Michael Purves is the Chief Global Strategist and Head of Derivatives Strategy at Weeden & Co. Here, he discusses what is keeping the VIX low and the four pillars of equity support perpetuating the “buy the dip/low volatility" regime. Michael will be speaking at Global Derivatives USA on cross asset volatility trading this November.
Monetary policy is the defining feature of today’s markets and it is inflation which is the swing factor which determines monetary policy. But persistently low inflation is the economic factor which seems to have most perplexed policy makers. This low, but confusing, inflation theme has played a central role in keeping long term nominal yields, and by extension the VIX, in a lower for longer condition.
The Fed is not alone in overestimating inflation, but it is the actions of the Fed (along with other Central Banks) which matter. The convergence of several deflationary trends – globalization, technology, the China output gap, and demographics – all help explain the new inflation condition. The problem is model recalibration amidst this confusion – and this creates a lively debate among the Fed officials and others. “Data dependent” can be interpreted as “our Philips curve and other models are broken, and we are figuring it out on the job”.
The instruments on the airplane the Fed is flying have stopped working and the pilots are relying on visual readings
If the dots are high and inflation low, the Fed’s actions have clearly taken the view that the real risk to the economy is deflation. Put another way, the instruments on the airplane the Fed is flying have stopped working and the pilots are relying on visual readings. If a mountain of inflation suddenly appears, the Fed has taken the view that it can adjust course without too much passenger discomfort. Given the substantial amount of interest rates sensitivity in the economy, the ability of the Fed to cure an upside inflation shock seems to be an easier problem for the Fed to solve than a deflationary spiral. So far, no harm, no foul.
Low (and confusing) inflation drives dovish policy and lower bond yields. But as the temporary emergency measures of QE have persisted, the stability of lower yields has established four solid pillars of equity support which perpetuate the “buy the dip/low volatility regime”:
- Relative Attractiveness. Low bond yield underscore the relative attractiveness of equity earnings yields.
- High Real Yields. Low inflation means that real earnings yields are still relatively high, even after continuous P/E expansion.
- Declining Cost of Equity Capital. Since QE began, the cost of debt, the equity risk premium, and the cost of equity capital have all declined. This raises the present value of projected cash flows.
- The SPX Considered As A Convertible Bond. When the SPX dividend yield remains proximate to the 10 year Treasury yield, the SPX has effectively become a quasi-convertible bond (a “coupon” with a call option on growth). So long as credit quality is maintained (which, broadly speaking, it has been), this condition limits the severity of market corrections and reinforces the rationale for dip buying.
The Key To VIX Reflation May Well Come From European Growth
So what ends this lower/longer condition for rates and the VIX? A more hawkish Fed Chair, a surge in wage inflation, a dramatic contraction in the China output gap, an upside shock to commodities are all possibilities. We argue that one key, but over looked, catalyst sits in the hands of the ECB and follow through on European growth and inflation.
The Fed’s strategically dovish approach has of course been aggressively adopted by other central banks. At $15 Trillion and counting, the collective balance sheet of the Fed, ECB, BOJ and the BOE is growing faster today than it did at the peak of QE3, even accounting for the recently announced Fed taper. Aside from the ever dovish BOJ, the big elephant and swing variable in the room is the ECB. Currently adding more than $70 bn/month in liquidity, an upside risk to European growth/inflation could push the ECB into a more aggressive taper, essentially making the ECB the swing variable in rate suppression. A substantial ECB taper would have an obvious downward impact on the rate of growth of the collective balance sheet and, most importantly the level of longer term Bund yields.
While longer dated Treasury yields are influenced by several factors, we can’t ignore that Treasury/Bund correlations have persisted (since Euro QE began, the average 60 day correlation of 10 year Treasury/Bund yields is 0.72). With 10 year Bund yields at 0.40 to 0.50%, a return to an “old normal” Bund rate of 1.5 to 2.0% could lift Treasury yields higher by as much as 100 basis points.
An imported taper tantrum would undermine the key pillars of equity market support discussed above, and all the more so as the higher rate environment would not come with the benefits of higher U.S. economic growth. Certainly a stronger Eurozone would help reinforce global growth and drive a weaker dollar (two risk positives), but a return to a persistent 3%+ 10 year Treasury yield will lift the VIX to a higher and more dynamic range.
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