The Quantum of Finance

Market professionals and private investors alike are struggling to come to terms with the ongoing fallout from the introduction of negative interest rates, by both the BOJ and ECB. Longstanding market relationships and correlations have been swept aside or turned on their head, by the introduction of this most unconventional of monetary policy tools. And it remains to be seen if these polarisations are temporary in nature or are here to stay for the foreseeable future.

Let’s examine some of this strange behavior and see if we can learn anything from it or perhaps find that have we entered a world akin to quantum physics, where nothing is at seems and where certainty has been replaced by best guesses and probabilities.

Let’s talk about Volatility

Over the past 20 years or more we have become used to the idea that the VIX index (which measures the implied volatility of options on the underlying constituents of the S&P 500) could be interpreted as a measure of fear in the markets. Greed was represented by low levels of volatility in a rising / trending market. Whilst fear showed its hand in elevated levels of volatility and was often described by sharp spikes in the VIX chart, as investor confidence faltered or crisis emerged.

Post 2008/9 the sensitivity of the VIX was, to an increasing extent, diluted by a plethora of ETFs & ETNs on the index. This dilution was compounded by the introduction of additional volatility metrics and futures contracts thereon and further by US QE and zero interest rate policies. Easy money and a perpetual buyer of financial assets (the Fed) effectively creating a one way market.

New normal

We grew used to this new normal, which was occasionally interspersed with volatile episodes or “flash crashes”. For example those seen in October 2014 and in July and August of 2015. The VIX responded on these occasions, but only briefly and it rarely troubled levels above thirty.

In 2016 however things changed once more. Historically in risk on markets, in which investors are greedy rather than fearful. Volatility indices such as the VIX would retreat and risk adverse assets such as government bonds would fall in price, as investors moved their money into assets that offered both higher risk and higher return.

But if we look at the chart below we can see that since mid-February 2016 that relationship has gone out of the window completely. German 5 year bond Futures or Bobls have risen back towards their recent highs, even as the VSTOXX, a measure of volatility in leading European equities, retreated sharply. A negative return on cash, under zero interest rates, is likely driving money into near cash assets such as German Government bonds, which to begin with at least, offered a positive or less negative return than cash.

Chart shows the VSTOXX Index vs 5Yr German Bond Futures.

Un-level playing field

And yet at the same time as the VIX and the VSTOXX continue to retreat from their New Year spikes other measures of volatility and risk appetite are behaving in a completely different way.

If we look at volatility in Forex markets we find that unusually the market is more concerned over short term i.e. three month risk, than it is over longer durations, of say 12 months or more. The curve is said to be inverted or if you prefer protection against that short term volatility is more expensive than that for a longer duration. We have not seen this situation since 2010, when Greece teetered on the brink of economic collapse and concerns about the very future of the Euro seemed well founded.

Crisis what crisis

Whilst we don’t face an existential crisis on the scale of 2010 the current geo political and economic situation is not without its own headaches. These include the Brexit referendum, perceived instability in Spanish politics and a banking sector in Italy that requires continuing triage, as well as the unresolved situation in Greece.  Not to mention the Syrian civil war and its ensuing migrant crisis. To say nothing of the US presidential election, China slowdown, Japanese stagnation and weak Oil prices etc.

The chart below plots 3 and 12 month volatility for both Sterling and the Yen and exemplifies the strange behavior we described above. In both cases three month volatility expectations have exceed that over 12 months, which we would normally expect to be higher. Because of a lack of visibility over that term. Commodity currencies such as the Canadian and Australian Dollar have also exhibited this unusual trait in recent weeks.

Charts shows 3 and 12 month Volatility expectations in JPY and GBP

Dig a bit deeper

We can look at the behaviour of Forex volatility over the longer term in the next chart (courtesy of @johnkicklighter). This chart plots yields on the bonds of countries that have implemented QE and overlays this with mid term FX volatility. You can clearly see  a historical relationship and then a change in behavior. But on this scale, using these metrics we can actually trace the change back to March 2015. Which would would suggest that the behaviour we have described above is part of a larger, longer term and as yet unexplained phenomenon.

QE exposed bond yields versus mid term Forex volatility

Spooky action at a distance

Finally let’s compare the VIX to an alternative measure of volatility or if you prefer fear and greed. Because in the end it is those basic animal spirits or emotions that these gauges attempt to measure (albeit through the medium of some quite complex financial markets and products). In essence these measures attempt to distill market sentiment down to its fundamental components, which of course is the very definition of the quantum.

This last chart, above (courtesy of Credit Suisse and Bloomberg) plots the VIX against an alternative measure of fear, which is calculated by the Swiss investment bankers. Who monitor the cost of buying downside protection or Put options on the S&P500.

More specifically they measure the deviation in what we might think of as a “free lunch” i.e. at what price or strike can investors buy put options, on the S&P 500 and sell calls, for no difference in premium (remember that a trade that is long put options and short call options creates a synthetic short position in the underlying instrument).

In effect the Credit Suisse fear indicator acts like a set of old fashioned kitchen scales, trying to find the equilibrium point in the market, as loads are added or subtracted, on either side of the balance beam.

In the last week this indicator has been skewed sharply higher (see the blue line above) in fact it’s moved to the highest level since its inception in 2011. At the same time however the VIX itself has continued to move lower. In essence then we have a mismatch between a classical theory and observation of what’s happening on the ground.

To my mind this has striking similarities to the situation in physics research in the late 1920s and early 1930s. When the findings of researchers and theorists in quantum mechanics clashed with and in fact directly contradicted the orthodox / classical theories of the period. In that case the quantum view won the day.

That is a concern because as Niels Bohr, the father of quantum mechanics, said “Anyone who is not shocked by the quantum theory doesn’t understand it” that sentiment was echoed by charismatic US physicist and Nobel laureate Richard Feynman in his famous comment that “if you think you understand quantum mechanics…. then you don’t”

Uncertainty looks likely to be the dominant characteristic of both physics and the markets for some time to come then.

This is a guest post written by Darren Sinden, an analyst at Admiral Markets