Why markets are like a duck: “calm above the surface, but furious churning below”
Mario Draghi celebrates compared the euro to a drone; Morgan Stanley analysts say global financial markets remind them of a duck: “calm above the surface, but furious churning below.”
The calm is reflected in a continued decline in realized or actual volatility in equity markets as global stocks hit all-time highs. Analysts, led by Andrew Sheets, observed in a Friday note that month-to-month realized equity volatility in the United States, Europe and emerging markets fell to the 25th percentile of the past 15 years.
But beneath the surface, “volatility has jumped” for other assets, they wrote, unveiling a new cross-asset gauge, dubbed the Sigma Composite Indicator, which hits its highest level in five years at the time. except for the turmoil induced by COVID. the second quarter of 2020 (see graph below). This reflects an increasing number of extreme movements over a day, defined as a standard deviation greater than 1.5.
Morgan Stanley Research
Anyone who has paid attention to the U.S. and global government bond markets over the past few weeks probably won’t be surprised to learn that the rate markets are at the heart of these moves. Indeed, the Composite Sigma indicator was influenced by extreme movements in yield curves; break-even inflation rates, which measure the difference between inflation-protected debt and nominal debt of the same maturity; and 2-year rates, analysts said.
Short-term government bond yields, including those on 2-year US Treasury bills TMUBMUSD02Y,
started a sharp rise in September as investors began to take a more aggressive stance from global central banks in response to inflation that turned out to be more persistent than expected. The spread between short-term and long-term returns has narrowed significantly, a yield curve phenomenon known as flattening.
The speed of movement has been interpreted by some investors as a potential harbinger of a “policy error,” in which central banks trigger an economic slowdown by tightening too aggressively. The moves also caught investors off guard, leaving some high-profile hedge funds with large losses in October, according to the Wall Street Journal.
Earlier: Hedge funds take heavy losses amid Treasury bets ahead of Fed cut, traders say
Two-year rates in Poland, meanwhile, rose 85 basis points, or 0.85 percentage points, a 12.2 sigma spread on the distribution of weekly rate movements, analysts noted. The UK has experienced “extreme dislocations” with rising short-term rates and falling long-term rates, while in commodity markets iron ore prices have fallen by 20%.
Related: Powell leads markets thanks to Fed move as international counterparts struggle
“Rates are the only driver of this movement, while other assets are exceptionally calm. Managing the risk of global rates is very different from dealing with stocks or currencies before the end of the year, ”the analysts wrote.
Stocks stumbled in September, but major indices roared in October and continue to hit all-time highs this month. The S&P 500 SPX,
was up 26.9% year-to-date through Friday, while the Dow Jones Industrial Average DJIA was up 21.2% and the Nasdaq Composite COMP,
advanced 23.9%.
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So what does all of this mean? “This suggests that the liquidity environment is already changing, although it is not evident in the S&P 500,” they said.
It also means that the risk premium is significant (see graph below).
Morgan Stanley Research
“Many of the markets with the biggest recent moves were the ones with the quieter environments. As idiosyncratic risk increases and risk management becomes more difficult, we see opportunities in markets with high versus low risk premiums, ”they wrote.