This time last year we got the start of the signal that lower and lower volatility wouldn’t be with us forever, with the biggest one-day percentage move in the VIX and the subsequent immolation of the linked inverse ETN, the XIV. Today, the VVIX, which measures the change in the VIX (that is, the volatility of volatility) is at its lowest since July 2017 (h/t @dynamicvol).
So, not only is nothing moving, it’s persistently not moving.
This, despite a plethora of events: earnings season in the US, a topsy-turvy Fed, Chinese growth disappearing, the UK weeks away from an unknown relationship with its largest trading partner, Germany in recession, and Italy inexorably and laughably stagnating into an inability to meet its EU deficit targets.
We have been here before of course. This was the story of 2017. The BTFD force is strong. But it’s supposed to be turning now that global QE is shrinking rather than rising.
Oh, but what a tangled web we weave, when we conspire to quantitatively ease.
All of that liquidity triggered an additional impulse of extra liquidity. There are three sources and they’re all still going strong:
1. The FOMO from BTFD means passive money has to pile into something somewhere.
Since the start of this year, credit spreads have narrowed and emerging markets have risen from the ashes with EM ETFs seeing all the inflows (h/t @EricBalchunas). BAML Jan Fund Manager Survey showed ‘US credit investors turned bullish on credit spreads for the next 3 months”. HYG saw the largest weekly inflows in two years. Yield is required.
2. The success of the “sell vol” strategy has created a self-fulfilling behemoth.
There is now a huge and lucrative market in trading derivatives on the S&P500 – specifically, rolling options structures that sell near-dated vol and buy the longer end. This creates identical hedging requirements for all the market makers in the SPX options market. Everyone has to sell and buy at the same levels, in narrower and narrower ranges to offset the passage of time. That compresses ranges further, shrinking volatility and encouraging more money into the “sell vol” trade. Right now, as our friend @patrol_pancake points out, the current hedging requirements are equivalent to selling 9,000 of March SPX straddles. That’s punchy.
3. To close the virtuous liquidity circle, financial conditions loosen.
With stock markets rising and money flowing into bonds, we are now left with the statistic that 40% of the Eurozone government bond market now has a negative yield, back to where it was in April 2018. That’s despite the fact that the ECB have stopped their QE programme.
And US financial conditions have now reversed almost all of their tightening from October when Fed Chair Powell told us that we may “go past the neutral rate” (h/t @fwred).
That’s despite the fact they’ve dropped accommodative policy and were always due a pause as growth slowed. Not least when Powell’s patron Mr. Trump is rampin up the criticism (and they enjoyed a very nice steak dinner at the White House last night by all accounts). Powell is merely juggling financial stability concerns with political concerns – but he’s not about to embark on some huge rate-cutting programme. Not yet, anyway.
So the central banks are stepping back, but the market is taking their place. They are mimicking the QE impulse.
As volatility falls, money flows into riskier assets. As money flows into riskier assets, their risk premium compresses, and volatility falls. This is the Faustian virtuous circle that gave us a ~20% return on the SPX in 2017 but with volatility of only ~5%.
Last year should have shattered this. But memories are short and never more so than in risk management models. The 2017 paradigm still, just about, works.
Until it doesn’t.
The most eye-catching stories of December involved two French banks, both renowned for their derivatives expertise. Both suffered horrendous losses as a result of poorly hedging their short volatility positions.
1. BNP Paribas
A cool $80mm loss for one of their SPX options traders just before Christmas, as he was caught offside from the collapse in the SPX. According to market makers, he was rolling a kind of calendar spread, selling Dec to buy Jan. Usually, that would be fine, with volatility naturally falling into the end of the year. The speed of the loss also caught him by surprise, with reports he went on holiday even as it was occurring.
In December, Natixis announced a 260mm EUR loss: 100mm that had already been incurred and a provision for another 160mm. For a bank which only made 599mm EUR from all of its equity trading in the previous year, this was punchy. What caused it?
The bank press release explained: ‘This item of exceptional nature relates to the deterioration of market conditions in Asia which was already flagged at the occasion of the second and third quarter results as weighing negatively on the equity derivatives activity. In the fourth quarter of the year, the model used to manage some specific products traded with clients in Asia led to a hedging strategy that proved to be deficient under current market conditions.’
More on this structured product business in Asia:
- These specific products had wonderful names like ‘Flash Lizard’ and ‘Cobra’.
- They were designed to give clients yield but protect them if stock markets suddenly dropped.
- Natixis aggressively built out its Asian structured products in order to win more business, partnering with the Korea Exchange in 2017 to launch the first equity-linked product called Kospi 3
- In August last year, it was awarded the accolade of “Korea House of the Year” by Risk magazine.
So they deliberately ramped up their risk, they wore a growing loss for two quarters and then finally finished themselves off at the end of last year. Well, aside from the small matter of that 160mm provision ‘to cover the management of this product book’. The head of Asian equity trading is nowhere to be seen of course, but the bank still committed to paying its 1.5bn EUR special dividend.
But no one cares. Volatility is low and stable. Yields are down. Equities are up. The positive-risk feedback loop is alive and well.
Except that these kinds of losses do make a difference. They can’t just be written off. Note that both of these losses were blamed on poor hedging strategies. Other banks had equally poor Q4 results, largely as a result of worse-than-expected trading profits. Risk management systems will have been tightened up. Unfortunately, that just tightens the noose around the market’s neck. If you can’t afford any more losses, you need to hedge more aggressively. But it exacerbates the breaking point too. If the market turns, you’ll have to cut your positions more aggressively.
So we shouldn’t be surprised that nothing much is moving. But equally, when it breaks, we shouldn’t be surprised when it does so with extreme force and speed.
This is why we focus on Brexit. It’s the biggest risk out there that is time-limited and where risk management has deviated so far from reality. Parliament couldn’t even bring itself to vote for more parliamentary time to prevent No Deal, preferring instead only to make a statement ruling it out, and only by a margin of 8 MPs. That’s not a huge groundswell consensus for avoiding the cliff edge.
The black swan price action on white swan events continues.
Tick tock goes the Brexit clock, but so too goes the volatility watch.