Posted by on June 23, 2017 3:39 pm
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Categories: Bank of Japan BOE Bond Business Central Banks China ECB Economy Equity Markets Finance Global Economy Government Stimulus Market Crash Market risk Mathematical finance money New Normal Option People's Bank Of China Recession recovery S&P/ASX 200 VIX Technical Analysis US Federal Reserve VIX Volatility Volatility smile

After getting virtually every market inflection point in 2015, and early 2016, so far 2017 has not been Marko Kolanovic’s year, whose increasingly more bearish forecasts have so far been foiled repeatedly by the market, and the same systematic traders that he periodically warns about. As a reminder, his most recent warning came last week, when he cautioned that even a modest rebound in VIX could lead to dramatic losses for vol sellers. As a reminder, here is the punchline from his latest note:

Days like May 17th and similar events “bring substantial risk for short volatility strategies. Given the low starting point of the VIX, these strategies are at risk of catastrophic losses. For some strategies, this would happen if the VIX increases from ~10 to only ~20 (not far from the historical average level for VIX). While historically such an increase never happened, we think that this time may be different and sudden increases of that magnitude are possible. One scenario would be of e.g. VIX increasing from ~10 to ~15, followed by a collapse in liquidity given the market’s knowledge that certain structures need to cover short positions.

So in light of a market that refuses to post even the smallest of drawdowns (we are not sure if the words “selling”, “correction” or “crash” have been made illegal yet), has Kolanovic thrown in the towel and declared smooth seas ahead? To the contrary: in a note released late last night, he echoes warnings made recently by both Citi and BofA, and predicts that receding monetary accommodation from ECB and BOJ will likely lead to “market turmoil, and a rise in volatility and tail risks” and just in case there is some confusion, he reiterates what he said last week, namely that the “key risk of option selling programs is market crash risk.”

In terms of near-term catalysts, what is Kolanovic most worried about? The same thing that Matt King warned about this week when he explained why he believes “markets will flounder as central banks try to exit” and showed the following chart:

Now it’s Kolanovic’ turn to make essentially the same warning:

Equity Volatility has been suppressed by relentless supply via yield generating strategies, macro decorrelation and inflow into passive and quantitative strategies….  Risky assets have been rallying for years, and market volatility is near record lows. Valuations are high, arguably supported by low interest rates and record pace of central bank monetary expansion. However, this may change in the near future. In the US rates are rising and monetary accommodation from the ECB and BOJ is expected to recede. Medium term, this is likely to lead to market turmoil, and a rise in  volatility and tail risks.

Indeed, and by now we can only assume that the rest of the actively trading community is well aware of these very risks. And yet, stocks refuse to budge, which either confirms what Kolanovic said recently, namely that only 10% of all market decisions are made by human traders, or that as King speculated, the market is now so broken it can no longer discount the future, especially if the event to be discounted is precisely the one that broke it in the first place.

Below are some additional excerpts from Kolanovic’s latest note, explaining why he is doubling down on his “market turmoil” call:

The landscape: Volatility is low across the board

Volatility across asset classes is near all-time lows. We have written extensively about the drivers of current low volatility which we summarize below.

Current pace of the Global recovery does not warrant a high volatility regime. Global growth is tracking ~3%, with disinflationary drag receding. In the US, slow and steady growth have alleviated fears of imminent US recession and China hard landing risk has been contained by PBOC easing and large Government stimulus. Medium term, as rates in the US rise and balance sheets of global central banks recede, this positive growth narrative will likely increasingly come under pressure.

While fundamentally volatility should not be high, it is clear to us that the current macro environment does not warrant all-time low volatility either. For instance, our analyses point that in equities, implied and realized volatility may be suppressed by 4-8 points by various structural drivers.

Selling of volatility across asset classes is one of the key parts of risk premia/smart beta programs. Selling of volatility is a yield generating strategy that can be benchmarked against bond yields. The key risk of option selling programs is market crash risk. Global central banks have helped in both aspects by lowering yields and reducing crash risks, increasingly inviting strategies that sell volatility outright or implicitly.

Figure 2 below shows changes in global central banks’ assets (6-month change), and volatility of global equity markets (6-month volatility of MSCI World). One can see that in the 2007-2013 time period, central bank asset purchases leaned against major increases of market volatility and thus reduced market tail risk (see here). The current wide gap – with a near record pace of central bank balance sheet expansion (highest since 2011) and record low levels of market volatility – poses significant market risk. This risk is likely to materialize as the balance sheets of global central banks are pared in 2018 as described below.

G4 Central Banks have resorted to “unconventional” policy measures to stoke the global economy in the wake of the 2008 financial crisis. Various QE programs from the Fed, BoE, BoJ and ECB resulted in central bank balance sheets ballooning from $6Tr in 2009 to $14Tr at the end of 2016. G4 QE should expand by a further $2Tr this year. However, 2018 will mark a major shift in this dynamic according to our Economic team’s forecast, as G4 QE programs should fall off a “cliff” (Figure 2). This will notably be due to the ECB and BoJ scaling down their large scale asset purchases (by $950Bn and $500Bn, respectively), and the Fed actually shrinking the size of its UST/MBS holding (by $330Bn). Such a disengagement from central banks could facilitate disruptive market moves.

We think that the current low levels of volatility are not a new normal and will not last very long given the amount of leverage, rising rates, and the approaching reduction of central bank balance sheets. While we don’t know when the next recession will happen, every Fed hike is bringing us closer to it. Increasing allocation to hedges, specifically tail hedges, may be prudent.

One day, Marko’s magic will return. For now, however, the relentless drift higher continues.

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