The world's most potent central bank, the Federal Reserve, officially halted its third round of Quantitative Easing (QE) on 29 October 2014. Since then, the S&P 500 is some 4.7% higher while the shape of the Treasury yield curve has become radically different, Fed jawboning not withstanding.
The then Fed Chairman, Ben Bernanke, started "tapering" the central bank's $85bn/month in securities purchases in February of 2014, gently kneading the market's dough - signaling the imminent cessation of kool-aid administration that the markets have so loved since debuting in 2009.
No one will ever doubt QE's efficacy in spurring multiple expansion in equities, or its vicarious atonement for the sins of too-big-too-fail financial institutions. However picturesque a picture the Fed's $3.2trn monetary stimulus has painted, the markets have been quick to shift their attention to another seemingly imminent event - a rate "liftoff" some time in 4Q15.
All Seems Well On The Surface
Most dollar-based markets including equities and treasuries have been in the money for the 5 months that have since elapsed since the passage of Taper. Although the view on the real economy is (constructively) mixed, the general consensus has been one of a strong and robust economy. The American economy is in our minds, the cleanest of the clean shirts; we cannot say the same for the rest of the developed markets exuding Germany, which probably falls in the same league.
On the surface, asset prices seem to have behaved rather well despite the multitude of turbulent episodes which was perhaps the market's way of throwing a tantrum after all that flow from the Fed was cut off. Across the board, most financial markets have risen in price. All that seems even shinier if we factored in the Dollar's epochal triumph over the rest of the world's currencies.
Or is something more sinister brewing, our curious minds wish to know...
Going Underground With Volatility
We wanted to go deeper underground with our analysis on the effects the end of QE have had and is currently having on US markets. Understanding that the end of QE also brought the imminence of a rate hike into prime question, our analysis therefore covered the dual faces of monetary policy tightening - halting asset purchases, and raising interest rates.
Measures of volatility - realized and implied - are often overlooked factors when strategizing trade ideas. The very definition of risk in of exposure in the financial markets is the variance of returns, or volatility of returns. Although unseen to the naked eye, implied volatility gets priced into the markets in the form of risk premiums. When we look at possible avenues to hedge our positions in our proprietary trading portfolio, the cost of such hedges is often heavily weighed by the volatility premium we pay to establish those hedges.
On the flip side, the presence of volatility in an asset's price creates opportunities for profits and losses. The absence of volatility would mean a stoically dead market; returns would have to be indirectly sought elsewhere. In essence, volatility is the market's lifeblood. Although there is a strong case that maps the correlation between liquidity (volumes) and volatility, we will be discounting the liquidity effect for the purposes of this note.
The most popular measure of volatility is the VIX, an index that quantifies the implied volatility of all S&P 500 index options that trade on the Chicago Board Options Exchange (CBOE). Also called the "fear index" the VIX is the most commonly used benchmark for measuring volatility in the US equity markets. However, looking at the VIX itself or even against equity returns would just reveal the known - that volatility increases when prices fall and moderate as they rise. This is nothing new.
A term structure imposes a snapshot view of where prices of each future contract trade relative to one another. A term structure usually comes in the form of a contango; where spot/near-dated prices trade cheaper than future prices. The inverse would be backwardation; where spot/near-dated prices trade dearer than future prices. For instance, we noted in a previous note that the term structure of crude oil futures were trading at an unusually steep contango, something that we felt implied that prices would either continue falling at a rapid pace of rebound sharply. Prices eventually saw a sharp bounce.
Equity Downside Protection Cost Surge
We consolidated a time series of daily VIX futures prices, which allowed us to create a visualization of how the entire VIX complex has traded over the last 35 months. The model on the right is the result of a rather tedious amount of data manipulation; we had to constantly roll all 7 series of VIX futures as they expire each passing month.
Our findings are nothing short of eye-opening, and correlates well to the fundamentals of monetary easing, or the lack thereoff in the current environment.
The visualization reveals a hidden development which has not been brought to light in financial media, at least not that we know about.
It seems to us that medium to long term protection against downside in equity prices is a theme that has been ongoing since the arguably deep correction in stock prices in September 2014 which saw the VIX term structure turning massively inverted.
The plausible explanations for this observation might be traders who were sellers of volatility premium (put writing) during the period where stock prices were constantly heading north with the entire term structure being incredibly flat, had reversed those positions in 4Q14.
And as further analysis from Goldman Sachs suggests, on top of vanishing put writing, OTM (out of the money) protection has become markedly more expensive since 2H14. In short, the cost to insure against downside in equity prices has sky rocketed. The reason? We are in an environment in which few are willing to assume the risks of writing protection.
Historically, there is a positive correlation between interest rates (money markets) and equity prices. What makes the current episode more treacherous to thread is the withdrawal of the largest source of demand for treasury securities. After years of purchasing treasury securities in the secondary market, the Fed's only means of flow stems from maturing bonds.
While we feel there is no dearth of reasons to be exposed mid to long dated treasuries, the key risk still lies in the Fed's interest rate policy, which in turn is suspended on a delicate string of inflation and inflation expectations.
Market participants certainly understand that the end of QE also meant that markets would become much more unpredictable and inherently more volatile; on the surface and underground.
No Crash, But Lots Of Chop
As we stated above, our analysis indicates to us that a major correction (defined as 10% or more price decline) in US equities remains unlikely despite a Fed that is practically sitting on the fence while deciding on the timing of a rate "liftoff".
The passage of QE has generated major fluxes in the volatility markets as we have spoken about above. These fluxes however do not seem to point to equity prices being perched on a cliff's edge. Rather, they seem to be telling us to expect a continuation of what we have already been experiencing for much of 2015 - lots of chop.
Without straying too far off topic, we should add that most of the markets we cover have become extremely data-dependent ever since the Fed signaled to the markets that they were contemplating a rate hike. The progression of its language in each FOMC meeting, that of which culminated with its latest policy meeting in March, seemed to have directed the market's attention towards US macro economic data more than anything else.
That being said, the Fed is given little choice but to carefully evaluate the progress of the metrics it uses to weigh the potential risks of raising the Fed funds rate prematurely. The diabolical nature of US macro data over the last 4 months is partly the cause of broad-based volatility we have experienced thus far. On one hand, we feel expectations have been erring too far on optimism that any "negative" print looks relatively weak. On the other hand, there is a real risk that the US economy might have entered a slowdown phase; there is ample evidence to suggest this.
Our analysis points to a sustained period of heightened vol of vol; that is volatility itself being more volatile than historically so. Corrections in stock prices should continue in their sporadic intervals. The internals also look to us to be more fragile than they have been since 2013, and medium to longer term hedging costs seemed to have increased significantly after mid-2014.
We strongly believe that the main reason attributing to this disconcerting juncture has been the offset of massive positions which were essentially indirectly bidding up equity prices through the sale of volatility premiums. The notion that the Fed has been writing puts underneath stocks prices has never been truer to this day. Now that the Fed's most potent backstop to a decline in equity multiples has disappeared, those positions of gargantuan notional had to follow suit.
In the absence of put writing, equity markets and their convexities have morphed into their naturally unpredictable natures. This should not be a surprise to seasoned professionals with skin in the game pre 2008. The virtuous effect QE had on stock prices has been gradually fading, and we feel the possibility of a rate hike in 2015 has terminally ended that moderating effect. It will be interesting to see how the markets will adapt to an era of minimal central bank intervention.