For The First Time Since January 2016, The Market Volatility Regime Finally Snapped
- August 17 marked the first time since January 16 when global equity, rates, commodity and FX vols all moved in the same direction.
- At the same time, short-dated cross asset correlation continued to rise reaching a level of 50%, its highest level in over 1y.
For months on end, traders, analysts and pundits have been pointing to record low implied vol as a sign of pervasive complacency (and in some cases, “trader paralysis“) in response to a market that made no sense, and where the only permitted direction was “up.” That may finally be ending, and not just based on references to seasonal patterns that have zero relevance in a “new normal” driven by central bank asset purchases, but because the market’s artificial sense of calm is finally starting to crack, as observed by the recent surge in 20-day S&P realized vol.
And when realized vol starts rising, implied vol promptly follows, and when implied vol rises, it creates a feedback loops in which vol sellers are forced to cover, raising realized vol even more, pushing implied vol higher, and so on, as the current cycle of unprecedented volatility selling eventually ends, with either a bang or a whimper (spoiler alert: the former).
Meanwhile, as both volatility metrics rise, cross-asset volatility – traditionally an indicator of latent market stress – follows. And in what may come as a surprise to some, while most have been lamenting the blanket of broad market complacency in the past year, which in recent months have been validated by near record low global cross-asset implied volatilities….
… Bank of America points out that short-dated cross asset correlation has been rising over the past few months and currently stands at 50%, its highest level in over a year. Meanwhile, the correlation of cross asset vols may have also reached a turning point: August has been the first month in over a year to witness a simultaneous rise in global equity, rates, commodity and FX volatility. In fact, August 2017 marked the first month since January 2016 in which all cross asset risk measures rose modestly over the month, even if they still remain in significantly benign territory.
To BofA’s derivatives strategist Benjamin Bowler, this suggests that various pockets of the market are finally beginning to agree on the presence of risk, albeit to varying extents.
More ominously, on a consolidated basis as noted above, in August short-dated (3-month) cross asset correlation continued to rise reaching a level of 50%, its highest level in over a year. Historically there have been 3 distinct cross asset correlation regimes since 1995.
Interestingly, the broad upward trend started in Oct-03, well before the Lehman bankruptcy in Sep-08. This is related to the liquidity driven crush in asset risk-premia that helped drive investment leverage higher. Long-term correlation established a new regime starting some time in 3Q13, similar to the ’03 to ‘08 correlation environment. With the recent surge in cross-asset vol, that regime may now be ending too.
The good news, as BofA also points out, is that the uptick in volatility and credit spreads in most cases was modest in magnitude, leaving global cross asset risk metrics well within benign territory amid a backdrop of rising geopolitical tensions on the Korean peninsula. This means that it is still historically cheap to purchase efficient hedges ahead of what is already proving to be a catalyst-rich fall.
As a final observation, BofA then lays out the cheapest derivatives across the entire global derivatives universe, in other words, those which have the highest upside in case of a crash.
The chart below shows crash returns of different assets during historical tail events per unit of current OTM option implied volatility. Ranked by the average, the screen shows that the hedges which are most underpricing historical drawdowns are: US & EU IG credit payers, Gold calls and RDXUSD (Russian equity) puts: US & European IG credit payers still rank as the best value hedges across all assets in our universe followed by Gold (and Gold ETF) calls. In equities, RDXUSD (Russia), NIFTY (India) and TWSE (Taiwan) puts screen as top hedges while puts on NASDAQ (US Tech), Top40 (S. Africa) and ASX200 (Australia) rank as the most expensive.
Finally, those who want to hedge against a crash may want to avoid buying USDJPY puts: USDJPY puts once again are at the very bottom of BofA’s screen (most expensive tail hedge) as the ongoing geopolitical risk flare on the Korean peninsula has likely increased demand for JPY as a risk-off asset. In contrast, Nikkei puts, while belonging to the same region, currently rank as the cheapest DM equity hedge.