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BofA: "The Longer This Continues, The More The Current Regime Echoes 2004-2007"

There is no getting away from it: in what has become a long-running tradition, every day brings a new explanation (or at least attempt) to the current low-vol regime from a major bank, and today it was (again) Bank of America's turn to explain why the VIX, and cross asset vol in general, both continue to trade near all time low.

In a nutshell, BofA, which prefaces the current conundrum as follows: "going into the summer break there are two questions investors seem to be grappling with. What to make of lowflation? And can the low vol regime last?", the bank attributes the record low vol not to selling of vol - something Morgan Stanely and JPM would disagree with - but the combination of low inflation, stable growth and solid corporate earnings. As the Bank's James Barty explains, "low volatility and lowflation are linked as the latter keeps central banks quiescent. But it is their combination with strong earnings in 2017 that has led investors to buy dips and keep realised vol so low. It is this, rather than selling of vol, that has dragged implied vol lower." On the other hand, BofA cautions that "the longer it continues the more the current low vol regime echoes 2004-07," and everyone remembers how that ended...

BofA also writes that while low vol can continue, the run of no 5%+ pullbacks has to end at some point and we see evidence of rising risks. Michael Hartnett's Bull Bear indicator, which we noted last week, is close to a sell signal (7.6 vs 8 threshold) "and the potential for a debt ceiling stand-off in September could be another catalyst. Investors should use the low level of vol to protect portfolios."

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Below we present BofA's full thoughts on lowflation and the "low vol conundrum":

Going into the summer break there are two questions investors seem to be grappling with. What to make of lowflation? And can the low vol regime last?

 

Neither was really expected coming into this year and investors are trying to work out what they mean for markets. Inflation has significantly surprised on the downside in the US, with the Fed now acknowledging it is not just down to one off factors. In the Euro Area too our economists are projecting inflation to be around 1% next year. That half of the reflation trade has definitely disappointed, even if the growth half hasn't. Yet despite (or perhaps because of) that, equity markets have prospered with vol almost non-existent. The VIX has been consistently sub-10 since mid-July and 100 day ealized S&P 500 vol is sub-8. Even Nikkei and SX5E 100 day realized vol is now barely above 11.

 

 

Lowflation may have been a blow to the reflation trade in its purest form but it is good for equity markets if it keeps central banks quiescent. As our derivatives colleagues have noted in vol near 90yr lows; what's driving it and how long can it last? it is important in keeping vol low, because central banks are not seen to be pulling the put from underneath markets so investors can buy the dip. That dip buying is important in driving low realized vol. Indeed, they argue that implied vol is being pulled lower by low realized vol rather than pushed lower by vol selling.

 

Although some have highlighted the vol selling as a driver behind low vol, it is worth pointing out that, despite the rise of short vol, ETFs' net vega in ETF products is still net long. Speculative short positions in VIX futures are also highlighted as evidence of ongoing vol selling, and for sure they are at record highs at the moment. Nevertheless, being short futures is the normal state of affairs other than at times of peak market volatility (see chart). So while vol selling might be having a modest downward effect on vol it is unlikely to be the major driver. Rather, we see the mix of stable fundamentals and the still visible effects of unprecedented central bank policy amidst a low growth recovery as driving vol lower.

 

It does though raise the question of how those short vol positions might accentuate any spike in vol in a sell off. There is clearly a risk that it might cause vol to spike higher than it would otherwise do.

 

 

The low level of realized vol weighs on implied vol simply through the effect of the cost of carry of any long vol position. Dip buying because of the central bank put is one theory as to why realized vol is low but to our mind it isn't the only or even the main reason.

 

Low inflation and supportive central banks have been there all through the periods of outsized volatility over the last few years. Compare, for example, the 2004-7 period with the 2014-17 period; the latter has seen much bigger drawdowns. The real difference this year is that low inflation is being combined with a solid economic upturn and strong earnings growth. Indeed, the chart below shows just how different 2017 is turning out to be on the earnings side compared to any other year since the GFC.

 

 

We link this back to the mid-cycle thesis from our last note. If we are mid-cycle then we can have accelerating growth, robust earnings and low inflation. The latter keeps the central banks gradual in their tightening cycle. Or as Ajay Kapur so succinctly put it in his recent Inquirer: "Hello Goldilocks".

 

As long as we are in such an environment then volatility is likely to remain low. Indeed, in 2004-2007 we saw such a period of sustained low vol. So perhaps we are exiting a higher vol regime characterized by fragile economic growth and a lack of sustained earnings growth into something more sustainable. Lowflation is important because as long as the central banks move gradually then markets are likely to remain calm as growth will not be choked off.

 

 

 

The charts above look at the different regimes of low inflation, rising or falling earnings and rising or falling inflation. The key conclusion is that vol is lowest when inflation is low and earnings are rising. And tends to be highest when earnings are falling.

 

It does not mean that there will be no vol events, it just likely means that they will prove short lived with investors buying the dip. Indeed, we continue to look for hedges that are low cost to provide protection when we think there are downside risks or markets are overbought, as per our NDX put spreads. One potential near term event is, of course, the debt ceiling brinkmanship in Sep/Oct. We already own NDX put spreads which we roll to October but today we add a collared call in the VIX, selling the 12 strike put to buy the 14-19 call spread, for around zero cost upfront. That just provides us with some protection over that potential standoff, which David Woo, our head of Fixed income and FX strategy thinks could get quite ugly.

 

The other big risk from a vol perspective that David also highlights tensions with North Korea. The issue with geopolitical risks though is how to gauge them and when they might occur. We prefer to hedge such risks with our relative variance positions, long SX5E, NKY, RTY vs SPX which continue to carry broadly flat and which we see as having convexity to the downside.

 

The big threat to the low vol regime outside such events would be when central banks get more aggressive in removing their easing bias. Lowflation has given them all the excuse they need to start to stretch out the likely tightening. In the FOMC statement this week the Fed dropped "somewhat" from the below 2% comment on inflation and Yellen has acknowledged that it is not just down to one off factors. A number of Fed members have noted that should inflation continue to undershoot the Fed's inflation target that interest rates hikes might have to be deferred. In short, compared to the dot plot, even the Fed is now saying the risks are that they undershoot.

 

 

Similarly for the ECB, Draghi's reiteration that any moves on rates would only follow the end to QE has prompted our economists to push out their expectation for the first technical rate hike to Q1 2019. They also think the more the Euro rallies the more the ECB is likely to drag things out on the tightening front. We drop our short Dec18 euribor trade in response to those views.

 

We would be a lot more concerned about lowflation if it was being combined with weak growth but that does not seem to be the case. The US data has been patchy but with Q2 GDP coming in at 2.6%, the economy has still expanded by around 2% ytd. Elsewhere, the data remains robust. While European and Japanese PMIs were off their highs, they are still elevated and the IFO survey and Tankan both hit new highs. German business confidence was actually described as "euphoric". Our GlobalCycle strengthened again in Q2, while our quant team's Global Wave and Style Cycle continued to post gains, the former for the 14th month in a row.

 

 

Of course there is a risk that if lowflation becomes embedded that central banks may end up in the next downcycle with inflation much lower than they would like. That is, the longer term risk but from our perspective lowflation fits with the view we discussed last month of a global output gap that is still negative, giving the central banks room to keep policy loose. That should be supportive of the ongoing rally in risk assets.

 

For bond markets though it is a different question. In our piece two months ago, we discussed the bond market equity market divide and argued that the one way where bond markets and equity markets could both be right was simply for inflation to remain benign even as growth stayed strong. We described that at the time as a narrow path. We still think that is the case given the very limited tightening priced into the Fed curve in particular, but we have to admit the path does seem to be a little wider than we thought.

 

Our stance has been to be defensive in the US bond market, short 3Y nominal and 10Y real rates, given we believe the biggest threat to our equity market longs is either a Fed scare or a taper tantrum. The latter might well be associated with the unwind of the Fed's balance sheet, which they confirmed they intend to proceed at the latest FOMC. We are comfortable doing that given we have added a bit more vol protection over a possible debt ceiling standoff.

 

 

So while lowflation and low vol have been unexpected this year they are, in our view, supportive of an ongoing rally in equity markets. Michael Hartnett still warns of the risk of a "big top" in the autumn (another reason we run hedges), but he acknowledges it probably requires more hawkishness from central banks or a top in EPS momentum. With the Q2 earnings season progressing well currently it doesn't look like the top is here just yet but we are getting closer on some measures. Our Bull Bear indicator which looks at a variety of different positioning and technical indicators has reached 7.6 now just shy of the 8 level which in the past has flagged a risk of a pullback.

 

Indeed, notwithstanding our view that low vol might be here to stay for a while we are conscious that a world where the S&P500 has not had a 5% pullback all year is not sustainable. So we continue to be of the view that investors should use the low level of vol to provide protection against a resumption of more normal market behaviour.