Equity and UST Volatility Re-align, Causing Headaches for Asset Allocators

Newsclips — July 27, 2018

Markets By Benjamin Breitholtz

Risks behind equities and sovereigns have reconnected, making the lives of asset allocators that much more difficult. Unexpected events have potential to damage nearly all asset classes in a similar fashion. Our belief is investors are aligning nearly all volatility expectations with the markets refusal to price in long-lasting inflation.

Summary

Risks behind equities and sovereigns have reconnected, making the lives of asset allocators that much more difficult. Unexpected events have potential to damage nearly all asset classes in a similar fashion. Our belief is investors are aligning nearly all volatility expectations with the markets refusal to price in long-lasting inflation.

Comment

U.S. equity (VIX) and Treasury (MOVE) implied volatility are again showing heightened positive correlation like the summer of 2017. Previous similar events coincided with significant geopolitical or financial events like 9/11, the flash crash, or S&P downgrade.

Therefore, the current event of connected risks is difficult to label just like a year ago. 

 

 

The next chart shows the 65-trading day correlation between implied volatility for each asset class and U.S. Treasuries. Highly correlated volatility implies unexpected events could damage nearly all markets, meaning there would be little place to hide. 

Are risk assets calmly awaiting the direction inflation expectations will finally take after an extremely dull, range-bound period?

 

 

The Federal Reserve is assisting this period of calm by uttering words of uncertainty at their lowest rate since 2006. The chart below shows the rolling 25-speech/statement sum of words like ‘concern’ or ‘uncertainty.’ In other words, Powell et al are the most assured in their expected path of the economy and rates.

 

 

But, the Federal Reserve’s steadfast belief in inflation and wage growth have yet to truly excite investors in inflation expectations like swap caps. Swap caps are effectively call options headline inflation will run above the strike for the defined time period.

The chart below shows headline CPI year-over-year exceeding the critical 2.5% threshold while caps with a 2.5% strike remain essentially dormant. Inflation expectations have not endured a period of excitement since late 2016.

 

 

The next chart is a favorite of ours showing the ratio between inflation swap caps and floors at a strike of 2.5% year-over-year. These ratios offer the odds headline inflation runs above 2.5% on average for the defined maturity from 2 through 30 years. 

Breakouts above the best levels of early 2017 are needed and eventually above 1-to-1 odds to show investors have fully committed to the rosy inflation outlook.

 

 

Most importantly, inflation expectations like U.S. 10-year TIPS breakevens are seemingly the de facto chair of the Federal Reserve. The relationship between three-month changes in U.S. 10-year TIPS breakevens (x-axis) and FOMC rate hike timing (y-axis) is shown below by year. 

In 2018, a 25 bps rise in TIPS breakevens have resulted in a 25 bps rise in expected rate hike timing, the steepest slope post-crisis. TIPS breakevens have been struggling to choose a direction, which reinforces low volatility throughout markets. Additionally, this has fostered a ‘wait and see’ approach by investors in nearly all risk assets. The eventual breakout, in either direction, by inflation expectations will transfer into nearly all asset allocation decisions.