Wednesday, 21 March 2012

Treasuries vs Equities and Forex volatility - A Tale of Three volatilities.

"By three methods we may learn wisdom: First, by reflection, which is noblest; Second, by imitation, which is easiest; and third by experience, which is the bitterest."

Given lately, we have been conversing on volatility (The two main drivers of equity volatility)  as well as the recent sell-off in US treasuries, we thought this time around we would entertain you with some interesting points made by our good cross-asset friend with whom we regularly discuss our macro and market interests.

Below you’ll find a historical chart showing the relative valuations of benchmark indicators for short-term implied vols in the three main asset classes (equities / forex / rates):
-Rates : Merril Lynch’s MOVE Index showing the trend in 1-mth atm implied volatility 2 / 5 / 10 and 30Y Treasuries options.
-FX : Credit Suisse’s CVIX Index showing the trend in FX main pairs atm 3month implied volatility.
-Equities : SPX 3mth options atm implied volatility (much more reliable than the VIX which is currently polluted by several technical factors).
At the bottom you can see UST 10 year yield evolution post QE2.
Source Bloomberg - (click graph to enlarge)

As indicated by our cross-asset friend:
Since the start of the bond market correction that started last week, we can clearly notice a disconnection between Treasuries volatilities (up quite strongly) and risky assets volatilities (equities and Forex volatilities remaining at the low end of their recent range).

If the bond market’s move truly is the start of a long rates repricing for “good” reasons (namely finally validating the huge risky assets run-up of these last 4 months on better macro data) then it makes sense to see a risk transfer from the equities/forex sphere to the bond market’s sphere. As a matter of fact, we noticed this kind of discrepancy during a rather similar period : in Q4 of 2010, following the QE2 announcement, where we saw 10 year yield move up 100 bps, SPX and most risky assets rallyed hard with the same type of cross-asset vols opposite moves.

However these kind of disconnections in cross-asset vol markets generally do not last long. A correction in risky assets or a larger bond market rout would effectively probably see SPX and forex short volatilities move up rather quickly. We’re talking short-term volatility here so obviously timing is key to put on recorrelation trades as you need to be right pretty fast...
To be continued !

"Three things cannot be long hidden: the sun, the moon, and the truth."

Stay Tuned!

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