Investors have become exceptionally comfortable despite financial media’s breakneck coverage of the Delta variant, persistent inflation (or maybe not?), the Jackson Hole Symposium, and more. Risk-adjusted returns measured via Sharpe ratios (rolling 100-trading days) across nearly all asset classes have tightly huddled together at quite favorable, positive levels. In other words, investors really could not have gone wrong allocating to just about any major asset class.
In fact, the range of Sharpe ratios is now the tightest since two past events in May 2004 and September 2015. These dates will ring bells because they were directly before the Federal Reserve kicked off the two most recent rate hike cycles!
Strong, widespread returns across risk assets are quite typical as central bank easing comes to an end. The chart below shows the rolling one-year change in central bank shadow rates (orange, left) along with the rolling one-year return differential between the S&P 500 and long-term US Treasuries (blue, right). We highlighted in gray the seven months from the bottom in shadow rate changes.
Unfortunately, healthy positive returns across risk assets habitually come to an end at this seven-month mark. Note how quickly the S&P 500’s outperformance of long-term US Treasuries subsides following the gray shaded areas. At this point, volatility expectations tend to rise as investors demand greater compensation for the risk taken.
Investors have enjoyed a tranquil landscape of hefty positive skew across economic data releases from August 2020 through July 2021. Strong fiscal and monetary support helped a consumer hellbent on continuing to spend weather the COVID storm.
However global economic data releases have begun to produce a sizable negative skew heading into the fall months. We do not view this as a dire situation for the economy, but an indication the exuberantly good times have moved into the rear-view mirror.
Investors choosing not to prepare for rising volatility are most easily seen across foreign exchange. The average three-month implied volatility for the Aussie dollar to South African rand has fallen to levels seldom reached. You will notice periods of similarly ultra-low currency volatility occurred as central banks shifted from easing to tightening or vice versa. These shifts in monetary policy accommodation occurring in 1996, 2007, 2014, and again in early 2020 were ultimately followed by eruptions in currency volatility.
Currency traders are surprisingly pricing in incredibly low risk of a tail event. The next chart shows the three-month 10-delta option butterfly volatility across seven major currencies. The volatility shown reflects the chances of currencies breaking through distant out-of-the-money call or put options within the next three months ahead.
Tai-risk via this measure is the lowest since June 2014 and January 2020, again marking significant bottoms in currency volatility. Remember June 2014 included the Fed’s taper while the ECB prepared to ramp up bond-buying over the ensuing months. Will we get another bout of policy divergence with the Federal Reserve tapering and the ECB remaining ultra-easy?
Large speculators have increasingly added to long US dollar positioning over recent weeks. Investors’ shifts to sizable long positioning have been sticky in the past. In other words, long positioning is indeed followed by a US dollar rally and increasing foreign exchange volatility.
Investors became concerned the number of assets capable of hedging risk assets had dwindled or evaporated. US Treasuries and investment grade corporates have seen their correlation to the S&P 500 turn back negative, making them obvious candidates yet again. However the US dollar has reigned supreme throughout the pandemic as a risk asset hedge. We view overall foreign exchange implied volatility as another similar vehicle to hedge given ultra-cheap option premiums.
Given the continued tranquility across financial markets, currency volatility may present the cheapest and best option to hedge tail risk moving forward.