Earlier today we showed a remarkable chart - and assertion - from Bank of America: "In every major market shock since the 2013 Taper Tantrum, central banks have stepped in (even if verbally) to protect markets. Following the Brexit vote, markets no longer needed to hear from CBs as they rebounded so quickly that CBs didn’t need to respond." As a result, buy-the-dip has a become a self-fulfilling put.
The immediate result of this dynamic has been two-fold: i) investors now buy every dip, or as Bank of America notes, "Investors no longer fear shocks, but love them, as it is an opportunity to predictably generate alpha.", and ii) selling of vol has become a self-reinforcing dynamic, in which lower VIX begets more vol-selling by "yield-starved investors", leading to even lower VIX as the shock that can reset the feedback loop is no longer possible, and thus the strike price on the Fed's put can not be put to a market test.
These observations prompt BofA's derivatives expert Benjamin Bowler to ask the rhetorical question: "volatility: new normal or bubble?" and answer: "It's a bubble." Indeed it is, but absent the abovementioned market-clearing shock, it is difficult, if not impossible to anticipate what can burst this bubble.
In the meantime, the market has spawned some spectacular distortions, including the following observation: "As one measure of volatility, the Dow Jones Industrial Average traded in its tightest trading range since 1900 this year." Here is Bowler:
While asset valuations are not at life-extremes, volatility is. In 2017 the Dow traded in a 110yr record tight trading range, the VIX hit all-time lows, and US equities reversed from sell-offs at near their fastest pace in 90 yrs. Investors no longer fear risk but love it, as it’s another opportunity to harvest “dip-alpha”. Volatility across asset classes has decoupled from uncertainty. Even if seemingly irrational, apathy to all risk has been the right trade and an impossible trend for most to fight – the definition of a bubble.
A bubble, he adds, "induced by years of heavy handed central bank influence, where investors have learned that it has not paid to panic." Bowler asks readers to consider the following:
As one measure of volatility, the Dow Jones Industrial Average traded in its tightest trading range since 1900 this year
Near 90yr records are occurring in the speed that US equities are recovering from dips
The VIX is near 26yr lows despite political & policy uncertainty recently near 26yr highs
Gold call options price less than 1 in 100 chance of rising North Korean tensions in the face of rising North Korean tensions
The above leads Bowler to concludes that "while there is active debate about whether risk-assets like equities and credit are overvalued, it is much harder to argue that currently depressed volatility levels are unsustainable when near 100yr records in terms of low vol and the lack of persistence of any shock are being recorded."
So when did the market "break", and when did the behavior of volatility change so dramatically?
This overarching question has been plaguing Wall Street strategists for much of 2017. In July, we presented one answer from Deutsche Bank's Aleksandar Kocic who pointed out the divergence between the economic policy uncertainty index and the VIX, which took place roughly in 2012, prompting the derivatives expert to conclude that something "snapped" roughly around that time, or as Kocic said, sometime in 2012 it was as if the markets “lost their capacity to deal with uncertainty.”
Bank of America takes a somewhat different approach, and instead of looking at the divergence between volatility and news - or shock - flow, highlights the moment BTFD became religion.
According to Bowler, "the nature of volatility since 2014 has entirely changed, with volatility shocks retracing at record speed. Investors no longer fear shocks, but love them, as it is an opportunity to predictably generate alpha." This is demonstrated in the following stunning chart which not only shows that every VIX dip is now just an opportunity to buy it, but that the market's "fragility" is at an all time high based on the surging frequency of vol spike events, which in turn, and paradoxically, reassure investors that a central bank backstop can not be too far away.
BofA is hardly the first to point out this phenomenon: almost exactly one year ago, it was JPM's "quant wizard" who highlighted precisely the same, if not through the perspective of VIX but the overall market response to recover from "shock" events:
It appears that the time horizon of macro traders has shortened, likely as a result of increased participation of machines and algorithms that are quicker to adjust to significant events and can eliminate trading activity of slower investors. Consider for example the US elections - traders in Japan registered a 5.4% Nikkei drop on the 9th, followed by a 6.7% rally on the 10th, while S&P 500 investors did not register a significant close-to-close move over the election (due to market hours difference). These two days were enough to shift the volatility regime (usually calculated from closing returns) for the whole of 2016 for the Japanese equity market, and leave it unchanged for S&P 500 (e.g. think of rebalancing needs of a hypothetical risk parity fund, or a short volatility strategy based on Nikkei vs. one based on S&P 500). We also noticed that for a number of significant catalysts this year (Brexit, US Election, Italy Referendum) broad expectations were wrong both on the outcome and the directionally forecasted impact. It is possible that the lack of market reaction (or a reaction that went against the accepted narrative) was in part driven by investors’ reluctance to transact (“two negatives equal a positive”).
Ah yes, the infamous "investor reluctance to transact", which has only gotten worse as we hinted in our "trader paralysis" post, and which Goldman demonstrated vividly just last month when the bank showed that hedge fund turnover has now dropped to an all time low as virtually nobody trades anymore.
Whatever the reason behind the broken market, however, whether it is central banks, machines, algos, risk parity funds, vol-targeting strategies, self-reinforcing "Pavlovian" dynamics, or simply traders no longer trading, the question is what comes next? While we will have a more detailed breakdown in a subsequent post, here are Bowler's three questions, and several answers of what to expect in 2018:
As we enter 2018, three questions are top of mind when it comes to volatility:
- Is 2018 the year when vol begins to normalize, or is this the “new normal”?
- As low vol threatens to sow the seeds of the next crisis, how will this end?
- Where does vol go in the longer-run; can we ever see the old-normal return?
Vol likely to rise off extreme lows; ’87 crash unlikely, but so is VIX averaging 20 While we will look at each question in more detail in turn, the short answers are:
- Higher not lower vol: We think 2018 is most likely to see higher (not lower vol) as the Fed builds more “ammunition” in terms of rate-hikes leaving them less sensitive to financial market conditions (i.e. pushing the Fed put strike lower), and as CB balance sheets peak in 2018.
- Vol bubble more likely to deflate than explode: While the risk of “fragility” shocks due to positioning and feeble liquidity is high, we think the level of leverage today, which is lower compared to the last time vol was this depressed (2007), does not present the same risks as then.
- Vol to remain low vs. long-run average: However, to the extent we remain in a low inflation/low rates environment, we may also remain in a lower than normal vol environment. So while VIX near 9 is an unsustainable bubble, VIX at 20 (the long-run average) may also be unsustainable in a slower growth world.
And BofA's conclusion:
What to watch for? In a world slaved to rates, inflation remains key
From a macro perspective, we continue to believe unexpected inflation is the kryptonite for volatility. Inflation presents a “triple whammy”, first driving economic vol higher, destabilizing bond markets (and putting bond/equity correlation at risk), but importantly handcuffing central banks from being as sensitive to financial markets. In other words it both drives fundamental risk higher and significantly impairs the protection markets have become dependent on. Rising rates vol is key to watch.
How bad can it get? From here Aug-15 shock likely but ’87 crash is improbable
Interestingly, while the world is hyper-focused on how big the “short-vol” trade is, history shows that any liquidity shock large enough to create an equity bear market (20% fall in equities, similar to 1987 or LTCM crisis) provides a forewarning in terms of rising volatility first (look for S&P vol to double from 10 to 20). Fragility shocks (similar to Aug-15) that happen without warning remain the bigger risk today in our view.
So, how do you trade this? Long “vol beta”, cheap options for direction
The most important question is, how do you trade this environment where investors have given up on risk (or have learned to love it as buying dips has been “free money”). Evidence of a “bubble in apathy” is strong, and we believe it is unsustainable. However, the problem with any bubble is not recognizing you are in it but rather timing its end. Hence the key is finding trades that will profit from a change in environment but carry well and hence don’t require perfect timing. The beauty of today’s low vol is that it can be cheap to own optionality (for example for upside stock replacement) which affords the benefit of not having to time when markets may peak.
Does this mean short vol is a bad idea? No, but it needs to be smartly managed
Importantly, believing that today’s low vol is unsustainable does not mean all short vol positions are bad. Don’t forget, owning any risk asset (equity, credit etc.) is a short-vol trade. The key is finding the best short vol opportunity (highest risk-adjusted returns), while managing downside risks appropriately. Harvesting rich vol risk-premia is key to funding cheaper long vol positions elsewhere.