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The Diminishing Return of QE Has Approached Zero: Prepare for Volatility


To the extent that QE and lower real interest rates are responsible for the rally in risk multiples, this has major implications.

Going into last week's meeting, there were expectations the Fed may provide hints it would be easier longer, lower the unemployment threshold, and attach a GDP stipulation to its forward guidance; there were some outlier suggestions it might even increase asset purchases. It did nothing, and "nothing" in the market's view was tighter. This is a critical distinction.

The first reaction to a mere mentioning of tapering purchases was met with a fierce unwinding of positions that had been predicated on higher inflation premiums. Carry trades that were short dollars, either implicitly or outright, exploded in epic fashion. Now we are seeing similar price action on the heels of the Fed's confirmation of the status quo. First it was less stimulus is tighter, now it's no further stimulus is tighter. It's as if the diminishing return of QE has now approached zero.

To the extent that QE and lower real interest rates are responsible for the rally in risk multiples, this has major implications. While stocks ended the week relatively unscathed, there were signs of increased sensitivity to the reduction in inflation premiums in other asset prices. The most glaring example among stock market charts was the relative performance of beta in the price action on Friday. The Dow Jones Industrial Average (INDEXDJX:.DJI) was outperforming (+.49%) the S&P 500 (INDEXSP:.INX) (+.29%) with the high-beta Russell 2000 (INDEXRUSSELL:RUT) (-.42%) seeing significant selling pressure.

Stock Market Indices: Russell 1000 Index Vs. Russell 2000

Volatility of Volatility

The collapse in vol of vol is also noteworthy as it suggests protection buyers have capitulated in the face of what could be an extremely volatile environment. As we witnessed in the spring, falling inflation premiums and rising real interest rates will put leveraged positions at risk. When leverage is under stress, implied volatility tends to rise as buyers seek to reduce exposure to a rise in realized volatility.

It seems as if the market is now highly exposed to a volatile environment, yet implied volatility is for sale. Should the rise in real rates persist, you could see a negative feedback where implied volatility lifts, putting pressure on short dollar leveraged positions which would strengthen the dollar further, thus lowering inflation premiums and pushing real rates even higher.

VIX Vs.10-Year Inflation Premium (Inverted)

It's time to buckle up. The markets have fired a shot across the bow, and investors need to realize what is happening under the surface. The entire QE regime has benefitted both economic and market activity predicated on high inflation premiums and low (negative) real interest rates. If last week's price action is a harbinger of a regime shift, then markets and the economy are going to be under pressure. This is a time to leave your position's confirmation bias at the door and heed the message of the market. If the past is any indication, this low-volatility environment is about to get volatile. If you are prepared and liquid, volatility can be your friend. If you are exposed and illiquid, volatility can be your worst nightmare.

Twitter: @exantefactor
No positions in stocks mentioned.
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