Thursday 13 June 2013

Rates - The end of the goldilocks period of "low rates volatility / stable carry trade environment"?

"When an idea reaches critical mass there is no stopping the shift its presence will induce." - Marianne Williamson 

Following up on our post from the 29th of May relating to the surge in bonds volatility, we would like to point out to some interesting points made by Bank of America Merrill Lynch on the structural shift going on in US rates volatility from their Liquidity Insight note from the 10th of June entitled - When good news becomes bad news.
"US rates vol has emerged and will likely remain a pivotal driver for all markets. The May nonfarm payrolls data are unlikely to silence the market speculation on tapering. This means the balance of risks for US rates vol continues to favor the upside, in our view. The clearest implication of continued repricing of US rates vol is the underperformance of carry trades. 

Everybody knows that at any given moment in time, there is usually one market more important than all the others – the one that sometimes becomes the principal driver of all other markets. Price action over the past month tells us that US rates, especially US rates vol, has become that pivotal market. The May NFP has not altered this." - source Bank of America Merrill Lynch

As per our previous comment on this trend:
"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...

Like Bank of America Merrill Lynch, and like our good cross-asset friend, we strongly believe higher USD rates vol will ripple through other asset classes and provide more cross-asset opportunities going forward. 

The goldilocks period of “low rates volatility / stable carry trade environment” of these last couple of years seems to have come to an end, in brutal fashion for Higher Yielding carry trades for sure (Emerging Markets, High Yield, Emerging Markets FX, etc). The recent move in the MOVE and CVIX indices we pointed out recently, are now starting to spillover to the equities sphere. We have added the VIX index to our previous chart - 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 pointed out by Bank of America Merrill Lynch's note stable carry thrives in low rates volatility environment, the recent spike in US bonds volatility has had some devastating effect in high yielding assets:
"Carry trades love low risk-free interest rates, but they love low interest rate volatility even more. This is why over the past three years, billions of dollars have poured into high yielding assets like risky corporate bonds, emerging market currencies, and dividend paying stocks (Chart 3), driving their risk premiums to abnormally low levels:
This is also why with the back-up in rates vol triggered by talks about the tapering of QE, these assets have witnessed a sizeable correction over the past month (Chart of the day)." 
- source Bank of America Merrill Lynch.

It is going to be a long and interesting summer for sure...

Stay tuned!

"The tighter you squeeze, the less you have." - Thomas Merton 

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