The volatility playbook for the week ahead

One aspect that I have addressed in the ‘Week Ahead’ playbook is the message I am seeing from the US bond market and it is a play that is progressively suggesting more risk averse positioning. It gives me some belief that implied volatility in markets could start to respond and move higher. I have mentioned in reports of past that the bond market has never fully bought into the reflation trade that so many economists had got quite excited about going into 2020. Where, if I look at the long end of the US Treasury or German bund curve, or even the copper/gold ratio, the market is saying reflation is a pipe dream, and instead, we may actually be too optimistic about the global growth story.

(Green – US 10-year inflation expectations, white – copper/.gold ratio)

We know the FOMC meeting is this coming week and while no one expects a change in the fed funds rate, we are expecting Jay Powell to be intensely probed about the Fed’s balance sheet and measures to support the repo market. Risk markets, such as equities, have been supported by changes to excess reserves, which despite calls to the contrary from the Fed, the market has taken these changes as QE, and this may well be coming to an end – or, should I say, the expansion of reserve growth will soon abate.

(White – excess reserves, yellow – Fed’s balance sheet, purple – USD index)

While incredibly simplistic, if excess reserves are not increasing, does this mean risk takes a breather?

A break lower in real (inflation-adjusted) yields could also result in a flatter bond curve, with implied volatility kicking-up a touch, as modest risk aversion stemming from the virus outbreak takes hold. We will continue to be focused on the contagion in China and while I am no virologist, it just seems that when you effectively quarantined 12 million of people there must be unforeseen consequences.

The parallels with 2003 SARS outbreak have been made and the moves higher in USDCNH (and lower in CHFJPY) are telling me the PBOC are expected to support economics. Consider that in 2003 we saw Chinese retail sales fall from 9.3% in March to 4.3% in May, and this is the playbook we have to contrast. This situation obviously has further to play out in markets, and the risk to the economics and the oil market is growing.

In the video I also focus on Aussie Q4 CPI and the BoE meeting which will get strong attention from market participants. Somewhat surprisingly, 1-week implied vols are still subdued, and while buying vol has been a poor trade, I would expect these ranges to be tested and this plays into position sizing and risk considerations.

(Implied volatility matrix)

Have a great weekend to all and happy Chinese New Year,