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Does a Volatility Collapse = Market Collapse?

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Does a Volatility Collapse = Market Collapse? Quantitative & Strategy d Cam Hui, CFA [email protected] 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. Confidential — Do not duplicate or distribute without written permission from Pennock Idea Hub Cam Hui, CFA | [email protected] Page 1 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. Cam Hui, CFA | [email protected] Page 2 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 Cam Hui, CFA | [email protected] Page 3 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. Cam Hui, CFA | [email protected] Page 4 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.” Cam Hui, CFA | [email protected] Page 5 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. Cam Hui, CFA | [email protected] Page 6 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. Cam Hui, CFA | [email protected] Page 7 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. Cam Hui, CFA | [email protected] Page 8 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.
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