Saturday 17 September 2016

Macro and Credit - Broken Arrow

"The seed of revolution is repression." - Woodrow Wilson, American president
While watching with interest unfolding our cross-asset correlation fears with equities, bonds, gold, oil and the lot getting the proverbial "sucker punches" thanks to VaR (Value at Risk) shocks and given Japan's on-going economic predicaments, we reminded ourselves the military code meaning of "Broken Arrow" when selecting this week's title analogy. "Broken Arrow" is a US military code phrase used at the last resort when a ground unit is facing imminent destruction from enemy attack and therefore needs all available air forces assets within range are to provide air support immediately. During the Battle of Ia Drang in Vietnam that took place on November 14–15 1965, as the battle along the southern line intensified, Lieutenant Charlie W. Hastings (USAF liaison forward air controller) was instructed by Lieutenant Colonel Hal Moore of the 7th Cavalry, (based on criteria established by the USAF) to transmit the code phrase "Broken Arrow", which relayed that an American combat unit was in danger of being overrun. When we look at the vicious rise in volatility, which is at the core of any allocation process, which we discussed in our previous conversation and what it entails for Risk Parity Strategies, Vol Control products and balanced funds getting "unbalanced", we do share the same concerns from various pundits such as Mark Spitznagel that, if indeed the Fed decides to "surprise" the market with a rate hike, things could indeed turn "south" very rapidly given that as our quote goes the seed of revolution is in our case "volatility" repression thanks for the actions of "The Cult of the Supreme Beings" aka central bankers. As we re-iterated in our previous rambling, "cash" is a "strategy" and given the potential risks that lies ahead (think Italy and more...), we think that rather than calling for a "Broken Arrow" to defend your positions from being "overrun" due to "herd mentality" and rapid deleveraging, you would be very wise to increase your cash levels accordingly in the current environment. While you might be at the mercy from yet another dovish Fed which would indeed be a catalyst for maybe yet another melt-up in assets, we do think that from our "credit perspective", we are indeed in the last innings of this credit cycle and we would stick with "Smart Alpha" (High Quality Investment Grade) rather than going for "Dumb Beta" (High Yield and High Dividends stocks) at this stage.

In this week's conversation we would like to look again at the dangerous paradigm of "repressed volatility" with "lower liquidity" and what it entails from a risk perspective for supposedly "diversified" strategies. We will also look again at "impaired" banking systems in Europe and why we continue to avoid like the plague "European banking stocks" such as Deutsche Bank due to their Investment Banking franchise being "broken" as well as it isn't only NIRP that is damaging their Net Interest Margins (NIM) on the "retail" side.

  • Macro and Credit - The seed of "repricing" is "volatility repression"
  • Macro and Credit  - Broken Investment Banking franchises in Europe, time for some players to call it a day.
  • Final charts: The business cycle is turning and storm season is coming

  • Macro and Credit - The seed of "repricing" is "volatility repression"
While last week we touched on the rising costs in hedging strategies for insurers in conjunction with the "fast deleveraging" risks for some "leveraged" strategies that doesn't mix well with "herd mentality" when everyone is investing the same way in a poor liquidity environment, we think, that when it comes to the risk of being "overrun" and a case for calling for a "Broken Arrow", no matter how repressed volatility has been, it is bound to go higher which, in the current environment will have a significant impact on supposedly "diversification" strategies. When it comes to raising your cash levels, anything worth doing is worth "overdoing" in this central bank manipulated environment we think. When it comes to the new paradigm of low volatility and poor liquidity, we read with interest Bank of America Merrill Lynch's take in their Securitization Weekly Overview from the 9th of September entitled "The poor liquidity-low volatility paradigm":
"The poor liquidity-low volatility paradigm 
Arguably, the post-Brexit collapse in market volatility is the dominant story in financial markets these days. Many market participants, including the BofAML Quantitative Strategy team, think a pickup in volatility in the fall is likely. The Fed, US presidential election, seasonality, and the principal of mean reversion are some of the factors cited by various market participants as reasons for an increase. Stated somewhat simply, the view on historically low volatility seems to be: “this cannot last; it always goes higher.”
While the arguments for higher volatility are compelling, we explore the possibility that low volatility may simply be the central banker offset to the new, post-crisis regulatory regime that has substantially reduced market liquidity, which we measure using the BofAML Liquidity Stress Index. We note that while volatility has declined recently, liquidity stress remains stubbornly high, which should constrain central bank policy tightening.
This has been a consistent theme of ours for years. For example, published almost three years ago, our 2014 Securitized Products Outlook was titled “Regulatory tightening sustains monetary easing.” The argument has been a simple one: the highly restrictive post-crisis regulatory regime is a primary factor contributing to low global growth (we think ageing demographics is the other big factor), which has forced global monetary policy to remain exceptionally accommodative. In turn, this historic accommodation has reduced market volatility to historic lows.
One always has to be extra careful about positing new paradigms, since oftentimes the mere act of offering the characterization usually marks the end of the conditions that define the so-called new paradigm; but we posit it anyway. In our view, what could end the poor liquidity-low volatility paradigm is a sustained shift to less accommodative policies, such as the Fed tried with its December 2015 rate hike; but such a shift could well be catastrophic.
As we now know, the spike in liquidity and financial stress in early 2016 forced the Fed into a multi-month retreat from further tightening talk, while other central banks eased further. Recent statements make it clear the Fed wants to tighten again, even as the market remains dubious: current probabilities of hikes by September or December are 30% and 60%, respectively. We share the market doubts about September, which tells us volatility can remain low. But the Fed’s surprisingly hawkish Jackson Hole rhetoric makes us cautious about our view.
After strong post-Brexit performance across most securitized products, and the risk of a September Fed hike (the BofAML house view is December), we turn neutral on securitized products credit and agency MBS. Given liquidity considerations on the credit side, we don’t like to shift allocations too often. But, in the wake of Jackson Hole, the risk for the near term is too high for our liking, and remaining overweight seems imprudent." - source Bank of America Merrill Lynch
Indeed, being "overweight", for the time being is, we think fraught with danger in the near term and looking at the recent macro data as of late, if indeed, the markets does suffer again from "optimism bias" and the Fed decides to pull the proverbial rugh under investors' feet by hiking, then markets would indeed face a much more nasty reaction than during Brexit.

The "rate hike" risk remains elevated as posited by Bank of America Merrill Lynch's report while their Financial Stress index remain elevated:
"While the arguments in favor of higher volatility are compelling, and an increase over the near term seems likely, as we discuss below, we think the case for low volatility remains in place. We still believe that the combination of ageing demographics and a restrictive post-crisis regulatory regime (which has substantially reduced market liquidity) forces central banks to remain exceptionally accommodative and that it is this reality that keeps volatility at historically low levels. Periods of heightened volatility are indeed possible, as central banks attempt tightening or cease easing, but the past few years have shown them to be relatively short-lived.
If the Fed hikes in September, at least a modest replay of early 2016 market volatility is possible. This may sound like a change from our recent assertion that the probability of a market-disruptive Fed hike is low. It’s not. It would simply be that the low probability scenario is realized. In other words, the assumption of exceptionally accommodative monetary policy would no longer be valid. The shift to neutral on securitized products is an attempt to balance near term uncertainty on the Fed and the longer term constructiveness on securitized products that we have articulated in recent months. 
The poor liquidity – low volatility paradigm: liquidity stress remains elevated 
One possible reason for a September Fed hike is that financial stress has declined substantially in the post-Brexit period. Chart 2 shows the BofAML Global Financial Stress Index (GFSI) dropping over the past two months, through the 30, 40, and 50- week trend lines, to the lowest level in over a year.

The upward trend that started in mid-2014 appears to have reversed, and seemingly gives the Fed room to hike.
But if we consider a sub-index of the GFSI, the Liquidity Stress Index (Chart 3), the picture is less benign. Liquidity stress has declined in the post-Brexit period, but it is still elevated by historical standards.  

For context, the current level of 0.53 was observed in November 2007. As Chart 4 shows, by that time, the Fed had already begun to cut the Fed Funds rate, and was on its way to zero over the next year.

In other words, the current level of liquidity stress triggered massive easing in 2007, not tightening, as the Fed is now discussing.
The Chart 5 comparison of the Liquidity Stress Index (LSI) with the broader GFSI over the past year and a half shows two things:
First, the current gap between the broad GFSI and the LSI is very high; in other words, although broad financial stress has declined substantially in the post-Brexit period, the decline in liquidity stress is far more modest.
Second, the gap between liquidity stress and broader financial stress has tended to be closed by a sharp rise in financial stress (GFSI). Consider October 2015, when the GFSI of 0.06 was near the current level of 0.08. Over the next 3+ months, the GFSI rose to a peak of 0.85 and closed the gap to the Liquidity Stress Index. 

The takeaway is straightforward. A September Fed hike could quickly reverse the post-Brexit decline in financial stress and cause a surge to the upside, which in turn could create at least a modest repeat of the market sell-off of late 2015-early 2016. The BofAML Economics team, which is calling for a December hike, has repeatedly stressed that the Fed is risk averse and will be very cautious as it goes about raising rates (see The Fed’s cacophony of sound”). Based on this characterization, it seems unlikely to us the Fed would risk a replay of another market meltdown. The more prudent path would seem to be to allow liquidity stress to decline further over the next few months and hike in December. Nonetheless, this is the chart that gives us greatest cause for concern, and pushed us to turn to neutral on securitized products. Post-Jackson Hole, a Fed-induced replay of October 2015-February 2016, where the GFSI rises sharply, seems quite possible.
The volatility-liquidity stress connection 
Chart 6 and Chart 7 provide long term views of liquidity stress relative to rate and equity volatility.

The differences between the pre-crisis and post-crisis data struck as noteworthy. Pre-crisis, liquidity stress was generally quite low, while volatility, especially rate volatility, was generally elevated. Post-crisis, liquidity stress is relatively elevated, while both rate and equity volatility have been relatively low

We believe elevated liquidity stress is a direct result of the highly restrictive regulatory regime implemented in the wake of the financial crisis (higher capital charges, liquidity ratio tests, proprietary trading restrictions, etc.). We also believe this elevated liquidity stress, or poor market liquidity, constrains the ability of central banks to tighten monetary policy (see our 2014 Securitized Products Outlook, “Regulatory tightening sustains monetary easing” for an earlier discussion).
The reaction to the Fed’s December 2015 rate hike, when liquidity stress was already high (about the exact same level as today) and the GFSI and volatility surged in the subsequent weeks, was a recent example of what happens when the constraint is not recognized by central banks – market meltdown. The Fed’s eventual reaction to that volatility surge – shelving additional tightening plans – highlighted the market feedback loop at work: the liquidity constraint will eventually be acknowledged and volatility will have to be forced lower before tightening talk starts again. The coincident surges in both liquidity stress and volatility in 2008 provides insight into what happens when they simultaneously move higher – crisis. We make the assumption that crisis is an unacceptable outcome.
This is our poor liquidity-low volatility paradigm succinctly explained. Due to the post-crisis regulatory regime, elevated liquidity stress is likely here to stay; the system cannot tolerate simultaneous elevation in liquidity stress and volatility; if tighter monetary policy leads to higher volatility, and high liquidity stress is permanent, then tighter monetary policy is not possible. The paradigm hypothesis may soon be tested. " - source Bank of America Merrill Lynch
Unfortunately, for the Fed and other central banks, the higher are cross-asset correlations, the larger will be standard deviation moves, the more unstable financial markets will become due to "Mechanical Resonance" thanks to poor liquidity and heightened volatility. As a reminder, "Mechanical Resonance" is the tendency of a mechanical system to respond at greater amplitude when the frequency of its oscillations matches the system's natural frequency of vibration (its resonance frequency or resonant frequency) than it does at other frequencies. It may cause violent swaying motions and even catastrophic failure in improperly constructed structures including bridges, buildings and airplanes—a phenomenon known as resonance disaster. In similar fashion, thanks to central banks meddling with "risk signals" such as interest rates and "volatility" (which is at the core of any allocation process again), playing with "cross-asset" correlations by messing with the signals will eventually lead to "Mechanical Resonance" at some point and trigger a "Broken Arrow" call from supposedly "diversified" players all having the same allocations and positions on. The trouble is that many pundits do not realize yet how depleted are central banks' ammunition depot. This will lead to more "unconventional" responses from "The Cult of the Supreme Beings" aka central bankers rest assured.

Of course as we posited last week, we are already seeing trouble brewing in "Risk Parity strategies" thanks to "Mechanical Resonance" triggered by a surge in "interest rates" volatility. This is as well clearly indicated in Bank of America Merrill Lynch Liquid Insight note from the 15th of September entitled "Getting unreal":
"Risk parity unwind 
One of the most talked about themes recently has been the impending unwind of levered risk parity portfolios (see here and here). Our equity analysts estimate that the recent moves (bond and equity sell-off) could trigger as much as $50bn in bond selling from risk-parity type investors. While data on holdings is minimal, the influence of risk parity deleveraging on real rates is clear from Chart 1 and Chart 2. 

As the correlation between equities and nominal bond yields turn negative, the risk parity community delevers, resulting in a sustained underperformance of real yields. While it is easy to think this is because risk parity performance mirrors nominal bond yields, our Chart of the day makes the compelling case that this is purely a real rate phenomenon.

If anything, risk parity underperformance has historically meant higher real rates and lower breakevens, with the breakeven beta being about half the real rate beta. This relationship is the primary reason why we would rather be short real rates as opposed to nominal rates for an unwind of the risk parity theme. Further, anecdotal evidence in both the taper tantrum and the China reserve sales episodes also support this view: real rates increased, breakevens declined as average risk parity performance fell more than 5%.
To us, the focus on risk parity unwinds is here to stay even beyond the next couple of weeks. As the polls for the US elections narrow further, higher volatility and increasing likelihood of fiscal stimulus will keep this theme alive." - source Bank of America Merrill Lynch
Now of course, if indeed "real rates" shoot up thanks to "Risk Parity Strategies" forced deleveraging, what is of interest to us has been in 2016 the return of Gibson's paradox. Given Gold price and real interest rates are highly negatively correlated - when rates go down, gold goes up. When real interest rates are below 2%, then you get bull market in gold, but when you get positive real interest rates, which could potentially be the case with a possible rally in the 10 year US government bond if we get a surprise rate hike that is, then of course, gold prices will go down as a consequence of the interest rate impact and gold miners will go down as well. This would lead to further "cross-asset correlations" playing out on the downside that is.

When it comes to additional banking woes in conjunction with the recent surge in volatility in the bond space, the recent large fine imposed on German Deutsche Bank continues to validate our long standing distate for European banks stocks and our much vaunted, yet more stable preference for credit when it comes to having some "banking" exposure. In our next point we will look at that not only NIRP has been a headwind for NIM (Net Interest Margins) as of late, but, European banks versus their American peers are as well facing a risk of "Broken Arrow" when it comes to their Investment Banking franchise.

  • Macro and Credit  - Broken Investment Banking franchises in Europe, time for some players to call it a day.
Many European banks when on to a hiring spree in 2010 following the significant bounce in 2009 as they were saved by central banks and by the suspension of the "mark-to-market accounting rule" as they believed that the "good days" were coming back. On our side we always believed that the changes facing banks were more structural in nature and kept thinking in terms of analogy that the banking industry would be facing a wave of restructuring not to dissimilar to what the Steel Industry went through in Developed Markets (DM) at the beginning of the 80s. As per our conversation "Thermidor" in August, we continue to disregard the "value" argument put forward by some pundits about the "cheapness" of the sector given, for us, a bank is the second derivative play on the economy and as a pure "beta" play, it is tied to changes in "credit impulse" leading to an acceleration of economic growth. As far as we are concerned, the "japanification" process in Europe runs unabated and the restructuring of the banking sector in Europe has only just started:
"We will not re-iterate why we dislike banks stocks and in particular European banks stocks given the "japanification" process and the significant on-going deleveraging. If there is indeed some clear culprits when it comes to "capital destruction" thanks to Zero Interest Rate Policies (ZIRP) and now with Negative Interest Rate Policies (NIRP), the blame is entirely on the shoulders of our "generous gamblers" aka central bankers and their experiments." - source Macronomics, 5th of August 2016
Not only are European banks facing earnings headwinds thanks to NIRP, but, when it comes to their Investment Banking franchises, some players are clearly facing too many hurdles to continue to make a case to maintain highly regulatory capital intensive activities such as Investment Banking. On this particularly subject we read with interest Société Générale's take in their Global Investment Banking note from the 15th of September entitled "Making sense of broken business models":
  • "I-bank sector’s ROE looks set to be only 6.2% in 2016, much lower than the COE (which we deem to be a simple 10%).
  • Most I-bank products achieve lower than 10% COE.
  • The bulk of capital continues to be allocated to the lowest return FICC products. Less capital-intensive equities products have higher profitability. Primary IBD products (especially DCM and M&A) are the most profitable of all.
  • US I-Banks have greater market share and more leadership positions compared with European peers.
  • European I-Banks are deleveraging in order to become smaller but more profitable niche players.
  • JPM continues to strengthen its position as the dominant “flow monster”, pulling away from GS, C, BoA and DBK.
  • Substantial capital can be released back to shareholders from winding down investment banking business, especially FICC.
  • CS has a CHF2.8bn capital deficit, DBK has €12.5bn deficit. Significant deleveraging could more than solve these capital deficits and put the banks in an excess capital position. Realistically, we think CS management is the one most likely to consider further deleveraging at its forthcoming strategy day (which should be on 7 December).

- source Société Générale

It should not come as a surprise that with the on-going "deleveraging" exercise taking place for many players, ROE has come down in conjunction with leverage and rising cost of regulations and new capital rules set up.

But, given recent woes for Germany's banking champion Deutsche Bank, it is interesting to note that, when it comes to its Investment Banking franchise, it is at risk of having a case of "Broken Arrow" as displayed in Société Générale's very interesting report:
  • Very weak capital strength has forced significant deleveraging. Cuts to the bonus pool have also caused significant revenue attrition. Core I-bank ROE is set to be only 2.6% for FY16e. Most products across the board have very weak ROEs.
  • DBK commits the bulk of its capital to FICC. Rates trading should have put DBK in a good position for decent revenue growth in 1H16 (similar to JPM), but it ended up being the third-worst FICC performer over the period. Franchise weakness is a key issue we think.
  • We believe DBK’s I-bank is a broken franchise and needs to be wound up almost entirely, leaving just a minimal platform to service its commercial clients. Doing so would release up to €35bn in equity, which would more than plug its €12.5bn equity deficit." - Source Société Générale
Not only is Deutsche Bank's struggling with legal issues, but, when it comes to the ROE of its FICC franchise at a very low 2.6%, one might wonder how long this will go on, until the music stops.

Furthermore, for pundits still believing in the "relative value" proposal of investing in bank stocks rather than having a less volatile credit exposure, we could add that as displayed by Société Générale, if the trend is your friend, when it comes to investment banking activities, revenues have gone down since 2009:
Total capital markets revenues have been declining since 2009 due to:
  • Tougher regulation (higher CET1 and leverage ratio requirements, Basel 2.5 mRWA inflation) 
  • Central bank QE measures – asset purchase schemes drain liquidity from trading 
  • Deteriorating macro conditions, as over-leveraged countries reach the limit of supply-led GDP growth
We expect modest growth from 2016e due to slightly stronger GDP growth and inflation. There are downside risks, however, from i) further deleveraging of I-banks; and ii) global asset deleveraging causing a recession." - source Société Générale
We do share Société Générale's concerns when it comes to the downside risks and when it comes to our profound dislike for European banks stocks in general, it will continue, rest assured as we continue to prefer the stability of Senior Financial bonds which benefits from the current "implicit" backstop from the ECB.

Still, should you want to have "stocks" exposure to the banking sector, from a cost/income ratios approach, you would be better off with having American exposure than European exposure as posited by Société Générale:
The most efficient banks have:
  • An intense focus on keeping structural costs low
  • A keen eye on integrating technology
  • Revenues with low volatility and steady growth
  • Strong capital adequacy
US banks are more efficient than European banks for most of the above reasons. Looking more specifically to I-bank operations, the US banks also are better than their European peers. A big caveat is that that the CIB operations of the US banks tend to include much more significant corporate banking, transaction banking, securities services and similar (i.e. non-capital markets) activities compared with their European peers, which makes the overall CIB ratios appear lower. We still believe that US I-banks have lower cost/income ratios in pure capital markets activities than their European counterparts." - source Société Générale
But, if you believe, like ourselves, that the US economy is weaker than expected and is slowing down as per the latest raft of macro data points, given the performances of the US banking sector as a whole in 2016, it might make sense from a "risk" perspective, to start trimming your exposure, unless of course, you are a firm believer in the Fed's normalization process (we are not...). As far as Europe is concerned, we already made our case that Southern Europe's credit impulse process is a case of broken credit transmission mechanism thanks to weaker banking players in Europe being capital constrained due to "bloated" balance sheets by unresolved Nonperforming loans (NPLs) as in Italy and Portugal.

There you have it, "japanification" in Europe is still up and running and when it comes to "banking woes", we do have the case of "broken franchises" which could lead to some "Broken Arrow" calls. While we have long been vocal about the lateness of the credit cycle, we do think that regardless of the recent complacency coming from "repressed" volatility, there is indeed a large storm brewing as we will show in our final charts for this week's conversation.
  • Final charts: The business cycle is turning and storm season is coming
 In January 2016 in our conversation the "Ninth Wave" we indicated:
"Whereas we disagree with Bank of America Merrill Lynch is with their US economy views, we believe that the US economy is weaker than what meet the eyes and that their economists suffer from "optimism bias" we think (more on this in our third bullet point), but nonetheless high quality domestic issuers are definitely credit wise a more "defensive" play.We think that for "credibility" reasons, the Fed had no choice but to hike in December given the amount spent in its "Forward Guidance" strategy and in doing so has painted itself in a corner. We ended up 2015 stating that 2016 would provide ample opportunities in "risk-reversal" trades. The latest move by the Bank of Japan delivered yet another "sucker punch" to the long JPY crowd. Obviously, should "risk" decide to reverse course in 2016, there will be no doubt potential for significant rallies in "underloved" asset classes such as Emerging Market equities. But, for the time being, the macro picture is telling us, we think that regardless of how some pundits would like to spin it, not only is the credit cycle past "overtime" and getting weaker (hence our earlier recommendations in our conversation) but, don't forget that there is no shame in being long "cash". It is a valid strategy." - source Macronomics, January 2016
It is time, we think to remember that indeed, cash is part of a "defensive" strategy, given many signs are now clearly pointing, such as CCC issuance being shut down, that there is a storm brewing. On this subject we read with great interest another Société Générale report from the 15th of September from their Global Volatility Outlook series entitled "Make hay while the sun shines (and prepare for the storm)" for our final charts of our conversation:
"US focus 
Business cycle update (the storm is coming) 
The data-based Fed policy has the appearance of a self-correcting system. Poor economic data allows for delaying further rate hikes, which reassures investors in the short term, while positive economic data, theoretically makes it possible for the Fed to gradually normalise policy. But the US central bank has remained so cautious for so long that it is now running late. While the labour market is close to full employment, corporate profits have already embraced the downturn, even without the burden of strong wage pressure. When put into historical context and despite a decent bounce in the last quarter (with the Energy sector recovering on more stable Oil prices), US corporate profit margins still are not growing. They are only decreasing less rapidly. This is exactly what you would expect at this time of the cycle (assuming a recession in mid-2019), making this cycle the longest (10 years) in history, alongside the 1991-2001 cycle.
The joint analysis of profit margins and equity volatility, which we have used widely in the past, tell us that equity volatility should be on the rise at this point of the cycle and not close to lows. While end-2015 and early-2016 led us to believe that the trend was underway, Q2 and Q3 look abnormal with the VIX sub 12%. In our view, central bank policy and the low yield environment are the culprits once again.
By delaying the cyclical forces for so long and keeping rates artificially low, the Fed has created an environment which distorts classic analysis frameworks. US equities, despite trading at very high valuations, look more and more like bonds, posting limited but steady returns with low volatility, while bonds are taking on the role of the risky asset.
On a medium- to long-term perspective, the situation looks too imbalanced and the reversal could prove painful. Also worries are mounting over the fact that central banks in general could be vulnerable to external shocks, leaving them with very limited options. In this environment, the hedging theme cannot be ignored and should be handled with care by investors.
Still, the trigger for a full-blown bear market is difficult to pin down. From a tactical standpoint it is fair to say that this regime has proved robust so far and that staying outside US equities is difficult in this low-yield environment Our equity strategists highlight that a very soft Fed (we forecast an exceptionally slow pace of tightening with the next rate hike likely in December this year, two in 2017 and a peak Fed funds rate of 1.5% in this cycle), more fiscal easing, higher oil prices and accelerating M&A all will be catalysts to push the S&P 500 still higher." - Source Société Générale
While some might enjoy continue "playing" another "melt-up", it is time, we think to start thinking seriously about "hedging" as we risk moving into a new higher "volatility" regime following years of "volatility repression" if one wants to avoid having to make that fateful "Broken Arrow" call we think.
"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning." -  Henry Ford
Stay tuned!

Wednesday 7 September 2016

Macro and Credit - The Society of the Friends of Truth

"Everything we hear is an opinion, not a fact. Everything we see is a perspective, not the truth." - Marcus Aurelius
Looking at the surging demand for insurance to protect cash aka "hoarding" taking place in Switzerland courtesy of NIRP, given this exactly what we discussed in our previous conversation "The Law of the Maximum", we decided again this week to pick yet another analogy in our chosen title towards the French Revolution given our "pre-revolutionary" mindset. The Society of the Friends of Truth (Amis de la Vérité) also known as the Social Club, was a French revolutionary organization founded in October 1790 and formulated political theories on democratic government, more equitable distribution of wealth and was the first revolutionary group to identify itself as cosmopolitan and made appeals to scholars worldwide. The Club's political orientation was liberal and promoted the ideal of a society composed of small and medium economic producers such as craftsmen, farmers, merchants and entrepreneurs. Given the rising critics relative to the "wealth effect", a strategy openly supported by the members of "The Cult of the Supreme Beings" aka central bankers, we wonder if we should not recreate through our musings "The Society of the Friends of Truth" hence our title. After all we have been hammering for a while the on-going "japanification" process of the European banking system and the unresolved issues of some banking system such as the Italian one in supporting economic growth through the "credit impulse" given their balance sheets "constraints". 

In this week's conversation we would like to revisit the threat of rising positive correlations thanks to the "The Cult of the Supreme Beings" and what it entails for diversification strategies, risk parity strategies as well as "hedging" for credit and more. After all, we do not think there is a better way to rekindle "The Society of the Friends of Truth" than discussing again the subject of "tail risks" and non-linearity events.

  • Macro and Credit - Watch out for rising positive correlations
  • Macro and Credit  - Is inflation back into play?
  • Final chart: The downward trend in bond yields has limited insurers' hedging budgets

  • Macro and Credit - Watch out for rising positive correlations
While we mused on twitter at the end of August the following: 
"Piece of advice for Central Bankers, rising cross-asset positive correlations and risk parity strategies do not mix well..." - source Macronomics, twitter feed.

It is time we think for the members of the Society of the Friends of Truth to reacquaint themselves with our wise words from our February conversation "The disappearance of MS München" in which at the time we said we were writing for posterity and tackling in depth various aspects of risk including the inadequacy of VaR (Value at Risk) as a risk measurement tool. You might already be wondering where we are going from there but as a gentle reminder, in our book, rising correlations reduces the benefit from diversification, in the end hitting fund's equity directly. Whereas we have mostly disregarded "diversification" this year we opted to avoid the diversification risk in a NIRP world (putting in jeopardy "balanced funds" with reduced downside protection of the bond buffer component thanks to lower yields) for a much simpler "barbell strategy". Therefore we bought our "put-call parity" protection (long US long bonds / long gold-gold miners), given that is there was a huge volatility in the policy responses of central banks, the option-value of both gold and bonds position would go up and apart from the most recent "jittery" Fed induced hiking or not hiking moves, for us this strategy worked out fairly well in 2016.

This is what we wrote in our February long conversation:
"Rising positive correlations are rendering "balanced funds" unbalanced and as a consequence models such as VaR are becoming threatened by sudden rise in non-linearity as it assumes normal markets. The rise in correlations is a direct threat to diversification, particularly as we move towards a NIRP world:
"When it comes to a macro-driven market as "central banks' put" are losing their "magic", correlations unfortunately are still moving higher, which, we think is a sign of great instability brewing. The correlation between macro variables such as bund yields, FX and oil and equity market factors (Momentum, Value, Growth, Risk) is now higher than the correlation between macro variables and the market. There lies the crux of central banks interventions. There is now deeper inter-linkages in the macro economy as well as financial markets globally post crisis." - source Macronomics, January 2016
In our Society of the Friends of Truth, rising positive correlations are a warning sign and also clearly indicative of central bankers meddling with asset prices. This can be clearly seen in the below CITI chart displaying rising cross-asset correlation and the VIX index:
- source CITI, H/T Steen Jakobsen

This also a subject we discussed in our May 2015 conversation "Cushing's syndrome". We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time:
In a ZIRP world plagued by rising positive correlations, we would argue that the luck of "balanced fund managers" is about to run out
We quoted  Louis Capital Markets Cross Asset Weekly report from the 20th of April entitled "No more safety net" at the time: 
"Buying uncorrelated assets will lower the volatility of a portfolio without diluting it to the same extent as the expected return. In a context of price stability, the bond asset class was the perfect diversifying asset for equities as long as equities were driven by the economic cycle. The problem of this market cycle is that the necessary hypotheses for this negative bond-equity correlation have disappeared. Monetary authorities have not managed to restore price stability in the developed world and economic growth is lower than before. As a consequence, the stubborn actions of central banks have distorted the pricing of bonds and they have therefore lost their sensitivity to the business cycle." - Louis Capital Markets
Thanks to central banks "overmedication" we are indeed facing more and more "Blue Monday" price action, rest assured and "Balanced funds managers" are facing an uphill struggle in maintaining their stellar records of the last decade in this environment.

Furthermore, there are some more indications of some other strategies being directly threatened by central banks intervention and rising positive correlations which could lead to some nasty non-linear price movements and VaR shocks we think.

This clearly the case for Volatility Control Products as indicated by Deutsche Bank in their Derivatives Spotlight note from the 24th of August entitled "Vol Control Products Disentangled: A Driver of Low-to-High Vol Transitions":
"One year later, vol control funds continue to draw focus in severe selloffs
One year ago today, on August 24, 2015, severe volatility drove S&P 500 futures to be halted in pre-market trading, listed SPX option markets to go black, and other equity market dislocations to arise. That moment was one of the most severe shifts in SPX volatility, switching from a relatively low volatility period to extremely high volatility (11% selloff in a week) almost instantaneously. Vol control funds, multi-asset investment portfolios with a dynamic asset allocation determined by market volatility, were important contributors to the severity of that selloff. In this piece, we provide background on vol control funds and guidance on how investors can monitor them going forward.
Vol up, sell stocks: a market feedback loop
Vol control products sell equities when volatility is rising and buy equities when volatility is falling, creating a market feedback loop. Product growth has slowed - but rebalancing impact has grown in illiquid, risk-averse markets. This has been, and continues to be a driver, of the repeated pattern of sharp selloffs followed by consistent rebounds seen in the last 2Y, and contributes to high skew and vol-of-vol in derivative markets. Several fund features - most importantly lags in trading following a volatility spike - keep the products from becoming a systemic risk. Vol control products are not the only large market feedback loop structure (risk parity, leveraged/inverse ETPs, and CPPI are other important ones) - but we believe they are the most important feedback loop given their size and responsiveness to market shifts.
 Sharp transitions from low vol to high vol are becoming increasingly common
The most important trading implication of a large vol control market is the funds' impact on sharp selloffs. We have had almost as many transitions from very low vol to much higher vol in the last 6Y as we have had in the prior two decades.

DB Vol Control Composite tracks current positioning
Through fund-by-fund research of $200bln of vol control funds, we have categorized the funds into four categories, and created a DB Vol Control Composite model based on systematic strategies that we believe captures the essence of these products' equity allocation patterns. We estimate that a sudden 4% global equity selloff today would drive $20bln of selling by vol control funds - less than earlier this year - as realized vol is now below many funds' thresholds.
Last August, around $50bln of equities were sold by vol control funds
We estimate that in the aftermath of the Aug-15 selloff, vol control funds sold around $50bln of global equities, and in the aftermath of the Brexit vote sold around $25bln. These numbers are large in absolute terms - and stand out when they're coming from an investment type that does minimal asset allocation rebalancing on a typical day-to-day basis.

Arguably rising positive correlations and repressed volatility are we think, recipe for large trouble ahead thanks to central banks meddling. A clear illustration of the impact of "Brexit" was discussed in our conversation "Optimism bias" back in June, which clearly caught "off-guard" many pundits. This "Brexit" sucker punch or Blue Monday" price action was clearly illustrated in Deutsche Bank 's very interesting report:
"Brexit: what matters is how big a surprise the vote was
In the aftermath of the UK's referendum to exit the EU, vol control funds likely sold around $25bln of global equities due to the sudden pickup in volatility. This would have been different had polls been more accurate: had market-implied Brexit likelihood drifted toward a Leave result over several days rather than shocking market participants in the middle of the night, markets may have ended at the same prices - but in a gradual path. Unlike what actually happened, this slow-motion drift toward Brexit would have left vol control products fully invested. It's not the outcome of the Brexit vote that drove selling by these investors - it's the path markets took to get there.

In the figure below, we compare the number of SPX shares held by a $10bln investment in a hypothetical fund linked to the S&P 500 Managed Risk Index - Moderate (a representative index of some vol control funds that we describe later in the note) under two scenarios: what actually happened, and a hypothetical slow-motion Brexit in which the market hypothetically realizes that Leave will win over the course of the vote week. The shock nature of the Brexit vote caused 900,000 shares of the SPX to be sold by this strategy than it would have had just four trading days' prices been replaced with a gradual descent toward the post- Brexit low.

Vol control products aim to achieve a fixed realized vol
Volatility control products are funds that promise their investors a specific realized volatility – either by aiming to achieve an exact number (e.g. 10% realized vol), a specific range (e.g 8-12% realized vol), or a limit (no more than 12% realized vol). The volatility objective is a constraint on the otherwise return-maximizing goal of the portfolio.
We define vol control funds as products having these characteristics:
■ Dynamic asset allocation. The percentage of assets invested in equites varies, at least partially systematically, over time based on market conditions.
■ Asset allocation is a function of volatility levels. The product's allocation to equities is primarily a function of how high either equity volatility or cross-asset volatility is, whether measured through implied, realized, or subjective metrics. We do not include products whose asset allocation is a function of asset classes' relative volatility to each other.
Typical vol control funds are global, multi-asset portfolios
Even though vol control funds are largely a US-based investment option, most vol control funds are managed as global asset allocation portfolios, including equities and fixed income, from both US and international markets. They typically hold almost-static allocations to either security-level or fund-level investments, and then manage the overall expected volatility of the portfolio by trading futures
contracts on global equity indices in response to changes in market volatility. The charts below show the asset allocation of the long and short sides of a typical vol control fund. The fund holds a diversified, multi-asset long portfolio, and then reduces its equity exposure by 17% of AUM via several short futures positions:

In similar fashion to CPPI strategies, these funds must decrease leverage to protect principal hence the dangerous feed-back loop for these strategies increasingly at risk from rising cross-asset correlations with reduced buffer from the bond allocations in some case such as the much vaunted stars of the last decade aka "balanced funds".

As we have pointed out, positive cross-asset correlations are on the rise and should be monitored and of great concern. As we pointed out in our short August conversation "Positive correlations and large Standard Deviation moves", indicates growing systemic risk we think. As a reminder, the greater the volatility, the greater the disadvantage of owing negative convexity bonds like you find in the High Yield space. In the current low yield environment, both duration and convexity are higher, therefore the price movement lower can be larger...That simple.

The below chart made on Bloomberg by Adnan Chian (through our twitter feed), represents an illustration of the risk for "balanced funds" getting "unbalanced" as mentioned above:
- source Bloomberg / H/T Adnan Chian - Twitter - 30th of August 2016

In addition to this, we read with interest Bloomberg's take on rising correlations from their article from the 31st of August entitled "Stocks and Treasuries haven't moved together like this since China's Yuan devaluation":
"The last time stocks and bonds moved in the same direction to this extent was in August 2015 after Chinese policymakers devalued the yuan, with strategists heralding the onset of "quantitative tightening."

In stark contrast to the recent experience, modern portfolio construction has typically been predicated on a negative correlation between stocks and bonds, lowering the overall volatility of the portfolio and producing better risk-adjusted returns.
"The correlation between stocks and bonds has been increasing as stocks have been driven more and more by the chase for yield but that shift from negatively correlated to positively correlated will play havoc for portfolio level risk management (and risk parity)," writes Peter Tchir, head of macro strategy at Brean Capital LLC.
The risk parity strategy, which, in very basic terms consists of a levered long position in Treasuries and a long position in stocks, has been on fire in 2016. Bank of America Merrill Lynch Head of Global Rates and Currencies Research David Woo has warned that tough times could be in store for this strategy if investors heading into the U.S. presidential election begin to price in the possibility of fiscal easing in the U.S., anticipating a clean sweep at the polls by either party." - source Bloomberg
While we have touched on "Vol Control Products", "balanced funds" and CPPI, no doubt to us that very successful "Risk Parity Strategies" could as well be impacted by the rising trend as put simply by Bloomberg in their article:

"The diversification benefits of a traditional 60/40 (stocks/bonds) portfolio would disappear in such an environment, causing portfolio managers to scramble and search for a new hedge." - source Bloomberg
In our Society of the Friends of Truth, which you hereby are a member by now, in our "investing book", these strategies are indeed directly threatened by the rise of "positive correlations". On the subject of "Risk Parity Strategies" we would like to redirect you dear member to the guest post from our Rcube friends  which we published on the 14 August 2013 entitled "Is Risk Parity a Scam":
"Because risk parity strategies always overweigh fixed income assets due to their low volatility, we can ascertain that this source of outperformance against conventional 60/40 allocations has dried up, even without invoking a big rotation that would bring 10-year yields back to a theoretical long-term equilibrium value.
According to the risk parity playbook, an investor should therefore increase his exposure to Treasuries alongside the Fed. In exchange for a minuscule return, the investor would, thus, face a substantial jump risk if the Fed had to apply a hurried “exit strategy” due to a surge in inflation…
From a broader perspective, we consider risk parity to be the antithesis of Minsky’s “financial instability hypothesis”. According to this view, investors increase their leverage when they believe an asset to be stable, which reinforces their belief that the asset is, indeed, stable (this is a perfect description of how risk parity investors behave in a given asset class). The cycle goes on until we reach the dreadful “Minsky moment”, where investors are forced to deleverage as the real risk of the asset reveals itself."
Due to the fall in government yields over the last 30 years, risk parity strategies have had an easy time compared to traditional asset allocations. We should therefore disregard all the performance based arguments that are often put forward by the proponents of risk parity.
From a conceptual standpoint, although it might seem unfair to make generalizations about a strategy that exists in many different variants and implementations, we believe that risk parity suffers from many structural flaws:
1) Risk parity requires to make choices between many different implementation options, asset selection, calculation parameters etc. These choices necessarily contain arbitrary components and will have a significant impact on the strategy's performance under different scenarios.
2) By placing diversification above any other consideration, risk parity portfolios can hold assets at (or even move assets toward) uneconomic prices. This problem is magnified as risk parity - or other approaches focused on diversification - become increasingly popular.
3) After all, risk parity’s quest for diversification might prove fruitless, as risk parity portfolios end up harvesting the same basic risk premia as traditional asset allocation (mostly the equity premium and the term premium), albeit at different dosages.
4) The leverage used by risk parity strategies makes them prone to deleveraging and, therefore, to crystallization of losses.
5) Risk parity’s false premise that risk can be quantified as a single number exposes it to highly asymmetric returns, which can happen to any asset class given the right set of circumstances.
If someone wants to run a passive asset allocation, we therefore believe that a market portfolio constitutes a better option from many perspectives: conceptual, foreseeable reward-to-risk and CYA.
For the same reasons, we strongly reject the idea that risk parity portfolios could represent an "all weather", quasi-absolute return strategy (we suspect marketing departments are the ones to blame for these outlandish claims).
There are certainly seasoned risk parity professionals out there who are able to mitigate risk parity's numerous flaws.
However, we have little doubt that when the next "black swan" terrorizes the financial world (as seems to be the case on an increasingly frequent basis), we will witness the implosion of many risk parity strategies (those that are based on high leverage, overly simplistic assumptions on asset risks, and/or an unfortunate choice of underlying assets). Trusting risk parity to manage one's life savings is therefore quite perilous, especially if it takes the form of a formula-based risk parity ETF - which should come out any day now.-"Is Risk Parity a Scam", August 2013
We could not agree more with our friends.  In addition to this, dear member of "The Society of the Friends of Truth", is that when it comes to Risk Parity and "Risk" we reminded ourselves Bank of America Merrill Lynch US Equity Derivatives Research note from the 30th of August 2015 entitled "Risk parity is not the risk, vol control is, but how big is it really?":
"Risk parity is not the risk, vol control is
Much has been made recently of the threat of forced selling by risk parity funds during market shocks as volatility spikes. However, the risk in our view lies not in the basic construct of a risk parity fund, but rather in the risk-management mechanism often overlaid onto risk parity funds (as well as other funds) which aims to manage an investment such that it has constant volatility. This “target volatility” risk overlay is a dynamic portfolio rebalancing mechanism that can induce rapid shifts in a portfolio’s allocation, particularly when volatility spikes from a low base level, which is when these funds apply maximum leverage.
The perverse side effects of vol of vol tail events
Our core thesis for volatility in 2015 was that we would witness a greater number of “local tail events” or contained but violent shocks in markets including volatility due to bank deleveraging, waning liquidity and the growth in high frequency trading. The recent market events appear to be yet another example of these risks playing out. A byproduct of these violent shocks, which erupt from a calm, low vol market, is true tail events in the volatility of volatility – the VIX recorded its largest 2-day percentage rise in history last week. This is also a toxic mix for strategies that aim for constant volatility exposure as the amount of leverage they employ is directly linked to their volatility.
Vol control applied to risk parity can further exacerbate risks
Because risk parity funds are inherently low volatility strategies (the recent volatility of an unlevered fund is less than 5%), they are often levered to achieve higher volatility (and higher returns), and in many cases a volatility control is also overlaid to maintain a more constant risk exposure through time. Risk parity derives its low volatility from the diversification benefits of holding both stocks and bonds in equal risk weighting. However, if a spike in volatility occurs at the same time that bond/equity correlation breaks down, this will lead to even larger spikes in risk parity volatility and therefore greater de-leveraging. In theory if these funds were large enough, their rapid liquidation of both bonds and stocks could lead to heightened correlation thus further exacerbating their rise in volatility and demanding further deleveraging.
From theory to reality, near term risks are much reduced
Volatility control is a dynamic risk-management strategy that has been applied widely in
recent years, not only to risk parity funds
. If we assume $400bn in risk parity funds, half of which use vol control, we estimate recent events could have generated $30-$80bn in selling pressure on equities and $50-150bn on bonds. Estimated selling pressure from risk-control funds applied to non-risk parity portfolios could equate to an additional $25bn- $50bn in equity selling, which together is less than 10% of the $1.7tn of S&P 500 e-mini futures traded last week. Interestingly, we also see almost no evidence of impact on the Treasury futures market despite estimated liquidity demands from risk parity rebalancing being even greater. This selling pressure also assumes funds all operate mechanically. Many funds can exercise discretion to smooth out their rebalancing. Importantly, for those funds that operate mechanically, they likely have already de-levered, and with volatility now elevated, further shocks will be much less impactful." - source Bank of America Merrill Lynch.
By now you probably understand our "nervousness" in these strategies given that if correlations break down, and they are by the way, then no doubt that there is a heightened risk of "fast and furious" deleveraging at play.

All these strategies suffer from not only "optimism bias" but from a "herd mentality", meaning everyone is playing the same way, this for us reinforce somewhat this "doom-loop" or negative feedback loop which would entail much steeper drawdowns for these strategies than anticipated. All in all, these strategies we discussed are very sensitive to a spike in volatility, and what matters therefore as shown by the "Brexit" episode is not the news outcome but the "velocity" of the news to have an impact on the forced deleveraging prospects for these investment strategies mentioned. After all asset allocation strategies allocate capital on the basis of volatility. When "The Cult of the Supreme Beings" aka central bankers mess with the signal (VIX index), we wonder how "Vol control" is going to operate if indeed we get very large volatility moves going forward as put it bluntly by Bank of America Merrill Lynch in their 2015 report:
"It is really the combination of a sudden, violent drawdown following an extended period of calm that is most toxic for target volatility funds and generates the largest potential rebalancing needs" - source Bank of America Merrill Lynch
So what to do in this kind of "environment", we think that "diversification" is being threatened by rising positive correlations, therefore, increasing cash levels, cash being a strategy is therefore paramount in the case of violent intraday drawdowns and sudden spike in volatility.

When it comes to Fixed Income, what would really drive a sell-off in the asset class, would be a return of inflationary pressures. When it comes to our views, us being members of the Society of the Friends of Truth, we are in the "lower for longer" camp and until we see a clear manifestation of wages pressure in the US we will sit tightly in the deflationary camp. This brings us to our second point about "inflation" and "flows".

  • Macro and Credit  - Is inflation back into play?
While back in March 2016 in our conversation "Unobtainium" we discussed the possibility of a rise in inflation hence the current perceived heightened risk of a rate hike in September by the Fed. Back in October 2015 in our conversation "Sympathetic detonation", we posited that US TIPS were of great interest from a diversification perspective given the US TIPS market is the one for which, on a historical basis, the correlation with other asset classes is least extreme. We argued at the time:
"US TIPS are more "compelling" than UK linkers and still are less positively correlated to nominal bonds for a very simple reason: their embedded "deflation floor" - source Macronomics, October 2015
Obviously has indicated by Markit, our case for UK linkers in August clearly blew away our preference given the performance of UK linkers over US linkers with a very significant performance overall:
- source Markit, H/T Simon Colvin

But, given our "deflationary" incline and the embedded deflation floor of US linkers, from a diversification perspective we continue to like the asset class, particularly given as of late of the significant inflows through ETF as indicated by Société Générale in their ETF Market Signals note from the 5th of September entitled "Record creations on inflation-linked bonds":
"Inflation-linked bonds came back to net creations after net outflows in July and posted all-time-high $600m monthly inflows, mainly thanks to USD denominated benchmarks (see chart 6).

- source Société Générale
 Now, as per our October 2015 conversation, inflation-linkers, even in a rising cross-asset correlation world bring diversification benefits, although they have not been immune to the rising trend in cross-asset correlations. However their embedded deflationary floors at least for US linkers make them, we think particularly attractive. What is of interest is that unlike US TIPS, Gilt linkers do not benefit from this "deflation" floor. In a growing NIRP world with now some European Investment Grade companies (Henkel, Sanofi), US linkers have the advantage that both the principal face value and the coupon payment can never decline below the value at issuance. How that for a financially repressed world we dare to ask dear members of the Society of the Friends of Truth?

If we are indeed, in a prolonged period of deflation, such as the one we think we are currently experiencing, the embedded "deflation floor" both applied to the stated coupon as well as to the face value of the bonds. These are indeed very interesting features that should not be neglected when selecting an exposure to the index-linked sovereign bond markets. This is particularly true for believers like us that, the US economy is weaker than what every pundits think and that, going forward, US growth is likely to disappoint (see recent PMI for services for example...).

As we asked ourselves back in October 2015, could the  the Fed really hike when US breakevens are falling , which could be clearly indicative of deflationary forces at play? This also another reason why the embedded "deflation floor" in US TIPS is so enticing:
- graph source Thomson Reuters Datastream - H/T Warburg on Twitter

But, there is a caveat, with the on-going discussions surrounding "fiscal stimulus", especially in the US as both presidential candidates are pushing for it. As well at play, we think there is, in similar fashion to "Brexit", markets it seems are falling once more for an easy victory for Hillary Clinton it seems. 
We know how that played out for "risky assets" once the news hit the screens. On that subject we read with interest Bank of America Merrill Lynch's Cause and Effect note from the 26th of August entitled "Pricing a perfect gridlock":
"Gridlock = Goldilocks
Our analysis suggests the market is pricing an easy victory for Hillary Clinton but a split Congress in the November elections. In other words, the market is pricing a high probability of continued gridlock in Washington. We believe this is the reason why the market is long risk parity trades and short volatility right now.
Risk-off ahead of November 8
Risk parity portfolios have not done well when uncertainty and volatility go up. History tells us to expect Clinton’s lead to narrow and volatility to rise in the final stretch of the elections. We recommend buying a 3-month AUD/USD digital put to position for a possible unwinding of risk parity trades that can become self-fulfilling once it starts.
Clean sweep = higher USD and higher US rates
We cannot remember the last time the FX and the rates markets have so much at stake in a US election. While gridlock probably means lower rates and a weaker USD, a clean sweep would likely lead to both higher USD and higher rates over the medium-term, in our view. We believe the volatility market is underpricing the bi-modal nature of the outcome of the election for US fiscal policy outlook." source Bank of America Merrill Lynch
From our perspective, as members of The Society of the Friends of Truth and given our long lasting contrarian stance, we would tend to fade the "easy victory" for Hillary Clinton and as, we posited in our first bullet point, we would rather go short risk parity trades and long volatility right now, no offense to Bank of America Merrill Lynch. We do not want to suffer from "Optimism bias" but we are not yet falling for the "pessimism bias", we tend to sit nicely in the "realistic bias" camp. Overall, the big issue for risk parity trades comes when both volatility and correlation of the underlying components rise together. This we think is going forward a very important factor to keep in mind. Furthermore, we think that option markets are too complacent and pricing too little of a potential move. With risk parity still remaining levered at elevated levels, this we think could turn out to be a "bad recipe" for asset prices and significantly "boost" the "velocity" in the surge of "volatility".

When it comes to our inflation expectations, we continue to believe that wages acceleration hold the key to the "recovery story", so far, we are not buying it, and we will continue to fade it hence our attraction for the embedded deflation floor of US linkers.

For our final chart, we would like to point out to our fellow members of the Society of the Friends of Truth, that the unintended consequences of the "The Cult of the Supreme Beings" aka central bankers has had an impact on hedging budgets (particularly because both duration risk and credit risk have risen).

  • Final chart: The downward trend in bond yields has limited insurers' hedging budgets
Our final chart comes from Deutsche Bank' s Derivatives Spotlight note from the 24th of August entitled "Vol Control Products Disentangled: A Driver of Low-to-High Vol Transitions". It shows that the unintended consequences of the trend in low bond yields has limited insurance companies' hedging budgets:

"Low interest rates, high vol-of-vol, and volatility aversion have driven growth
Three financial market trends have been catalysts for growth of vol control
■ High vol-of-vol. Volatility itself has been volatile for the past few years, and as a result insurers' hedging costs have been changing quickly. In this environment, vol control funds' more stable volatility profile is particularly valuable to issuers.
■ Low interest rates. Interest on invested funds can be another source of hedging funds for insurers. With US interest rates repeatedly hitting new lows, insurance companies have little margin for error. Stabilizing hedging costs is one way to reduce the need for this cushion.
■ Post-financial crisis worries. Investors continue to be haunted by the ghost of 2008: recency bias has driven heightened worry about another 2008-like event. This volatility aversion has made volatility control attractive to investors (as a peace-of-mind feature) - even in products that do not have the technical hedging needs that drive much of the growth." - source Deutsche Bank
Furthermore, there is a well a clear warning in Deutsche Bank's note for the pundits such as pension funds that keeps picking up pennies in front of a steamroller namely selling volatility:
"Tail protection for short vol strategies increasingly timely at low vol levels
The growth of vol control products has, at least at the margins, the potential to re-frame how volatility sellers manage their positions. Conventional wisdom has typically been that selling vol is more dangerous at very high vol levels than it is at low levels despite the seemingly more attractive entry points. However, the potential for market feedback loops like vol control funds to intensify selloffs that start at low vol levels makes short vol strategies riskier at low starting vol levels - increasing the need for tail protection as an overlay." - source Deutsche Bank
 As a member of the Society of the Friends of Truth, we could not agree more. Any good trader will tell you that being short gamma is a very poor risk/return proposal....particularly pension funds with fiduciary duties we think...

"In a time of universal deceit - telling the truth is a revolutionary act." -  George Orwell
Stay tuned!

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