SocGen: "Low Vol Is Gone And This Changes Everything"

Goldman Sachs, Bank of America, Morgan Stanley: while Wall Street banks and their research teams tend to disagree on most aspects of market analysis and forecasting, one common theme they currently all agree on is that the VIX, currently trading around 20 vols, will slide over the near-term as it gradually mean-reverts with recent record low levels achieved in 2017, as a result of the historic 2017 collapse in cross-asset correlation.

Or rather "almost all" because one bank vocally disagrees.

According to recently outspoken contrarian, SocGen, the French bank is confident that the consensus on where volatility goes next is woefully wrong, and what is coming will be nothing short of another VIX-plosion, one which may put the February volocaust to shame.

As the French bank writes in VOLT, a new publication dedicated to cross-asset volatility, the surge of the VIX is leading the emergence of a higher regime for cross-asset volatilities, and - as a result - bank strategist Olivier Korber predicts that "the summer should be hot for US equity and oil volatilities, as vulnerable positioning and geopolitical risks are major looming threats."

So what happens "when the dust settles"?

SocGen responds in a distinctly vivid manner, comparing the current vol regime to a rubber band, noting that "gradually stretching an elastic string, even gently, accumulates tension until it breaks."

However, "astonishingly, the imperturbable parabolic price action of the S&P did not decisively disrupt the low volatility regime that has prevailed since end-2016, despite the index reaching stratospheric levels, the mounting volatility of single stocks, the accumulation of short variance positions (still a key risk for the VIX) or the Fed embracing its tightening cycle."

Korber continues:

The VIX shock revived a seismic fault that painfully challenges strategies harvesting the volatility risk premium, like every time a carry trade collapses. Now that the dust is settling, medium-term vol remains high in non euro area equity vol, while normalisation seems in process or achieved in most other markets (Graph 3). Euro and yen 1y implied vols are trading on lows in both FX and rates, while the volatility of USD and GBP rates have already taken  off given the earlier rise in rates. Trade wars shook oil and USD/CAD (commodity currency linked to oil) option markets, though levels are softening as US/China rhetoric is not escalating. Therefore, significant heterogeneity in the cross-asset vol complex is likely to persist.

And this is where SocGen's call differs from the other banks:

Low vol is gone and this changes everything

The French bank predicts that after the February VIX eruption, "low vol is gone and this changes everything" and adds that "after the brutal wake-up call in early February, we have not seen the end of the squeeze higher in US equity vol (Graph 1) and expect it to remain elevated."

Here is the big picture on SocGen's quasi-apocalyptic outlook:

  • We believe that equity volatility is here to stay, as all our models still point to higher realised volatility over the next year. The massive selling volatility flow that prevailed in the past two years and was preventing fundamentals from dominating has faded. The epicentre of this turbulence lies in the US, and after the wipe-out of crowded positions on VIX-related ETPs early February, the next big risk is to short positions on S&P 500 variance swaps. We recommend avoiding short S&P 500 volatility risk and would look to build long positions on US equity volatility and convexity.
  • In Europe, we see more subdued volatility levels and option premiums due to the strong growth dynamic, ECB policy and the lack of political catalysts in the coming months. We expect Eurostoxx 50 volatility to stay durably below S&P 500 volatility (and VIX above VStoxx). Key risk & best hedge: The key risk to our view is a return of a strong risk-on environment and renewed appetite for selling volatility systematically. In such a scenario, the current relatively elevated volatility levels would look like a good entry point.

Some additional details on what this transition into a "hell" regime will look like:

Like a diver hitherto stuck under the surface of a frozen river, volatility has finally found a way out, and there is no going back under the surface again (Graph 1). We think it is a disruptive change, as most of the trades that have been doing well over the past few years are unlikely to be profitable in this new environment.

It also means that the unwinding of the substantial positions accumulated during the “old normal” may not be done in an orderly manner, potentially squeezing the parameters significantly.

... And how to trade it:

We think the S&P 500 variance swap market is particularly at risk in this context. We recommended starting to invest in convexity, as the window for pricing to catch up, or overshoot, is likely to be small.

Moreover, investors need to take a new approach to their volatility trades and arbitrage. Some of the ‘rules of thumb’ of the past five years are unlikely to be valid any more. This especially applies to the belief that eurozone equity volatility will be systematically above US equity volatility.

Finally, what does the imminent equity vol fallout mean for the cross-asset complex?"

Rates vol is gradually heading into spring. Inevitable ECB normalisation will likely propel EUR rates vol, while USD short rates vol could also outperform if the market ultimately converges on the Fed’s dot plot.

FX vol is the  main exception, as it should remain immersed in a longer winter. We think EUR and USD rates vols are set to be conflicting forces for EUR/USD vol, keeping it under pressure and generally ensuring a low FX vol regime despite the trade wars. The quantitative allocation of our vol portfolio also identifies the risk premiums to harvest in G3 FX vol. In sharp contrast, in commodity vol, cheap gold vol should be an effective hedge to summer jitters.

Finally, on timing:

The old adage advising stock investors to ‘Sell in May and go away’ could prove even more critical for volatility investors, given their structurally convex profile. Except for core FX and US long rates, our volatility views suggest that a set of fundamental risks are likely to produce some stress in the months ahead.

In other words, "now"