Thoughts on the Eerie Calm That Shrouds Markets
The VIX, the volatility of the S&P 500, is sometimes touted as a "fear index." Today is it extending its push below 9%, to fall to its lowest in nearly a quarter of a century.
There has been four (Finland, Austria, the Netherlands, and France) successive European election that did not produce a victory for the euro-skeptics, who want to leave either the EU or EMU or both. In Germany, the AfD has imploded and may be lucky to be represented in the Bundestag after the national elections in September. A few months ago, some were talking about the possibility that Merkel is defeated in her bid for a fourth term as Chancellor. Merkel and the CDU have done well in the state elections, and will likely do well in this weekend's contest in NRW, the most populous German state.
Three-month implied volatility in the euro, a common benchmark has broken below 7% to trade at its lowest level since late 2014. The low since at least 1999 was set in 2014 near 4.75% and besides briefly in 2007, it has not traded below 5%. The fact that volatility has come off suggests participants are less worried about macro-events and in terms of the spot are anticipating range trading.
The risk-reversal (skew in the pricing of puts and calls equidistant from the money, in this case, 25 delta) has steadily moved to reduce the premium that is paid for euro puts. In February, the premium for (three months) puts over calls swelled to more than 3%. This was the most in five years. The premium fell and today stands near 0.25%. Calls were briefly at a premium last February for the first time since 2009.
The yen, like the VIX, is often thought of as some sort of fear measure. Yet to think of the yen as a safe haven may be misleading. When anxiety is running high, and the pendulum of market sentiment swings toward fear from greed, global investors are not rushing to buy Japanese stocks or bonds.
Instead, two things happen. First, the US Treasury market is the safe haven. Investors do in fact flock to the depth, breadth, and security of the US Treasury market. This exerts downward pressure on US interest rates and weakens the yen through the differential. Second, often in such anxious moments, Japanese investors who typically exports their savings, stop doing so. Given Japan's current account surplus (driven, incidentally, by investment income (e.g., coupon payments, dividends), without the export of savings to recycle the inflows, the yen "naturally" rises.
In any event, the yen has been weakening steadily since the middle of April. On April 17, the dollar bottomed in front of JPY108. The US 10-year yield bottomed the next day near 2.16%. The dollar poked through JPY114.00 for the first time since the Federal Reserve hiked rates in the middle of March. The dollar has punched through the downtrend line from the year's high and March highs to approach the 61.8% retracement objective of this year's decline (~JPY114.65)
Three-month implied yen volatility is a little firmer today after reaching its lowest level in more than a year yesterday a little ahead of 8.0%. The correlation between the implied yen volatility and the VIX (percentage change 60-day rolling basis) is near 0.35 today, the highest so far this year.
Looking at the put-call skew, one sees that the premium for dollar puts has been sharply reduced since the end of February when it reached 2%. The skew is now less than 0.5%, the least since late January. Historically, dollar puts (yen calls) often trade a premium. The thought was that Japanese corporations who have dollar receivables hedge in the options market by buying dollar puts (yen calls). One thing the options market may be telling us is that participants are less concerned about a weaker dollar.
The price of gold has fallen for the past three weeks. With today's losses, the yellow metal is back to levels seen in mid-March when the Fed last hiked. It fell through the 200-day moving average last week ($1250) and appears to be making a decisive break of the 100-day moving average (~$1224). Gold appears headed toward a test on the $1180-$1210 area, which may help shape the medium term view.
One need not be a hardcore contrarian or an options trader to take notice of the markets' calm. Minsky warned that due to the perverse dynamics and incentive structure, stability could itself can fuel instability. The French and UK elections next month are interesting but unlikely to shake up investors. Success is an aphrodisiac, and the former Socialist Macron is drawing candidates that want on his banner. In the UK there is little doubt that May will lead the Tories into victory. The German election in September is Merkel's to lose.
Many observers seem to recognize that Italy's election next year may be the next important European test. However, it is a year away. Perhaps Italian banks are the "ultimate" risk asset. An index of Italian bank shares is up by more than a third since the end of February. Yesterday, it reached its highest level since April 2016.
Geopolitics can always come back to bite. Consider that just yesterday, for the first time this year, a Russian jet violated Estonia's airspace. Reports indicate that it did so around half a dozen times last year. Russia's foreign policy agenda may not be dependent on who occupies the US White House. Recall, Russia invaded Georgia in 2008 when George W Bush was president. General Eisenhower was president when the Soviet Union invaded Hungary. Johnson, who had projected US power in Vietnam, the Middle East, and the Caribbean when the Soviet Union invaded Czechoslovakia.
Russia's asymmetrical warfare has been successfully deployed on what it calls the near abroad. It borders. It has harassed the Baltic States, like Estonia. The airspace incursions are a subject of diplomatic protests, but not an escalation of tensions. Where is that line? Russia can find a small border town in a Baltic country that the majority of people speak Russian and may even have Russian passports. Isn't this a logical "next move" in the chess game Putin is playing in central and eastern Europe?
Meanwhile, the Trump Administration is pursuing less antagonistic policies toward China. Remember, after the electoral college victory, Trump spoke to the president of Taiwan, and even questioned the US one-China policy. Trump has not levied a 25% tariff on Chinese goods. China has not been cited as a currency manipulator. The US may also be backing off from challenging China in the South China Sea. The New York Times reported that the Department of Defense had rejected the last three proposals for freedom of navigation operations. These essentially are a display of US force in waters that some countries, such as China, claim are theirs.
The point here is to note the extremely low levels of anxiety in the market. The VIX, US Treasuries, gold and the volatility of the yen and the euro, all are pointing in the same direction. There is not the reason it cannot continue, and this should not be read as a call that the Sky is Falling. It is meant to show how extreme the calm is, and remind ourselves, that large moves typically do not happen when volatility is high, and investors are anxious and nervous. It happens when things are calm, and investors see TINA (there is no alternative). Geopolitics and the divergence of policy, and asset/liability and duration mismatches have not gone away. It is a reminder that we are often lulled into complacency just before being shocked by how treacherous things really are.