Time to hedge against a (second) equity sell-off?

Yvan Berthoux - 4 April 2019

After the aggressive equity sell-off we experienced in the last quarter of 2018, equities have catapulted higher, recovering almost all the lost ground. The S&P500 index was up by nearly 13 per cent in Q1, registering its strongest quarter since Q3 2009. However, many participants are unpersuaded by the recent rally as corporate margins look set to decline and leading indicators point to a weakening of global economic activity. As the S&P500 slowly approaches its October high of 2,925, is now a good time to buy volatility in anticipation of a sudden sell-off?

The last two weeks of March were marked by an interesting development in markets: the inversion of the 3M10Y US yield curve for the first time since July 2007. Even though the prolonged period of low interest rates in the past decade have challenged the reliability of the yield curve as a predictor of recessions, it is still an important behavioural indicator of the current global sentiment on expected growth dynamics. Figure 1 (right frame) shows that a negatively-sloped yield curve tends to be followed by a significant increase in implied equity options volatility (VIX) over the following 2 years.  

Figure 1

Data Source: Eikon Reuters

In addition, although global uncertainty has eased in recent months according to the EPU (Economic Policy Uncertainty) index, it is still pricing in a much higher VIX in this current climate according to figure 2 (left frame). We know that one of the main reasons why equity market reversed in the beginning of the year was due to the Fed pivot, with Chairman Powell drastically changing his guidance on the level of short-term rates, switching from ‘a long way from neutral’ in his October speech to ‘appropriate stance’ in his post-meeting conference remarks in late January. Moreover, US policymakers guided market participants towards the curtailment of quantitative tightening (QT) and eventually announced the end of balance sheet shrinkage program in September. This action removed the uncertainty around the threat of excess reserves held at the Fed falling below the ‘fortress level’ of US$800bn, bring cheer to US and global equities. However, figure 2 (right frame) shows that despite the recovery in stocks this year, market participants are still pricing in at least one cut by December 2020, with the Dec20-Dec19 implied Eurodollar yield curve trading at -30bps.

Figure 2

Data source: Eikon Reuters, Baker et al. (2016)

Another indicator that raises doubt about the health of the equity rally is the unresponsiveness of risk-on assets such as the Aussie Dollar and the lack of improvement in long-term Treasury bond prices. Figure 3 (left frame) shows that while the SP500 surged from 2350 to 2875, AUDJPY has remained steady oscillating between 77 and 79. The 10-year yield on the US Treasury currently trades at 2.51 per cent, which is still 70bps lower than the early October levels.

High frequency US economic indicators data have disappointed since the start of the year, with the Citi Economic Surprise index down from a high of 70 in early January to -45 this week. Even though annualised real GDP growth is still expected to print between 1.5 per cent and 2 per cent in the first quarter of this year, according to the Blue Chip consensus, it seems that the bond and short-term interest rate markets are pricing in a further deterioration in US and global economic activity in the next few months. With the VIX now back to 13, this seems an opportune good time to be positioned for rising volatility.

Figure 3

Data Source: Eikon Reuters

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