Market Insights

It’s volatility Jim, but not as we know it…

Six days after the VIX prints a multi-decade low, it then spikes up to the month’s highs in the course of just a day. The one day move was the 8th largest in its history. This then prompted much gnashing of teeth about market mayhem, as Brazil’s stock market and currency lost the best part of 10%, words such as ‘impeachment’ were bandied around, and the 10yr US rate came within a whisker of hitting the year’s lows.

So now what? What’s the driver? Well, there’s a few candidates…

  1. Carry

Carry on carrying has been the motivation of markets ever since central banks forced it upon them. Never-ending cheap money was deliberately designed to pump up risky assets. It was designed to subdue volatility. It was designed to keep everyone in a safe space until the world was well enough to withdraw the methadone. That was all fine until….

  1. Politics

Yes, The People intervened. It turned out this massive rally in risky assets benefited the asset rich, just as those most reliant on the state were told that they needed to pay the price for massive debts and bank bailouts. Years of austerity may have been designed to hurt everyone similarly, but the pain felt unequal. The rage exploded into unexpected political outcomes. That saw some big market moves, but then it all became fine when politics became too shouty and confusing to bother with…

  1. The Economy

Ah but it’s OK, because the global economy is back in action. Reflation is afoot, with China producer prices emerging from 5 years of deflation last September. The deflation demon has been slayed. So that’s all fine too then…?

We don’t know, do we, which of these we really are fine with. It’s tricky. We are now entering a volatile period as these themes fight it out for dominance.

  1. Carry

The central banks are rowing back, aren’t they? Two Fed hikes in 4 months; the BOJ won’t let 10yr yields fall below zero; and the ECB are actively discussing when to discuss ending QE. Previously this caused a tantrum from the methadone-fuelled market, but now, as long as they take it easy, we don’t seem to care. This is because economies are improving, and also that their easy-does-it stance seems to have lulled everyone into not caring. Furthermore, the ongoing rally in the stock market, plus tighter credit spreads, keeps financial conditions accommodative. So, the tightening hasn’t really happened yet. Here’s US financial conditions – they’ve been getting easier ever since the Fed actually started hiking:

US FCI

So the carry motivation remains strong. As long as the world isn’t volatile, right?

  1. Politics

This has thrown a spanner in the predictability works for the last 12 months. But it’s Ok now, because all those pesky binary referendum/election events are over with aren’t they? Just the German election to get through, but the choice is Mutti Merkel versus the former President of the European Parliament, so no populism risks there eh? And in any case all these elections haven’t killed the markets or harmed their economies yet have they… so let’s just forget all about it.

Then the risk of the US President becoming embroiled in criminal proceedings springs up. Just as he could rip up or sign up to a trade deal in a heartbeat. Or trip up in diplomacy with China or North Korea. Those risks can’t be ignored. Meaning that future volatility is definite, but unpredictable. Even Bernanke (remember him?) commented earlier this week, ‘It puzzles me that markets are very blasé about political risk until the last minute’. It shouldn’t puzzle him. He more than anyone knows that the market is obsessed with quantifying risk and then parcelling it away. But political risk is not quantifiable. This leaves the Carry trade in a Schrodinger’s Cat of a quandary. If we can’t measure the political risk, does that mean it’s not there?

  1. The Economy

Even if we can’t get a handle on the conditions for the carry trade, can we at least agree on the underlying growth of the economy? For this, it’s worth checking out the US economic surprise index – which has been plunging in the past few weeks:

US Economic Surprise index

This leads to a debate over whether the Fed can really keep raising rates. Which leads to a question of whether carry can work. Which leads to a question of whether volatility can remain low. Which leads to a question of whether unquantifiable risks can be taken into account. Which leads to a question of whether the central banks can keep withdrawing stimulus…. And so on.

So for now, pick your poison:

  • The economy is faltering – sell stocks, buy Tsys, risk neutral
  • Politics is imploding – sell stocks, buy Tsys, risk off
  • Volatility is low – buy stocks, sell Tsys, risk on
  • Politics is irrelevant – buy stocks, sell Tsys, risk on

We are likely to try out all of these scenarios over the next few weeks as we break into a new framework for what is driving the market. Unfortunately that means the market will be fragile. Just as Cable suffered a big figure flash crash at random yesterday, we also saw the Dollar rally on a misinterpretation of a Comey video, and today the Taiwanese dollar gained over a percent on a simple restatement of the central bank’s currency policy.

In this world, don’t get wedded to anything.

The New Guy at the Country Club

You’re a businessman, or at least you’ve spent your life trying to cut deals. In fact, you made “You’re Fired” into a catchphrase. Let’s say you end up in a completely new leadership role. What do you do? Well, test out your new powers of course. Figure out where the levers are. You didn’t come this far in life without knowing how to make things happen, right?

If Donald Trump’s new job had been head of the country club, these first few months might have gone like this…

  1. You decide you don’t like certain folks joining the club without being fully vetted. So you send all members a memo emphasising the criteria, pointing out anyone who doesn’t meet them can’t come in, for the time being.
    1. But you don’t realise that you can’t prevent people from coming in, just because you’re the new chairman…
  2. You decide you don’t like the reform whereby members didn’t need to wear jacket and tie anymore. So you decide to repeal it and replace it with something else.
    1. You have learnt that you can’t do this unilaterally, so now you shout at everyone to make sure this is implemented.
      1. Oh but you didn’t realise that they don’t have to listen to you when you shout…
  3. You’ve got a bunch of new buddies you put into place in your leadership team. You keep them jostling for power as you’ve always done, by briefing against each of them to the others.
    1. You forgot that to the club’s members, and the outside world, this makes you look weak, not strong…
      1. In fact, you’re in danger of looking irrelevant. You’re just the guy on the brochure, smiling with your thumbs up

So now, you’re frustrated, angry, irritated. You’re the head of the goddamn country club for chrissakes!! Why isn’t everyone doing as you say? I mean, you knew you’d have to bed in for a bit, learn the new scene, but not to this extent! It’s as if these people have a master other than you!

Then one guy comes in. Starts poking around about a chat you had with a golf club maker. You wanted to do a deal, maybe get in some cut price clubs for the members. Something tangible, of benefit to the members. Something they’ll raise a glass in your honour for at the bar. This guy starts making trouble, asking questions, wondering if it’s all above the board. (Doesn’t he know I *am* the board??) So one day, you just fire him.
Yeah, that’ll teach him. Throw him out into the cold. Who does he think he is? No-one will listen to him now, the chair of the club ditched him. Loser!

Ah, but then you forgot that he was in charge of his own organisation. And it’s well respected. And it keeps records of events. And it’s listened to. And not just by the members of your club, or the wannabe members. But by everyone in the town. By your enemies.

……and the big question is not what happens to the head of the country club after all these misfiring spats; it’s what it does to the reputation of the club in the process. And of course, it’s way bigger than that. What if the club were the only club in the whole country? What if its credibility to operate were cast into doubt?

This is where the next phase of the Trump Presidency gets into trouble. Not because someone is deliberately mad, bad or dangerous (although they may be) – but because governing with someone who is testing out government is going to end up testing the credibility of those institutions. And any loss of institutional credibility is going to end up creating a risk premium. It’s not just the political risk associated with the one-off binary election risk that matters (was it ever?) for asset prices; but rather the requirement to take note of how governing actually happens. The market thought it could ignore Trump blundering around as he fiddled with the levers of power, deciding he was an impotent irrelevance. Now it’s starting to realise the entire process of government is powerfully important indeed.

Strange Things are Afoot at the Market K

Let’s start with something esoteric. The Eurodollars options market has been having a little fun with the June Fed meeting. Having been priced in completely, the market is now “only” pricing an ~80% chance of a hike that month. This has come about despite low volatility, (allegedly) low political risk, tighter credit spreads, and basically any indicator that screams and shouts woohoo the world is allllright thank you ma’am. Usually a hike might get priced out because of fears the economy isn’t as great as first thought; or because the Fed themselves might guide it lower. Well, we’ve had Ok-ish data, and the Fed have been falling over themselves to continue to push out the hawkish boat. Former dove Rosengren is just the latest, telling us on Wednesday that ‘along with a gradual reduction in the level of the balance sheet, it would still be reasonable to have three rate increases over the remainder of this year’. Three! We’ve barely got 1.5 priced.

As BM’s great heroes Bill and Ted once spotted, strange things are afoot.

The reason that the options market is playing around with that June date is because it’s a cheap way to get on a hedge in case the world goes wrong. If Trump does accidentally miscalculate over North Korea; or if France’s National Front suddenly capture masses of parliamentary seats; or if, heaven forfend, Labour’s Corbyn takes the UK back to the 1970s (hey, weren’t we outside the EU then too?)…. then you might want something in your portfolio that could capture it.  These so-called tail hedges used to take the form of buying the VIX. But those using it as “cheap” insurance have come to find that astonishingly it’s not worth the paper it’s written on. The VIX keeps on going lower. After all these years of owning it, it not only fails to protect your portfolio, it actually ends up hurting it – as the persistent vol selling funds just keep on smacking it down lower.

It’s not just that there was no point paying for the insurance because your house didn’t burn down; but that the world instead decides fires are now extinct and the insurance contract is worth less and less every day.

Hence the need to find other ways to protect a portfolio cheaply – and hence the esoteric dive into the pricing of Fed rate hikes.

Clever markets, eh? Always finding a newer, cheaper way to manage risk?

Oh but this is where it gets reflexive, as Soros might say.

We use prices to tell us things. The reason that everything looks so euphoric is because the prices are telling us that everything actually IS euphoric. The credit crisis taught everyone to look at prices they had never looked at before, in order to be ready in case something bad happened again. Equity guys didn’t use to give a monkeys about money markets: on a trading floor it was literally as if the former felt they were Ferrari-driving masters of the universe, while those mucking about in overnight deposits were pond slime. When the credit markets froze up in August 2007, it took another 6 months before equities stopped rallying. When everyone realised that if banks couldn’t lend to each other that was pretty bad for, y’know, the valuation of everything.

So now, everyone looks at indicators like the LIBOR-OIS spread for signs of credit market stress, along with classic indicators of risk-off, like Emerging Market bonds, or that old favourite, the VIX. These are now all plumbing decade lows. That means everything is great!

And these days, that means more than just being relaxed that nothing bad is going to happen.

Just as we used them to warn us if things blew up, now they’re used to ensure max risk is on. All of the deliberate pumping up of asset prices through QE means the story of the last few years was to buy the dip. Don’t miss out – don’t leave anything off the table, go all in. If anything, the Brexit vote and Trump win only reinforced this; the dips were brief, despite the doom-mongers. This is partly because there is a genuine global trend towards reflation that is asserting itself despite the politics. But that could be derailed in a heartbeat by a change in policy. And where in the world right now do we have new untested leaders doing new untested things?

The mistake here is thinking that political risk can be priced. Not all risk can be quantified.

This shouldn’t be new for the market. Remember all those panicked CFOs during the crisis who pleaded it was a “six sigma event”? Something only supposed to happen once every 1.5 million years? We know now that the quantitative models were just wrong.

So what if the current measurement of risk is also just wrong? What if using the prices from the market to put risk on is reinforcing those selfsame pro-risk market prices? What if the real risk is somewhere else?

To conclude: what could the LIBOR-OIS spread tell us about the probability of the US President firing the head of the FBI and thus undermining the institutional credibility of the country that leads the free world?

Answers on a postcard please.

Climbing the Wall of Worry – Part 5

Emmanuel Macron’s coronation was followed either by fretting that “over a third still voted for a fascist” or “he’ll never get anything done anyway”. While both of these are valid comments, they should not be concerns. Rather than fret over France’s secular uptrend in fascism votes, consider instead that neither of the big established parties got through to the second round. That gives a sweeping mandate to anyone who can deliver change. Much like how Theresa May is now likely to gain a significant majority by delivering Brexit that 48% of the country didn’t want, it is possible to capitalise on The Mood Of The People, even if they didn’t vote for you. France had had enough. This is Exhibit A for Macron to deliver some reforms.

Aha, but what about the fact his party hasn’t existed long enough to deliver a majority in Parliament? Surely that will stymy his efforts and we should be just as afraid as we were before the Presidential election began?

Mais non, mon petit choufleur. Stop for a moment and tell me the name of any French Prime Minister. Any at all. Not just the ones that have run for President, and that’s why you’ve heard of them. In fact, tell me about a time when France was resplendent, abundant with joy, awash with positive change.

Tricky, isn’t it? The French economy has struggled for years. The focus of any hopes for change have always rested on the head of one man alone, and that’s the President.
For all the attention on the US Presidency, the French equivalent has more power within the system. This is because he gets to choose his Prime Minister and approve his cabinet; whereas the US Speaker of the House is elected by the dominant party without any Presidential involvement. Thus in France, the executive has a much stronger hold on the legislature. During cohabitation it can indeed be tricky for the President, as he has to choose a PM with the support of the majority party of the National Assembly that may not be his. Many appear to think that Macron will suffer the same fate as En Marche will be too new a party to command many seats.

This is actually Macron’s trump card. He’s unknown, and his party is new. He can work with either of the biggest parties in the legislature without losing face. He can be flexible. He can put together a coalition of the willing, that changes as he launches each new policy – and he will not be criticised for it.

Equally, the tribal loyalties that prevent Republican MPs from legislating for Socialists (or vice versa) can also be put aside. The deputes can also therefore be flexible. And who wouldn’t want to back the man who came out of nowhere to easily win two-thirds of the vote? Momentum matters in politics.

Right now, Macron is at his most powerful. He’s not failed to deliver anything; he gained declarations of support from both Republicans and Socialists in the run-up to the vote; he is the figurehead for France. If parliament were to gang up and prevent him implementing his agenda at this stage, they look deliberately obstructionist. Now, if The People’s mood changes, then he will struggle. Let’s say Le Pen starts to poll 45% as the years go on and nothing changes; then he would have to change course. But that’s years away. Right now, he can do anything.

For all the murmuring about the National Assembly elections then, they’re really only of interest if you are specifically investing in an area that the minutiae of policy might affect. But from a macro perspective, they’re pretty much irrelevant.

Much more important for macro thinkers will be how Macron acts on the world stage. What stance will he take towards Theresa May? Or Michel Barnier? Or Juncker? Or Merkel? It’s much more relevant to consider what he might do with the rules over the UK/France border point created in the Le Touquet Accord – coincidentally, Macron’s family home is in this seaside town. Or his pledge to prevent UK firms from tendering for EU public contracts. The Brexit Battle Lines are being drawn, with significant ramifications for both sides. Now this, I am worried about. It’s going to be messy, noisy and nasty – as all negotiations carried out in public are.

For now, though, the VIX can continue to plumb the depths, on Tuesday hitting its lowest level since December 1993, and stocks and risk-positive assets can remain happy enough. In the new world, remember that volatility eats itself on the way down as well as on the way up. The systematic vol selling funds just keep on keeping on, picking off those who like to pick up a little portfolio insurance. As long as this insurance ends up worthless, as it has so far, the selling will continue. And as the selling continues, allocators continue to plough more and more into risky assets. It’s a virtuous circle.

What could cause this to change?

  • A genuine unexpected risk-negative event pops up
  • The market becomes unbalanced: just too much risk goes into positions that can’t be liquidated as quickly as thought
  • A realisation that political risk is no longer just a binary election-driven event, but an ongoing process of governing electorates who are increasingly fractious and divided  – leading to more volatile policy-making
  • The secular shift towards higher interest rates globally causes a re-pricing of stocks

Now, these are all issues to worry about. They are in fact the issues that should occupy thoughts throughout the rest of the year. Not who wins the French elections, nor when the Fed hikes, or North Korea gets jumpy. Macron will govern. The Fed will be hawkish. North Korea will be jumpy. The question is how prepared the market is for these events and what positions would be vulnerable to a reversal. For starters, let’s expect the VIX to print a new all-time low very soon – and the longer it stays down there, the more violent the reversal will be. Climb that wall of worry!

Is there a Fed Meeting tonight?

Tonight’s Fed decision is considered a non-event, due to the lack of press conference or new projections. All the action is expected to come in June instead, although action might be too strong of a word for it. Ever since this first proper hiking cycle began, the market has never really believed it meant anything much: the US 2 year rate is now only ~0.30bps above where it was when they started. Woohooo!

The market is pricing in 1.5 hikes for the rest of this year. It’s like ever since the taper tantrum put the fear of God into the Fed, and the oil price collapse led to global deflation, we just can’t imagine a world of properly rising interest rates.

Short-term, post Trump’s election, we did see an attempt to put on speculative positions for higher US rates. That proved to be wishful thinking, and this position was wiped out in the past couple of months. In fact it now stands at a net long position, and the longest since the safe-haven-demand days of 2008:

This position adjustment means that the path is now clear if the Fed wants to signal higher rates ahead. They may want to do just that, as all of their hiking so far hasn’t even affected managed to tighten financial conditions:

This is largely due to the rally in the stock market alongside the fall in volatility. Effectively even as the Fed are hiking, the US is facing easier policy. The hikes aren’t doing anything.

So, the backdrop is fairly calm for them to signal tighter policy ahead, should they so desire. There is a raft of speakers on Friday (Fischer/Williams/Roesngren/Evans/Bullard/Yellen) which could provide the opportunity, even if tonight is as snoozy as expected.