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.