Tuesday, 25 June 2013
Rates volatility & Cross Asset volatilities - a follow up on the "Regime Change"
"Hope in reality is the worst of all evils because it prolongs the torments of man." - Friedrich Nietzsche
As a follow up to our end of May post where we indicated the risk of repricing of bonds courtesy of a surge in bond volatility, which to some effect has spilled into both the currency sphere as well as the equities sphere, it is time for a follow up courtesy of our good cross-asset friend in relation to the relation between credit and equities volatilities and the potential further surge in equities volatility.
Back in January we indicated that Central banks are key drivers in terms of volatility regime change.
The meteoric rise in bond volatility. The MOVE and CVIX indices rising contagion spilling to the equities sphere closely followed by a rise in the VIX index albeit more muted - graph source Bloomberg:
MOVE index = ML Yield curve weighted index of the normalized implied volatility on 1 month Treasury options.
CVIX index = DB currency implied volatility index: 3 month implied volatility of 9 major currency pairs.
As displayed by the move in MOVE, US rates volatility has been exploding and spilling to FX (CVIX). So far Europe and US volatilities have been underperforming on a relative basis. The stress in the equity space has so far been confined to Emerging Markets.
Volatility ETF EEM US (MSCI Emerging Markets) versus Volatility S&P 500 3 months ATM (At The Money) - graph source Bloomberg:
It is difficult to envisage some stability in the Emerging Markets space until US interest rates stabilize.
US T-Note curve (5th of May 2013 versus 25th of June 2013 - graph source Bloomberg:
Credit wise, although early May in Europe the Investment Grade credit index (Itraxx Main) and High Yield credit index (Itraxx Crossover) appeared too tight relative to equities, the recent violent moves and surge in spreads in the last two weeks have triggered a reconnection between those two risk indicators (credit versus equities).
Spreads and Equities volatility are now in line with their two years historical levels. A similar trend has happened between spreads and spot equities according to our good cross-asset friend.
Itraxx Crossover (roll-adjusted) versus Eurostoxx 50 volatility 1 year ATM (At The Money) - history two years:
Itraxx Crossover (roll-adjusted) versus Eurostoxx 50 spot index - history two years:
As we posited in our conversation on the 13th of June "The end of the goldilocks period of low rates volatility / stable carry trade environment?":
"The huge rally in risky assets has been similar to the move we had seen in early 2012, either, we are in for a repricing of bond risk as in 2010, or we are at risk of repricing in the equities space."
Looks like we have both...
We strongly believe higher USD rates vol will ripple through other asset classes and provide more cross-asset opportunities going forward.
Here are Morgan Stanley's views in relation to the potential "regime change" courtesy of the latest US central bank jitters:
"VIX has rallied 60% since May 15th lows, however, it is not very high by long term standards (57th percentile back to 1990). VIX of ~20 tends to be a transitory level – in a risk-off regime volatility could rise significantly higher, while in a normalization over the coming weeks it could fall to the low teens.
We have seen several spikes in VIX over the last six month. What is different this time around is the persistency in the move higher (vol has been steadily rising for the last month), and the dynamics across the volatility term structure – risk premiums have been reprised over longer time horizon, not just in the near term. This dynamics suggests a broader change in risk aversion among equity investors and reflects a potential transition to a different volatility regime.
Volatility tends to show persistent characteristics over time - clustering effects and mean reversion. Early spikes in returns help detect future volatility clusters. QDS team has developed a number of proprietary signals to help identify potential shifts in volatility regimes. One of the signals used in our VolNet suite of systematic volatility trading strategies is designed to avoid volatility clusters, which if otherwise exposed to, can lead to large losses on short volatility positions. The triggers are activated if we see outsized moves in the underlying cash market. Historically, these risk off events were often followed by significant spikes in volatility (red dots in the 2nd chart below indicate when the product has no short vol exposure due to the risk off features).
VolNet risk off trigger was activated on SX5E on May 29th, 2013 and on SPX last Thursday, June 20, 2013. The VolNet Indices have been live since Apr 2011 and the signal was successful at avoiding the Aug 2011 vol spike in SPX.
VolNet Risk-Off Trigger would have avoided many large volatility spikes in the last 20 years:
Looking across asset classes, US equity volatility remains relatively low versus interest rate and FX implied volatility, despite the moves higher (3rd chart below). Volatility in all asset classes has increased in recent weeks, but equity volatility had declined more in late 2012 and early 2013 than other asset classes, and has more room to rise should uncertainty in the rates market continue."
Vol has picked up across all assets, but US equity vol still has room to rise relative to Rates and FX vol
- source Morgan Stanley.
We agree with Morgan Stanley, namely that the latest market jitters courtesy of the Fed, clearly indicates that volatility in the US equity space as well as in the European space (V2X) have room to rise relative to FX and Rates volatilities.
Evolution of VIX versus its European counterpart V2X since 18th of April 2011 - source Bloomberg:
"We are more often frightened than hurt; and we suffer more from imagination than from reality." - Lucius Annaeus Seneca