Is The Fed Short Volatility? (Or Is Jerome Powell Actually Thurston Powell III?)

The Federal Reserve doesn’t activley manage its interest rate exposure on its over $4 trillion balance sheet. Yet it purchases and sells Treasury Notes/Bonds and Agency Mortgage-backed Securities (AgMBS) in a measured way to impact interest rates.

Chris Whalen has a nice writeup on Fed Chair (to be) Jermore Powell’s thoughts on expanding and then shrinking the balance sheet.

[W]hen it is time for us to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. So there are a couple of ways to look at it. It is about $1.2 trillion in sales; you take 60 months, you get about $20 billion a month. That is a very doable thing, it sounds like, in a market where the norm by the middle of next year is $80 billion a month. Another way to look at it, though, is that it’s not so much the sale, the duration; it’s also unloading our short volatility position.

we look like we are blowing a fixed-income duration bubble right across the credit spectrum that will result in big losses when rates come up down the road. You can almost say that that is our strategy.

I hope Powell’s messaging skills have improved since 2012 when he uttered these words. He does sound more like billionaire Thurston Howell III than a future Fed Chair.

Yes, The Federal Reserve can manipulate interest rates through its policies and INFLUENCE the volatility and duration of Treasuries and Agency MBS. (He should have made that clear, particularly for Agency MBS).

Here is a chart of U.S. JP Morgan Treasury Investor Sentiment Active Client Net Long positions are The Fed has been SLOWLY unwinding its Treasury Note/Bond portfolio over the past year. Notice that net long sentiment is in negative territory.

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For Treasury shorts, the investor sentiment has been rising with the slight T-note/bond unwind.jpmsohr.png

10-year Treasury Note volatility remains repressed despite the teeny sales of The Fed’s balance sheet.

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It really does look like The Fed is scared to actually try to unwind its balance sheet, particularly for Agency MBS extention risk where duration (risk) rises with rate increases. Particularly since we are in a low rate environment where small rate increases can crush note/bond/MBS prices.

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Here is a photo of the next Fed Chair, Jerome Powell.

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When do we start calling Powell “The Skipper”? And who gets to be Vice Chair “Gilligan”?

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Addicted To Gov: VIX and TYVIX Volatility Have Been Suppressed By The Fed (And Aren’t Increasing YET With Rates Increasing And “Unwinding”)

In 2008, The Federal Reserve embarked on their infamous quantitative easing (QE) program, that together with their Zero-interest rate program (ZIRP) has suppressed both stock market volality (VIX) and Treasury note volatility (TYVIX).

(Bloomberg) It’s pretty simple: in three decades since the Cboe Volatility Index was invented, 2017 will go down as the least exciting year for stocks on record. There are three trading days left and the VIX’s average level has been 11.11, about 10 percent lower than the next-closest year.

It’s tempting to say nobody thinks it will last, but that would be to ignore the walls of money that remain stacked up in bets that it will. Going just by the sliver represented by listed securities, about $2.4 billion is in the short volatility trade as of this month, the most on record. Hundreds of billions more are betting against beta in things like volatility futures.

Still, that doesn’t mean investors are ignoring the possibility of a resurgence, or at least a reversion to the mean. Here’s a look at volatility positioning as it stands now.

Surging Cost of Protection Against VIX Upside

Nervousness about next year is visible in the relative cost of betting on an increase in volatility, which has surged to a peak compared with wagers on a decline. (The spread is based on three-month VIX skew in data compiled by Bloomberg.) Someone, somewhere is spending money to capitalize on a rebound in the gauge.

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But it’s the furthest thing from a one-way bet. The global short volatility trade currently has more than $2 trillion in various strategies, according to an October report by Christopher Cole, the founder of Artemis Capital Advisers hedge fund. He compared the strategy of betting that volatility, already near record lows, will fall even further, to a snake “blind to the fact that it is devouring its own body.”

Reptilian autosarcophagy aside, as of December 2017, betting against volatility has been the trade that worked. An analysis on the ETF.com website Tuesday said that seven of the 20 worst-performing exchange-traded securities this year were long VIX and other volatility measures.

Investors see a 74 percent probability that equity price swings will widen next year as the current levels of volatility are “unsustainable,” according to asurvey of 229 investors representing $6 trillion in managed assets conducted by Absolute Strategy Research. The VIX rose for a second day to 10.25 on Tuesday after hanging below 10 for about 20 percent of the time this year.

Record Number of Investors See Stocks as Overvalued
Between rising corporate profits, a pick-up in global growth and laudable message-management by central banks, volatility has had few catalysts. But as the S&P 500 Index has reached 62 all-time highs this year, a record number of investors see stocks as overvalued, according to a Bank of America Merrill Lynch survey last month.
Perhaps as a result, smart-beta exchange-traded funds purporting to offer a haven from chaos have taken in more than $3.5 billion in 2017.

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Anyone in a short-volatility position should be aware that when the end comes, it usually comes fast.

“Look at what happened in January 2016, a drop of more than 5 percent in the S&P — and a spike in volatility — came out of the blue,” said Michael Antonelli, an institutional equity sales trader and managing director at Robert W. Baird & Co. “When vol goes up, it moves quickly, making it hard to exit when you’re short volatility in a significant amount.”

Earnings Dispersion and Volatility Pick-Up
For Mike Wilson, Morgan Stanley’s chief U.S. equity strategist, the death knell for dormant volatility next year will come from less benign global macro conditions. A more challenging global growth environment, the Federal Reserve tightening coupled with the tax uncertainty will lead to a wider dispersion in economic data and earnings data, resulting in more volatility.

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Another hint that the low VIX doesn’t bespeak a dumbfounded unanimity is the volatility curve.

In a blog post last month, New York Federal Reserve economists pointed out that investors are paying noticeably more to hedge against price swings a year from now than for shorter-term volatility. Their analysis found that the difference between one-month implied volatility and one-year was about three times as steep as it normally is.

Ah, but what the New York Fed’s blog is not discussing is the impact that The Federal Reserve had on both stock and bond volatility due to their zero-interest rate policies (ZIRP) and quantitative easing (QE) 10-year programs.

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But as The Fed has started raising their target rate (4 times in a little over a year compared to once in 8 years under Obama) and unwinding their T-notes and T-bonds, we have yet to see a rebound (or mean reversion) in stock and bond volatility.

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The lack of mean reversion in volatility is largely because The Fed is SLOWLY raising rates and unwinding their $4.4 trillion balance sheet. What happens when The Fed REALLY starts raising rates to some long-term average (and shrinks their balance sheet to something like only $1 trillion)? By NOT being more “speedy” about withdrawing their tenacles in financial markets, The Fed is actually perpetuating low-zero volatility.

Did zero-interest rate policies get replaced with zero-volatility policies?

You might as well face it, you’re addicted to gov. And risk mispricing.

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VIX Flash Crash & Rebound, TYVIX 10Y T-Vol Hits All-time Low

‘Twas the day after Thanksgiving …

The stock market volatiity index VIX had a flash crash and a prompt rebound.

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And the US Treasury 10-year note volatility index just hit its all-time low.

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I think I am going to have a turkey leg wrapped in bacon (aka, A Swanson) for dinner tonight.

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Winter is Coming! The Fed And Volatility Suppression (Stocks And Bonds)

Volatility for the 10 year Treasury note (TYVIX) has been suppressed since The Fed hammered down on vol starting in late 2008.

The same holds true for equities and the VIX. Suppressed since 2008.

But what happens IF The Fed (and other central banks) begin their great unwinds?

Winter is coming!