Yesterday, we showed that after a September with the lowest implied vol on record, October is starting off with the lowest (annualized) realized vol on record.
Of course, as we have shown previously, when looking across capital markets, it’s not just equities: vol has dropped to all time lows across virtually every asset class.
All of this should be familiar to readers who have been observing the effect of central bank liquidity injections across markets. What may come as a surprise, however, is that according to a new analysis by Bank of America, the standard deviation of global growth is the lowest it has been in decades at the same time growth is accelerating. In other words, as the bank describes its “chart of the day”, variability in GDP growth across countries is at the lowest in 50 years, or stated simply, the volatility of the global economy has tumbled to all time lows.
The chart above has major implications not only for collectors of correlations (maybe market vol is low because economic vol is low or vice versa), but for analysis as well. As BofA’s Shyam Rajan explains, much of the last four years has been spent debating relative growth differentials and policy divergence. This has been apparent not only in the G5, with the US leading its counterparts, but also within EM. This differentiation in growth led to the dominance of two investment philosophies:
- (1) on the macro front, FX was in the driver’s seat driving most asset classes and
- (2) on the flow side, crossover foreign demand drove domestic bond markets, both government and spread markets (corporates, mbs, high yield etc).
However, with the collapse of cross-economic variability, this shift reverses the above two trends: it moves the global growth trade from FX to rates and dramatically slows crossover foreign demand.
More ominously, with yet another vol collapse and a resulting “coiled spring” mean reversion potential, it also raises the risk of a synchronized rise in bond yields driven both by global central bank expectations and rising term premia.
In BofA’s view, it is the chart above, and the associated implications, that explains market moves since September: higher global yields, muted reaction in the USD and selling by Japanese private investors-mark the start of this transition.
So what are the practical, trade implications of a variability collapse that has not only “flatlined” vol across capital markets, but global economies as well… and just what really happened at the Shanghai Accord in early 2016?
Here are the full observations from BofA:
Multi-speed cacophony to…
Global growth over the last few years has been dominated by isolated bright spots and idiosyncratic problem stories. The US has led the way within the G5, Europe/Japan have been noticeable laggards and UK/Canada have been dealing with domestic shocks (Brexit and oil prices). Similarly in EM, better growth in India and sideways growth in China has been met with increased political risk in Brazil and risk from commodities to Russia. This multi-speed global economy has helped fuel two major investment philosophies
- On the macro front, it exaggerated central bank policy differentials (Chart 1): making FX and front-end rate differentials the easiest expression of macro views.
- On the flow side, crossover demand from foreign private investors given interest rate differentials became the single largest theme driving both Treasury yields and spread product such as corporates. Nearly every story on flow since the end of Fed QE has focused on Japanese and European demand for US fixed income assets.
… a perfect symphony
However, this is set to change, in our view. Our Chart of the day plots the standard deviation of global real GDP growth across 45 countries. According to current forecasts, 2017 is set for the lowest variation in growth we have seen across countries in the last 50 years. Even on a rolling three-year basis (Chart 3), variability in global growth is dramatically lower than the usual 2.5-3.5% range. Note this also holds within different aggregates. Standard deviation of growth rates within the G5, the Euro area and within APAC have all been declining recently (Chart 4).
While lower volatility in growth is in itself good news, the real shot in the arm is that this is happening at a time when global growth projections and leading indicators are improving. As Table 1 shows, September 2017 saw a clean sweep for manufacturing PMIs across the world with every major country comfortably above 50.
What does this mean for macro trading?
To us, the conclusions from the lower variation in global growth are as important as the direction of global growth.
- From FX to rates: Ultimately, synchronized global growth coupled with low volatility across countries reduces the focus on rate differentials and raises the risk of coordinated moves in central bank policy (as fears of unwarranted FX appreciation and its negative feedback reduce). In this regard, the BoC hikes, upcoming BoE and Fed hikes and expected ECB taper decision all within the span of a few months stand as evidence. It also challenges the consensus view that low levels of global bond term premia are here to stay. The trade thus moves from being led by FX (driven by policy differentials) to outright rates.
- From foreign demand to domestic: Second, it also nullifies the argument that a domestic yield rise will be met with increased buying from foreign investors (specifically Japanese and European). Foreign investors looking to add duration would likely stay on their sidelines as even their respective bond markets reprice. If anything, losses on domestic portfolios could motivate selling foreign bonds to protect accumulated gains over the last few years.
The proof in the September pudding
September already stands as evidence for the start of this price action, in our view: (1) major countries saw a coordinated rise in yields (Chart 5); (2) while the dollar rallied it was a rather muted reaction given around a 30bp increase in yields; and (3) recently released data suggests Japanese investors did not step in at higher yields and in fact sold bonds-they sold about 11bn foreign bonds in the last week of September alone. If growth momentum sustains, all the above raises the risk of a synchronized move up in global bond yields driven both by central bank expectations and term premia in the months ahead.
To this all we add is that when central banks – all of them, across the entire world – are collectively injecting trillions in liquidity, during the so-called year of the “coordinated global recovery”, it appears that one should expect not only a catatonic market with no vol, but a uniform global economy with little to no variability, in which the new endogenous liquidity lifts all boats at the same time.
The real question, as Deutsche Bank’s Alan Ruskin asked this morning, is what happens when the liquidity starts getting drained…
…. as will soon be the case. We should have the answer in less than a year, which is when the current $2 trillion/year increase in central bank balance sheets fades to zero.