Wednesday, 14 May 2014

Japan and Nikkei volatility - Time for some Abe fireworks?

"I guess we all like to be recognized not for one piece of fireworks, but for the ledger of our daily work." - Neil Armstrong

Interesting comments today from a trading desk relating to the technical situation for Nikkei volatility:
"Long-dated Nikkei volatilities getting destroyed – time to BUY? Not a consensus trade yet but worth a look

Hearing from the street main exotic houses down $US250mm in 5mth…a blood bath.
Volatilities look cheap and you keep accumulating at a cheaper level…averaging down. Until when do you have to add? Main issue on the Buy-side is you can’t wait and need to show a steady growing P&L.

Issuance from the Uridashi is 2-3 times less than 2012, vega outstanding is only at $US20mm and we are already at the same volatility levels than in 2012 with a market at 14000…What's going to happen if we correct even more and test the 13000 level? It will be a disaster! Very tough time for pure volatility accounts

Until 6 months ago, the street was thinking that tapering would create some volatility. Now nobody believes in it. When the market goes down, FED prints a lot. When the market goes up, FED still print… but less. In fine, FED maintains the equity market high and rates low. Their politics have zero impact on the real economy but brings the market’s volatility at zero…Believe the current trend in volatilities will continue…more downside.

If there is a risk of a massive unwind of the “Japan trade” in the next 3 to 6 months, why looking at 2 year maturity options? Better to focus on September/December maturities. More gamma / more liquid. If you anticipate high realized volatility before the year-end, why trading long-dated volatilities with the risk of seeing them dropping an additional 2 vol points? Exotic desks are bleeding and if spot keeps dropping, their long vega exposure will keep growing…

Nikkei 2 year ATM (at the money) IV is now at 18.90% so down 2.5 points in one month. 4 year percentile at 4.9% so we're extremely closed to the historical lows. That trend is not only specific to equity. Vols across all the asset class are at their lows. FX (USDJPY) 1 month vol is at absolute historic lows. The market seems to be too complacent, something is "mispriced" and we think it’s the right time to accumulate volatility.

Why Nikkei and not another index or asset? Because that's the only one with catalyst... a ticking bomb or a fireworks box depending on the efficiency of Abe's government and the BOJ/GPIF action over the next few months."
Nikkei 2 year ATM IV since 2008:
-market source

The market has been driven mostly by structured products with dealers getting more and more long 2 year vega short the spot. It has been a regular trend for quite a few years, but in recent weeks, there has been some capitulation with the Nikkei falling from 15000 to 14000 in addition to the index trading in a tight range. If one thinks the Nikkei index could move either way strongly during the second part of the year, then going long volatility on December 2014 could make sense for exemple. In similar fashion volatility on the Japanese Yen has followed the same path.

Dynamic between FX and Equities as illustrated by this Bloomberg graph displaying not only the surge of the Nikkei and the USD/JPY but also the reverse Itraxx Japan CDS index:

If the economy suffers as a result of April’s tax change, the BoJ has stated its intention to respond with increased monetary stimulus.

As we have argued in our November 2012 conversation "Cold Turkey", while some recent "trade fatigue" did materialized in recent months on the Japan rocket "lift-off", we still think that we are in an early second stage for the Multistage Japan rocket:
"A multistage (or multi-stage) rocket is a rocket that uses two or more stages, each of which contains its own engines and propellant. A tandem or serial stage is mounted on top of another stage; a parallel stage is attached alongside another stage. The result is effectively two or more rockets stacked on top of or attached next to each other. Taken together these are sometimes called a launch vehicle. Two stage rockets are quite common, but rockets with as many as five separate stages have been successfully launched. By jettisoning stages when they run out of propellant, the mass of the remaining rocket is decreased. This staging allows the thrust of the remaining stages to more easily accelerate the rocket to its final speed and height." - source Wikipedia

We still don't see Japanese going "cold turkey" on liquidity "injections" for the time being hence our "contrarian" volatility take and we still recommend you closely monitor Japan's foreign bond buying spree. 

On the Abenomics "second stage rocket" subject here is what Barclays had to say in their latest Japan update from the 14th of May entitled "Abenomics trades - Standing at a crossroads":
"Financial markets I (Abenomics trades; long Nikkei/short JPY) – One more leg towards summer? As mentioned above, market positioning in Abenomics trades appears to have become much cleaner in both Japanese equities and forex. Given the significant drawdown of positions since the beginning of the year, it is most likely that equity prices and USDJPY will respond to developments in a fairly straightforward manner in near term. In other words, we expect one more leg of Abenomics trades to be initiated on the back of series of events expected in next couple of months, including additional QQE by the BoJ (expected in July, but might be frontloaded depending on financial conditions), announcements on asset reallocation by GPIF and other public pension funds (likely in June), and another for growth initiative proposal (also likely in June) along with additional fiscal stimulus measures (in July-September). That being said, whether overseas investors are likely to take the lead in these trades and hold the positions beyond the summer remains uncertain. With less risk-taking capability and less enthusiasm (or sense of urgency) in being re-involved in Abenomics trades, their investments may remain within the range of opportunistic trades, rather than those with long-term commitments. For overseas investors to share a firmer and longer-term commitment to Japanese markets, the government and corporates will likely have to deliver something new, rather than continue to depend on QQE by the BoJ. Some measures to encourage corporate management to promote shareholders value through share buybacks and/or higher dividends, given ample cash on hand, would be one example, along

Financial markets II (JGBs) – A “widow maker” for overseas investors? Last, but not least, we have not observed any significant positioning in JGBs. Most overseas investors are still tempted to trade JGBs on the back of a “terminal” view of Abenomics (regardless of whether it is succeeding or not): rising long-term rates with steepening bias to the curve. If Abenomics is successful, higher and more sustainable inflation expectation should lead to higher yields, with the BoJ most likely to stay behind the curve by remaining patient on the timing of alternating the direction of policy. If Abenomics fails, there will be resurgence of deflation fears, at least at the initial stage, so that yields could be lower. However, this will eventually lead to less sustainability of government debt with a structural bias towards an external deficit so that long-term rates should imply higher fiscal premium. That being said, there is a limited amount of conviction in terms of whether or not to trade JGBs now based on these terminal views of Abenomics, given the dominance of the BoJ in the market as the sole provider of liquidity. At least in the near term, if there is a temporary selloff in the JGB market, it will be either liquidity-driven, as was observed in 2003 and after the introduction of QQE in 2013; policy-driven, as JGB purchasing operations by the BoJ may fail at a certain point; or flow-driven on the back of rapid portfolio rebalancing by GPIF and other public entities. With the terminal views on Abenomics mentioned above in mind, however, whether JGBs remain the widow maker they have been in the past is essential for understanding the future prospects of Abenomics." - source Barclays

Finally here what is we had to say on Japan's reflationary play in April 2013 and the impact on Europe:
"Moving on to Europe, we are unfortunately pretty confident about our deflationary call in Europe, particularly using an analogy of tectonic plates. Europe was facing one tectonic plate, the US, now two with Japan. It spells deflation bust in Europe unless ECB steps in as well we think." - Macronomics - 27th of April 2013 - "The Coffin Corner"

"A kamikaze is a surprise attack, according to our ancient war tactics. Surprise attacks will be successful the first time, maybe two or three times. But what fool would continue the same attacks for ten months? Emperor Hirohito must have realized it. He should have said 'Stop.'" 
- Saburo Sakai, IJN flying ace (quote used in our conversation "The Coffin Corner" 27th of April 2013).

Stay tuned!

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