Vol Themes: Monetary Policy Turbulence Strikes Back
The volatility landscape is finally showing sign of true change. After a long period of highly depressed volatilities, most asset classes, with the notable exception of FX, have seen a clear pickup, with rates, equity and commodity vols off their lows. The Fed’s U-turn and the more dovish tone of central banks may well be one of the reasons for the general volatility increase, but nor is the world free of sources of uncertainty (trade wars, Brexit, US election…).
This is why we decided, in this new edition of our Vol Theme, to dig deeper into the links between cross asset volatilities and the rising monetary policy uncertainty.
Classically, monetary policy cycles fit into business cycles with central banks easing policy around recessions (at the end and beginning of the cycle) and tightening in the middle of the cycle. But, although monetary cycles should in theory closely follow the business cycle, changes in monetary policy stance have on average a higher frequency than business cycles. This is due to the uncertainty surrounding economic prospects and mid-cycle adjustments. This uncertainty fuels volatility increases, sometime at different timings than what pure business cycle analysis (which can only be assess ex post) would suggest. Hence, looking at monetary cycles and monetary uncertainty makes analysis of vol dynamics more granular.
Rate-cut cycles primarily impact the rates volatility environment. This is even more the case in a world of muted inflation, when rate-cut cycles are more aggressive than rate-hike cycles. But rate-cut cycles also coincide with the rise of equity volatility, potentially more because they are symptomatic of the rising uncertainty on corporate earnings at the end of the business cycle rather than for their direct impact. The increase in equity volatility is currently strongly counterbalanced by the gamma supply, another consequence of the low yield environment. FX volatility on its side is hesitantly re-emerging, but interest rate turbulence has been barely channelled into it so far. The unprecedentedly tight spot range of EURUSD is freezing the realized vol, as well as the oversupply of gamma (like everywhere else). But the turning point might not be too far away, as we find that EURSUD vol pickup is lagging those in EU-US short rates by about one semester historically. This spread peaked in November 2018 and EUR/USD vol has already hit its floor. With EU-US rates tightening again, FX vol should decisively pick up in early 2020.
On top of a complete review of the impact of monetary uncertainty by asset class, the Vol Themes report “Monetary Policy Turbulence Strikes Back” explores the intertwined relationship between Credit and Equity volatility. Societe Generale Quant team has developed a strategy which systematically goes long credit and uses the income to buy equity puts. It can be set up as a carry strategy with reduced tail exposure or as a hedging strategy with reduced carry cost. With yields getting more and more depressed by monetary policy, the blend of Carry and Convexity is paramount. The report also presents some rules of thumb as well as a list of single and cross-asset ideas to navigate the current monetary policy environment
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This editorial contains financial analysis which reflects the opinion of the Cross-Asset Research department of Societe Generale at the date of its publication. It does not necessarily reflect the views of the other departments of Societe Generale nor the official opinion of Societe Generale. This interview is dedicated to institutional and professional investors and is not deemed to be seen and used by retail investors for investment purpose. The viewers shall consult their own financial advisers to make their own appraisal.