Volatility Erupts Everywhere as Trade War Becomes a Currency War

(Bloomberg) -- Volatility is here and set to spread.

That's the view from Wall Street, which holds that Tuesday's rebound in risk assets from the biggest decline in the S&P 500 Index of 2019 is just a lull in what has traditionally been a rocky month.

Selling sparked by forced adjustments among systematic investors and a plunge in global equity sentiment combine with the seasonal pattern of volatility to thoroughly alarm Masanari Takada, cross-asset and quantitative strategist at Nomura.

“It would be a mistake to dismiss the possibility of a Lehman-like shock as a mere tail risk,'' the strategist warned.

The S&P 500 plunged 3% Monday after China let its currency weaken to the lowest in 11 years, sparking fears that the trade war had entered a more unpredictable stage. Treasuries surged with gold and the yen on demand for havens. Risk assets bounced back somewhat Tuesday after Beijing strengthened the yuan, but investor nerves remained frayed.

“The waters appear to be as opaque now as they were in the fall of 2015 when China hard-landing fears defined global risk markets (if for different types of reasons),'' Michael Purves, chief executive officer of Tallbacken Capital Advisors LLC, wrote in a note to clients. “Accordingly, dip buying will be tricky in the near term, and we expect volatility will be elevated, until valuation resets handsomely (such as it did in December).''

The Cboe Volatility Index slipped to 22 Tuesday after almost hitting 25 a day earlier. It has averaged 15.6 this year. In the short term, that means markets will have to digest an onslaught of selling from funds that will now be deleveraging to realign their exposure to equities based on a set level of market unrest.

“Call it a few tens of billions of equities to sell over the next couple of sessions,'' said Benn Eifert, chief investment officer of QVR Advisors.

So far, institutional selling of short-term puts in equities -- which has the effect of dampening stock volatility -- hasn't reached nearly the same scale as in the fourth quarter or May drawdowns, according to Eifert. This smaller supply of downside volatility on offer has been a partial contributor to the magnitude of the VIX's recent surge.

The acute reaction in equity volatility prompted Macro Risk Advisors to recommend alternative methods to protect against a further stock sell-off. Derivatives and quantitative strategist Maxwell Grinacoff suggests targeting exchange-traded funds that focus on gold and its miners.

The firm recommended buying call spreads in the GLD and GDX ETFs to take advantage of the rich skew on the call side.

“This ‘tilt' in the basket of hedges that would traditionally be more heavily weighted in equity index protection is driven by gold's higher correlation to CNH (which could see further devaluation as the trade war persists),'' he wrote.

With currency brought to the fore of the escalating clash between the world's two largest economies, it's difficult to see investor angst only reaching extremes in equities.

“Vol is still underpricing the risk of escalation -- especially a currency war,'' wrote Bank of America strategists led by Gonzalo Asis. “With much room left to run to match Aug 2015 returns and cross-asset volatility mostly below long-term averages, options appear attractive to position for further stress.''

Only U.S. equity and oil volatility are above their long-term averages going back to May 2007, according to Bank of America, while foreign exchange vol is just in the 26th percentile over this timeframe. The team believes “the rising risk that the trade war morphs into a currency war” will foster the outperformance of this asset's volatility much faster than in 2015, making currency-based hedges particularly attractive at this juncture.

The potential for heightened foreign-exchange swings threatens to upend a favored strategy use to generate positive returns in a world awash with negative yields. For instance, the euro-funded Brazil carry trade erased months of gains in the three opening sessions of August.

“We continue to caution that carry trade unwinding via FX-carry or bond-carry is one of the biggest risk at hand,'' writes Saktiandi Supaat, head of foreign-exchange research at Maybank. “With EUR and JPY's funding currency status being further enhanced due to their relative ‘cheapness' amid ECB and BoJ's willingness to keep monetary policies accommodative, a re-escalation in trade tensions may well see funding currencies (especially more so for JPY) in demand.''

To contact the reporter on this story: Luke Kawa in New York at lkawa@bloomberg.net

To contact the editors responsible for this story: Jeremy Herron at jherron8@bloomberg.net, Rita Nazareth

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