27/4/18: The Goldilocks Economy of State Policies

My column for the current issue of the Cayman Financial Review is out: http://www.caymanfinancialreview.com/2018/04/19/the-goldilocks-economy-of-state-policies/.

25/4/18: 90 years of Volatility: VIX & S&P

A great chart from Goldman Sachs via @Schuldensuehner showing extreme events in markets volatility using overlay of VIX and realised volatility from 1928 on through March 2018:

For all risk / implied risk metrics wonks, this is cool.

27/2/18: Volatility & Uncertainty are Back with a Bang

My recent article on markets volatility for the Sunday Business Post https://www.businesspost.ie/business/volatility-uncertainty-back-bang-408742

7/6/17: Equity Markets Continue to Mis-price Policy Risks

There has been some moderation in the overall levels of Economic Policy Uncertainty, globally, over the course of May. The decline was primarily driven by European Uncertainty index falling toward longer-term average (see later post) and brings overall Global EPU Index in line with longer term trend (upward sloping):

This meant that short-term correlation between VIX and Global EPUI remained in positive territory for the second month in a row, breaking negative correlations trend established from October 2015 on.

The trends in underlying volatility of both VIS and Global EPUI remained largely the same:

The key to the above data is that equity markets risk perceptions remain divorced from political risks and uncertainties reflected in the Global EPUI. This is even more apparent when we consider actual equity indices as done below:

Both, on longer-run trend comparative and on shorter term level analysis bases, both S&P 500 and NASDAQ Composite react in the exactly opposite direction to Global Economic Policy Uncertainty measure: rising uncertainty in the longer run is correlated with rising equities valuations.

23/2/17: Welcome to the VUCA World

Much has been said recently about the collapse of ‘risk gauges’ in the financial markets, especially on foot of the historically low readings for the markets’ ‘fear index’, VIX. In terms of medium-term averages, current VIX readings are closely matching the readings for the period of ‘peak’ ‘Great Moderation’ of 1Q 2005 - 4Q 2006, while on-trend, VIX is currently running below 2005-2006 troughs. In other words, risk has effectively disappeared from the investors’ (or rather traders and active managers) radars (see chart below).

At the same time, traditional perceptions of risk in the financial markets have been replaced by a sky-rocketing uncertainty surrounding the real economy, and especially, economic policies. The Economic Policy Uncertainty Indices have been hitting all-time highs globally (see chart below), and across a range of key economies (see this for my recent analysis for Europe: http://trueeconomics.blogspot.com/2017/01/15117-2016-was-year-of-records-breaking.html, this for Russia and the U.S.: http://trueeconomics.blogspot.com/2017/01/17117-russian-economic-policy.html). In current data, Economic Policy Uncertainty Index (EPUI) has been showing extreme volatility coupled with extreme valuations. Index values are rising above historical norms both in terms of medium-term averages and in terms of longer term trends.

 Another interesting feature is the direct relationship between the EPUI and VIX indices. Based on rolling correlations analysis (see chart below), the traditionally positive correlation between the two indices has broken down around the start of 2Q 2016 and since then all three measures of correlation - the 6-months, the 12-months and the 24-months rolling correlations - have trended to the downside, turning negative with the start of 2H 2016. Since November 2016, we have a four months period when all three correlations are in the negative territory, the first time this happened since June 2007 and only the second time this happened in history of both series (since January 1997). Worse, the previous episode of all three correlations being negative lasted only two months (June and July 2007), while the current episode is already 4 months long.

Final point worth making is that while volatility of VIX has collapsed both on trend and in level terms since the start of H1 2016 (see chart below), volatility in EPUI has shot up to historical highs.

Taken together, the three empirical observations identified above suggest that the current markets and economies are no longer consistent with increased traditional risk environment (environment of measurable and manageable risks), but instead represent VUCA (volatile, uncertain, complex and ambiguous) environment. The VUCA environment, by its nature, is characterised by low predictability of risks, with uncertainty and ambiguity driving down efficacy of traditional models for risk assessments and making less valid traditional tools for risk management. Things are getting increasingly more complex and uncertain, unpredictable and unmanageable.

26/12/15: A Trendless World of 'Recovery'?

Anyone watching financial markets and economics in 2015 would know that this year was marked by a huge rise in volatility. Not the continuous volatility along the established trend, but a 'surprise' volatility concentrated on the tails of distributions of returns and growth numbers. In other words, the worst kind of volatility - the loss and regret aversion type.

Here are two charts confirming the said pattern.

Starting with asset classes:

Source: BAML

In the 'repaired' world of predictable monetary policy with well-signalled forward guidance, 2015 should have been much calmer, as policy surprises were nowhere to be seen (Bank of Japan continued unabated flooding of money, while ECB embarked on its well-in-advance-flagged QE and the Fed 'cautious rates normalisation' switched was anticipated for months, amidst BOE staying put, as predicted by everyone every time London committee met). Alas, that was not the case and 2015 ended up being a year of more extreme shifts into stress than any other year on record.

Likewise, the U.S. economic growth - the most watched and most forecasted series in the global economy - produced more surprises for forecasters:

Source: Goldman Sachs

Per above, 2015 has been a second consecutive year with U.S. GDP growth surprising forecasters to the downside. Worse, yet, since 2001, U.S. GDP growth produced downside surprises compared to consensus forecasts in 12 out of 15 years.

In the past cycles, the early 1990s recession produced an exit from the downside cycle that resulted in 2 consecutive years of upside surprises in growth; for the exit from the 1980s recession, there were five consecutive periods of upside growth relative to the forecasts. Even in the horrific 1970s, the average forecast over-optimism relative to outrun was closer to zero, against the current post-recessionary period average surprise to the forecast being around -0.5 percentage points.

In other words, if you need a confirmation that four years after the 'recovery' onset, the world of finance and growth remains effectively 'trendless', have another look at the charts above...

9/6/2014: 2 charts, 2 markets, same nagging sensation...

Two charts worth paying close attention to:

The first one from Deutsche Bank:

The above is showing ratio of S&P500 Price/Earnings ratio to VIX (quarterly) volatility indicator. Recent uplift in the series is down to simultaneously:

• Rising equity price relative to earnings, and
• Falling markets volatility

The second one is via TestosteronePit, showing the first bit: rising equity prices relative to falling earnings, except not for S&P, but for European equities:

Care to draw any conclusions as to rational expectations vs short-term profit chasing?..

25/6/2013: What the hell is going on in the markets?

Two charts from Pictet neatly illustrate the ongoing bonds markets correction:

My two cents on what's going on in the markets today:


Wednesday opening last week at the cusp of FOMC statements, US 10 years were  yielding ca 2.15%. and 4 trading days later, these were at 2.61% or 41 bps up. 30 years are up from the nadir of 2.83% on may 2 to 3.56% currently.

And what about the other QE-infused or enthused market? In just over 3 weeks, FTSE 100 is down 846 points, from 6,875 on 22 May.

Equities and bonds are moving same way? Why?

Because of three factors:
1) When bonds go down, with them goes down capital. Mandated investment vehicles and banks take a bit of a shower.
2) When US or other advanced economies bonds take a shower, Emerging Markets take a bath because of liquidity pull out to cover leveraged losses elsewhere.
3) When EMs and bonds tank, capital-backed leverage falls, so liquidity falls in the advanced markets too, dragging down all risk assets.

These are the tripartite consequences of a liquidity trap, whereby intermediated short-term funding underpins investment activities. Put differently, when humans have less cash (real economy slow recovery, coupled with tax and financial repression), while banks and other institutions have more cash (including, for the latter, via access to banks leverage against Central Banks funding), markets become correlated, even where hedges existed before, correlations turn positive. Where there is contrasting access to the same asset via both financial paper and physical or real assets (e.g. gold vs gold coins), the two diverge, with financialised asset moving in synch with other financial assets, while real/physical asset moving in the opposite direction.

Thus, Brazil's 30-year bonds (dollar-denominated) are down now more than 25% in recent weeks, and instead of flowing into safe havens or rather 'safer hells', the cash is being tucked away into reduced leverage, leading to the US bonds compression down and UK gilts erasing all gains made since October 2011 (when QE2 kicked in).

The only thing that behaves predictably so far is VIX, which has gone from low-flat around 13.6-14.0 between March 24th and May 24th to over 20 average since June 20th through today. Short term VXX index is up from 18.03 on May 17th to 22.81 today.

Not quite panic, but pressure… and pressure is a trigger. And FOMC, and the rest of the Impossible Monetary Dilemma, are triggers too. The point is, given the recent drama in bond markets and equities and EMs, triggers are dangerous in trigger-happy times. When you have lots of capital tied up in 'safe assets' and lots of leverage tied up on top of that capital, pulling the rug from underneath capital quality leads to accelerating cascades across the board.

This is bad news for strategies over the short-term, as traditional allocations based on previously stable relations between asset classes are broken down. Gold co-moves with equities and bonds and currencies. The good news: once financialisation of the long positions is unwound, leverage is reduced and repricing of 'bubble'-like assets (aka financialised assets as opposed to real assets) is finished, the stable relations will return. In the long run, we all are… well, in the long run.

1/1/2012: Groundhog Year 2012 - part 1

In the tradition of looking back at the year passed, let's take a quick view of one of my favorite indicators for risk assets fundamentals: the VIX index.

CBOE Volatility Index finished the year well off the inter-year highs, but nonetheless in an unpleasant territory. VIX closed December 2011 at an elevated 23.40, ahead of December 2010 close of 17.75, 2009 close of 21.68 and only behind the December 2008 levels of 40.00. December 2007 close was 22.50 and December 2006 was 11.56.

More unpleasant arithmetic emerges when we consider inter-annual performance. Historical maximum for daily close (from January 1990 through present) is 80.86, while maximum for 2010-present was 48.00 set on August 8, 2011.

The historical average for VIX is 20.57, while the average for January 2008-present is 27.74, for January 2010-present is 23.38 and for 2011 as a whole - 24.20, implying that wile 2011 was not the worst performing year on the record, it was certainly worse than 2010. Table below summarizes annual data comparatives.

Average intra-day volatility actually marks 2011 as the worst year on record. Average intra-day spread for VIX stands at 9.28 in 2011 against 8.97 in 2010-present and 9.08 in 2008-present. And both 3mo and 1mo dynamic standard deviations posted poor performance for VIX in 2011, making it the worst year on the record other than 2009. VIX dynamic 1mo semi-variance closed the year on 7.80 and annual average of 4.26 against 2010 average of 3.96 and 2009 average of 5.78.

Charts below highlight the fact that 2011 was a poor year for fundamentals-based analytics:

All above suggest that volatility is the starting point for 2012. Welcome back to the New 'Groundhog Day' Year.

09/09/2011: VIX - another blow out

EU debt disaster and US own woes or just EU debt disaster, who knows, but VIX - that indicator of overall risk perceptions in the markets - is again above the psychologically important 40 mark.

Charts to illustrate:
Vix has gone to close at 40.50 today having opened at 35.53 and hitting the high of 40.74. In terms of historical comparatives:

• Intra-day high achieved today was 170th highest point reached by VIX since Jan 1, 1990, 147th highest reading since Jan 1, 2008 and 15th highest since Jan 1, 2010
• VIX closing level was 156th highest in history since Jan 1, 1990, 129th highest since Jan 1, 2008 and 8th highest since Jan 1, 2010. The latter being pretty impactful

Intra-day spread was pretty high, but not too remarkable, ranking as 179th highest since Jan 1, 1990, 102nd highest since Jan 1, 2008 and 49th highest since Jan 1, 2010, suggesting possible structural nature of elevated readings in VIX overall.
3 mo dynamic standard deviation of VIX index reached 8.981 - the highest level of volatility in VIX since January 1, 2010 and 90th highest since both Jan 1, 2008 and Jan 1, 1990. We are now clocking the highest level of VIX volatility (on 3mo dynamic basis) since February 2009.

Looking at semi-variance:
1mo dynamic semi-variance for VIX is now running at 15.73 - not dramatic, but showing persistently elevated trend since August 5, 2011. Today's reading was, nonetheless, only 27th highest since Jan 1, 2010. To flag that - below is the snapshot of short series range:Yep, folks, with VIX stuck at elevated levels with occasional blowouts like today, with European banks beefing up their deposits with ECB and Bank of Japan, with investors throwing money at Uncle Sam and Bundesbank (at negative interest rates) and demand for CHF undeterred by the threats of continued devaluations, what we are seeing is fundamentals-driven run for safety. Nothing irrational here, unless feeling sh***less scared is irrational...

18/08/2011: VIX signals crunch time for the crisis

Summary:


Few charts on VIX - hitting historic, second highest ever, 1-day dynamic semi-variance range:
VIX itself above and intraday range below:

3mo dynamic STDEV showing emerging and reinforced trend up on semi-variance side:
And same for straight volatility (symmetric)
This, folks is a crunch time.

The reasons I bothered with this are here.

10/08/2011: Was US markets panic behind Irish banks shares crash?

I've just crunched through some interesting data on VIX and Irish Financials index IFIN and there are some interesting results.

To remind you - VIX is in effect a market-based metric of risk in the US markets.

The main premise advanced by the proponents of the argument that US financial crisis drove Irish financial crisis is that panics in the US have caused irrationally pessimistic revaluations of the Irish financial equities and thus led to the collapse of the banks shares in H2 2007- H2 2009.

To assess this, I divided daily data from VIX and IFIN into three periods. Pre-crisis period covers data from January 2000 through July 2007. Financial crisis period covers data from August 2007 through December 2009, while Sovereign crisis period runs from January 2010 through today.

Given the nature of data, VIX data for intraday spreads is only available since September 2003.

Table below summarizes core stats on the data:
Several features worth highlighting in the above:

• IFIN data shows declining positive skew over the evolution of the crises, while VIX shows growing positive skew. This suggests that rising US risk aversion (VIX) was becoming structural over time as crises progressed from financials to sovereigns, while Irish financials were moving from positively skewed distribution in the pre-crisis period (positive non-risk premium to Irish financials) to progressively smaller positive skew in the crises periods. This is not consistent with the risk spillover from the US to Ireland story.
• Intraday variation in Irish financials remains smaller than in VIX, but shows qualitatively similar dynamics to VIX. However, increase in intraday variation during the crises is much stronger in the Irish financials than in VIX, which again suggests that risk pricing in the US markets had little to do with Irish financials risk-pricing. Notice that intraday spreads are highly non-normal in their distribution with third and fourth moments off the charts.
  
• 1-month dynamic correlations between VIX and IFIN remained negative across all periods (implying that rising US risk was associated with falling IFIN valuations), but relatively weak (at maximum mode of 0.35 on average). median correlations show a bit more dynamism during the crisis, rising from -0.41 in pre-crisis period to -0.51 during the Financial crisis period and declining to -0.45 in Sovereign crisis period. However, these are not dramatic either. In fact, positive skewness was reinforced during the Financial crisis period, while negative kurtosis declined in absolute value.

Chart above summarises the entire series of data, showing historically relatively weak, but negative (as expected) correlation between the values of Irish financial shares and the risk levels in the US markets.

Chart below breaks this down into three periods:
What's interesting in the above chart is that:

1. Correlation remains negative but explanatory power significantly declines in the period of Financial Crisis (so the picture is the opposite of the claim that the US 'panic' spilled over into Irish markets), while the slope remains relatively stable.
2. More interestingly, the relationship completely disappears since the onset of the Sovereign crisis. basically, once the IFIN hit 4,000 levels, there is no longer any meaningful connection between Irish financial shares prices and risk attitudes or perceptions in the US markets. Guess what - that magic number was reached around 29/09/2008.

Chart below plots 1mo dynamic correlations between VIX and IFIN
While correlations tend to stay, on average, in the negative territory, as the table above shows, they are not significantly large. In fact, overall during the Financial crisis period there were 318 instances of the correlation equal to or exceeding (in mode) 0.5 - or 51% of the time. In pre-crisis period this number was 42% and during the Sovereign crisis so far - 45%. But there is a slight problem in interpreting this 51% as the spillover effect from the US. During the Financial crisis period, pre-Lehman collapse, higher correlations took place 58% of the time, while post-Lehman collapse they took place 45% of the time. So overall, it appears that US risk attitudes (aka 'panics') were more related to adverse movements in IFIN before the Big Panic took place than during and after the Big Lehman's Panic set on.

Interestingly, there is also no evidence that changes/volatility in the US attitudes to risk had any significant serious impact (adverse or not) on volatlity Irish financial shares valuations, as shown in the chart below:
In no period in our data is there a strong relationship between changes (volatility) in US risk attitudes and the Irish financial shares valuations volatility.

A note of caution - these are simple tests. The data shows a number of problems that require serious econometric modeling, but overall, so far, there is no strong evidence to support the proposition that Irish banks shares or financial shares have been significantly and systematically adversely impacted by the US 'panic' or by 'Lehman collapse'. Our banks problems seem to be largely... our banks own problems...

08/08/2011: What VIX tells us about today's markets meltdown

Let's chart what I called the Roy Lichtenstein-styled "KABOOM" moment for the markets today. Recall that by definition the CBOE Volatility Index (VIX) is "a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, VIX has been considered by many to be the world's premier barometer of investor sentiment and market volatility."

Now, basically, VIX is as close to a pure price risk bet as we have. Again per CBOE: reported VIX index values represent "market estimate of expected volatility that is calculated by using real-time S&P 500 Index (SPX) option bid/ask quotes. VIX uses near-term and next-term out-of-the money SPX options with at least 8 days left to expiration, and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index."

Now to the charts.

Starting from the top, we have actual VIX itself - today's close at 48.00 which was:

• Still well below the historical max of 80.86 attained on 20/11/2008
• Well ahead of the historical average of 20.35 or January-2008 to present average of 27.21 or the average since January 2010 of 21.11
• Today's close VIX reading was 63rd highest daily reading for the entire history of the series and the highest since January 2010
• All 64 top readings (equal or above that attained today) were recorded in the period since January 2008.
  

Today's intraday spread of 35.65% is below Friday intraday spread of 45.52. However, the two readings are quite extraordinary:

• Intraday spread average for historical series is 3.01%, while since January 2008 through present intraday spread averaged 9.06%.
• Today's spread was 7th highest in history of the series, the 5th highest since January 2008 and the second highest (after last Friday's) since January 2010.
• Friday's intraday spread was the 5th highest daily spread in the history of the series and the 4th highest since the crisis start (January 2008)

To see just how extraordinary last couple of days are, consider two time horizons for volatility in VIX itself:
and a shorter horizon:
3mo dynamic standard deviation for today's close is only 433rd highest reading in the series history and the 60th highest since January 2010, while 1mo dynamic standard deviation is the 56th highest over entire history and the 5th highest since January 2010.

However, in terms of daily percentage changes, today's rise of 50% is the fourth highest daily increase since the beginning of the VIX history and the highest since January 2008.

In terms of 1mo dynamic semi-variance (measuring only variance for the days of increasing VIX index, in other words - only for those days when risk rises), the last chart above clearly shows that we are in for a treat in these markets.

Economics 28/06/2010: Watch out for VIX

Short-term VIX options and VIX itself are starting this week on the upside... is risk contagion spreading from sovereign bonds to corporate?
An interesting view here.

Let's put this on record - I think we are now in 50:50 chance of a new recession - Euro area, UK and US, plus Japan. Time horizon - 6 months.

Economics 17/08/2009: US markets jitters

US Markets: I've told you to be weary of the return of volatility. Chart below shows today's sudden- 17% jump in VIX volatility index and the coincident fall-off in the main markets (sorry, crumbling Eircom broadband infrastructure means I can't get my hand on better charts right now):

Even more worrisome is the following chart, showing that both near-term VIX and long-term VIX are actually in excess of the current VIX, so markets are now pricing higher volatility for the foreseeable future.
Another telling graph above - notice negative correlation of the last few months turning positive about a week ago and back to negative now - this is a likely holding pattern as in 2007 late Summer and 2008 Summer-Fall.

China was the latest trigger today, but it all goes back to trade flow, as China is a barometer of this and trade flows are a barometer of global growth...

Volatility falling?

In a rare piece of good news VIX index measuring (albeit imperfectly) revealed risk assessments in the US markets, has fallen below 40 on the final trading day of the year, for the first time since October 1. The VIX is the Chicago Board Options Exchange Volatility Index shows the market's expectations for volatility over a 30-day period.

As my students in Investment Theory course would know, only human imagination is a limit to the number of ways one can think about (and depict) market volatility. Here are three simple (my favourite criteria for empirical validity) ways of doing this.

Chart 1 plots VIX data since January 1990. This shows a dramatic fall in VIX reading since November highs. But, it also shows the cyclicality of VIX – an approximate 3:5:3 cycle of 3 years rising volatility trend, followed by 4-5 years of elevated ‘flat’ trend, concluding with a 3 years of falling trend. By this pattern, we are not out of the woods. Indeed, we have just finished the 3-year rising trend bit around mid 2008, implying that a long-term elevated volatility period may be still ahead for us.
Chart 2 plots intra-day variation in VIX (High-to-Close, alongside the same logic as semi-variance models of risk pricing). Note the unusually elevated red peaks since ca July 2007. This disputes the common claim that it took some time for credit markets troubles (starting in mid-Summer 2007) to feed through into the markets for real claims (assets with fundamental underpinnings). Once again, the latest moderation in VIX reading may be simply concealing the historically high volatilities in risk perceptions that drive daily markets.

Chart 3 shows three alternative, albeit slightly similar, measures of risk dynamics. Note that up until around mid February 2007, daily deviations in VIX readings measured as ‘High’-to-‘Low’ and ‘High-to-Close’ tracked one another and were roughly in line with the weekly Moving Average in the standard deviation. In other words, while risk itself might have been rising or falling over time, the uncertainty about the future risk levels was much lower and more static prior to the beginning of 2007.
This ‘calm’ was first challenged in February and then finally shattered in late September 2007. Once again, no matter how positive the latest decline in VIX to below 40 may sound, we are not of the woods yet.

Expect:
• More intra-day and intra-week volatility, and
• Less predictability in volatility trend.
2009 seas of financial market are going to be no less choppy than the ‘Perfect Storm’-torn 2008.