The German election is over and the confrontation over the US debt ceiling has ended, so event risk should be minimal, right? Not so fast, UBS’ Mike Schumacher warns – plenty of pitfalls could trip markets. Forward-looking measures of ‘risk’ are beginning to show some signs of less-than-exuberance reflected in all-time-highs across all US equity indices and if previous episodes of ‘low-vol’ are any guide, the current complacency is long in the tooth… no matter how ‘top-heavy’ stocks become; bloated by the flow of heads-bulls-win-tails-bears-lose ambivalence…
As @Not_Jim_Cramer recently pointed out, the VIX decline appears on borrowed time… (we recently noted, suppressing ‘normal’ volatility leads to “problems” down the line)
And credit markets have already begun to show ‘doubts’ in the short-term…
As event risks remain across the globe…
Via UBS’ Global Investment Research,
One caveat before we go further. We are bond guys, which means that we naturally look for blue skies to become gray. Even so, risks abound.
We begin with Europe, where news flow should continue to accelerate. The Greek debt burden remains a problem. Furthermore, Ireland probably will seek a precautionary credit line. We expect Portugal to get and use an Enhanced Conditions Credit Line. The May 2014 elections for the European Parliament could pose a test for markets. This statement may seem wild, since the Parliament has only a very indirect effect on financial markets. However, the new Parliament may well contain a significant proportion of members who are “eurosceptic”. If this turns out to be the case, further steps in banking union, and toward greater European integration, could become much more difficult. It is also possible that national governments could reflect the same sentiment and become more populist, thereby hindering these processes even more.
In addition, European markets will be looking for the German Constitutional Court’s blessing on the ECB’s Outright Monetary Transaction policy. The Court is likely to rule in favor. However, there are risks around whether it imposes restrictions on executing the program and what form they might take.
Japan has become a major source of volatility. Its latest event risk is the consumption tax increase, which is due to occur in April. This is a “known unknown.” Still, we worry that the economy could be derailed, leaving the Bank of Japan to increase its already stupendous purchases of Japanese government bonds. Yields probably would fall, even though the 10yr rate of about 0.60% already is near an all-time low and has plunged 30bp since June 30. Although this Japan risk is quite troubling, the good news is that an economic slowdown likely will not become evident until at least June.
While Europe and Japan have challenges, we consider the US the biggest source of event risk over the next three months. We are particularly concerned about a “hat trick” of issues in late January / early February:
Fed transition. Assuming that Janet Yellen’s confirmation proceeds smoothly, the transition at the Federal Reserve will occur on February 1. US economist Drew Matus points out that a new Fed Chair typically has to deal with a bout of market volatility early in his/her tenure.
Debt ceiling. We hate to mention this horrid topic, but cannot avoid it. The ceiling has been suspended through February 7. The UBS public policy team opines that a “grand bargain” on the US budget is very unlikely, thereby making for acrimony over the debt ceiling. We suspect that virtually everyone reading this publication shares our hope that the discussions proceed more smoothly than they did this month. Nonetheless, we expect the debate to heat up in late January.
Fed tapering. Finally, the market should be abuzz over potential Fed tapering. The UBS economics team continues to look for tapering to be announced in January and begin in February. We share this view. The consensus appears to be for tapering to start in March. Regardless, by late January the market should be abuzz with speculation and repositioning around tapering.
How to play it
Our main conclusion from the discussion of risks is that implied volatility should rise over the next three months, particularly on USD assets. Investors who can transact in options have numerous alternatives. Our top choice is to buy vol on a forward basis. For instance, the investor could purchase options that expire in six months and sell two month options on the same underlying asset, such as a USD 10yr interest rate swap. A client who can only go long options should consider buying 4-6 month expiries.
Fixed income investors who do not use options still can gird themselves for rising vol. For example, we recommend avoiding bonds that are callable in three to six months. Furthermore, they should consider selling agency mortgage-backed securities. We have been negative on this sector for several months, and the potential increase in vol gives us one more reason to be skittish.