By Andreas Steno Larsen, Nordea Markets

Despite a trade war, a flat USD yield curve and shrinking central bank liquidity, volatility across asset classes is once again at depressed levels. We find at least seven reasons why cross-asset volatility is (too) low.

After a short-lived spike in February/March this year, volatilities are once again depressed across asset classes despite a whole string of signals that would suggest otherwise higher volatility levels.Is it the strength of the US upswing that works as a cushion against volatility in developed markets despite emerging markets turmoil and less benign central bank balance sheet policies?

Below we list seven reasons why the current market pricing of cross-asset volatility looks complacent.

Reason 1: Central bank liquidity is shrinking

It is no longer a surprise to anyone that the Fed balance sheet/ SOMA portfolio is shrinking month by month, leaving fewer excess USDs in the commercial banking system. As the Fed’s bond portfolio is allowed to slowly mature, the USDs that the Fed receives are withdrawn from the system. Fewer USDs around often coincides with a higher price of the remaining USDs (read: higher short-term USD rates and a stronger USD – this has been the case broadly speaking since quantitative tightening started).

A stronger USD tightens financial conditions in emerging markets first (which we have already seen substantial signs of), but developed markets are next in line ̶ both via spill-backs from EM and via the direct monetary policy impulse on activity. Furthermore, less excess USD liquidity will also tend to alleviate the price cushion of risky assets slowly but surely, as private risk takers are gradually lured inwards on the risk curve, as the Fed leaves a portion of the safest part of the risk curve “up for grabs”.

A smaller excess liquidity price cushion for risky assets (Central Bank Liquidity: In to the dessert) and negative spill-backs from EM to DM activity suggest a higher vol-premium in DM assets in to 2019.

Chart 1: Less USD liquidity around suggests a higher volatility premium (note the reversed left axis)

Reason 2: The USD yield curve tells us that volatility is too low

“Wherever you go, I will follow”

The USD yield curve is showing a late-cyclical mindset. That is at least the conclusion you get if you take the yield curve on trust (Two years to the next US recession? That’s what the yield curve says). There may be reasons that this time is different ie the yield curve is not telling us much, as eg QE has erased term premiums (who knows?). The lack of trust in the yield curve signal (due to the big amount of what ifs from QE) on the macro trajectory from here may be one reason why volatility remains low despite a late-cyclical yield curve mindset.

While the yield curve puts the next US recession roughly two years out, it also puts the arrow for volatility firmly upwards for the next 36 months. Do you dare to take the yield curve on trust? In case of a yes, FX volatility is yours for cheap.

Chart 2: FX volatility is bound for a pick-up, if you take the USD yield curve on trust

The same conclusion goes for the VIX index, which lags the trend in the USD yield curve by roughly three years. The quarterly average of VIX is set for a new bounce in early 2019 at the latest, if the yield curve is to be trusted.

Chart 3: “Wherever you go, I will follow”, said VIX to the USD yield curve

Reason 3: The market is positioned towards even lower volatility

The market has once again built up a stretched short position in the VIX index. We view positioning as a decent contrarian indicator, as a big short position in VIX indicates that the market has already positioned for smooth sailing on financial markets. This means that less is needed to spur a round of position squaring in short volatility positions, compared to a scenario with a lighter volatility positioning. The market is now shorter VIX than it was ahead of the February meltdown of S&P 500 (and short VIX products).

The recent trends of higher-than-anticipated business surveys and weaker-than-anticipated coreinflation in the US have likely re-fuelled the smell of “goldilocks” in the air. Though we don’t find good risk/reward in betting on a goldilocks scenario of higher business sentiment and weaker core inflation into 2019 (Week ahead – US goldilocks reincarnated?). So while arguments are good for low volatility as per the current climate, this could change rapidly in 2019.

Chart 4: The market is now shorter VIX than prior to the February meltdown of S&P 500 and short vol products

Reason 4: Financial market volatility is cheap compared to political volatility

Global political uncertainty is on the rise again. US midterm elections are approaching, the Brexit deadline is moving closer by the day and Emerging Markets political risks are high. The global policy uncertainty index is at levels that usually applies at least double-digit FX volatility. Will political risks materialize in large moves in eg USD or GBP? Currently the broad FX volatility indices price in a much smoother political scenario than political uncertainty indices do. Which one will be on the right side of history?

Chart 5: FX vol is priced cheaply compared to global policy uncertainty indices

Reason 5: Issuance calendar suggests a re-ignition of treasury volatility around the corner

Recently the TYVIX index (measuring volatility in 10yr treasury bonds) hit an all-time low despite an outlook of quarterly increases in net issuance in the US, as far as the eye can see. Especially in a scenario with i) weak appeal of US duration for international investors due to high FX hedging costs, ii) the potential of a second round of the US twin deficit scare and iii) increasing net issuance by the US Treasury, the low volatility scenario looks a little fishy to us.

In 2008-2009 TYVIX rose to levels above 13. This was the last time the Treasury issued at the same pace as now. Are levels around 3-4 in TYVIX sustainable if the macro picture turns less benign in the US, while the Treasury continues to issue at a high pace in an environment with mediocre appeal of treasuries for international investors? We doubt it. Volatility in treasury bonds looks arbitrarily low.

Chart 6: Low issuance, low volatility. What will happen when US issuance continues to surge?

This argument risks being temporarily invalid if the debt ceiling is not lifted during H1 2019. (FX weekly: Who wants to impeach a +60 ISM president?). In such case, a government shutdown or a debt ceiling stand-off though could prove to be a driver of volatility in itself.

Chart 7: A debt ceiling stand-off and a following government shutdown is usually a source of volatility

Reason 6: Something almost always happens to VIX in October or November

Seasonality is also a factor. Except for 2015 we have seen a material spike in VIX in either October or November in each of the last six years in a row. Something almost always happens in either October or November that leads volatility to spike.

Chart 8: What is wrong with October and November? Volatility usually spikes

Reason 7: Volatility is cheap compared to historical volatility (and in certain cases also realised volatility)

Volatility is also cheap seen from a historical perspective. Measured in standard deviations (z-scores) from the historical mean, most G-10 FX volatility trades at least 1 standard deviation below historical means. Scandi volatility is not as cheap as volatility in other majors as eg JPY pairs. USD/JPY has been surprisingly stable recently. History suggests that it will not continue that way for too long.

Chart 9: FX volatility is cheap compared to historical levels. More so in EUR and JPY than in Scandis

Do you dare to take these seven indicators on trust? In case of a yes, cross-asset volatility is yours for cheap. History doesn’t repeat itself, but it often rhymes (as Mark Twain said).

Whether you want to utilise this to buy volatility as an outright bet or to buy portfolio downside protection via out-of-the-money puts, the fundamental case is the same. Broadly speaking risks are priced cheaply compared to our overall allocation view, which includes a negative tilt on risky assets into 2019 (Nordea View: Waiting for the star to fall).

Attached you will find two trade ideas (FX and Rates) with our suggestion on how to play volatility as an outright bet.

Seven reasons why cross asset volatility is too low – v2.pdf

Trade Ideas volatility FX and Rates.pdf


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