Does a Volatility Collapse = Market Collapse?

Quantitative & Strategy

DOES A VOLATILITY COLLAPSE = MARKET COLLAPSE?

April 22, 2019

Table of Contents EXECUTIVE SUMMARY

In the past week, there has been a lot of hand wringing about the collapse in volatility across Worried About The all asset classes. Equity investors know that the VIX Index has fallen to a 12-handle, and Collapse In Volatility? ...... 2 past episodes of low VIX readings have resolved themselves with market corrections. Some Volatility Can Be Ignored ...... 5 The MOVE Index, which measures bond market volatility, has also fallen to historic lows.

Which Way The Greenback? ...... 8 Low volatility has also migrated to the foreign exchange (FX) market.

Macro And Investment Implications ...... 12 We find that low equity and credit market volatility have not been actionable sell signals, but low FX volatility is a bit more worrisome. In the past, extremely low FX volatility has

Timing The USD Rally ...... 13 been followed by a large move in the USD, though the direction is unclear. Investors need to understand the potential of the move, work through the implications, and prepare accordingly. The market may be setting up for a major currency market move either later this year or early next year. Investors should be aware of such a development and be prepared for a return of market volatility. At this time, too many unknown variables exist to reliably forecast the direction of stock prices, but history shows that equity returns have not been significantly correlated with the USD. Nevertheless, a mean reversion in FX volatility may be the most important driver of asset returns over the next 12–24 months.

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April 22, 2019 Quantitative & Strategy

Worried About The Collapse In Volatility? In the past week, there has been a lot of hand wringing about the collapse in volatility across all asset classes. Equity investors know that the VIX Index has fallen to a 12-handle, and past episodes of low VIX readings have resolved themselves with market corrections.

Exhibit 1: The VIX Index Is Falling

Source: Stockcharts The MOVE Index, which measures bond market volatility, has also fallen to historic lows.

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April 22, 2019 Quantitative & Strategy

Exhibit 2: Bond Market Volatility Nearing Historic Lows

Source: Bloomberg, BAML Research

Low volatility has also migrated to the foreign exchange (FX) market.

Exhibit 3: FX Volatility at Historic Lows

Source: Topdown Charts

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April 22, 2019 Quantitative & Strategy

As a sign of the times, Bloomberg reported that Europe will soon see a new short-volatility corporate debt ETF. The 50-million euros ($56 million) product, ticker TVOL, aims to deliver steady gains so long as markets demand a higher cushion for price swings on speculative-grade debt compared with what comes to pass, or the volatility-risk premium. This dynamic -- selling volatility when it’s high and waiting for it to deflate -- has spurred the post- crisis boom in financial instruments tied to shorting equity swings. Now it offers ETF traders income in the potentially more-stable world of fixed-income options. “The premium available has been relatively persistent over the last 10 years,” Michael John Lytle, chief executive of Tabula, said in an email. “Most of the time it has also been larger in credit than in equity.” The Tabula product tracks a JPMorgan Chase & Co index that simulates the returns of selling a so-called options strangle on a pair of credit-default-swap indexes referencing high-yield markets. The underlying index has returned an average 2.9 percent over the past five years but has posted losses over the past 12 months, a period that coincided with the fourth-quarter meltdown in risk assets. This ETF launch is a classic case of investment bankers feeding the ducks when they’re quacking. What could possibly go wrong? Is this the calm before the volatility storm? What’s next? The answer was rather surprising.

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April 22, 2019 Quantitative & Strategy

Some Volatility Can Be Ignored While it is true that low volatility periods are eventually followed by high volatility periods, the mere existence of a low vol state is not an actionable sell signal. For example, OddStats showed what happened to the market after the VIX Index fell from over 20 to 12 within 60 trading days. Exhibit 4: S&P 500 When VIX Fell from Over 20 to Under 12

Source: OddStats Bloomberg reported that Harley Bassman, who invented the MOVE Index, voiced some concerns about the low MOVE Index readings, but they were only cautionary signals. “Low volatility, by itself, is not a sign of bad things to come,” Bassman said in an interview. “But together with low rates and a flat curve, all three send the same message: Volatility is going to rise as things become problematic with the economy.” A recession isn’t imminent, but mid-2020 “would be a fine time for historical indicators to reprise their prescience,” he added... Low implied volatility doesn’t cause market disruptions, but it’s often “found loitering near the scene of the crime,” Bassman says. It’s associated with negative convexity, a sort of accessory after the fact that can accelerate a market move in progress. But a flattening yield curve followed by tightening credit spreads usually precede it, and are the usual suspects when the economy winds up in the tank. You can also think of low volatility as fuel, Bassman says. As a sign of ebbing demand for risk- management products and overexposure to risky assets such as triple-B-rated bonds (thus the tightening credit spreads), it’s necessary for the explosion, but “is not the match, it’s the gasoline.”

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April 22, 2019 Quantitative & Strategy

Another reason for the low level of MOVE is lower term premium, according to Variant Perception. As long as the market’s view of uncertainty for holding longer dated fixed income securities persists, bond market volatility will stay low.

Exhibit 5: MOVE Highly Correlated with Term Premium

Source: Varian Perception

Low FX volatility is a bit more worrisome. In the past, extremely low FX volatility has been followed by a large move in the USD, though the direction is unclear. Investors need to understand the potential of the move, work through the implications and prepare accordingly.

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April 22, 2019 Quantitative & Strategy

Exhibit 6: Low FX Volatility Have Resolved with Big USD Moves

Source: Topdown Charts A mean reversion in FX volatility may be the most important driver of asset returns over the next 12–24 months.

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April 22, 2019 Quantitative & Strategy

Which Way The Greenback? Which way is the USD likely to move, up or down? Different techniques yield different results. The classic method of purchasing power parity (PPP) points to an overvalued greenback, according to The Economist’s Big Mac Index. The Big Mac index is based on the theory of purchasing-power parity (PPP), which states that currencies should adjust until the price of an identical basket of goods—or in this case, a Big Mac— costs the same everywhere. By this metric most exchange rates are well off the mark. In Russia, for example, a Big Mac costs 110 roubles ($1.65), compared with $5.58 in America. That suggests the rouble is undervalued by 70% against the greenback. In Switzerland McDonald’s customers have to fork out SFr6.50 ($6.62), which implies that the Swiss franc is overvalued by 19%. According to the index most currencies are even more undervalued against the dollar than they were six months ago, when the greenback was already strong. In some places this has been driven by shifts in exchange rates. The dollar buys 35% more Argentinian pesos and 14% more Turkish liras than it did in July. In others changes in burger prices were mostly to blame. In Russia the local price of a Big Mac fell by 15%. The following chart shows the raw Big Mac Index on the top panel and the GDP-adjusted index on the bottom. As the top panel shows, very few currencies are overvalued against the USD, and most are on the left of the chart, indicating undervaluation. The GDP-adjusted index was developed to address “the criticism that you would expect average burger prices to be cheaper in poor countries than in rich ones because labour costs are lower”, and it shows the USD to be more fairly valued.

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April 22, 2019 Quantitative & Strategy

Exhibit 7: The Big Mac Index

Source: The Economist While PPP-style techniques like the Big Mac Index does offer some insight into equilibrium exchange rate levels over a 10-year period, The Economist offered the following caveat for the shorter term: Such deviations from burger parity may persist in 2019. Exchange rates can depart from fundamentals owing to monetary policy or changes in investors’ appetite for risk. In 2018 higher interest rates and tax cuts made American assets more attractive, boosting the greenback’s value. That was bad news for emerging-market economies with dollar-denominated debts. Their currencies weakened as investors grew jittery. At the end of the year American yields began to fall as the global economy decelerated and investors anticipated a more doveish Federal Reserve. But the dollar has so far remained strong.

On the other hand, other analytical techniques indicate a bullish outcome. From a technical perspective, the USD Index may be forming a bullish cup and handle formation.

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April 22, 2019 Quantitative & Strategy

Exhibit 8: A Possible Cup and Handle Pattern

Source: Stockcharts Currency strategist Marc Chandler also made the case that the greenback is about to enter another significant bull leg: In the big picture, we argue that the dollar’s appreciation is part of the third significant dollar rally since the end of Bretton Woods. The first was the Reagan-Volcker dollar rally, spurred by a policy mix of tight monetary and loose fiscal policies. The rally ended with G7 intervention to knock it down in September 1985. After a ten-year bear market, a second dollar rally took place. It can be linked to the tech bubble and the shift to a strong dollar policy. Chandler identified three phases of the USD rally. The first phase began Reagan-Volcker era, followed by the Clinton era and tech bubble, which drew foreigners into Dollar assets, and the third phase was the Obama rally, as the U.S. economy recovered faster than its major trading partners in the wake of the Great Financial Crisis. Chandler believes the U.S. is about to take the global lead in growth again, which would put upward pressure on the USD. With the fiscal stimulus winding down, the dollar may enter the third phase of its super-cycle: a return to divergence. Recall that the global slowdown began in H2 18, but the fiscal stimulus that is saddling the U.S. with more a trillion dollar a year deficit helped mitigate the pressure. It grew at an average pace of 3.8% in the middle two-quarters last year. The German and Japanese contracted in Q3 and Q4 was only a little better. The Italian economy contracted in both quarters. Historically, USD strength has been correlated with GDP growth. Renewed growth in the US economy would put upward pressure on the greenback.

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April 22, 2019 Quantitative & Strategy

Exhibit 9: USD Strength Correlated With GDP Growth

Source: FRED, Federal Reserve Bank of St. Louis

Viewed from this perspective, the technical cup and handle formation makes perfect sense.

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April 22, 2019 Quantitative & Strategy

Macro and Investment Implications

For investors, even knowing the USD is poised to strengthen will be tricky to navigate. There are many moving parts to currency appreciate. Here are some first order effects:  Dollar strength means commodity weakness, which could spark a manufacturing renaissance as the price of inputs fall in the U.S.  A rising USD will put downward pressure on imported inflation, which gives the Fed more room to ease, but  Rising USD will put pressure on vulnerable EM economies with Dollar debt, and raise financial stability concerns, and  The flip side of the rising USD coin are depreciating foreign currencies, which will increase trade tensions.  In the short run, the earnings of large-cap multi-nationals would face headwinds, as roughly 40% of the revenue of the companies in the S& P 500 are non-U.S., but  Domestic earnings would be boosted by better U.S. growth. There are many moving parts whose second order effects are not known. What will the policy response be to these developments? From the Fed? From major trading partners? How will U.S. trade policy change as its currency rises? These are all very good questions with no answers. For equity investors, we can make the assurance that while the short-term effects of USD strength is negative on earnings and margins, the historical experience shows that stock prices are not correlated in any form to currency movements.

Exhibit 10: USD Uncorrelated With Stock Prices

Source: FRED, Federal Reserve Bank of St.Louis

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April 22, 2019 Quantitative & Strategy

Timing The USD Rally The timing of a Dollar bull move may not be immediate. There are a number of factors working to suppress the USD and a breakout in asset volatility. Firstly, large speculators are already bullish on the USD, and they are adding to their aggregate long positions.

Exhibit 11: Large Speculators Are Already Long the Dollar

Source: Haver Analytics In addition, the USD is unlikely to break upward until we see some definitive signs of economic strength. The market just underwent a global growth scare. While expectations are starting to turn up, as evidenced by the latest results from the BAML Fund Manager Survey, a consensus about renewed economic momentum is not evident among market participants or policy makers.

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April 22, 2019 Quantitative & Strategy

Exhibit 12: The Reflation Rally Is Only Just Starting

Source: BAML Global Fund Manager Survey To be sure, economic growth is recovering. The Atlanta Fed’s GDPNow nowcast of Q1 GDP growth has recovered to 2.8% from a low of 0.3% in early March, the New York Fed’s nowcast is 1.4%, and the St. Louis Fed’s nowcast is 1.9%. The real test for Fed officials will come later this year when the growth outlook recovers and stabilizes. When will policy start to tilt more hawkish and when will they signal likely rate hikes, and how will the market respond to the resulting clash between the White House and the Fed?

Exhibit 14: Atlanta Fed Q1 GDP Nowcast

Source: Federal Reserve Bank of Atlanta

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April 22, 2019 Quantitative & Strategy

In conclusion, the market may be setting up for a major currency market move either later this year or early next year. Investors should be aware of such a development and be prepared for a return of market volatility. At this time, too many unknown variables exist to reliably forecast the direction of stock prices, but history shows that equity returns have not been significantly correlated with the USD. Nevertheless, a mean reversion in FX volatility may be the most important driver of asset returns over the next 12–24 months.

Cam Hui, CFA | [email protected] Page 15

April 22, 2019 Quantitative & Strategy

Disclaimer

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