Tuesday, 22 January 2013

Volatility Regime Change and Central Banks - a key driver

"If you do not change direction, you may end up where you are heading." -  Lao Tzu

While we recently asked ourselves about the possibility of a regime change in the volatility space in early January:
"Long dated volatilities a regime change?"

and touched as well on the change in volatility regime in both the US and Europe:
"The Change in volatility regime - a follow up"

A note from Goldman Sachs entitled "The Buzz - The Great Compression - VIX regimes over the last 23 years" from the 22nd of January seems to confirm the shift into a lower vol regime:
"Our VIX analysis back to 1990 shows that the VIX has been through seven “statistically” distinct volatility regimes over the past 23 years. The model currently assigns an 89% probability that the VIX has shifted into an even lower gear, and is currently transitioning into its 8th regime characterized by lower volatility levels."
- source Goldman Sachs.

More interestinggly has we have been discussing in our recent credit conversations, we have to agree with Goldman Sachs note, namely that when it comes to a lower volatility regime, Central Banks have been a key driver:
"Our statistical test allows us to track the probability of a regime shift over time. The probability of a new lower vol regime hit a low of 14% in mid-summer 2012, and then accelerated higher post ECB President Draghi’s comments in July to do “whatever it takes” to preserve the Euro. After the official launch of QE3 in the US and ECB monetary stimulus in September the probability moved from the low 30’s to where it stands now in the high 80’s, over 6x its mid-July level. Our simulations show that a replay of VIX levels over the last two months would push our regime shift probability to 95% and make the new VIX regime official from a statistical perspective." - source Goldman Sachs.

Following the footsteps of our recent conversation relating to the regime change in the volatility regime, Goldman Sachs in their note argue the following:
"While much has been written on the imbalances which led to the “Great Recession" and the unprecedented volatility levels reached, understanding the common post-crisis volatility patterns can have strong implications for volatility investors. The VIX averaged 17.8 in 2012, on par with 2007 levels, and has averaged 13.7 in the early stages of 2013, similar to the average level from January 2004 through mid-2007. The VIX transition from the Great Recession to the Great Compression has been a long, slow healing process, and the number one question we have gotten from investors in 2013 has been: “Is the VIX shifting into a lower vol regime?” The short answer: The statistics say YES."
- Source Goldman Sachs, Krag Gregory, Ph.D., Jose Gonzalo Rangel - 22nd of January 2013.

When it comes to measuring or not the probability of regime change, according to Goldman Sachs, the probability of a new VIX regime has increased six-fold since mid July 2012 and stands currently at 89%. The chart below from Goldman Sachs shows the probability of rejecting the hypothesis of "no regime change". Data as of January 18, 2013:
- Source Goldman Sachs, Krag Gregory, Ph.D., Jose Gonzalo Rangel - 22nd of January 2013.

Goldman Sachs makes the following points in their research note:
"-Supply/Demand: Trading behavior could also put pressure on the back-end of the volatility curve. In low vol environments investor behavior often changes. From a supply/demand perspective, in lower realized volatility environments investors become reluctant run pure long volatility strategies and often try to minimize carry. That is often done through calendar spread trades which sell the back to fund the front-end of the volatility curve. That flow would put downward pressure on the back-end of the VIX and S&P curves. 

-Investors continue to search for yield: In an environment where rates are exceptionally low, investors have had to look to other asset classes to generate income. Low vol regimes typically bring out the vol sellers. Investors often wait for persistently low levels of VIX and realized volatility to sell puts, straddles and strangles. This shift in trading behavior from long vol to short volatility risk premium generation strategies may also push vol lower. 

-Caveat: Shouldn’t the VIX curve be steeper now than in 2007 given VIX ETN’s? One issue which makes comparisons to 2007 and quantifying potential term structure shifts difficult is that VIX ETN’s and ETF’s did not exist in 2007. These products by their construction have a tendency to steepen the VIX curve. So we may not see the same flatness we saw in 2007 unless volumes on these products decline considerably." - source Goldman Sachs

More importantly, Goldman Sachs makes the following important points in regards to a sub-14 VIX level:
"What is a sub-14 
-VIX telling us?What is a sub-14 VIX telling us? The VIX landed at 12.5 last Friday, and has averaged 13.7 YTD. The VIX has traded at an average spread of 4.4 vol points above S&P 500 one-month realized volatility back to 1990. If taken literally, VIX levels below 14 in early 2013 suggest that the VIX is "forecasting" sub-10 realized market volatility, at least for the near term. S&P 500 realized volatility was 12.8 in calendar year 2012, one- and three-month realized are around 13, and ten-day has dropped below 6.
-Equity volatility and the business cycle: Our US Economics team is currently forecasting real GDP growth of 1.5% for 2012Q4, with an expectation for 1.5% in 2013Q1. The ISM manufacturing index has been hovering around the 50 mark over the past few months and our economists expect little change in 2013Q1. Over the last 50 years S&P 500 realized volatility has typically averaged about 14 in months when the ISM was between 50 and 55 and 14.8 in quarters when GDP growth rates were in the 0%-2.5% range.
-Our economic model for S&P 500 one-month realized volatility suggests that volatility should currently be trending around 14 based off of current levels of manufacturing, consumer spending, and labor data. So benchmarking relative to the ISM, GDP, or our own formal model, suggests realized volatility should be around 14.
-But benchmarking relative to the economics may be less relevant now. In our view changes in volatility are about changes in information content. So low but steady levels of ISM and GDP growth for prolonged periods may not be indicative of higher volatility levels. We have been in this macro environment for a while and we argue it is sharp changes in the macro and financial information sets that are volatility inducing. We are also in the unchartered territory of unprecedented global Central Bank liquidity which may make comparisons to typical volatility levels in past economic states more difficult. In short, no bad news equals good news for lower VIX levels, especially if we get through the debt ceiling and sequester debates unscathed." - source Goldman Sachs.

As we argued in March 2012, in our conversation "The two main drivers of equity volatility":
"The two main drivers of equity volatility are for us, credit availability (Merton model) and revisions of earnings forecasts estimates."

VIX since 2005 - Source Bloomberg:

One thing for sure, the on-going excessive search for yields could have a long-term impact (relative immunisation risk of credit versus equities).

"Consequences are unpitying." - George Eliot, British author.

Stay tuned!

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