It’s been a crazy few weeks crammed into a couple of days. In the aftermath of a cooler than expected payrolls report, the VIX surged to ~65 and the SPX corrected 10%. The Treasury yield curve bull steepened (short-term rates fell more than longer-term rates), as shorter Treasuries were bid to the highest levels in two years. And suddenly, the market went from the expectation of two rate cuts in 2024 to more than four.
So how much can this volatility be attributed to the world’s most influential economy’s weakening? No question, economic data is revealing a slowdown, but is this a downshift from fifth gear to third gear or to neutral or even reverse? It’s too early to tell, but we are pretty sure that this kind of reaction has a lot to do with...
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The impact of a presidential election on the market is typically measured by the behavior of equities. In this election cycle, we believe that the bond market is a better guide. While inflation has been the Achilles heel for Biden, neither Biden nor Trump have a plan to “Whip Inflation Now,” à la political campaigns of the 1970s.
Biden’s policies such as energy transition, tariffs, and steady-state approach to immigration, are no doubt inflationary. Trump’s policies, articulated thus far, take it a step further with increased tariffs, lower taxes, increased budget deficit, and tighter immigration/deportation policies. It’s also no secret that Trump dislikes the more hawkish Chairman Powell. Have you ever met a real estate professional who didn’t want lower interest rates?
Immediately following the Presidential debate, the 2- to 10-year Treasury curve surged 20 basis points, reflecting the expectation of higher inflationary conditions down the road. This corresponds with price action following Trump’s unexpected victory nearly eight years ago. Specifically, the curve steepening was a back-end sell off, not a front-end bid, a “Trump Term Premium” if you will (Chart 1 and 2).
The question is, assuming Trump continues to gain momentum, does the curve re-steepen and term premium hold? If Trump is elected in November and empowered with enough support from Congress (a significant assumption), we should expect policies that promote a loose fiscal, lax monetary, high tariff, tighter labor supply. Add this mix to several years of economic expansion already contending with new structural inflationary forces, and the risk of higher inflation is likely.
Biden’s poor performance in the most recent debate has revealed underlying market forces that could have a structural impact. The risk remains that a higher term and inflation premium will have a material impact on stocks, real estate, and, of course, bonds.
In last month’s Cross Asset Volatility piece, we made the case for a “Not So Cruel Summer” with healthy earnings, an easing-biased Fed, and very few “unknown unknowns.” At this point, the Fed is in “tweaking mode,” and the bond market is closely aligned. For equities, there is much ado about nothing if the Fed cuts in September. What’s important is that equities are supported by earnings growth and not by P/E expansion. Chart 1 shows earnings growth year-to-date for the SPX Equal Weight Index (“SPX Equal Weight”) and the Magnificent Six (“Mag6”). We see the SPX Equal Weight is up 4%, in line with earnings. The Mag6, on the other hand, is up 38% with 26% earnings.
Source: Tallbacken Capital Advisors, L.L.C., Bloomberg L.P.
Consistent with a strong equity market, correlations are dropping. Charts 2 shows one-month implied and realized correlations for the leading stocks within the SPX. Chart 3 shows 3-month correlations for the same set of stocks. These correlations are at, or very close to, lifetime lows.
As we have addressed in past CAVs, the VIX tends to rise and fall with correlations (Chart 4). Correlations tend to rise when investors sell equities. Correlations tend to fall when investors buy equities. Said another way, investors buy single stocks and short the index.
Chart 5 shows us how sectors were correlated from February to June. In the bottom right, the “average of the averages” is 0.4. Chart 6 shows the average of the averages back to 2008. 2024 is close to the lows of 2017.
Source: Tallbacken Capital Advisors, L.L.C., Bloomberg L.P.
Source: Tallbacken Capital Advisors, L.L.C., Bloomberg L.P.
Since the tech sector is so important right now, we provided cross-sector correlation for tech in Chart 7. The average tech cross-correlation in 2024 sits at a record low. This is especially significant given tech’s weighting in the broader index. Keep in mind, these correlation grids are unweighted. Parlay that into the overall market and correlations are likely to stay lower for longer. Low stock and sector correlations reinforce a lower volatility and lower VIX regime. That being said, any major market shock will have a dramatic impact on a VIX at 12 and an average of the averages correlation at 0.4.
Source: Tallbacken Capital Advisors, L.L.C., Bloomberg L.P.
There is always news that can spark a bout of volatility: the unknown unknowns. That said, we anticipate a quiet summer led by the recent strong earnings and falling interest rate volatility.
Q1 was good with an exceptionally high percentage of earning beats (Chart 1). Equally as impressive was the breadth of those earnings beats, well beyond just tech. Chart 2 illustrates that most sectors are seeing solid earnings acceleration. Chart 3 illustrates that most of those sectors have also experienced margin expansion since the beginning of the year.
Continued earnings growth will be critical to maintaining the bull trend. There is no good reason to sell equities with the most recent data in hand. In fact, a backdrop of broad-based earnings growth will allow investors to be more discriminating in their stock and sector selection. This could lead to lower cross-stock correlation and to lower equity index volatility.
Source: Tallbacken Capital Advisors, L.L.C., Bloomberg L.P.
Source: Tallbacken Capital Advisors, L.L.C., Bloomberg L.P.
Source: Tallbacken Capital Advisors, L.L.C., Bloomberg L.P.
Rate volatility has been exceptionally high over the past three years but is starting to come in and test key levels (Chart 4). This is important because interest rates have soared, contracted, and are rising again. Even with a lot of rate drama, rate volatility is looking forward and settling down. Why? In the last five months, the number of rate cuts expected in 2024 dropped from seven to just one. In the May 1 Fed meeting, Chairman Powell made it clear that there would be no hikes; the question is a matter of how many cuts and when. In other words, the bond market now has a ceiling AND a floor. We can expect tweaks but no wholesale adjustments to policy rates. Zero to three cuts in 2024 are well within expectations and Fed projections. A stable bond market has a meaningful impact on equity volatility because investors can predictably discount cashflows.
It is also worth noting that other cross asset volatility metrics are contracting. FX and crude oil volatility are also trending lower (Chart 5). Anything can happen, of course, but assuming business as usual, we think we are heading into a pretty low vol summer.
Gold has rallied 25% from its October 2023 lows and 40% from its September 2022 lows. This price improvement occurred despite persistent dollar strength, high real and nominal interest rates, and a Fed which has stopped hiking but has yet to initiate or commit to the idea of a proper cutting cycle (Chart 1).
Gold has been playing aggressive defense, but not so aggressive offense. It has steadily reached new highs without the explosive moves we have come to expect. In fact, gold ETFs have been losing, not gaining, (open) interest during this impressive rally (Chart 2).
Who has been pushing gold higher? It is not Wall Street; it is central banks. In chart 3, we see that central banks have been quietly accumulating gold over the past several years. Typically, when gold rallies, so, too, do silver and mining shares. This is not the case when central banks are the driver as they do not buy silver nor mining shares (Chart 4). Further, when central banks accumulate gold positions, they do it quietly and in an orderly fashion, with a long-term time horizon. This results in a discreet rally with low volatility, on an absolute basis and a relative basis, specifically to Treasury and foreign exchange volatility.
If Wall Street fully engages in the gold rally, we expect to see the aforementioned proxies rally and gold volatility rise. We believe the tipping point is fast approaching because the current technical pattern looks eerily similar to the triple top which occurred between 2007 and 2009. When that pattern eventually broke out, gold nearly doubled in price, until it reached the blow off top in September 2011 (Charts 6, 7).
If the gold rally continues to trend higher, we expect that hedge funds, commodity trading advisors, and retail investors will become more actively engaged. If this occurs, mining stocks and silver should also rally, and traders should see outsized performance in these more volatile asset classes. However, if gold continues to rally in isolation, we expect central banks to ease purchases and let Wall Street lead the way. As leadership changes hands, the complexion of the rally will evolve from low volatility to high volatility with more explosive moves higher and more violent moves down.
Despite a market rally, the VIX has slowly and steadily climbed higher since the December FOMC (Chart 1). Why has this happened? We believe that the steady march higher in realized volatility has played a part. In Chart 2, we see that 20-day realized SPX volatility climbed from 6, a very low level, to 13, almost double.
In last month’s CAV, we addressed the relationship between the VIX and cross stock correlations. Generally, when correlations move lower, there is less macro risk, and the VIX moves lower. In this circumstance, investors worry less about the risk of the equity asset class and focus more on the specific attributes of individual stocks. Conversely, as correlations increase, the VIX moves higher. In March 2020, the most recent VIX spike, correlations across stocks surged to nearly 1.0.
In Chart 3, we observe that 1-month implied correlations have started climbing, even with 3-month implied correlations at historically low levels. To us, this suggests that the risk of a market sell-off is priced into the near-term, but not the long-term. This appears to be a statement that, after such a blistering rally, a correction is due. Maybe not a major one, just yet.
Interest rates have been steadily creeping higher. The roughly seven cuts priced in early January now stand at roughly four cuts. In Chart 4, the 2-year Treasury yield (which is more directly impacted by Fed policy than longer term interest rates) has risen steadily since the December meeting. Even though it has recently come in, there is still an enduring question regarding whether the Fed’s projection of three cuts (not four or more as currently priced in) will come to bear. If the economic data continues to be reasonably strong, then rates may push even higher.
If rates continue to rise and settle into a higher range, will that lead to a bear market in equities and a nasty bout of volatility? The answer is, it depends. If economic growth, rather than inflation, is the key force keeping rates higher for longer, then perhaps there is a good case that the VIX, and rates, are both adjusting to a higher, yet not destabilizing, range. In the late 1990’s, the economy was strong, rates were high, and the market produced a historic rally. The VIX was also much higher. From 1997 through 2000, the equity market rallied at an unbelievable 24%/year CAGR with the lowest closing print for the VIX at 16 (Chart 5). This marks a recent period where we had a strong economy with higher rates, and, importantly, a Fed that was not inclined to dramatically lower interest rates at every whiff of economic weakness. This could be our template for the rest of this year.
Over the last several years we have seen massive and abrupt jumps in equity volatility. Even during conditions where economic and earnings reports were stable, there were no Fed or geopolitical tape bombs, and the market was not overbought. What is underlying and exacerbating these jarring market periods? Is it the overdevelopment of option trading strategies designed to generate alpha from selling volatility in some form or fashion? In February 2018, we had the implosion of the short VIX ETN (“XIV”) while the manic price action just prior to Christmas of that year was heavily driven by the massive rise, and subsequent fall, of Iron Condor strategies (selling option premium tied to the SPX). The record VIX spike in March 2020 was driven by the COVID shock, but this was exacerbated by the massive implosion and forced position closing of various option dedicated hedge funds that had been short volatility. Short volatility is a great strategy, until it isn’t.
A dispersion trade is when a trader pairs a basket of single stock volatilities against index volatility. A trader that is long single stock volatilities and short the index volatility against that basket is essentially betting on correlations among those stocks declining. Correlation increases as volatility increases and as equities sell off. The dispersion trade can be thought of as earning a correlation risk premium.
Generally, when the equity markets rally, the VIX tends to contract and the correlation among the stocks and sectors decline. This makes sense because, in a risk-on trend with less macro risk, the market can discern which companies are doing better than others. Conversely, if there is a macro shock, investors sell equities indiscriminately. In this scenario, correlations across stocks spike, as does the VIX.
Using the VIX as a proxy, SPX index volatility is based on implied volatilities of SPX options. The VIX is a forward-looking measure, calculated from a basket of SPX index options - various strike prices of both puts and calls over the coming four to six weeks. Realized correlation, however, is the actual co-movement of stocks based on a mathematical calculation of trading history. This data is important but, because it is historic and not forward-looking, is therefore of limited help in determining if single stock implied volatilities are likely to move more or less in tandem.
The implied correlation, however, is a calculation which is derived by how the basket of single stock option volatilities (again, forward-looking) trade relative to the SPX index volatility. If the basket of single stock volatilities moves in lock step with the SPX implied volatility, then implied correlations are very high. When the implied volatilities do NOT move in lockstep with each other, they are reflecting a higher level of individual signal stock issues.
For example, in a benign economic and market environment, as we currently have, Exxon (“XOM”) might have a downside surprise, see its stock fall, and volatility expand. While, on the same day, Meta Platforms Inc. (“META”) might have a big upside surprise, see its stock rise, and volatility expand. At the index level, the stock prices might offset each other, but the trader might profit from long volatility on both. Interestingly, SPX index volatility could be flat or even lower. Said another way, unless the stocks in the index are perfectly correlated, an index will always have a lower volatility than the average of its constituents.
The Chicago Board Option Exchange (“CBOE”) produces indices of implied correlation which can be seen on the CBOE website or on Bloomberg. These indices measure one-month and three-month implied correlations. While the CBOE calculation is not exactly what practitioners use, it illustrates the market’s view on stock co-movements and is a helpful guide as to what is happening with this part of the options market.
Chart 1 shows the VIX alongside the realized and implied correlations. We can see here that the implied correlation index tends to track closely with the VIX. During the record VIX spike in March 2020, correlations, both realized and implied, went to 0.8 – 0.9.
In theory, volatility exposure is neutral, because the trader is long the same amount of Vega (a notional amount of volatility from the options the trader is long) from the single stock basket that he is short on the index. The trade is short both correlation and correlation convexity. Short correlation means that the position will lose as correlations increase. As discussed, correlations increase in a market drawdown. In addition, as correlations increase, the trade will lose money at an increasing rate. This is the classic short Gamma profit and loss profile that can cause volatility markets to have violent spikes due to forced buying and selling as traders need to stop out and/or de-risk their books.
But, when a market shock happens, all implied volatilities and correlation among the stocks will gap higher. However, the index volatility will typically gap much higher than the basket of single stocks. Which, as mentioned, will come from a much higher base than the VIX.
Last year was set up perfectly for the long single stock basket and short SPX index volatility dispersion trade. There was a strong run in equities after 2022 with declining macro/interest rate risks and a wide divergence across and within sectors. Correlations went from middling to low, consistently realized below what the market implied. This worked quite well for the dispersion trade. Low implied correlation is key to the success of the dispersion trade. Specifically, realized (actual) correlation underperforming implied correlation. This is how correlation “risk premium” is harvested, not unlike how iron condor or other short index volatility strategies harvest the SPX volatility risk premium - the spread between the VIX and the SPX realized volatility which is usually positive. In Chart 2, we can see that not only have realized and implied correlations declined, the spread between implied and realized correlations has been positive. Realized correlation underperforming implied correlation is what a dispersion trader wants to see.
However, there are suggestions that this trade may have worked too well, for too long. Consider the level of implied correlations today – three-month implied correlations are at just 0.2 – the market is pricing only a minimal amount of “macro” into the single stock correlations. The only time that implied correlation levels have been lower was at the end of 2017 – just prior to “Volmageddon” (Chart 3). As noted, realized correlation has also dropped to extremely low levels. We can see in Chart 4, the only time that realized correlations have been lower was at the end of extended bull runs, i.e., late 2017.
Another way to consider how little “risk-off macro” is priced into single stock options is by considering the ratio of the implied correlation to the VIX. Clearly volatility has contracted dramatically over the past two years and as discussed, so have correlations. However, as we can see from Chart 5, the level of implied correlations relative to the VIX is close to lifetime lows: a great example of how far this trade has been pressed.
We discussed above that the only time implied correlation reached these levels was early January 2018. Just prior to the VIX explosion in February, magnified by the implosion of the XIV (Inverse VIX Short). In Chart 6, we see how similar so many volatility metrics are today:
What is also striking is that, while volatility was especially low in both periods, we have seen the VIX rising both in 2017-2018 as well as today (Charts 7, 8).
Now, let’s consider the broader market/macro back drop today versus early 2018. Both 2017-2018 and 2023-present were strong risk-on conditions, represented by P/E expansion and generally strong tech leadership. In both instances, we experienced large declines in correlation. That is why the dispersion trade worked well during these periods. Further, both Januarys that followed (2018 and 2024) had positive equity performance, good earnings performance, and moderately rising yields (Chart 9).
The long single stock volatility/short volatility trade is fine, until it isn’t. As noted above, if we experience a market shock, realized and implied correlation will increase dramatically, which means dispersion trades will become mechanically short volatility in an accelerated manner (in variance, not volatility scale). If these traders close out (voluntarily or otherwise) their trades, they will be forced to cover their short SPX volatility, which means buying back SPX index options which, in turn, drives the VIX higher. Closing out the long option positions on the single stock volatility positions will only offset some of this negative profit and loss for the trade.
In Chart 10, we show a scatter plot of the VIX three months after the implied correlation sinks below 0.25 over the course of the lifetime of the correlation index (which starts in 2014). We can see that, while some jumps are modest, many instances point to a meaningful shift higher in the VIX.
The dispersion trade has worked well over the past year, but our sense is that it has simply been pushed too far. The dispersion trade, a strategy which sets up a basket of long single stock options offset with a short volatility position on the relevant equity index (e.g. the SPX) works well when economic and macro conditions are benign and correlations among stocks falls - conditions which aptly describe today’s environment. While today’s economic and earnings data is still quite strong, we believe that this trade has simply been pushed too far and the potential for a convex market whiplash may be around the corner. A variety of volatility metrics are eerily like January 2018, just before the manic VIX surge. We are NOT saying this will happen this week, or next week. But we are saying there is plenty of gunpowder, and plenty of matches lying around close by.
It should also be noted that these market dislocations from short volatility implosions are as severe as they are sudden. In all three of these examples, the SPX dipped sharply, and in all three examples, equity investors were handsomely rewarded if they bought that market dip.
The December FOMC meeting marked a key event in this interest rate cycle. The Fed started talking about rate cuts and stopped talking about rate hikes. We have seen many dovish pivots in the past but what makes this one unique is that they are pivoting into a strong economy. Despite one of the most aggressive hiking cycles in history, unemployment remains low (consistently below 4%), GDP is strong (2023 GDP growth is expected at 2.4%), and consumer spending is still strong. Inflation is falling and the Fed feels (rightly so, in our view) that they need to pre-empt a further surge in real rates. If inflation continues to fall, real rates will continue to move higher. Perhaps, too much in the Fed’s view. Announcing the pivot in December enabled them to get the messaging out of the way before we get too far into the election process. While the Fed has walked back a bit of the super dovish messaging, the critical point is that the hard, ugly work of the Fed is behind us. Financial conditions are still at the very low end of the range, established during the Fed hiking cycle (Chart 1).
For the worker-consumer, things are in pretty good shape. Wages continue to march higher, while gasoline, and a wide range of other prices, are falling. Interest rates have also contracted, which is easing credit costs. Critical, at this stage in the cycle is that, even with excess savings from COVID dwindling, the consumer, with higher real wages, can continue to spend “higher-longer”. What is so unusual is that we have these two Goldilocks dynamics happening at the same time. Chart 2 summarizes the “Dual Goldilocks” condition.
For starters, we believe that investor’s risk appetite will remain strong, reinforcing a stronger backdrop for the rotation into cyclical stocks, broadening the stock market rally. We believe that interest rate volatility (MOVE) will continue to contract from elevated levels in 2022 and 2023. At the same time, persistent economic strength means that the Fed will remain defensive. Today, there are nearly six cuts priced into the Fed Funds futures markets. If the Fed continues to walk back some of the surprisingly dovish message from the December FOMC, we expect to see a backup in yields (2-year Treasury, in particular) and some enduring tension in rate volatility and, by extension, equity volatility. Still, at this point, we think these are tweaks, rather than the massive wholesale adjustments the Fed made to interest rates during 2022-2023. To put this in the perspective of cross asset volatility levels, Chart 4 shows the ratio of equity volatility (VIX) to Treasury volatility (MOVE). This ratio is at lifetime lows, extremely low equity volatility and extremely high Treasury volatility. We expect this ratio to normalize later this year - with Treasury volatility gradually coming down more than equity volatility rising.
It’s important to remind ourselves what we have been through over the last four years: a once in a century pandemic; a shooting war between two major commodity producing countries; a massive fiscal and monetary response to COVID, which led to the ensuing inflation; one of the most aggressive hiking cycles in history, in both magnitude and speed; enormous economic volatility with US GDP surging to 5.8% in 2021, and then falling to 1.9% in 2022; and economic projections that provided substantially no guidance. Further, inflation proved not to be transitory, at least not in the short term. While we are not yet out of harm’s way, we believe that we are heading toward calmer waters. Inflation, and oil, have slowed their roll. However, we continue to keep a close eye on housing prices, as they have yet to roll over, and food prices, as they continue to push higher.
Even with all the shocks and surprises over the past few years, we think 2024 will be much more subdued. In many respects, 2023 was a year of price discovery for the bond market – largely coming to terms with a new interest rate regime, and what higher term premia means for longer term interest rates. In Chart 1, we see the 10-year yield has moved from 0.5%, to 5.0%, and then back down toward 4.0% in the past three years.
There will no doubt be movement in the bond market next year including the trend towards ‘normalizing’ the Treasury curve. Even with that, we still believe that the most difficult and volatile part of price discovery for interest rates is behind us, particularly with the Fed appearing to have reached its terminal rate. The more likely questions are, will the Fed cut next year, and if so, by how much? Term premia has risen in 2023 but now seems to have largely stabilized (Chart 2).
In previous Cross Asset Volatility commentaries, we have discussed the MOVE Index in detail. In Chart 3, we see that the MOVE Index has been elevated and at historical levels in 2022 and 2023. Next year, we believe that rate volatility will decline and hold steady in a much lower range. While rates may move higher or lower, the movements won’t be as extreme, as we expect the Fed to largely remain on the sidelines.
What does this mean for equities and investors’ risk appetite in general? Interest rate stability and a lower MOVE will improve investor confidence and allow them to make more considered asset allocation decisions. We believe that this environment will allow investors’ risk appetite to largely remain healthy. No doubt, the risk of a hard landing remains, but in the absence of that, equities should be supported.
SPX pierced 4,600 in late July, the top of an aggressive rally which subsequently set up a roughly 10% correction through the end of October. August 2023 through October 2023 was the first three-consecutive-negative- months since Q1 2020. Despite the bearish price action in equities, the VIX averaged 15.4, and within a tight range of 13 to 17.
Equity volatility has been subdued because correlations across stocks have been low. This is a function of widespread dispersion in returns and valuation expansion within the index, the ‘Magnificent Seven’ vs. everything else. In addition, as equities sold off in Q3, rates rose, and rate volatility declined. Interestingly, the MOVE made its cycle low on September 15th, the same day the 10-year yield reached a key breakout level (Chart 1).
In Chart 2, we see that the MOVE and the VIX have largely moved in tandem for the better part of this year, jointly making cycle lows, on September 15th.
Historically, while the MOVE and VIX are very correlated (Chart 3), but interestingly this year, the VIX is trading at a historically low level given the market environment. To illustrate this, we look to the ratio of the VIX over the MOVE. During the last several months it has been among the lowest on recent record (Chart 4).
Over time, the VIX/MOVE ratio should normalize. The MOVE will either move lower or the VIX will move higher, or more likely, a bit of both. At this juncture, however, we think that unless Treasury volatility declines substantially, it’s hard to imagine the VIX resides in the lower teens. If that happens, equity markets will likely be range bound and choppy. Certainly not, in a clear bull trend.
Interest rates at the longer end of the curve are rising while interest rate volatility remains relatively low. If this combination continues, we expect the VIX will remain in check. However, we can still experience major shifts in the investment landscape, with moderate volatility. As shown in Chart 1, interest rates and the MOVE Index were positively correlated in 2022. Aside from a few instances in 2023, the pause at 3.5% and the breakout at 4.5%, interest rate yields and the MOVE index have been negatively correlated. The recent Treasury selloff may have felt violent, but it was fairly steady and deliberate.
Why is Treasury volatility so low when yields at the longer end of the curve have pushed through last year’s highs? The increase in interest rates in 2022 was driven by the Fed’s abrupt reaction to an unprecedented surge in inflation. 2022 saw a record number of hikes in an unusually short period of time. The only notable comparison on record is 1980. But, history teaches us that Treasury volatility contracts when the Fed reaches a terminal rate. Today, the Fed has arrived at or near the terminal rate. Chart 2 identifies periods when the Fed reached the terminal rate (upper panel) and the MOVE index dropped (lower panel). Thus, lower Treasury volatility is to be expected.
The Fed’s near-term policy is not what’s moving long-term yields, but rather the expectation that the Fed will maintain these higher rates for longer. Consider the SOFR forward curve. The SOFR curve reflects the market’s implied forecast for the Fed’s policy rate at different points of time. In Chart 3, we show this curve over a five-year time frame – both in early March (the orange line), when the Fed was especially hawkish and messaging an incremental 50 basis hike was likely. The current curve is shown on the blue line. We can see that today’s expected policy rate over the next 18 months is actually lower today than it was in March. On the other hand, going out three to five years – today’s curve reflects expectations of much higher yields than were implied in March. What’s driving this Treasury sell-off is the market perception that, not only is the Fed less likely to cut rates in a major way next year, but it is also going to keep them higher for longer.
This reappraisal of the longer-term Fed policy rate is also coupled with the fact that central banks are adjusting their policies to a still-sticky-inflation environment. Yield curves across developed economies have been re-steeping in tandem (Chart 4). Related to this, the amount of debt which is negative yielding is trending quickly towards zero (Chart 5). A steady move away from expectations of an aggressively dovish central bank policy around the world appears to be taking hold.
The key point here is that the factors driving rates are slower-moving than the recent Fed hiking cycle in 2022. If the velocity of organic forces is slower, are they any less significant? We think this year’s rate move is actually more significant than last year’s rate hike. Interest rates could remain elevated for years, with the newfound support of the central bank and the continued stubbornness of inflation. Ultimately, this adjustment is inherently a slower moving process but, if it continues to playout is a significant one that will potentially last longer. All this said, we still have to caveat for geopolitical shocks, such as what we are seeing in the Middle East, which could moderate the upward trajectory of bond yields. Since the tragic events in Israel this past weekend, 10-year Treasury yield has come in 20 basis points.
If we are correct, and rates at the longer end of the curve rise, this will have massive implications for key asset classes like equities and credit. There is a very good chance that the VIX will remain low, because of the slower pace of change, as assets are repriced.
We noted in our July CAV, that crude oil and gasoline prices were starting to rise. Over the course of August, crude prices continued higher. In Chart 1, we see crude oil breaking out of the trading range established at the end of 2022.
As anticipated, headline CPI printed a higher number for July, 3.2%, up from 3.0% in June. In Chart 2, we see headline inflation reverse after its steady drop from the October 2022 peak. Core and the Fed’s “Super Core” (inflation without housing) has continued lower.
Rising oil prices without a resurgent Chinese economy, European economic decline, record high U.S. oil production (Chart 3), and record low Strategic Petroleum Reserve (Chart 4) is very concerning.
Energy prices are volatile, which is why the Fed focuses on core. That being said, if crude prices stay higher for longer, it will eventually creep its way into core inflation. Chart 5 compares crude prices with 5-year breakeven inflation, they are historically correlated. Today, there is a big gap – with the market-based measures of inflation failing to climb materially higher despite crude climbing higher. If the pricing of TIPs is correct, then the crude move is temporary. If not, and crude stays higher for longer, it becomes likely that these breakeven rates will increase, threatening the notion that much of the “scary inflation is behind us”.
It will be interesting to watch how crude prices and CPI trend in the coming months as Chart 5 shows us that the current gap between WTI and the 5 Year Breakeven Inflation Rate is likely to close over the next few months. If oil stays higher for longer, we think this will put upward pressure first on headline, and then, core inflation. The Fed’s “NowCast” CPI metrics are indicating an uptrend in headline inflation (Chart 6), which will make their 2% target harder to achieve and rate cuts less likely in the coming quarters.
While crude prices are just one part of the inflation puzzle, its influence is meaningful on stocks and bonds alike, and may lead us to a higher inflation and higher interest rate environment. We think the shift will be slower and more subtle than was caused by the Ukraine-induced oil shock and the abrupt change in Fed policy last year. Historically, a slower more diverse regime change tends to be more enduring.
The recent rally in crude oil prices, combined with the change in the Bank of Japan (“BOJ”) Yield Curve Control policy will continue to put upward pressure on U.S. interest rates and U.S. interest rate volatility. As noted to in our past Monthly Reviews, higher interest rate volatility translates into higher equity volatility. After maintaining a bearish view on equity volatility for the first half of the year, we believe that the markets are now transitioning to a higher interest rate (“MOVE”) and equity (“VIX”) volatility environment.
The subsiding of ‘scary’ inflation is one of many reasons why markets have rallied in 2023. Both headline and core CPI levels have steadily declined (Chart 1) and, in turn, the Fed has stopped hiking aggressively leading the market to believe the Fed has engineered a ‘soft landing’ for the U.S. economy. The forecast for less Fed intervention means a more stable interest rate environment. In turn, lower interest rate volatility means lower equity volatility. And declining equity volatility was our general thesis for the first half of 2023.
The recent rally in crude oil supports the case that inflation may not yet have been brought to heel. Whether it be supply, like today, wage or demand-driven, inflation seems not to want to go away quietly. Crude oil has rallied nearly 20% off the June low, breaking a trend that began over a year ago (Chart 2).
Last month's low headline CPI readings benefitted from substantial base effects. In Chart 3, we see that the 2022 surge in gasoline prices make today’s gas prices look low. Prospectively, year-over-year comps won’t tell much of a story because gas prices collapsed at the end of 2022. As with crude, gas prices have started to surge, with the prospect for a potential breakout to the upside. Again, this should pressure CPI higher in the coming months.
The Fed’s NowCast inflation tool attempts to provide a timelier indicator of GDP Growth than CPI or CPE. And to date, their methodology has proven accurate throughout this inflation cycle. In Chart 4, we see that the headline estimate is starting to climb. If energy prices return to a higher range, we expect higher core inflation. In this scenario, the Fed will be less inclined to cut rates, even if the US economy contracts reversing the expected ‘soft landing’ scenario.
The US bond market must now contend with the BOJ’s adjustments to their Yield Curve Control policy, a method to control the shape of the Japanese yield curve by pinning shorter rates and the 10-year government bond yield. At the end of July, the BOJ increased its target yield from 0.5% to 1%. As a result, in the last few days, the yield on Japanese bonds (JGBs) has soared to multi year highs (Chart 5). If we consider Japanese sovereign yields in the context of German and U.S. yields in Chart 6, we see that while Japanese yields are substantially lower, the trajectory is higher. This is meaningful, as Japan is the last major economy to move off extremely low, often negative, levels. Chart 7 shows the aggregate amount of negative yielding debt in the world continues to drop.
Both inflation and interest rates are not as stable as they appear. Factors such as crude oil prices and Central Bank policy outside the U.S. (both outside the control of the Fed), will impact inflation ‘data’ and decision-making in the U.S. As a result, should interest rates become less stable, higher levels of volatility should be expected in both the MOVE and the VIX. We believe this environment will make it difficult for companies to sustain current higher P/E multiples.
The use of equity options has increased substantially in the last several years. In this piece, we will look at some of those trends.
SPX option volumes have grown steadily for years leading up to 2021. In Chart 1, we can see that SPX option volumes have doubled since 2021. While SPX options are leading the charge in volume, we see similar trends in other equity index options (e.g. QQQ, NDX, RTY).
Interestingly, Call volumes have grown at a much faster rate than Puts (Chart 2). While usage of Calls has surged, the Put-Call ratio has dropped to some of the lowest levels on record (Chart 3). This is typically a bullish indicator.
The velocity of trading, as measured by open interest, has increased nearly as much as volumes (Chart 4). This is especially true on the Call side as Chart 2 shows the overall Call volume well above the Put volume while in Chart 4 the Open Interest in Puts remains well above the Calls, thus revealing the explosion of short-term Call trading. We see further evidence of this by looking at the ratio of volume to open interest, in Chart 5, where we can see that the velocity of trading, the rate at which options are traded relative to their open interest, is soaring as well. Essentially, positions are initiated and closed much more quickly.
0DTE options were introduced to the market a bit more than a year ago. They have grown like wildfire. On some days, they represent more than half of the total SPX options traded. Because they expire at the end of the trading day, they are not included in open interest calculations. This is essentially an undocumented increase in trading volume. Today, we view 0DTE options as more of a short-term trading instrument, like a futures contract. While the 0DTE options provide some insight into the short-term behavior of market participants, they do not inform us of institutional positioning. It is also worth noting that when markets gap higher, bad behavior goes unnoticed.
Even if we strip out these 0DTE options, volumes have increased substantially. More importantly, in Chart 6, we see that option volumes have soared, especially in the last 2 years while cash equity trading volumes have returned to pre-Dotcom levels. We expect this anomaly will lead to some unusual trading behavior, in the short run, as dealers square-up positions. This typically leads to aggressive buying or selling – driving up short-term volatility – just not so far this year.
YTD 2023 has been a bull market. Short-term Call buying is part of the story behind this rally. If this trend reverses and we see short-term Put volumes outpace short-term Call volumes, the market could drop more than investors anticipate. Options volumes are telling us that trading is driving this market, and trading is not investing!
The equity market rally in 2023 has, thus far, been driven by price-to-earnings ratio (“P/E”) expansion. S&P 500 (“SPX”) has rallied 11.5% year-to-date and forward P/E multiples expanded by 11.3%. Nasdaq-100 (“NDX”) has rallied 33% year-to-date and forward P/E multiples expanded by 27%. The P/E expansion occurred against a backdrop of higher interest rates. Typically, P/E multiples move inversely to interest rates. Chart 1 shows the 10-year Treasury Bond rates and SPX earnings yields (the inverse of P/E multiples). While not perfect, we see that earnings yields tend to decline with lower interest rates, and vice versa.
In 2022, SPX earnings yields and interest rates moved in lockstep through the Fed's hiking cycle. The 10-year yield increased by more than 200 basis points, and the SPX earnings yield increased by 126 basis This might not seem like a big jump, but in P/E terms, it equates to an absolute change of 4.6.Chart 2 shows the 2022 changes and Chart 3 shows the 2023 changes in SPX Index Price, Earnings, P/E, Earnings Yields, 10-year Yield, and the Equity Risk Premium (“ERP”), the spread between the earnings yield and the 10-year yield.
In 2023, however, we have seen P/E climb with interest rates. For a P/E driven rally, this raises a very important question. Is the market rally sustainable without a big jump in earnings? This question is especially relevant for big tech. Big tech is very sensitive to rates and has seen the most significant P/E expansion in 2023. Chart 5 summarizes the year-to-date changes for the NDX.
What is especially striking is how small the NDX ERP is today. In Chart 6, we see that NDX is at its lowest level in years, near negative territory.
It is important to note that NDX ERP can reside in negative territory. For example, in Chart 7 we see that NDX ERP between 2002 and 2007, negative for extended periods. This was also true for the S&P 500. At that time, inflation was elevated, and the 10-year range was 4% to 5%. Similarly, in the 1990s, SPX ERP frequented negative territory, when the 10-year range was 5% to 9%. ERP tends to slip into negative territory with higher rates.
In conclusion, we believe that big tech, which dominates the NDX and SPX, will need to generate substantial earnings growth or there will likely be a significant correction – particularly if inflation and derivatively rates remain higher for longer.
April proved to be a cruel month if you were long volatility. The VIX closed at 15.8, the lowest level since November 2021 when the equity market was on fire. Chart 1 shows the ferocity of the decline despite anxiety about the banks, the Fed, the economy, and the debt ceiling.
Not that cheap.Some folks think that the VIX is headed back to the mid-20s or higher, given the array of potential problems in commercial real estate, bank runs, lagging impact of rate hikes, and so on. Two weeks ago, an investor bought a very large number (~100,000 contracts) of the June 26 strike calls - a big bet on a big volatility spike.
Before we get too excited about buying volatility, we need to understand why the VIX has been trading lower. First, realized volatility, the actual changes in the SPX, not forward- looking volatility (VIX), has been declining dramatically (Chart 2).
Second, the VIX looks at the realized volatility of the SPX, and then, in effect, incorporates a forecast of future volatility. The VIX typically trades at a premium to realized volatility (20-day). In Chart 3, we see that the spread of the VIX to realized volatility is currently around 4 points. The average premium for April was nearly 5 points. A 4- point premium is in the top 30% of all readings over the past year. With that in mind, it is hard to argue that the VIX is cheap. Said another way, you must believe that realized volatility is going to rise rapidly, in the next few weeks, for a long VIX bet to pay off. Further, VIX futures, the instrument that you can trade, typically trades at levels higher than the VIX spot. As VIX futures contracts approach expiration, the price moderates to spot value.
Third, the average value of the VIX, going back to 1990 is ~20. More important than the modal value, is the median value at which the VIX closes, ~13, well below the lifetime average. The modal value is excessively high, because the VIX spikes for short periods and then moderates. We caution investors as our view is that the current VIX level seems rich.
Correlations Fall.An important reason behind the VIX and realized volatility dropping is that correlations among stocks within the SPX are falling, a lot. Generally, the VIX spikes when correlations spike, and vice versa. When market conditions are constructive, investors can buy or sell the stocks based on how individual stocks perform. Conversely, selling is less methodical and often related to liquidity, therefore stocks are more often sold collectively increasing correlations. In Chart 4, we see that 1 month realized correlations are more volatile than the 3 month realized correlations. Both metrics retreated to levels last seen in 2021.
Buyer Beware. To buy the VIX right now means you must believe in a catalyst, or a series of catalysts that cannot be addressed by the Fed. If you believe in the catalysts, then you must believe that correlations will align.
In our view, catalysts are starting to dwindle. Roughly half the companies in the S&P 500 have reported Q1 earnings better than expected. The Fed is nearing its terminal rate. We are certainly not dismissing the aftereffects of the Fed′s rate hikes or continued risks among regional banks, but, at this point, economic data has been reasonably good and well received. There are risks associated with banks having still more deposit problems, and a presumed tightening of credit standards. However, these factors, and any weakness in the economy and anticipated earnings outlook will likely be a slower moving process. A slow and predictable path is much easier for the market to digest.
The abrupt collapse of Silicon Valley Bank (“SVB”), the forced acquisition of Credit Suisse by UBS, and the mandatory restructuring of a handful of other banks, caught the market, which was anticipating a 50-basis point hike and substantially bearishly positioned, by surprise. The market reaction was to reprice the 2-year Treasury yield as a result of a flight to quality directed at the shorter end of the curve. In two days of trading, the 2-year yield fell from 5% to 4% (Chart 1).
As noted in our February Commentary, Treasury volatility is tied to strong economic data. With this repricing, Treasury volatility hit record levels. Chart 2 shows the surge in the MOVE index. It has since tapered but remains well above its historical mean. Interestingly, the VIX did not share in the excitement. It briefly hit 30 on the SVB news, then reverted to finish the month at 18.7, its lowest point of the past year.
The muted VIX can be attributed to renewed interest in the Nasdaq (“NDX”). Expectations that tighter lending standards would dampen earnings for cyclical stocks, and the Fed′s continued tightening cycle would lead to increased demand for big tech names. These names typically have less credit dependency and perform better in weaker economic conditions. To illustrate, the NDX rallied 8%, since the collapse of SVB, and now sits above 20% year-to-date
The NDX rally has been driven, almost exclusively, by P/E expansion. Since the start of 2023, the NDX P/E is up more than 4 points, to 24.4x forward earnings, according to Bloomberg consensus estimates. We believe that we will need to see strong Q1 earnings from big tech, at month end, to validate the current bull trend. Chart 3 shows NDX month-end equity risk premium, illustrated by the spread between NDX earnings yield and the 10-year Treasury yield, at 60 basis points. If the 10-year Treasury yield climbs and big tech earnings disappoint, we expect to see more equity volatility.
To that end, we are also watching the spread between NDX and SPX volatility as this spread is still very low compared to its long-term mean. To our eye, it appears that the risk of the NDX is not properly priced.
Another curious development, which has arisen from the banking crisis, is the spread between NDX and value and cyclical stocks. Chart 4 shows the spread of the NDX earnings yield (the inverse of the P/E ratio) relative to the SPX Equal Weight (a proxy for value and cyclical stocks). This spread reached record levels at the end of March - top 1% of all readings over the past decade. If the bull trend continues, we expect to see a rotation into cyclical and value stocks. Said another way, it is hard to imagine the broader market appreciating without value and cyclical stocks outperforming.
We are now at a point where fundamentals (earnings) need to deliver, particularly if rates start climbing again. If rates rise and earnings are weak, it will be difficult for the U.S. market to continue higher. If you expect earnings will expand as quickly as P/E, then stay the course. If you do not believe that, then we think it is time to get more defensive.
We think rate volatility will continue to come in from the record levels, and as this happens, equity volatility will continue to edge into a lower range. However, we caution that there are new inflationary forces on the horizon which might create new challenges for the Fed, and the markets.
So why is the MOVE heading higher? Look no further than the January jobs report. While it is not the only reason, it is the most important one for now. The jobs report was released on February 3rd, a day after the Terminal Rate and MOVE reached its recent low. Chart 2 shows the MOVE with the Terminal Rate - both inflecting higher since this jobs report.
Between November and January, Fed Funds Futures were pricing in the last rate hike to occur at the May or June meeting. After the January jobs report, the timing of Terminal Rate has been pushed back as far as the September meeting. In Chart 3, we see that the number of months expected to reach the Terminal Rate has pushed higher since early February, in concert with interest rate volatility moving higher.
This might be a subtle and nuanced concept, but it stands to reason, if there are more Fed meetings with which policy can shift, Treasury option traders have more opportunities to play outcomes, which can lead to higher volatility. More broadly, there will be more economic data and Fed messaging to consider over the next eight months.
As we have discussed, the VIX and the MOVE are highly correlated. What is interesting, however, is that this relationship has just made fresh lows (Chart 4). The current price ratio of the VIX to the MOVE is the lowest it has since 2004. Generally, these ratios tend to mean revert – meaning either equity volatility must move higher or Treasury volatility must move lower, or a bit of both. We believe that there is a good chance that the VIX will continue to edge lower, but this probably won′t happen until Treasury volatility returns to January levels.
The Treasury sell-off has more to go. The VIX will continue lower until Treasury volatility subsides. For the time-being, equity markets will remain rangebound.
We think rate volatility will continue to come in from the record levels, and as this happens, equity volatility will continue to edge into a lower range. However, we caution that there are new inflationary forces on the horizon which might create new challenges for the Fed, and the markets.
The MOVE is an index which captures near dated implied volatility across the key maturities. As highlighted in our November commentary, the MOVE index soared to its highest level since the Financial Crises in 2008 (Chart 1). As we can see in Chart 2, the MOVE index has fallen since the October 2022 peak, but remains above recent historical levels.
Typically, extreme levels of volatility are difficult to maintain. There are four key reasons why we believe Treasury volatility is contracting:
Rate volatility is a key factor impacting equity volatility. Uncertainty in the risk free rate leads to uncertainty in valuing equities. Uncertainty in valuing equities leads to wider price swings.
While we believe that the trend is lower in both rate and equity volatility, we don′t think that it will fall back to decade- long lows. Inflation is lingering with stickier than expected wage growth, tight commodity supply driving energy and metals prices higher, and the re-localization of the economy. As long as the markets think that they are smarter than the Fed, there will continue to be elevated volatility.
In 2022, gold was a perfect sideways trade. It started the year at $1,829/oz. and finished the year, $3 lower, at $1,826/oz. We think gold volatility is attractively priced and both its price and volatility will move considerably higher in 2023.
To answer the above question, we need to address what drove gold down, and then back up again, over the course of last year. In Chart 1, we see that gold reached its high of $2,043/oz. in March, when real rates (measured using the 10-year TIPS/Treasury break even inflation rate) were trading close to its low. Then, as real rates began to rise, gold sold off to its 2022 lows in September ($1,624/oz.). As real rates stabilized and the traded lower in the fourth quarter, gold prices climbed higher into the end the year.
If we measure gold price against the dollar′s relative strength to other major currencies, we see a very similar pattern. Chart 2 shows that gold sold off from the peak in March in lockstep with a steady rise in the dollar. It also bottomed in September as the dollar began to weaken. The dollar′s rise and fall against key currencies is typically influenced by a currency′s real rate (the carry trade). The correlation between these two charts is therefore not surprising. In short, when both U.S. real rates and the dollar trend lower, gold should do so as well.
In 2023, real rate, dollar, and gold trends will be defined by the Fed. Amongst the major central banks, the Fed was the most aggressive and earliest to start hiking, and they are also likely to be the first to take their foot off the brake. As the Fed approaches the terminal rate (expected sometime this spring or early summer), we expect the Euro and Yen to strengthen and the price of gold to increase.
While gold is off its September lows, gold volatility has continued to remain low (Chart 3). This is unusual, especially considering that, unlike equity volatility, gold′s volatility tends to expand when it rallies. As gold moves higher through key technical levels, short covering and trend following will likely create an explosive bid for gold call options.
If we zoom out, and consider gold′s volatility relative to other asset classes, we can see that, on a relative basis, it is much lower than other major asset classes. Chart 4 compares certain major asset classes current implied volatility levels and their respective percentile rankings with 10-, 5-, 3- and 1-year look backs. With that, we can see that while asset volatility levels are elevated, gold volatility has underperformed – gold′s current implied volatility relative to its 10-year history is in the top 40%, whereas all the other implied volatility levels, particularly Treasury and FX volatility, are in the top 12% or 5%.
The divergence between rate volatility and gold volatility is striking - for the simple reason that gold volatility tends to move higher or lower with Treasury volatility. Chart 5 provides a long-term view of the MOVE Index (VIX equivalent for the Treasury curve), the GVZ (VIX equivalent for gold implied volatility), and then the ratio of the GVZ/MOVE index in the lower panel going back to inception of the GVZ, 2008. We see that this ratio is at its all-time low and thus we expect some mean reversion in this ratio in 2023. Even if this mean reversion is driven in large part by Treasury volatility coming in, as a result of approaching/arriving at the Fed′s terminal rate. It also appears likely that some expansion in gold volatility will occur as arriving at the Fed′s terminal rate should also push gold and its implied volatility higher.