EVENT RISK - Volatility Ahead

Event Risk: Down But Not Out 11-03-13 Zero Hedge

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...

and longer-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.

FEDERAL RESERVE - The Policy Options Avaiable to the Fed

Figuring Out The Fed 11-03-13 Lighthouse Investment Management's Alex Gloy,via ZH

Since 2008, the Federal Reserve has been trying one program after the other in order to kick-start the US economy. It culminated in currently buying around $1 trillion of bonds a year. But economic growth remains weak. Why does the Fed continue its ultra-lax monetary policy despite evidence it doesn't help much? The people at the Fed are not stupid, so there must be a rational explanation. This is an attempt to figure out their 'game plan'.

Via Lighthouse Investment Management's Alex Gloy,

In a debt-based economy (like ours), GDP grows only if the overall pile of debt is growing. As long debt doesn't grow faster than GDP, the system is stable. You may grow debt faster than GDP for a while (depending on your starting point), but eventually you reach a point where the whole thing becomes unstable. There is no magic number, but anything north of 100% debt-to-GDP probably makes you prone to mayhem. The US is at 100%.

Here's how debt and GDP have been growing over past periods.

From 1950-2000, GDP grew slightly faster than debt, so smooth sailing. In the 13 years since the millennium, debt grew more than twice as fast than nominal GDP. And over the past six years, the fork opened even wider. It doesn't take a genius to see the problem with the current situation.

Two elements make up nominal GDP growth: real growth (volume, green bars) and inflation (price, red bars).

For debt purposes it doesn't matter how the growth is achieved. If real growth is insufficient, you could, theoretically, make up the difference via inflation. We would currently 'need' around 10% inflation. Of course, in that case, yields on 10-year bonds wouldn't remain at under 3%. Unless the Fed declares a 'yield cap'. It could, for example, promise to buy any bonds yielding more than 3% (they have done so in the past). But that would imply a negative real return of 7% for holders of those bonds, and the Chinese and Japanese probably wouldn't keep their trillions of bonds in that case. The Fed would simply have to purchase all outstanding Treasury bonds. So this plan would probably not work.

So...

The Fed tries and tries. It might seem as if it ran out of tricks, but there are a few cards up the sleeve...

Full Lighthouse letter below...

Lighthouse - Letter to investors - 2013-11.pdf by Alexander Gloy