Fasanara Capital: The Vol Feedback Loop Has Reversed; What Comes Next?

Original post

Submitted by Fasanara Capital, as excerpted from:

What’s next? How QE’s Positive Feedback Loops Act In Reverse (full pdf)

While the crisis may be over for the time being, a dominoes of cause-effect relationships has been triggered, which leads to a possibly tough Q2/Q3 if volatility persists. The autolytic reaction is now jumpstarted, but will take time to spread across. If this scenario proves right, what may we see from here?

  • ​Volatility (implied and later realized) further spreading to nearby asset classes.
  • Volatility staying sustained, finding a floor well above the previously held line of 9-10 VIX. No return to status quo.​
  • ​Critical slowing down. This is a general property of a system approaching critical transitioning into an alternative stable state, according to professor Marten Scheffer (as described in edge of chaos). The speed with which markets return to new highs, assuming they do, is slower than previous recoveries (Nov16 Trump election, Jun16 Brexit, Jan16 commodity slide, Aug15 Renminbi deval, Oct14 slide, among others).
  • ​Correlation increasing across asset classes. The sneaky Beta to the downside risk which surfaces during times of stress.
  • ​At some point along the way, CTAs and trend-chasing algos will delever portfolios due to the persistence of higher volatility, but not intra-day or daily volatility, as they often rebalance with lower frequency than daily and referencing longer-dated measures of volatility (which has not reacted fully yet, as shown above)
  • Somewhere along the fine line, a second failed Buy-The-Dip (possibly around the 200 days moving average on the S&P) may convince momentum strategies to follow through, beyond pre-defined strikes, and pre-identified weak points / fault lines on order books . After that, CTAs again, and those behavioral Risk Premia funds linked to momentum factor style or volatility factor, or both (multi-factor portfolios), directly or indirectly. Trend-driven investors more generally, including retail, are likely to follow. Those machine learning quant funds that learned to buy-all-dips over recent years may also learn to sell.
  • Finally, Risk Parity funds and other Target Vol vehicles at large, may sell assets, if realized volatility and correlation persist and gets recorded in monthly rebalancings. If we are to believe what we are told these days by RP largest promoters, they will all sell later (Jeff Gundlach may say, ‘’at a lower price’’). Cliff Asness of AQR: ‘’we have done pretty much no trading in risk parity [these days]’’. Bob Prince of Bridgewater described the fund as ‘’the most boring thing really, it is definitively not driving global asset prices. It just sits there like a turtle’’. Technically, if volatility persists, the longer they wait the higher the chance that the rebalancing may reflect redemptions, instead of higher realized volatility.

  • Naturally, ETFs and passive index funds are programmed to follow through, whatever the circumstances, mechanically and unemotionally. Sentiment may further exacerbate the move, as ‘noise traders’ with incorrect beliefs – in the definition of Richard Thaler – create additional pressure at turning points (page 23 here).
  • Value investors, who in previous occasions came to the rescue and picked up good names, will buy at the margin as  the market falls, providing some counterbalancing flows, with any dry powder left and the little AUM that has not transitioned yet to passive strategies or long bias.

Eventually, it becomes a game of musical chairs. The motto goes: if you need to panic, panic early. Especially true for institutional investors, as the imposition to sell can come for one of two reasons: model-driven, due to an increase in realized volatility, a broken trend,  a flipping correlation… or client-driven, due to redemptions. The earlier of the two.

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The Structure Of The Market Is Combustible

The structure of the market is the key driver of market dynamics in a QE world, above all over-fitting economic narratives: the interaction of Trend/Momentum, Volatility, Correlation. Factors such as Trend and Volatility, disseminated across the industry in the last several years, under the push of QE and NIRP, and created Correlation across 90% of the investment strategies (here), leading to an unstable equilibrium vulnerable to small perturbations. They can now all act in tandem again, but in reverse.

The autolytic reaction needs to be jumpstarted, which is what tiny short vol ETPs may have just done.