One of our key interpretative points was to place emphasis on what appeared to be a contradiction between the significant event risk here in Q4 and the low implied volatility in the capital markets, in particular the S&P 500, the euro and yen at the start of the quarter. We expected the contradiction to be resolved in the favor of greater volatility.
Even if one does not trade options or pay much attention to volatility this insight is important because there seems to often be a directional bias to volatility. For example, the volatility of the S&P 500 tends to rise when shares are falling.
The currencies are more complicated. However, our work led us to believe that an increase in implied euro volatility was more likely to happen as the euro declined. Similarly, we had anticipated implied yen volatility would more likely rise as the yen strengthened.
The S&P 500 peaked on Sept 14 and has been moving lower it a saw-tooth pattern. On Wednesday, it closed below 1400 for the first time since early August. Implied volatility bottomed in early October near 13.7%. Now it is near 19%, near a four-month high.
Implied yen volatility (three-month) bottomed on October 10 near 6.55%. It recently traded as high as 7.75%, but has since pulled back toward 7.33%. Interestingly, the implied volatility rose as the yen weakened rather than strengthened as we anticipated. The relaxation in volatility has been experienced as US yieldsif and share prices have fallen. This suggests rather than trending lower, the market may expect that the yen may have simply moved in a new trading range.
In fact, implied volatility may trend lower if it appears that the yen drifts to the other side of the trading range, which we initially suspect is in the JPY79.30-50 range. It probably takes a break of the JPY79 area to convince players that a yen-bottom (dollar-top) is in place. Volatility may firm on such an event.
The euro, as we have noted, has been the exception. Implied volatility did not increase in October. Indeed, the 3-month implied euro volatility fell to new multi-year lows on Wednesday in the immediate aftermath of the US election, when it appeared that the euro was going to recover back above the $1.28 support area that had been violated at the start of the week.
However, when the euro reversed, so did implied volatility. Implied 3-month volatility recovered from near 7.86% to 8.2%. What is noteworthy is that euro volatility has not finished the New York session above its 20-day moving average in two months. That moving average comes in near 8.26%.
The Greek parliament narrowly approved the lasted austerity measures. This is the key to getting the Troika to sanction the release of some funds. If for some reason, parliament fails to approve next year's budget, which seems less likely after Wednesday's vote, some domestic compromise may be sought that does not jeopardize the agreement with the Troika. It is the less significant of the two votes.
Nevertheless, we continue to think event risk is substantial. We continue to believe that the two main flash points currently--Europe and the US--are unresolved. German parliamentary approval appears necessary and Greek officials cannot be 100% sure that it will be secured. Many, including ourselves, suspect that additional assistance for Spain is nearly inevitable, but Rajoy continues to bide his time. In addition, the Catalonian election in a few weeks underscores the centrifugal forces seen throughout Europe (Scotland, Catalonia, Venice and Bavaria's court case seeking end its subsidies for the poorer states in Germany). Meanwhile, the regional economy is contracting and hope is the only thing pointing to a shallow and brief downturn.
In the US, the fiscal cliff still looms and the cast of characters has not changed substantially by the election. In addition, Operation Twist is set to be completed in the coming weeks and the decision whether to roll the Treasury purchases into QE3+ is awaited.
The bilateral harassment of Japanese and Chinese patrols in the South China Sea appears to be an accident waiting to happen. Nationalist forces are on the rise in Japan and they are never appear far from the surface in China. In addition, with the reconstruction push fading and foreign demand (China an Europe) soft, the Japanese economy is sliding back into contraction mode.
Geopolitical uncertainty in Syria and Iran could also easily escalate and pose new challenges for investors and policy makers.
This list is not meant to be exhaustive, merely suggesting of the range of potential risk events on the horizon and why we continue to suspect that protection, as measured by implied volatility, still seems relatively inexpensive. In terms of price action, this warns of the risk of further declines in equities and the euro. The immediate direction of the yen is less clear by this study.