Second Crash Warning From The IMF – This Time It’s About Vol
Another week, another warning regarding financial crash scenarios from those keen minds at the IMF.
In “Here Is The IMF’s Global Financial Crash Scenario” last week, we highlighted the institution’s surprisingly candid discussion hidden away in its latest Financial Stability Report “Rising Medium-Term Vulnerabilities Could Derail the Global Recovery”…or as we paraphrased the IMF’s “politically correct way of saying the financial system is on the verge of crashing”.
As we noted previously, in the section also called “Global Financial Dislocation Scenario” because “crash” sounds just a little too pedestrian, the IMF uses a DSGE model to project the current global financial situation, and ominously admits that “concerns about a continuing buildup in debt loads and overstretched asset valuations could have global economic repercussions” and – in modeling out the next crash, pardon “dislocation” – the IMF conducts a “scenario analysis” to illustrate how a repricing of risks could “lead to a rise in credit spreads and a fall in capital market and housing prices, derailing the economic recovery and undermining financial stability.”
This week the IMF has gone a step further, courting the mainstream financial media to publicise its warning about the dangers of historically low volatility and related short volatility strategies.
As The FT reports, The International Monetary Fund has warned that the increasing use of exotic financial products tied to equity volatility by investors such as pension funds is creating unknown risks that could result in a severe shock to financial markets. In an interview with the Financial Times Tobias Adrian, director of the Monetary and Capital Markets Department of the IMF, said an increasing appetite for yield was driving investors to look for ways to boost income through complex instruments.
“The combination of low yields and low volatility facilitates the use of leverage by investors to increase returns, and we have seen rapid growth in some types of products that do this,” he said.
It explains some of the short vol strategies that we’ve been expressing concern about for several years. To wit.
Mr Adrian’s warning comes amid increasing evidence that pension funds and insurance companies are venturing into riskier types of investments to gain income.
Some are also effectively writing insurance contracts against a market crash to pocket premiums. Last year the $14bn Hawaii Employees Retirement System said it was writing put options to boost its income, while other US pension schemes such as the South Carolina Retirement System Investment Commission and Illinois State Universities Retirement System have also hired outside managers to use option writing strategies. The IMF estimates that assets invested in volatility targeting strategies have risen to about $500bn, with this amount increasing by more than half over the past three years. Marko Kolanovic, head of macro, derivative and quantitative Strategies at JPMorgan, last month warned of “strategies that sell on ‘autopilot’”, and how risk management models that use volatility could be luring investors into taking on too much risk.
“Very expensive assets often have very low volatility, and despite downside risk are deemed perfectly safe by these models,” he wrote in a note to clients.
While we applaud this warning from the IMF, it’s absurdly belated and the short vol “horse” has long since bolted. Moreover, we think that the IMF is seriously under-estimating the magnitude of short vol risk in financial markets. Indeed, the IMF’s research department would do well to read the recent report from Artemis Capital Management which we drew investors’ attention to.
Artemis estimates that financial engineering strategies that are short vol, either explicitly or implicitly, amount to more than $2 trillion. However, both Artemis and the IMF are “on the same page” when it comes to what would unfold if there was a sustained spike in volatility. The FT continues…
The IMF believes that sustained low volatility increases incentives for investors to take on higher levels of leverage while causing risk models that use volatility as an important input to understate real levels of risk participants may be taking on.
“A sustained increase in volatility could then trigger a sell-off in the assets underlying these products, amplifying the shock to markets,” Mr Adrian said…
With equity implied volatility continuing to drop over the course of this year, investors who have bet that markets will remain tranquil have been rewarded. Yet the true quantity of complex products being sold that are linked to volatility of various assets is hard to ascertain due to such deals mostly being done in private. Regulators therefore find it difficult to map out the risks in the event of an unexpected market shock.