Earlier today, it was Goldman's cross-asset team which looked at the historic collapse in equity return correlations, and went on to caution that "the last time correlations were this low was in 2007, just preceding the financial crisis."
The warning came just as the VIX plunged under 9.90, the lowest intraday print in a decade, and shortly before Citi released an ominous warning of its own, in which it looked at the bank's proprietary Macro Risk Index, and observed that "a sixth consecutive monthly decline in risk aversion has taken our Macro Risk Index to extreme lows. Readings below last Friday’s 4.1% have only been observed on 31 days since 1997."
For those unfamiliar, Citi's Macro Risk Index measures risk aversion in global markets, based on asset prices that are typically sensitive to risk. The short-term index is a measure of changes in risk aversion while the longterm index is an indicator of the level of risk aversion. The indices are updated daily and range between 0 (low risk aversion) and 1 (high risk aversion).
And with the index currently trading at 4.1%, Citi goes on to warn that "comparable low levels of risk aversion have historically been followed by higher volatility, stronger USD, higher bond prices and weak performance of global equities."
Here is why Citi's quant Sukrita Chatterji has decided to pull a Kolanovic, and make a bold prediction that a volatility surge in just around the corner, observing the recent fall of the Macro Risk Index into deeply risk loving territory.
On Friday, 5 May the index stood at just 4.1% on a scale where 100% denotes extreme risk aversion. The last six calendar months which have all seen declining risk aversion, make up the second longest consecutive risk rally since 1997 (surpassed only by the recovery from the Global Financial Crisis). Figure 1 shows that with the exception of moderately elevated swaption volatility, all MRI components are close to their 1-year lows at the moment.
What happens in the past when the index crashes to such levels? According to Citi, nothing good:
Historically we have seen the MRI revert sharply higher after reaching extreme lows. For example, in 2010 it shot up to 70% within three months of a record low reading of 1.1%. The shifting normalization base could be part of this story, but we also think reversion can be attributed to actual moves in risk sensitive asset prices, which at stretched levels are sensitive to bad news.
In Figure 2 we show the average changes in various volatilities, DXY USD index, Citi World Government Bond Index (WGBI) and equities subsequent to the MRI registering readings below 10% on any given day since 1999. The picture is one of consistently higher risk aversion: low risk aversion has been followed by higher volatility in FX, US rates and equities, stronger USD, higher bond prices and lower equities both in the US and emerging markets (sample: 154 partially overlapping observations since 1999). The average rise in VIX has been the most prominent, 4.6% points over the subsequent quarter (Figure 2). FX volatility in USD crosses has risen by a more modest 0.5% points on average, while USD has strengthened 2.8% and S&P500 has fallen 1.7%, all over a the subsequent three-month horizon.
While it is challenging to predict which event could trigger risk aversion to rise – there are both geopolitical and economic uncertainties on the horizon – current stretched levels of the Macro Risk Index and historical market behaviour tell us that investors should exercise caution with risk-on trades in the coming months. The signal for higher risk aversion would be even stronger if our G10 Economic Surprise Index fell into negative territory (+20.5 as of 5 May).
Translation: expect new all time highs shortly.