The Old Regime Is Done: Why The "Equilibrium Market Volatility Is Higher"

Rafiki Capital Management's Steven Englander has emphasized a macro underpinning to the sell-off, basically arguing that rising inflation expectations and a hawkish Fed mean that they have suspended the 'Fed Put' for the time being.

Others emphasize the collapse of inverse vol funds and deleveraging of risk-parity portfolios.

As Englander details below, these explanations are two sides of the same coin...

Consider the chart below which shows 10 year  yields and the S&P.  The obvious point is that yields and equity prices were moving in the same direction from September through late January and since have diverged. Bond prices and equity prices were moving in opposite directions. This green area corresponds to the period in which tax reform optimism was getting priced into asset markets, and the pink area to the sell-off period.

From a macro viewpoint I would argue that in the first period investors saw tax reform as a shock to demand and quite possibly productivity that would raise profits and generate higher real rates, but these would coexist peacefully with moderate inflation and real interest rates moving in line with productivity and equity prices.

So far so good. Around the middle of January inflation expectations began to rise sharply.

I have argued elsewhere that the Fed and asset markets have a different relationship when inflation is viewed as likely to stay below target versus when it is approaching or at target (see pdf below). In the first instance the Fed has the market's back. In the second it doesn't. In practical terms, below target  inflation means the Fed put limits market downside because they do not want to risk even lower inflation. When inflation is at or above target that Fed put disappears and the probably of market outcomes includes the traditional fat tail to the downside. So higher inflation means more asset market volatility and a downside adjustment to risk-adjusted returns. 

From a vol perspective this means that equilibrium market volatility is higher.  Once this adjustment process started we entered into the realm of specific vol products and their characteristics, which greatly amplified the initial move. But the reason vol began to move higher was the market realization that the risk distribution had shifted.

Now consider this from a risk-parity perspective. In the intial period you would hold a leveraged portfolio of stocks and bonds because the market assumptions was that the shocks that hit the market were basically output or demand shocks, essentially positive. So bond yields went up, their prices went down but these were offset by the upward move in equities. The opposite positions reduced risk and the leverage goosed up returns. 

Once the market began to fear that the next set of shocks would be inflation driven, inducing Fed tightening and a higher discount factor for all assets, both bond and stock prices began to move in the same direction.

These portfolios have to be deleveraged because both stocks and bonds represent essentially the same risk.

In the green period (in the first chart above) markets viewed the shocks as sustainable demand/productivity shocks that would increase both profits and raise the equilibrium return to capital and the equilibrium interest rate.

In the pink period the dominant fear was inflation shocks which would move bond and stock prices in the same downward direction.

Looking forward, the question is whether you think that the market macro assumptions are correct. I have argued that the pessimism may be premature, while acknowledging that even if I am right it may take a while to find out (link).  If I am correct the bond/equity correlation is like to move closer to zero or even back to negative, which would reduce market volatility and reverse some of the deleveraging that we have seen. To me these are the fundamental drivers that we should be debating, even if the discussion is taking place in different market languages. 

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