A few thoughts on volatility

Market volatility is low, whether measured on an historical or option-implied basis.  Indeed, based on a measure of the normalized deviation of cross-asset implieds from long-term averages, it's the lowest since at least 2001 (the currency volatility index data only begins in that year).   Given the nature of asset markets in the 1970's-90's,  this essentially means that cross-market volatility is at its lowest level of the post-Bretton Woods era.


Now, you don't have to be a particularly discerning Fed-watcher to have realized that certain segments of the FOMC are getting a little antsy about the low levels of market volatility.  It's not quite at the level that they are shocked, SHOCKED to find that gambling is going on here....but it's not far off.

Indeed, the recent warnings from the Fed recall previous episodes of hand-wringing...notably Greenspan's (in)famous "irrational exuberance" speech in November 1996, as well as global monetary disquiet over the "complacency" and low levels of market vol a decade later.

Naturally, they would never admit to their own culpability, even though a cynic suffering macro punter anyone who sees better than Stevie Wonder realist might suggest that some of the culpability lays at their door.

Now, Macro Man will concede that it is somewhat tautological to use one measure of market volatility to explain other such measures.    However, the indicator that he likes to follow, the spread between the second and fourth eurodollar futures contracts, has historically been a pretty good proxy for Federal Reserve monetary policy expectations.  And as the nefarious Professor Woodford will tell you (or at least Ms. Yellen)...the FOMC can exert a great deal of power over market expectations of policy, and that these expectations themselves can have a substantial impact on markets (if not, as their voodoo might suggest, the real economy.)

In any case, if we look at the volatility of the 2/4 ED spread over the last quarter century, what do we find?  In late 1996, for example, the volatility of that spread was at its lowest point to date in the sample....just as Greenspan was moaning about irrational exuberance in the equity market.   Gee, Al, can you guess why equities were so perky?   



The last tightening cycle, of course, was incredibly well-telegraphed through the use of guidance-laden statements of the type we see still see today- "considerable period", "measured" withdrawal of accommodation, etc.   Greenspan, of course, famously credited the concurrent bond conundrum of low yields to his credibility and efficacious communications.   He must have been sleeping when those Asian central banks were buying hundreds of billions of dollars worth of Treasuries per year.....

In any event, the lack of volatility in expectations, which Greenspan triumphed in his self-fellating autobiography as a victory for transparent policy-making, naturally led to another massive misallocation capital and risk, most notably in the housing and volatility markets.  While the regulators have of course chosen to blame the cupidity of market participants (some of whom, it must be said, were truly loathsome), Macro Man cannot help but observe that they occurred simultaneously with a nadir in the volatility of Fed policy expectations.   The hangover, of course, required a little more than a few aspirin and a bacon sandwich to vanquish.

Fast forward to today, and we see that unsurprisingly, the measure of Fed expectations vol quite literally approached zero a couple of years ago, but has steadily risen since (though still remains at levels consistent with previous lows.)  Still, it's worth noting that the blow-ups generally seem to occur only after this measure eclipses 15 bps.    Russia/LTCM, the popping of the NASDAQ bubble, and the implosion of the Bear Stearns credit hedge funds in the summer of 2007 all occurred shortly after the 15 bps threshold was breached.

Perhaps it's a coincidence.  At the very least, there is no guarantee that the correlation implies causality- indeed, one could argue that some of the causality in the past may have worked in the opposite direction.

Nevertheless...in reference to the top chart of the post, Macro Man may not know when the next 2 SD move in cross market vol is going to come....but he has a damned good idea of which direction it's going to be in.  

With the FOMC and payrolls this week, it may be tempting to think that the rise in vol will come sooner rather than later.   Perhaps it will.   On Macro Man's read, however, we probably need to get a little closer to the whites of the eyes of the tightening cycle before vol buyers get the all-clear.
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Anonymous
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July 28, 2014 at 9:42 AM ×

Tks for post as ever.

"Market volatility is low, whether measured on an historical or option-implied basis"

SX5E implied vol vs realised = +3vol spread in 3m expiry, so that is +80 percentile on 6m/1y/2y time frame. Hence agree absolute vol is low on historical basis, but implied vol is still (paradoxically) rich to hold... which is preventing many from sitting on long vol as it means you just bleed theta.

Agree with last statement though.... Maybe September FOMC post this wk's GDP/US jobs is the kick off point for change in discourse we began to see at semi annual speech from Yellen.

Then again, as every man and his dog expects higher yields (80% of primary dealers according to ny fed survey) does the lack of surprise factor limit the punch?

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Anonymous
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July 28, 2014 at 10:09 AM ×

Macro Man,

Back in the day - as it were, you used to publish a spread sheet of actual positions etc.

I gather you do not do so any more due to regulatory concerns?

It was quite a thing for you to have done and got you respect from those of us 'in the trenches'.

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Anonymous
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July 28, 2014 at 12:11 PM ×

Vol can conceivably get cheaper. Used versions of this however.....

http://www.amazon.com/Quotations-Chairman-Greenspan-Words-Shake/dp/1580624200/ref=la_B001ILHEUO_1_4?s=books&ie=UTF8&qid=1406545606&sr=1-4

Sorry - couldn'y help myself

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abee crombie
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July 28, 2014 at 1:37 PM ×

If credit spreads are going to lead to an increase in vol, which I think they are, perhaps the first tiny move has started, though it would be odd for spreads to rise as the US economy improves.

Or perhaps it is FX land that shoots the warning sign? Euro holding below 1.35 now.

In the nascent but growing Europe HY market apparently strong h1 flows have slowed and new issues are losing pricing power, though you wouldnt know it by looking just at the Europe HY Index (HIVOL CDSI GEN 5y)

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Macro Man
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July 28, 2014 at 1:59 PM ×

@ Anon 9.42...yes, note that I said vol was low, not cheap, as the two are far from synonymous. The trick is to get some in just before it all kicks off...at which point it will be cheap.

Anon @ 10.09- Yes, I abandoned the blog portfolio when I switched jobs in 2008. To be honest I thought hard about reviving it upon my return, but didn't feel like there were enough good independent themes to populate it.

Abee, certainly credit spreads have historically been associated with increases vol, usually because of a deterioration in credit quality. I suspect that this time around it is the liquidity withdrawal that will be the most important factor in driving vol. Ironically, I suspect that much of the eventual widening in credit will come from the wonderful policies put in place by regulators, that will make sell side guys unable to warehouse inventory, such that any selling will be passed on directly to the street. In a one-way market, that could conceivably get quite ugly.

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Leftback
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July 28, 2014 at 9:39 PM ×

Abee is right. HY spreads are creeping wider already, as though a few punters don't want to be left holding a bag full of illiquid goodies. Technical action in the IWM ETF is similarly sobering for those of an ├╝ber-bullish persuasion.

Three things to fear for market participants this week, 1) Data that might cause more hawkish Fedspeak, 2) Fear of more hawkish Fedspeak or more hawkishly nuanced FOMC statement, and 3) Fear of Fear itself.

If 3) is in play at all in these sleepy summer markets, then we might get one of those days tomorrow where he who sells early sells best.

Or as you say, cheap vol might become cheaper. Rinse and repeat.

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Leftback
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July 28, 2014 at 9:44 PM ×

We would also note the recent debut of a stock with the ticker "LOCO", representing a chicken outlet called El Pollo Loco, which translates to "the crazy chicken". At some stage in what has essentially become a game of chicken, it is investors in just those kinds of vehicles who will start running around like chickens with their heads off.

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Mr. T
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July 28, 2014 at 11:21 PM ×

I would not put fed-anything on the list of things market participants should or will fear.

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Polemic
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July 28, 2014 at 11:45 PM ×

Or another reason HY yields are moving is that in having attacked the gates of stock indices and failing miserably to break them down the bears are trying to tunnel under the castle by undermining the HY instead.. Sappers indeed.

I m still convinced that the fear of fears is the fear of stocks doing the IDFBI move higher.. (I dont f.ing believe it). perhaps yhe bubble of calling a bubble has to pop to inflate the underlying bubble enough for it then to pop..

not there yet.. bit like getting on a fast train and missing your stop..." Jeez when will this stop so i can go back to where I'm meant to be".

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Macro Man
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July 29, 2014 at 12:25 AM ×

I'm sorry, but this "bubble" argument is just a straw man. One needn't think that stocks or credit are a bubble to think that the price might be adversely affected when confronting the first US monetary tightening in 8 or 9 years, particularly given trailing Sharpe ratios that are multiple SDs above historic norms.

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Polemic
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July 29, 2014 at 12:30 AM ×

MM. do you have any data on amount if leverage being employed in eq lings at the moment vs history? its leverage that kills especially when rates rise as multiples of funding differences arise. I just havent seen any data on leverage.

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Polemic
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July 29, 2014 at 12:31 AM ×

and to translate late night phone typos.. of leverage... equity longs...

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Macro Man
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July 29, 2014 at 12:40 AM ×

No, as Bloomberg has just pulled my transition account :(.

I do think leverage in certain credit spheres is high, however, particularly relative to the size of the door on the way out. I think this point cannot be emphasized enough; the door will never have been this small on the way out, thanks to D-F, Volcker, blah blah blah.

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Macro Man
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July 29, 2014 at 12:44 AM ×

...and 2 mimutes of research reveals that NYSE margin debt is now substantially higher than it was in 2007 in gross terms, though relative to market cap I dunno.

{http://www.nyxdata.com/nysedata/asp/factbook/viewer_edition.asp?mode=tables&key=50&category=8}

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Skippy
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July 29, 2014 at 1:02 AM ×

MM,

Chris Wood at CLSA had a few facts on the return of "risky lending" a few weeks ago:

US High Yield Bond Issuance $43 bn in 2008, to $336 billion in 2013 and $182 bn in the first half of 2014.

CLO issuance $82 billion in 2013, only 15% below 2006 peak and likely to reach $100 bn this year.

US cov-lite loan volume up 41% yoy to $84 bn in year to mid June.

US leveraged loan issuance rose by 68% yoy to 1.1trn in 2013.

And NYSE margin debt is indeed near peak levels.

In contrast, lending to the "real economy" has remained subdued, with US bank loans only up 4.8% yoy versus 10% average growth pre-crisis.

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abee crombie
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July 29, 2014 at 3:36 AM ×

Pol I am with you here, not that i have seem so many cycles but it just seems odd that this one will peak with so much skepticism still. Sure there are pockets of craziness, gpro, loco etc and most stocks aren't cheap. So I don't rule out a Marc Faber 87 style spike but I think we have room to run if the economy ever picks up. GDP will be closely watched.

As skippy says, yes leverage has moved into the markets but not the economy overall.

I have no doubt money printing will lead to some un intended consequences but that it might just be a lot longer down the road than many expect.

If I am wrong then the best short is probably Europe. Looking like japan without the massive bubble preceding the crash.

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Anonymous
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July 29, 2014 at 9:55 AM ×

C Says
Poor old Tullett looks like a decent proxy for the issue. One might soon be tempted to use it that way?

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Anonymous
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July 29, 2014 at 11:22 AM ×

C Says
Re leverage the last time I checked US leverage peaked in Feb '14 took a hit and then started to recover in May. Given the time of year my take would be that the Feb peak is still in even though the equity market moved to new highs. Obviously ,in historical terms that combination has proved a good signifier to expect a market turn albeit the dataset is small and market turns don't usually happen according to a nice and neat timetable.

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Anonymous
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July 29, 2014 at 11:56 AM ×

The ATM DAX strangle for Aug is roughly 2.5%; seems well priced considering the recent price action; however, if you want to pick up a side you have a 1.25% natural stop for the next 2,5 weeks. Not bad considering the next 3 days calendar and the simmering eastern ukraine where I believe russia's end game might soon be clear with the rebels close to being surrounded.
I won't even mention Yen vols for fear of being laughed out of here.

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Anonymous
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July 29, 2014 at 11:58 AM ×

The ATM DAX strangle for Aug is roughly 2.5%; seems well priced considering the recent price action; however, if you want to pick up a side you have a 1.25% natural stop for the next 2,5 weeks. Not bad considering the next 3 days calendar and the simmering eastern ukraine where I believe russia's end game might soon be clear with the rebels close to being surrounded.
I won't even mention Yen vols for fear of being laughed out of here.

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Anonymous
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July 29, 2014 at 12:41 PM ×

The ATM DAX strangle for Aug is roughly 2.5%; seems well priced considering the recent price action; however, if you want to pick up a side you have a 1.25% natural stop for the next 2,5 weeks. Not bad considering the next 3 days calendar and the simmering eastern ukraine where I believe russia's end game might soon be clear with the rebels close to being surrounded.
I won't even mention Yen vols for fear of being laughed out of here.

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Yulva
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July 29, 2014 at 1:22 PM ×

VXST $14 put, a casual 100+% in a few hours:

http://imgur.com/NVaYQBo

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Polemic
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July 29, 2014 at 4:54 PM ×

Thanks so much for the reply MM and I ll be back on the comments on your follow up post.

Abee.. re GoPro btw, as a less well paid non-city exec these days I have been tapping into chinese bypass products and have just ordered this Go Pro equivalent

http://www.banggood.com/SJ4000-Waterproof-HD-1_5-Inch-Car-DVR-Camera-Sport-DV-Novatek-1080P-p-917037.html

Can't see Go Pro Going Pro for too long.

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MacroManFan
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July 29, 2014 at 6:49 PM ×

MM, completely agree with you on the trigger for volatility increase. I suspect we could get a situation where credit spreads themselves don't widen very much (as, truthfully, credit quality is quite good in an improving economy), and the entirety of the move higher in corporate bond yields is through the risk-free rate. Even if there was some credit deterioration, given liquidity constraints it still may be entirely driven by the risk free rate as one of the only reasonably liquid ways to hedge. In fact, if this analysis is correct, you would expect treasury futures to trade at a substantial discount to fair (as they will be one of the few vehicles to hedge)

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