On September 12 at the 7th Annual Cboe European Risk Management Conference (RMC), presentations on  The Interest Rate Volatility Environment - Can Rates Volatility be the Next "Safe-Haven"?  were delivered by two experts - Yoshiki Obayashi, Head of Research, Applied Academics, LLC and by Kokou Agbo-Bloua, Managing Director, Global Head of Flow Strategy & Solutions, Société Générale.

Topics covered in the presentations included:

  • What drives rates volatilities and what do long-dated and short-dated interest rate volatility measures tell you about the state of markets
  • Macro, structural dislocations and trigger points
  • Long vol with a positive carry: tactical vs. systematic solutions
  • Equity/bond correlation instability as the Achilles heel of multi-asset portfolios
  • Hedging the very steep "illiquidity skew" with cross-asset volatility

TYVIX INDEX

The Cboe/CBOT 10-year U.S. Treasury Note Volatility Index (ticker symbol: TYVIXSM) uses Cboe's well-known VIX® Index methodology to measure a constant 30-day expected volatility of 10-year Treasury Note futures prices, and is calculated based on transparent pricing from CBOT's actively traded options on the T-Note futures (www.cboe.com/TYVIX).  The historical patterns of TYVIX in many cases exhibit upward spikes when 10-year Treasury note and futures prices experience large swings, especially on downswings.

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Drawdowns in the IEF 7- to 10-year Treasury bond ETF often coincide with spikes in the TYVIX Index.

ASYNCHRONICITY OF BUSINESS CYCLES

  • Business cycles around regions are asynchronous with diverging velocity as they are heavily influenced by the timing and magnitude of monetary and fiscal policies
  • Europe is now entering the re-leveraging phase where corporates and households are likely to re-engage in balance sheet re-leveraging (after a long process of balance-sheet repair.
  • The U.S is already in the late cycle with balance sheet re-leveraging taking place via debt-funded share buybacks (e.g., ‘Equity Easing’)
  • Corporate credit quality usually worsens at this stage of the cycle

VOLATILITY RISK PREMIUM

Regarding interest rate volatility, most of the time implied volatility (as measured by TYVIX) has been higher than realized volatility.

HIGH VOLATILITY OF VOLATILITY

While seeing the levels of the TYVIX Index, some people wonder if the TYVIX could have big moves. The TYVIX had some big moves (in percentage terms) -- here are the levels of past volatility of volatility cited in the presentation:

  • 131% - VIX Index
  • 126% - JGB VIX Index
  • 71% - TYVIX Index

VOL ROLL ON RATES (VRR) STRATEGY

Unlike most asset classes, the USD Rates Volatility Term Structure is inverted. Furthermore, the combination of the macro and technical factors that have driven volatility to its current lows is coming to an end. The VRR Strategy (Vol Roll on Rates) is a systematic investment strategy that takes advantage of this “backwardated” shape of the USD Volatility Term Structure to generate persistent positive carry from: Buying “cheap” forward volatility using simple ATM Swaption Straddles on the expiry/tenor with the highest expected carry.

The VRR Strategy offers a unique combination of diversification features vs. traditional and Risk Premia portfolios:

  • A generally persistent positive carry
  • A low correlation to traditional asset classes and risk premia in a normal regime
  • A risk-off profile in stressed scenario

CONCLUDING REMARKS

  • The Credit Cycle clock is ticking with a probable global growth slowdown in 2019 and 2020.
  • “Low volatility is inherently destabilizing” - Hyman Minsky.
  • Corporate balance sheets are over-levered, particularly for small caps, making them highly vulnerable to higher rates.
  • Higher volatility in equity/bond correlation could trigger a regime change and cause more P&L volatility for asset managers as QE ends.
  • Equity/bond correlation has been and is likely to become more volatile going forward.
  • “Liquidity skew” and gap risks seen in 2018 (VIX, BTPs) make fixed-income hedging a key priority for asset managers, as banks are no longer providing liquidity because of regulatory constraints.
  • Great opportunities for rates volatility or forward volatility as long vega strategy with positive carry and portfolio diversifiers or safe havens.

MORE INFORMATION FROM CBOE

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