Reflation Reset? ... Growth vs Reflation vs The EU Implied Vol Bonanza

One of the themes in our Q1 2017 Macro deck was Reflation’s Peak. It wasn’t overly complex – it was largely just a base effect dynamic given cycle low commodity prices in Q1 of 2016.

It played out in near textbook fashion.

With positive price momentum and declining volatility, net long futures and options contract positioning showed investors firmly behind the reflation trade.  Indeed, just a month ago, 6 out of the top 7 most extended net futures and options positioning were in commodity contracts (“Extended” on a Z-score basis).

Pricing The Peak

Unsurprisingly, as the market began to price in the reality of Reflation’s Peak, both price momentum and sentiment have come under pressure.  

Moreover, alongside that repricing in reflation expectations, shifting sentiment around European event risk helped amplify the recent dollar & rate weakness and, collectively, have seemingly overshadowed the positive inflection in domestic growth. 

In other words, U.S. growth accelerating as inflation decelerates in Q2-Q4 (QUAD 1) looks supportive of the U.S. dollar and higher interest rates, but Europe remains a major factor.

To quickly review the broader setup. 

Last week, in detailing the stalled progression of the reflation narrative, we summarized the factor flow as follows:  

The expedited repricing of the growth outlook drove crowded positioning in reflation exposures => the market began to price in Reflation’s Peak as we traversed trough energy comps in 1Q => Le Pen’s odds rolled over, the Euro got a relative bid, German yields moved up, US-German spreads tightened => Euro strength, improving yield differentials, and a “dovish hike” put some short-term pressure on the USD and US Treasuries ….  => Oil weakness and rising concern around the prospects for health reform (and its impact on the tax reform/fiscal stimulus timeline) add further angst around the base reflation narrative. 

And here we are.  

EURO Net Short Positioning = 3 Yr Lows

The latest CFTC data offered further confirmation of the influence of shifting Eurozone sentiment (vis-a-vis rates & $USD) as Euro net futures and options positioning increased +20K contracts w/w to net short -18K contracts. This is a 3-yr low in the net short position and shows this positive shift on the margin that has pressured the U.S. dollar. There hasn’t been a net long positioning in the Euro since beginning of May 2014 before the U.S. dollar started its major bull run, but now it’s close. The market moved shorter of British Pounds w/w to a new record net short position – the negative bias on the POUND remains firmly intact.

EUROPE | IMPLIED VOL BONANZA

While relative FX and sovereign spreads show that risk has shifted to less negative across Europe, one dynamic that has been pervasive over the last month (and we believe it is political event risk driven) is that premiums paid for insurance in major European equities continue to get more expensive. It’s hard to argue the negative sentiment in Europe across equities and FICC is washed-out. We observe this perceived equity market risk in implied volatility spreads….

Implied volatility continues to diverge from recent market trends. We track this daily, over multiple durations using a factor we call the “implied volatility premium.” It compares the difference in at-the-money put implied volatility on a contract that expires in the future to realized volatility over that same duration looking backward (implied on a 60D expiry vs. realized 60D vol in a security for example).

If you back up exactly a month, European equities screen with the most extended implied volatility premiums in the world across asset classes. These premiums have moved even wider currently. So while implied volatility premiums show marginal risk being priced increasingly higher, the major European indices have outperformed. The “implied volatility premium” factor is one we use as a consensus view on forward risk. We show this dynamic in a series of charts below.

1. Implied Volatility Expansion (1^st & 2^nd Charts):  The major European equity indices have seen the largest expansions in volatility expectations. The first table shows the pop in implied volatility across European tickers w/w. In the 2nd chart we show a long time series of this premium expansion in the FTSE 100, DAX, and CAC40.
2. Relative Implied Volatility Premiums (3^rd & 4^th Charts): On a sigma basis, implied volatility’s divergence from realized volatility is most extended in the world based on TTM and 3-Yr Z-score analysis
3. A Full Circle Look (5^th chart): We use the example of the CAC 40 Index to show a multi-duration view of the change in the implied vs. realized relationship. The table has red boxes to direct your attention to the fact that as realized vol has moved tighter vs. 1 and 3-Mth averages, implied vol continues to expand over realized volatility. For example, at-the-money put implied volatility on a contract that expires in 60 days on the CAC 40 trades at 18.8 implied volatility which is now a +92% premium to realized 60 day volatility. Again this premium expansion over the last month has come as European equity indices have outperformed U.S. equities.

REFLATION RESET

In short, what we have at this point is a bit of a cross-asset class reflation expectation reset.  Spec positioning in small cap domestic growth is back to net short, EM currencies have fully retraced their post-election weakness, Commodity/Industrial exposures are underperforming, cross equity and cross asset correlations have decayed, cross currency basis swaps are as tight as they’ve been in a year and the Euro & Yen are flirting with pre-election levels.  

As we see it, there a couple primary implications:

• Growth:  A correction in overextended reflation positioning alongside a positive shift in sentiment around EU political risk and a (overdue?) negative discounting of domestic policy expectations positions the fundamental data as a more central driver. With an expectation for growth to accelerate and inflation to slow, we continue to like Quad 1, real growth levered exposures such as Consumer Discretionary, Tech, and Healthcare from a sector perspective. 

• Reflation:  That momo in inflation expectations began to ebb and commodity related reflation exposures came under pressure as the market more thoroughly considered and priced in Reflation’s Peak hasn’t been particularly surprising.  It’s also why we haven’t been buying Energy/Commodities/Industrials on down days.

Christian B. Drake

@HedgeyeUSA

Ben Ryan

dty