Cross Asset Volatility.

• Strong Defense
• A Rally Without Volatility
• More Volatile Hands

Gold has rallied 25% from its October 2023 lows and 40% from its September 2022 lows. This price improvement occurred despite persistent dollar strength, high real and nominal interest rates, and a Fed which has stopped hiking but has yet to initiate or commit to the idea of a proper cutting cycle (Chart 1).

Chart 1

Strong Defense

Gold has been playing aggressive defense, but not so aggressive offense. It has steadily reached new highs without the explosive moves we have come to expect. In fact, gold ETFs have been losing, not gaining, (open) interest during this impressive rally (Chart 2).

Chart 2

A Rally Without Volatility

Who has been pushing gold higher? It is not Wall Street; it is central banks. In chart 3, we see that central banks have been quietly accumulating gold over the past several years. Typically, when gold rallies, so, too, do silver and mining shares. This is not the case when central banks are the driver as they do not buy silver nor mining shares (Chart 4). Further, when central banks accumulate gold positions, they do it quietly and in an orderly fashion, with a long-term time horizon. This results in a discreet rally with low volatility, on an absolute basis and a relative basis, specifically to Treasury and foreign exchange volatility.

Chart 3

Chart 4

Chart 5

If Wall Street fully engages in the gold rally, we expect to see the aforementioned proxies rally and gold volatility rise. We believe the tipping point is fast approaching because the current technical pattern looks eerily similar to the triple top which occurred between 2007 and 2009. When that pattern eventually broke out, gold nearly doubled in price, until it reached the blow off top in September 2011 (Charts 6, 7).

Chart 6. Gold Price, Daily

Chart 7. Gold Price, Weekly

More Volatile Hands

If the gold rally continues to trend higher, we expect that hedge funds, commodity trading advisors, and retail investors will become more actively engaged. If this occurs, mining stocks and silver should also rally, and traders should see outsized performance in these more volatile asset classes. However, if gold continues to rally in isolation, we expect central banks to ease purchases and let Wall Street lead the way. As leadership changes hands, the complexion of the rally will evolve from low volatility to high volatility with more explosive moves higher and more violent moves down.

• Steady rise in the VIX
• Correction may be overdue
• Rates can push higher
• The Fed can hold its ground

Steady rise in the VIX

Despite a market rally, the VIX has slowly and steadily climbed higher since the December FOMC (Chart 1). Why has this happened? We believe that the steady march higher in realized volatility has played a part. In Chart 2, we see that 20-day realized SPX volatility climbed from 6, a very low level, to 13, almost double.

Chart 1.

Chart 2.

Correction may be overdue

In last month’s CAV, we addressed the relationship between the VIX and cross stock correlations. Generally, when correlations move lower, there is less macro risk, and the VIX moves lower. In this circumstance, investors worry less about the risk of the equity asset class and focus more on the specific attributes of individual stocks. Conversely, as correlations increase, the VIX moves higher. In March 2020, the most recent VIX spike, correlations across stocks surged to nearly 1.0.

In Chart 3, we observe that 1-month implied correlations have started climbing, even with 3-month implied correlations at historically low levels. To us, this suggests that the risk of a market sell-off is priced into the near-term, but not the long-term. This appears to be a statement that, after such a blistering rally, a correction is due. Maybe not a major one, just yet.

Chart 3.

Rates can push higher

Interest rates have been steadily creeping higher. The roughly seven cuts priced in early January now stand at roughly four cuts. In Chart 4, the 2-year Treasury yield (which is more directly impacted by Fed policy than longer term interest rates) has risen steadily since the December meeting. Even though it has recently come in, there is still an enduring question regarding whether the Fed’s projection of three cuts (not four or more as currently priced in) will come to bear. If the economic data continues to be reasonably strong, then rates may push even higher.

Chart 4.

The Fed can hold its ground

If rates continue to rise and settle into a higher range, will that lead to a bear market in equities and a nasty bout of volatility? The answer is, it depends. If economic growth, rather than inflation, is the key force keeping rates higher for longer, then perhaps there is a good case that the VIX, and rates, are both adjusting to a higher, yet not destabilizing, range. In the late 1990’s, the economy was strong, rates were high, and the market produced a historic rally. The VIX was also much higher. From 1997 through 2000, the equity market rallied at an unbelievable 24%/year CAGR with the lowest closing print for the VIX at 16 (Chart 5). This marks a recent period where we had a strong economy with higher rates, and, importantly, a Fed that was not inclined to dramatically lower interest rates at every whiff of economic weakness. This could be our template for the rest of this year.

Chart5

• Shocks to the Market
• Dispersion Trade defined
• Short volatility conditions
• From adversity rises opportunity

Shocks to the Market

Over the last several years we have seen massive and abrupt jumps in equity volatility. Even during conditions where economic and earnings reports were stable, there were no Fed or geopolitical tape bombs, and the market was not overbought. What is underlying and exacerbating these jarring market periods? Is it the overdevelopment of option trading strategies designed to generate alpha from selling volatility in some form or fashion? In February 2018, we had the implosion of the short VIX ETN (“XIV”) while the manic price action just prior to Christmas of that year was heavily driven by the massive rise, and subsequent fall, of Iron Condor strategies (selling option premium tied to the SPX). The record VIX spike in March 2020 was driven by the COVID shock, but this was exacerbated by the massive implosion and forced position closing of various option dedicated hedge funds that had been short volatility. Short volatility is a great strategy, until it isn’t.

What is the Dispersion Trade?

A dispersion trade is when a trader pairs a basket of single stock volatilities against index volatility. A trader that is long single stock volatilities and short the index volatility against that basket is essentially betting on correlations among those stocks declining. Correlation increases as volatility increases and as equities sell off. The dispersion trade can be thought of as earning a correlation risk premium.

Generally, when the equity markets rally, the VIX tends to contract and the correlation among the stocks and sectors decline. This makes sense because, in a risk-on trend with less macro risk, the market can discern which companies are doing better than others. Conversely, if there is a macro shock, investors sell equities indiscriminately. In this scenario, correlations across stocks spike, as does the VIX.

Using the VIX as a proxy, SPX index volatility is based on implied volatilities of SPX options. The VIX is a forward-looking measure, calculated from a basket of SPX index options - various strike prices of both puts and calls over the coming four to six weeks. Realized correlation, however, is the actual co-movement of stocks based on a mathematical calculation of trading history. This data is important but, because it is historic and not forward-looking, is therefore of limited help in determining if single stock implied volatilities are likely to move more or less in tandem.

The implied correlation, however, is a calculation which is derived by how the basket of single stock option volatilities (again, forward-looking) trade relative to the SPX index volatility. If the basket of single stock volatilities moves in lock step with the SPX implied volatility, then implied correlations are very high. When the implied volatilities do NOT move in lockstep with each other, they are reflecting a higher level of individual signal stock issues.

For example, in a benign economic and market environment, as we currently have, Exxon (“XOM”) might have a downside surprise, see its stock fall, and volatility expand. While, on the same day, Meta Platforms Inc. (“META”) might have a big upside surprise, see its stock rise, and volatility expand. At the index level, the stock prices might offset each other, but the trader might profit from long volatility on both. Interestingly, SPX index volatility could be flat or even lower. Said another way, unless the stocks in the index are perfectly correlated, an index will always have a lower volatility than the average of its constituents.

The Chicago Board Option Exchange (“CBOE”) produces indices of implied correlation which can be seen on the CBOE website or on Bloomberg. These indices measure one-month and three-month implied correlations. While the CBOE calculation is not exactly what practitioners use, it illustrates the market’s view on stock co-movements and is a helpful guide as to what is happening with this part of the options market.

Chart 1 shows the VIX alongside the realized and implied correlations. We can see here that the implied correlation index tends to track closely with the VIX. During the record VIX spike in March 2020, correlations, both realized and implied, went to 0.8 – 0.9.

Chart 1.

Why the dispersion trade is inherently a short volatility trade?

In theory, volatility exposure is neutral, because the trader is long the same amount of Vega (a notional amount of volatility from the options the trader is long) from the single stock basket that he is short on the index. The trade is short both correlation and correlation convexity. Short correlation means that the position will lose as correlations increase. As discussed, correlations increase in a market drawdown. In addition, as correlations increase, the trade will lose money at an increasing rate. This is the classic short Gamma profit and loss profile that can cause volatility markets to have violent spikes due to forced buying and selling as traders need to stop out and/or de-risk their books.

But, when a market shock happens, all implied volatilities and correlation among the stocks will gap higher. However, the index volatility will typically gap much higher than the basket of single stocks. Which, as mentioned, will come from a much higher base than the VIX.

Context For Today’s Dispersion Trade

Last year was set up perfectly for the long single stock basket and short SPX index volatility dispersion trade. There was a strong run in equities after 2022 with declining macro/interest rate risks and a wide divergence across and within sectors. Correlations went from middling to low, consistently realized below what the market implied. This worked quite well for the dispersion trade. Low implied correlation is key to the success of the dispersion trade. Specifically, realized (actual) correlation underperforming implied correlation. This is how correlation “risk premium” is harvested, not unlike how iron condor or other short index volatility strategies harvest the SPX volatility risk premium - the spread between the VIX and the SPX realized volatility which is usually positive. In Chart 2, we can see that not only have realized and implied correlations declined, the spread between implied and realized correlations has been positive. Realized correlation underperforming implied correlation is what a dispersion trader wants to see.

Chart 2.

Have we gone too far?

However, there are suggestions that this trade may have worked too well, for too long. Consider the level of implied correlations today – three-month implied correlations are at just 0.2 – the market is pricing only a minimal amount of “macro” into the single stock correlations. The only time that implied correlation levels have been lower was at the end of 2017 – just prior to “Volmageddon” (Chart 3). As noted, realized correlation has also dropped to extremely low levels. We can see in Chart 4, the only time that realized correlations have been lower was at the end of extended bull runs, i.e., late 2017.

Chart 3. Three-month Implied Correlations

Chart 4. Three-month Realized Correlations

Implied correlation relative to the VIX

Another way to consider how little “risk-off macro” is priced into single stock options is by considering the ratio of the implied correlation to the VIX. Clearly volatility has contracted dramatically over the past two years and as discussed, so have correlations. However, as we can see from Chart 5, the level of implied correlations relative to the VIX is close to lifetime lows: a great example of how far this trade has been pressed.

Chart 5

Comparisons with early January 2018

We discussed above that the only time implied correlation reached these levels was early January 2018. Just prior to the VIX explosion in February, magnified by the implosion of the XIV (Inverse VIX Short). In Chart 6, we see how similar so many volatility metrics are today:

• VIX: comparable, broadly low
• Implied Correlation: comparable, extremely low
• Implied Volatility/VIX: comparable, extremely low
• Put-call Skew: higher then, but still relatively low

Chart 6.

What is also striking is that, while volatility was especially low in both periods, we have seen the VIX rising both in 2017-2018 as well as today (Charts 7, 8).

Chart 7. VIX Daily (September 2023 to January 2024)

Chart 8. VIX Daily (September 2017 to January 2018)

Now, let’s consider the broader market/macro back drop today versus early 2018. Both 2017-2018 and 2023-present were strong risk-on conditions, represented by P/E expansion and generally strong tech leadership. In both instances, we experienced large declines in correlation. That is why the dispersion trade worked well during these periods. Further, both Januarys that followed (2018 and 2024) had positive equity performance, good earnings performance, and moderately rising yields (Chart 9).

Chart 9.

So how can today’s dispersion trade turn into a massive VIX spike and market risk?

The long single stock volatility/short volatility trade is fine, until it isn’t. As noted above, if we experience a market shock, realized and implied correlation will increase dramatically, which means dispersion trades will become mechanically short volatility in an accelerated manner (in variance, not volatility scale). If these traders close out (voluntarily or otherwise) their trades, they will be forced to cover their short SPX volatility, which means buying back SPX index options which, in turn, drives the VIX higher. Closing out the long option positions on the single stock volatility positions will only offset some of this negative profit and loss for the trade.

In Chart 10, we show a scatter plot of the VIX three months after the implied correlation sinks below 0.25 over the course of the lifetime of the correlation index (which starts in 2014). We can see that, while some jumps are modest, many instances point to a meaningful shift higher in the VIX.

Chart 10.

In Summary

The dispersion trade has worked well over the past year, but our sense is that it has simply been pushed too far. The dispersion trade, a strategy which sets up a basket of long single stock options offset with a short volatility position on the relevant equity index (e.g. the SPX) works well when economic and macro conditions are benign and correlations among stocks falls - conditions which aptly describe today’s environment. While today’s economic and earnings data is still quite strong, we believe that this trade has simply been pushed too far and the potential for a convex market whiplash may be around the corner. A variety of volatility metrics are eerily like January 2018, just before the manic VIX surge. We are NOT saying this will happen this week, or next week. But we are saying there is plenty of gunpowder, and plenty of matches lying around close by.

It should also be noted that these market dislocations from short volatility implosions are as severe as they are sudden. In all three of these examples, the SPX dipped sharply, and in all three examples, equity investors were handsomely rewarded if they bought that market dip.

• Dovish pivot into a strong economy.
• Consumers can continue to spend with higher real wages.
• What does Dual Goldilocks mean?

The December FOMC meeting marked a key event in this interest rate cycle. The Fed started talking about rate cuts and stopped talking about rate hikes. We have seen many dovish pivots in the past but what makes this one unique is that they are pivoting into a strong economy. Despite one of the most aggressive hiking cycles in history, unemployment remains low (consistently below 4%), GDP is strong (2023 GDP growth is expected at 2.4%), and consumer spending is still strong. Inflation is falling and the Fed feels (rightly so, in our view) that they need to pre-empt a further surge in real rates. If inflation continues to fall, real rates will continue to move higher. Perhaps, too much in the Fed’s view. Announcing the pivot in December enabled them to get the messaging out of the way before we get too far into the election process. While the Fed has walked back a bit of the super dovish messaging, the critical point is that the hard, ugly work of the Fed is behind us. Financial conditions are still at the very low end of the range, established during the Fed hiking cycle (Chart 1).

Chart 1. GS Financial Conditions Index

For the worker-consumer, things are in pretty good shape. Wages continue to march higher, while gasoline, and a wide range of other prices, are falling. Interest rates have also contracted, which is easing credit costs. Critical, at this stage in the cycle is that, even with excess savings from COVID dwindling, the consumer, with higher real wages, can continue to spend “higher-longer”. What is so unusual is that we have these two Goldilocks dynamics happening at the same time. Chart 2 summarizes the “Dual Goldilocks” condition.

Chart 2.

What Does Dual Goldilocks Mean for the Markets?

For starters, we believe that investor’s risk appetite will remain strong, reinforcing a stronger backdrop for the rotation into cyclical stocks, broadening the stock market rally. We believe that interest rate volatility (MOVE) will continue to contract from elevated levels in 2022 and 2023. At the same time, persistent economic strength means that the Fed will remain defensive. Today, there are nearly six cuts priced into the Fed Funds futures markets. If the Fed continues to walk back some of the surprisingly dovish message from the December FOMC, we expect to see a backup in yields (2-year Treasury, in particular) and some enduring tension in rate volatility and, by extension, equity volatility. Still, at this point, we think these are tweaks, rather than the massive wholesale adjustments the Fed made to interest rates during 2022-2023. To put this in the perspective of cross asset volatility levels, Chart 4 shows the ratio of equity volatility (VIX) to Treasury volatility (MOVE). This ratio is at lifetime lows, extremely low equity volatility and extremely high Treasury volatility. We expect this ratio to normalize later this year - with Treasury volatility gradually coming down more than equity volatility rising.

Chart 3.

Chart 4.

• Reflecting on the last four years.
• Price discovery for the bond market is largely behind us.
• Healthy risk appetite for equities.

It’s important to remind ourselves what we have been through over the last four years: a once in a century pandemic; a shooting war between two major commodity producing countries; a massive fiscal and monetary response to COVID, which led to the ensuing inflation; one of the most aggressive hiking cycles in history, in both magnitude and speed; enormous economic volatility with US GDP surging to 5.8% in 2021, and then falling to 1.9% in 2022; and economic projections that provided substantially no guidance. Further, inflation proved not to be transitory, at least not in the short term. While we are not yet out of harm’s way, we believe that we are heading toward calmer waters. Inflation, and oil, have slowed their roll. However, we continue to keep a close eye on housing prices, as they have yet to roll over, and food prices, as they continue to push higher.

From 50 to 500 Basis Points.

Even with all the shocks and surprises over the past few years, we think 2024 will be much more subdued. In many respects, 2023 was a year of price discovery for the bond market – largely coming to terms with a new interest rate regime, and what higher term premia means for longer term interest rates. In Chart 1, we see the 10-year yield has moved from 0.5%, to 5.0%, and then back down toward 4.0% in the past three years.

Chart 1

There will no doubt be movement in the bond market next year including the trend towards ‘normalizing’ the Treasury curve. Even with that, we still believe that the most difficult and volatile part of price discovery for interest rates is behind us, particularly with the Fed appearing to have reached its terminal rate. The more likely questions are, will the Fed cut next year, and if so, by how much? Term premia has risen in 2023 but now seems to have largely stabilized (Chart 2).

Chart 2

Will the MOVE Stop Moving So Much?

In previous Cross Asset Volatility commentaries, we have discussed the MOVE Index in detail. In Chart 3, we see that the MOVE Index has been elevated and at historical levels in 2022 and 2023. Next year, we believe that rate volatility will decline and hold steady in a much lower range. While rates may move higher or lower, the movements won’t be as extreme, as we expect the Fed to largely remain on the sidelines.

What does this mean for equities and investors’ risk appetite in general? Interest rate stability and a lower MOVE will improve investor confidence and allow them to make more considered asset allocation decisions. We believe that this environment will allow investors’ risk appetite to largely remain healthy. No doubt, the risk of a hard landing remains, but in the absence of that, equities should be supported.

Chart 3

• VIX was unusually low and in a tight range as the market corrected.
• Volatility bottomed out on September 15.
• Relationship between interest rate volatility and equity volatility should normalize.

SPX pierced 4,600 in late July, the top of an aggressive rally which subsequently set up a roughly 10% correction through the end of October. August 2023 through October 2023 was the first three-consecutive-negative- months since Q1 2020. Despite the bearish price action in equities, the VIX averaged 15.4, and within a tight range of 13 to 17.

Equity volatility has been subdued because correlations across stocks have been low. This is a function of widespread dispersion in returns and valuation expansion within the index, the ‘Magnificent Seven’ vs. everything else. In addition, as equities sold off in Q3, rates rose, and rate volatility declined. Interestingly, the MOVE made its cycle low on September 15th, the same day the 10-year yield reached a key breakout level (Chart 1).

Chart 1

In Chart 2, we see that the MOVE and the VIX have largely moved in tandem for the better part of this year, jointly making cycle lows, on September 15th.

Chart 2

Historically, while the MOVE and VIX are very correlated (Chart 3), but interestingly this year, the VIX is trading at a historically low level given the market environment. To illustrate this, we look to the ratio of the VIX over the MOVE. During the last several months it has been among the lowest on recent record (Chart 4).

Chart 3

Chart 4

Over time, the VIX/MOVE ratio should normalize. The MOVE will either move lower or the VIX will move higher, or more likely, a bit of both. At this juncture, however, we think that unless Treasury volatility declines substantially, it’s hard to imagine the VIX resides in the lower teens. If that happens, equity markets will likely be range bound and choppy. Certainly not, in a clear bull trend.

• Steady and deliberate repricing of treasuries.
• Lower interest rate volatility at the terminal rate.
• Again, higher rates for longer.
• Central banks are moving away from a dovish policy.
• Slow organic move is more sustainable.

Scary Inflation.

Interest rates at the longer end of the curve are rising while interest rate volatility remains relatively low. If this combination continues, we expect the VIX will remain in check. However, we can still experience major shifts in the investment landscape, with moderate volatility. As shown in Chart 1, interest rates and the MOVE Index were positively correlated in 2022. Aside from a few instances in 2023, the pause at 3.5% and the breakout at 4.5%, interest rate yields and the MOVE index have been negatively correlated. The recent Treasury selloff may have felt violent, but it was fairly steady and deliberate.

Chart 1

Terminal Rate and Low Volatility

Why is Treasury volatility so low when yields at the longer end of the curve have pushed through last year’s highs? The increase in interest rates in 2022 was driven by the Fed’s abrupt reaction to an unprecedented surge in inflation. 2022 saw a record number of hikes in an unusually short period of time. The only notable comparison on record is 1980. But, history teaches us that Treasury volatility contracts when the Fed reaches a terminal rate. Today, the Fed has arrived at or near the terminal rate. Chart 2 identifies periods when the Fed reached the terminal rate (upper panel) and the MOVE index dropped (lower panel). Thus, lower Treasury volatility is to be expected.

Chart 2

Higher for Longer

The Fed’s near-term policy is not what’s moving long-term yields, but rather the expectation that the Fed will maintain these higher rates for longer. Consider the SOFR forward curve. The SOFR curve reflects the market’s implied forecast for the Fed’s policy rate at different points of time. In Chart 3, we show this curve over a five-year time frame – both in early March (the orange line), when the Fed was especially hawkish and messaging an incremental 50 basis hike was likely. The current curve is shown on the blue line. We can see that today’s expected policy rate over the next 18 months is actually lower today than it was in March. On the other hand, going out three to five years – today’s curve reflects expectations of much higher yields than were implied in March. What’s driving this Treasury sell-off is the market perception that, not only is the Fed less likely to cut rates in a major way next year, but it is also going to keep them higher for longer.

Chart 3

Central Banks Dovish Policy

This reappraisal of the longer-term Fed policy rate is also coupled with the fact that central banks are adjusting their policies to a still-sticky-inflation environment. Yield curves across developed economies have been re-steeping in tandem (Chart 4). Related to this, the amount of debt which is negative yielding is trending quickly towards zero (Chart 5). A steady move away from expectations of an aggressively dovish central bank policy around the world appears to be taking hold.

Chart 4

Chart 5

Slow Organic Move is More Sustainable

The key point here is that the factors driving rates are slower-moving than the recent Fed hiking cycle in 2022. If the velocity of organic forces is slower, are they any less significant? We think this year’s rate move is actually more significant than last year’s rate hike. Interest rates could remain elevated for years, with the newfound support of the central bank and the continued stubbornness of inflation. Ultimately, this adjustment is inherently a slower moving process but, if it continues to playout is a significant one that will potentially last longer. All this said, we still have to caveat for geopolitical shocks, such as what we are seeing in the Middle East, which could moderate the upward trajectory of bond yields. Since the tragic events in Israel this past weekend, 10-year Treasury yield has come in 20 basis points.

If we are correct, and rates at the longer end of the curve rise, this will have massive implications for key asset classes like equities and credit. There is a very good chance that the VIX will remain low, because of the slower pace of change, as assets are repriced.