Below we draw the notable conclusions from our daily monitoring of key pricing and sentiment factors, much of them derivatives-markets based. We publish key conclusions ~monthly in cohesion with shifting conditions. Because many of our internal volatility factors shift daily, this note is intended to be a summary of process.
Observing reflation-linked performance and asset allocation through our GIP-Model lens, the move from QUAD 1 (growth accelerating as inflation decelerates) to QUAD 2 (growth accelerating as inflation decelerates), which is now in the rear view, can be directly observed in derivatives markets. We debated this QUAD ping-pong extensively in a recent note worth internalizing: Debating Inflation Hawks.
Volatility has been suppressed and contract positioning is longer across the universe of “reflation” whether we’re looking at crude oil or the Aussie dollar to name two. A key risk we’re pointing out is the high probability for pullback in inflation and its market exposures, a key attribute of the QUAD2 to QUAD1 re-shifting – the market certainly doesn’t appear positioned for the difficult comps associated with Reflation’s Peak in Q1 2017.
Here are the key flags we’re making into year-end:
- CFTC Positioning: With the exception of a small trimming w/w the net long futures & options position in crude oil is the largest ever in # of contracts and the most extended in global macro on a Z-Score basis. The speculative pool of investors has gotten longer as volatility has compressed.
- Commodity Volatility: The sharpest compression in volatility expectations over the last month has come in the commodities space - think crude oil and base metals. OVX continued to make new 3yr lows this week. In crude oil specifically, both realized and implied volatility continue to trend lower. At the S&P 500 sector level, near-term volatility expectations are actually lower in energy (XLE) than the index (SPY). “Lower” refers to “percentile” levels to normalize across markets.
- Commodity Currency Directional Tilt: Various measures of volatility surface tilts and past vs. forward-looking measures of overall volatility in our G20 currency watch point to a positive consensus view on both the Australian Dollar and Canadian Dollar.
- Sector Dispersion: The widest trending dispersion at the sector level can be observed in the most yield sensitive sectors like Utes, Staples, and Financials with the clear volatility discounts observed in the Energy sector.
- Russell Factor Performance: Although still much wider than the historical average, the spread that investors pay for Russell 2000 “value” volatility is trending at its tightest price since February to “growth” factor volatility. What were large premiums in the “value” pocket are now discounts. However, volatility expectations across Russell factor exposures continue to trend in low single digit percentiles.
- Updated Short-Interest: Outside of some minor sector rotation, 2017 has not seen been a year where total market short-interest has shifted much as a % total float. Q1 of 2016 was unsurprisingly the cycle high before spending the next year being washed out from the February 2016 low.
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CFTC Positioning
With the exception of a small trimming w/w the net long futures & options position in crude oil is the largest ever in # of contracts and the most extended in global macro on a Z-Score basis. The speculative pool of investors has gotten longer as volatility has compressed.
One trade that has now been unwound is the yield spread compression trade which peaked Mid-November when the short front-end curve trade was the loudest position among global macro consensus. The 2-10 spread has widened out this week to Mid-November levels off a cycle low of +51bps which was put in at the close last week.
Commodity Volatility
The sharpest compression in volatility expectations over the last month has come in the commodities space - think crude oil and base metals. OVX continued to make new 3yr lows this week. In crude oil specifically, both realized and implied volatility have continued to trend lower. At the S&P 500 sector level, near-term volatility expectations are actually lower in energy (XLE) than the index (SPY). “Lower” refers to “percentile” levels to normalize across markets.
Commodity Currency Directional Tilt
Various measures of volatility surface tilts and past vs. forward-looking measures of overall volatility in our G20 currency watch point to a positive consensus view on both the Australian Dollar and Canadian Dollar among others.
We show 2 different volatility factors in the visuals below:
1) Volatility Surface Skew (Multi-duration)
2) Implied Volatility (Multi-duration)
The skew readings (25-delta risk reversals) compare the cost of upside vs. downside among G-20 currencies against the USD. To use an example in the first chart below, a low percentile reading for USDCAD is the same as the high percentile reading for AUDUSD – downside protection in those two commodity currencies has gotten much cheaper. Upside exposure relative to downside exposure in the Aussie Dollar is at its most expensive point (in volatility terms) of the last 5 years.
Sector Dispersion
The widest trending dispersion at the sector level can be observed in the most yield sensitive sectors like Utes, Staples, and Financials with the clear volatility discounts observed in the Energy sector.
The visuals below compare the volatility premiums at the SPDR sector level relative to the index (ETF). Financials have been the best relative performer m/m and until this week, the outperformance was helped by expanding volatility expectations. We show a time series view of this expanding volatility below. In other words, consensus moved longer of volatility on outperformance which was probably a good short-term tailwind. Utilities and Staples are the other sectors with the widest forward-looking dispersion which is why we asked the question of a “fork in the reflation road”. This week's move in long-term yields has obviously added to this dispersion.
Russell Factor Performance
Although still much wider than the historical average, the spread that investors pay for Russell 2000 “value” volatility is trending at its tightest price since February to “growth” factor volatility. What were large premiums in the “value” pocket are now discounts. However, volatility expectations across Russell factor exposures continue to trend in low single digit percentiles.
"Valule" trading at a discount to "growth" is more in line with history, with Q2/Q3 2017 being the widest-ever anomaly.
Another key call-out with regard Russell factor dispersion is the return to large-cap “growth” favorability. It’s the one exposure where implied volatility trades at a relative discount to realized volatility. Although again we're talking about minor shifting in volatility within a very low vol environment for the Russell - things could change quickly from the givens. See our Russell Performance & Factor Dispersion Scorecard below for the numbers.
Not surprisingly, this volatility compression in the Russell 1000 "growth" index/ETF comes on the back of the best relative performance over the last month within Russell factor exposures, bringing the “growth” outperformance to “value” in the Russell 1K at +~1800bps YTD. This factor outperformance is greatest at the Large-cap threshold.
Updated Short-Interest
Outside of some minor sector rotation, 2017 has not seen been a year where total market short-interest has shifted much as a % total float. Q1 of 2016 was unsurprisingly the cycle high before spending the next year being washed out form the February 2016 low.
Again on the topic of energy, it’s the sector that has seen the largest decline in short-interest over the last 3 months.
Short-Interest in Consumer Staples has increased most over that same time period.
Ben Ryan
dty
