Category Archives: Market Risk

What is the Fed Telling Us ?

Well yes it is FOMC time again and its seems to me that it is all dovish again and that definitively the Fed will stay behind the curve as long as is needed to have 100% certainty that when they hit the brakes they will not send the economy back into a tailspin ..However this still plays well into my scenario of a forthcoming bond crash as in doing so they will leave ample time for investors to front run them when time comes to take this liquidity away (My next post looks at the ICI latest data release on US Mutual funds flows, so watch out…)…all this seems very bullish equity and bearish dollar if you ask me….but you may have already read my previous posts …anyhow I though I would try to go quantitative on the Fed semantics and try to see if we have any notable changes in their wording by creating a word cloud for their July release versus this September. Basically the script looks at the frequency of each words in the release and scale those words accordingly to the observed frequency. So the more repeated the word the bigger it is represented in the cloud. As you can see from the below it does not seem to be any material change…..same all same all….this monetary policy is not about to change…..

July release September release

Time to Think FX…

It seems that the risks flagged for September are slowly vanishing and that the risk agenda is now relatively clear for the remainder of the year. Syria is still a concern but there is now a possible alternative to a direct military intervention which is somehow good news. The German elections are nearing and though some uncertainty remains as highlighted by recent surveys, Merkel remains the likely winner. Of course there is the Fed meeting on the 17th & 18th and the market eagerly speculating on the semantics of the Fed communique. Tapering or business as usual ? My thought is that all this is overblown and that we have been given a clear path of what will be the Fed monetary policy in the forthcoming cycle…so no real tradable surprise…Anyhow the equity market is taking this pretty well so far as reflected by last month performance and the low level of risk implied by the VIX. So business as usual…long those equity betas and short bonds….

FX market have been correlating fairly well with the equity market and we have seen commodity currencies recovering significantly over the last few sessions . Also the Yen carry trade still in favour with USDJPY breaking the 100 level. That being said most of the currencies have remained within statistically normal boundaries as indicated by the below charts which show the current T-Stats for major dollar crosses and also their rolling 3-month T-Stats relative to a 95% confidence interval.

The below charts shows the sensitivity of the BTOP FX to major dollar exchange rates and therefore and idea of the portfolio content of most FX managers. The USDJPY seems to be the trade favoured by the speculative community as well as dollar long generally speaking. Maybe more interesting is the second chart that shows an estimate of the leverage used by the FX managers peer group. It is derived by comparing the variance of the BTOPFX index and the Variance of the estimated sensitivities for an unleveraged portfolio.

Overall the level of positioning seems to be pretty average by historical standard. This lead me to think that there are still some good opportunities left in FX going to the end of the year. Assuming that no event comes to spoil the party I would hope to see a continuation of the recent trends…namely a sell off of the dollar as US investors focus on international opportunities and more upside in yen crosses as they re-leverage…that being said I probably would remain cautious on outright long USDJPY due to the current positioning and equity flows potentially weighting on the Greenback…

Quick Update on US Mutual Funds Flows…

Ok I have to admit last month was not as rosy as the previous 9 months if you invested in equity markets, but clearly this is not a disaster unless your time horizon is that short.

The good thing is that despite the short term underperformance of stocks the appetite for global equities and the hatred for bonds is relentless as seems to indicate the latest release of the ICI data.

Bearing in mind the overall size of the US Mutual Funds market and the outstanding disproportionate bond holdings this should be comforting to the equity bulls. Even more comforting is that all my equity risk metrics and my regime switching model give a green flag for holding equities.

Of course there is Syria, the forthcoming discussion (or speculations) of tapering at the September Fed meeting as well as the German election to potentially exacerbate financial markets risk premium. However September is generally a month where liquidity comes back and this tends to dilute market risk….my bet is for a good old fashioned year end rally…sit tight !

Bond Managers , Tin Hat on Please !

Ok the latest ICI data on US mutual fund has just been released and guess what ? moms and pops are still selling bonds like it is going out of fashion and buying equities like there is no tomorrow. Hence the red squares on my chart that shows the T-Stats of the inflow/outflow for each asset buckets over diverse time horizons. …and yes those 10 year bond yields are still going higher and further incentivising the laggards to come out of their bond holding….

To the risk of repeating myself we all know that there is a massive overhang in bond holdings, so my contention is that we may have entered a spiral and that somewhere on the line we are going to see a repeat of 94…..a good old fashioned bond market crash….

Meanwhile as we gathered from the Fed minutes everyone is getting very cagey about mentioning when they will start tapering (or is it tampering…) ….looks like the street is about to dictate the Fed monetary policy by jettisoning those low yielding assets for something more sexy…..

Is This What We Have Waited For ?

The answer seems to be yes as far as what took place in June. This is the start of a proper bond bear market, thank you Mr Bernanke. When one looks at the June data on outflow / inflow in US mutual funds just released by the ICI it becomes obvious that we are not dealing anymore with ordinary moves. The outflow in taxable bond funds was similar in term of intensity to what we observed in equity funds in October 2008. There is a smell of panic amongst bond investors and with good reason, the remaining inventory is massive and the gate is narrow. The guys at PIMCO would know about it as they had an estimated US$ 10bn outflows last month. What is quite exciting about all this is that we have seen some inflow in international equities over the same period. This clearly looks like the onset of the shift in asset allocation I have been so fond of over the last year and half (see my previous posts). Anyhow I thought I would display my usual charts….please look away if you are still overweight bonds…

The above charts shows the monthly inflow outflow in US mutual funds. The chart on the left plot the data relative to its long term median and 95% up/ interval of confidences. The data for bond is way out of scale. The chart on the left shows the T-stats of the inflow/outflow (i.e. how significant they have been) over various time period. Despite the recent inventory adjustments bond holdings still remain very rich which would indicate that there is further room for a significant sell off in fixed income unless the Fed shy away from its view on tapering, better watch this job data then…..

The charts above shows the outflow/inflow relative to the VIX. We have not seen much increase volatility in the equity markets, the VIX averaged 17% in June. We just had a minor outflows in US equities but also interestingly a notable inflow in both hybrids and international equities….This looks like the onset of an asset allocation shift to me. Finally it may be worth to start mulling over what would be the effect of further significant investing in foreign assets by US investors on the strength of the US$…..

Risk On Risk Off….

Ok despite a down session in Asia and in Europe so far this morning it is fair to recognise that the stock markets have somehow recovered over the last few sessions. I thought it would be a good idea to look at my Markov model to see in what market state we are now. I use the VIX as an input.

An yes it has been risk on since the 26h of June……bearing in mind the typical duration of 21 days of the “Risk On” state July should turn out as a good month unless atrocious fundamental data hits us…..

US Mutual Funds Flow Survey

Ok yesterday’s call on the VIX was great , no need to say thank you. Anyhow I thought it would be timely to look at the Investment Company Institute data and that it would be interesting to visualise the data and to look at the effect of risk on investors preferences for the assets classes in time of market stress. The following show the inflows/outflows in bonds, equity and hybrid US mutual funds. Quite clearly Mr Bernanke speech dented the appetite for bond products but despite appetite for equity product abating it did not really substantiate significant outflows there. The charts below show the monthly inflows / outflows relative to their median and a 95% interval of confidences. The charts on the right just give a distributional representation of the monthly data.

The chart below shows the T-Stat (i.e. the level of significance) of the inflows across 4 different time periods. The outflows in bonds switched to negative over the last 3 months but equities and particularly holdings in international have hedl well.

In the below I used a bit of code wizardry to look at what happen when market risk increases. I use the VIX as my risk metric. When markets went “postal” in October 2008 it was quite clear then US equities suffered the most outflows but the bond market remained quite resilient as the fed came to the rescue.

Clearly the financial volatility has not reached levels experienced in the last quarter of 2008 and there is clearly no dislocation of the financial system this time. So no reason to panic. The chart below shows the Bonds were the main recipient of the market aversion but all this is very tame by any means.

My thought is that as the market normalise and comes to terms with the Fed policy we will see further sell off in the bond markets and that the proceeds will be reinvested in the equity markets as the shift in the Fed monetary policy will be driven by better economic fundamentals….no need to go into cash this time….

Is it armageddon yet ?

There is a smell of burning coming back to the financial markets. It seems that yet again the market has decided to focus its attention on the likelihood of the Fed tapering down the stimulus it provided. We are now all waiting for the dreaded NFP release again. But hold on a moment ! where is the logic behind all of this sudden short-termism embraced by market makers and speculators? Surely the FOMC has better and more real time access to economic data than we have ? if they decide to taper down it is likely that their view is that the economy is improving. Surely things are getting better, At 7.5% the US unemployment is at its lowest in the last 4 years and exporting companies have thrived on a weak dollar . True the last few days have been a bit incisive for any equity portfolio but overall the year to date performance remains excellent.

1-month performance of global equity markets

6-month performance of global equity markets

Personally I would not bet on one Non Farm Payroll data release influencing the FOMC decision one way or the other nor on them withdrawing all of the liquidity provided too quickly. The approach will be gradual. Of course there will be worries of the markets front running the exit and ensuing serious fall out in the bond markets but central bankers have been very resourceful at finding ways of controlling markets exuberances. It seems to me that all of this should not be a surprise as it has been already widely and openly debated. What we observing is rather more likely to be a case of the market going in summer mode to take a few Bulls out for a ride. In those moment of frenzy I like to look at some quantitative risk classifiers rather than focussing on the flurry of headlines of journalist and analysts who are paid by the line. The level of implied volatility in the equity market as express by the VIX, sometime labelled the fear Index is a good start but it does not give us the full picture. I tend to prefer to look at the volatility of the VIX itself as a measure of (un)stability of the perception of risk (I.e how volatile and unpredictable the risk itself has become). Finally the ratio of the two (VIX Volga / VIX) which I label the shock index is also a good measure as it expresses how quickly the risk has become unstable over a window of 21-day. The chart below shows these measures and also frame them within their historical distribution.

So far it does not seem that the market is behaving in a dislocated way…..I ll hang on those long equity positions for a while then…