The search for yield has, for example, sparked a significant shift down the credit spectrum. By early July, global assets in high-yield bond funds had increased 1,866% on a cumulative flow basis since January 2012, according to data from EPRF.
Tapan Data, global head of asset allocation at Aon Hewitt, believes: “Markets are very anxious about any small change in the Fed’s language. It is not just about when the Fed will start raising rates, but the reaction function to economic news. This is where the potential for a spike in volatility comes.” The Fed is very aware of the dangers of a change in its language and will want to do everything possible to ensure an orderly transition to higher volatility. However, the divisions in the Fed are already bubbling beneath the surface, which opens the door for policy mistakes.
Christopher Wood, managing director and chief strategist at CLSA, who is known for having predicted the 2007 financial crisis, recommending investors sell all exposure to the US mortgage securities market as early as 2005, says: “There are people at the Fed who are uncomfortable with QE, for understandable reasons, and want to end it as soon as possible, and there are people like chairwoman [Janet] Yellen for whom the whole issue is data dependent. This is why if the data does not improve in the American economy in the way the consensus expects, the disagreements within the Fed will be exposed.”
Wood believes US economic growth is, best case, likely to remain in the 2-2.5% range it has been in since the recovery began in mid-2009, which, he says: “is not strong enough to prompt the likes of a Janet Yellen to raise interest rates unless there is real evidence of stronger wage growth. Still the fact remains that average hourly earnings growth has yet to pick up in a material way. But if it does then the monetary tightening scare will hit markets.”
While wage pressure remains absent, Wood’s base case remains that the Fed, under Yellen, will take longer to raise rates than the market currently anticipates, “if indeed it raises rates at all,” he stipulates. “Still,” Wood continues, “if investors want to hedge the risk of a monetary tightening scare, they should hedge long equity portfolios by betting on rising credit spreads and/ or rising foreign exchange volatility.”
CATCH-22
The challenge for investors is navigating portfolios through the expected pick-up in volatility, which might be orderly or a sharp shock, and which may come soon or take a number of years to materialise. One of the best ways to protect portfolios from a potential spike in volatility is to reduce exposure to risk assets, especially where the period of consistently low volatility may have lulled them into a false sense of security in taking on more risk in the portfolio.
However, in a world of low yields and interest rates, this presents a challenge for institutions looking to meet liabilities as the opportunity cost of doing so could be significant if the rise in volatility takes a while to materialise. It would, however, pay off if volatility were to spike in the near future, for example if US wage growth picked up more than expected, prompting markets to predict an earlier move by the Fed.
Buying protection is an alternative. Holding a long volatility position is one option, but not without cost. Although this kind of protection is cheaper than in the past, it is still a potentially expensive proposition given the high cost of rolling futures and the steep nature of the volatility term structure (i.e. longer-dated volatility contracts are considerably more expensive than shorter-dated contracts that would require more frequent rolling).
If volatility takes time to materialise, these costs will mount. Although most experts agree volatility is likely to rise, they remain deeply divided on the speed and scale of change to come. Investors will have to decide whether taking protective measures are worth the associated costs.
“In the recent period of low volatility, people who have been taking risk in credit and equity have been rewarded for doing so and have thus sought to take more risk,” according to Chris Jones, managing director at consulting firm bfinance.
He adds a stark warning, however. “The world is underestimating future volatility at the moment. The smart money is using this period of low volatility to hedge at low cost.”
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