And perhaps most notably, this time unlike before, Kolanovic refuses to further stake his reptuation and make an explicit prediction either way for one simple reason: in this market, even the most sophisticated and experienced traders have no idea what will happen next.