As I have been writing in recent weeks, there are a lot of markets that, when analyzed separately, are saying something different, but when analyzed together, are saying the same thing. Put the market for implied volatility at the top of that list. Last weekend I came across the most interesting tweet
from Lake Hill Capital
"Vol of vol has recently reached levels consistent with the crisis in 2008 and few are talking about this. Look beneath the 'surface.'"
This obviously got my attention.The firm followed up with a post of an analysis
it had performed on the spike in the volatility in the VIX
"If we go back through history, we find that most of the high VIX environments are consistent with high periods of 'vol of vol'— until now. Despite a cosmetically low VIX price, the current volatility of the VIX is suggestive of crisis."
When I read this analysis I immediately thought this was indicative of a lot of negative gamma embedded in the market. With my limited option market resources, I tried to I recreated the firm's chart of the volatility of volatility looking at a few different relationships that corroborated its findings. I also found that the 5-day realized volatility of the front month VIX futures contract shows an ever greater spike relative to past crises.
VIX Futures 5-Day Volatility
In four months through April we have seen spikes in vol of vol that rivals previous severe market disruptions without so much of a whimper out of the market this implied volatility is pricing. What could be causing these massive swings in implied volatility prices?
When you drill down to the specific time frames you will see that the spikes in vol of vol began at the turn of the year, the week ending February 22 and the week of April 12. What I found interesting is that the latter two dates occurred during weeks where FOMC minutes were released. Hmmm...
When QE3 was launched in September
2012, unlike previous QE announcements, the Fed didn't place an expiration date on the program, and instead used the following language:
"If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability."
This "open-ended" QE was a clear message to the market that the Fed was putting the pedal to the metal. Because the amount of MBS purchases was equal to the market's new production, spreads and yields collapsed. The market viewed this commitment to taking out all new MBS supply from the market for the foreseeable future and pushed current coupon MBS directly on top of Treasury yields. Investors were in effect forced to sell a call (prepay) option for zero premium. Not good.
The following December
, as Operation Twist was due to expire, the Fed sent QE3 into overdrive, adding Treasuries to the program and increasing the open ended language by raising their inflation target (emphasis mine):
"…the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal... The Committee views these thresholds as consistent with its earlier date-based guidance."
This was a big statement from the Fed. You will recall that at the Fed's previous Jackson Hole conference, the big buzz was not from Ben Bernanke but rather from Columbia Economics Professor Michael Woodford
, who was advocating a policy initiative akin to a nominal GDP target. When the Fed opted to raise the inflation target in the context of open-ended purchases, this was in fact a de facto nominal GDP target. This was a major policy shift.
As I wrote in Bernanke Capitulates, Launches de Facto Nominal GDP Target
"As I forecasted back in July at Wednesday’s FOMC
announcement, Bernanke capitulated and opted to attach what are being called 'thresholds' to the Fed’s uber-easy and accommodative monetary policy by raising their inflation target to 2.5% in order to bring the unemployment rate down to 6.5%.
"Make no mistake about it, this is a de facto nominal GDP target."
Bernanke was throwing down the gauntlet, but at the same time that he was trying to increase the impact of QE, he was also increasing the risk. I concluded:
"As I have been saying since the Fed launched QE3 in September, the biggest risk in the markets today is a loss of confidence that Bernanke can hold this thing together. In my opinion there is a very large false sense of security that they know what they are doing and can indeed wield a wand to control asset prices. However, at the end of the day, this is still a confidence game. They can only do so if the markets believe that they can. If the markets lose faith, then all bets are off and the costs and unintended consequences could be severe."
The most misunderstood market impact of the Fed’s QE program is the effect on interest rates and risk assets. The erroneous presumption is that purchases push yields lower, forcing investors out of the risk curve. This interpretation is almost a universal truth, primarily because this is the Fed’s own view (portfolio balancing channel). The evidence over the past few months, however, proves otherwise.
QE does not influence markets via pumping money into the bond market, which in turns inflates asset prices. QE expands the monetary base, which in turn increases the inflation premium in the yield curve. This inflation premium manifests itself in lower, and in recent cases, negative real interest rates, which in turn raises the present value of cash flows from risk assets.
The spread between nominal Treasury yields and TIPS yields, a.k.a. the breakeven spread, represents the bond market’s inflation premium for the given term structure. This spread is extremely important because of the discount it represents.
TIPS outperformed as interest rates fell and underperformed as interest rates rose. The differing performance is not because more money was invested in TIPS compared to nominal USTs, it is because of the higher inflation discount embedded in the yield curve due to QE. In effect nominal yields are being pushed around by real yields that are a function of the QE inflation premium. This suggests that the QE trade is not a function flow but rather a function discount. This is a major distinction that is key to understanding what is going on today as real interest rates rise.
With the launch of an open-ended and inflation/NGDP target, QE3 risk assets went vertical. This obviously made some members of the Fed very uncomfortable, and as we learned with the release of the January FOMC minutes
the committee decided to perform an ex post cost/benefit analysis of the QE program (emphasis mine):
"...many participants also expressed some concerns about potential costs and risks arising from further asset purchases. Several participants discussed the possible complications that additional purchases could cause for the eventual withdrawal of policy accommodation, a few mentioned the prospect of inflationary risks, and some noted that further asset purchases could foster market behavior that could undermine financial stability... In light of this discussion, the staff was asked for additional analysis ahead of future meetings to support the Committee's ongoing assessment of the asset purchase program."
Whoa. So only a month later all of sudden a full-fledged commitment to an open-ended inflation target and the Fed had developed a major case of buyer’s remorse. The problem with this second-guessing of the costs of the program was that the market was already levered long an open-ended inflation target commitment.
Regardless of which asset class is invested, short USD carry trades that rule global risk markets have two common characteristics: They are short volatility and they are all long the yield curve's inflation premium.
VIX Vs. 10-Year TIPS Breakeven (Inverted)
The March FOMC meeting was when the QE cost/benefit was presented. While the results weren't published until the minutes
were released in April, Fed rhetoric suggested the writing was on the wall. The Fed was thinking about abandoning its open-ended inflation target commitment. This was not lost on market participants, and beginning in March, the inflation premium embedded in the spread between TIPS and nominal yields collapsed. When the minutes were released on April 10 it became obvious that the committee was preparing to pull the plug (emphasis mine):
In light of their discussion of the benefits and costs of asset purchases, participants discussed their views on the appropriate course for the current asset purchase program. A few participants noted that they already viewed the costs as likely outweighing the benefits and so would like to bring the program to a close relatively soon. A few others saw the risks as increasing fairly quickly with the size of the Federal Reserve's balance sheet and judged that the pace of purchases would likely need to be reduced before long. Many participants… expressed the view that continued solid improvement in the outlook for the labor market could prompt the Committee to slow the pace of purchases beginning at some point over the next several meetings...
This statement made it clear that the open-ended inflation target commitment was being de-committed. This was a major policy shift and one that I think market participants are grossly underestimating.
Five-Year Inflation Breakeven Emerging Market CDX and Gold
In discussing this concept with Kevin Ferry
of Cronus Futures, he went on to eloquently describe it as a "ruse bordering on the confirming of a lie." This is a dangerous game to play with highly leveraged investors. The Fed was reneging on their open-ended inflation target and this lowered the boom on the carry trade they had engineered.
As I wrote the following week in Gold, Interest Rates, And the Great USD Short Unwind
At the same time you have Fed rhetoric discussing tapering purchases in order to reduce the growth of the balance which is also net dollar positive. What was once a no-brainer dream trade has now become a very complex and volatile nightmare.
VIX 10-Day Volatility Vs. S&P 500 (INDEXSP:.INX) and JPY 10-Day Volatility
Due to Fed policy over the past decade, market prices have been the function of a bunch of USD short carry trades that on the surface look very complex. These trades come in many forms including emerging market bonds, multinational stocks, gold, TIPS, and farm land. Whether short the dollar explicitly through leverage or implicitly through exposure, the risk is the same and very simple to analyze.
The initial reaction to the yen collapse has been an explosive rally in risk assets. As the smoke clears we are starting to witness the true macro effects of dollar strength with falling nominal yields, rising real yields, and collapsing commodity prices. This is exactly type of price action you would expect if the great short USD carry trade was unwinding, and I don’t think investors currently appreciate the significance of what that means or how ugly it could get.
Cue the April spike in volatility of volatility. In analyzing this development in the context of realized volatility of the equity market for which the VIX is priced vs. the realized volatility of the market that finances carry trade positions, the move looks to be a function of financing costs.
Presumably a market that is short gamma and long inflation premiums was forced to lift volatility because inflation premiums collapsed, raising the cost of financing the trade. I believe this is a shot across the bow that leveraged positions are under pressure.
This past week the Treasury supply was not well received, and when the 30-year auction tailed on Thursday due to weak demand, “someone” felt compelled to leak a story to the Wall Street Journal
to calm markets. The fact that the Fed felt the need to do this less than a week before an FOMC meeting where Bernanke will hold a press conference reeks of desperation and should be viewed as much more serious than the initial spin would have you believe.
When Bernanke gave his Joint Economic Committee testimony on May 22, his prepared remarks tried to subdue tapering expectations, but in the Q&A he admitted that it was forthcoming. The equity market saw a blow-off top and reversed hard to close down on the day. Thus far that is the market top, and each attempt at a backtest has been turned away. This week may be the most important FOMC meeting of Bernanke’s tenure. He will no doubt try to calm markets that are in the process of re-pricing the inflation premium. It will be very interesting to see how real interest rates perform based on what he says. If real rates are rising and the equity market fails yet again, it could be the final nail in the QE carry trade coffin.
I have been anticipating this day ever since QE3 was launched last year. I didn’t know how it would unfold, but realized the Fed had upped the ante, and that despite the temptation to increase risk exposure, it was time to dial it back. In Charting a Course Balancing Open-Ended QE
Most investors are looking toward 2013 worried about the results of the election and whether the fiscal cliff gets resolved. These are the known risks. The unknown risk is what I am worried about. To me, that is how and when QE comes undone. The big trade in 2013 might not be about the effect of a fiscal policy debacle; it might be about the effect of a monetary policy debacle.
It’s happening right under everyone’s noses, but they can’t see it because they don’t understand how QE impacts market prices. They are focused on the flow of QE and not the discount. It’s not the flow of purchases that affects risk assets, it’s the inflation discount embedded in the yield curve. The US economy and capital markets have been reliant on the Fed successfully engineering a negative real interest rate regime. By reneging on their commitment to inflation, the negative real rate regime is imploding -- and with it, the QE carry trade they engineered.