There is a chicken and egg conundrum prevailing in risk markets presently, which goes something like, “What came first? Low volatility or implied low volatility?” One great example of the framework of this argument was articulated in a piece published by Christopher R. Cole of Artemis Capital Management LP, who cleverly used ‘The Ouroboros’ to embody his perspective of a low-volatility market devouring itself. This piece was published in October 2017 and, some 19 months later, the rigidity of this low volatility feedback loop remains unchallenged, despite a couple of risk-off moments along the way.

Notwithstanding the challenging risk/reward dynamics, directional long-risk strategies predicated on central bank puts remain highly popular, but does a brand of complacency transposed over a low-volatility status quo equate to contemporary wisdom? It certainly might, but it is without a doubt the right time to aggressively debate this paradigm, especially given that a painful currency war is one consequence of a US Fed concerned with political amicability and stock market stability over all else.

“It’s a basic fact of life that many things ‘everybody knows’ turn out to be wrong.” – Jim Rogers

Core Views

  • Dovish central banks globally are still supporting risk, and have the will to continue easing
  • Look for steepening in US Treasury curves with the Fed rooted to its most recent path despite data holding up
  • UK Gilts look too rich, even under a hard Brexit scenario
  • Curve flattening pressures remain prevalent in Europe, Italy is still vulnerable at current levels
  • Developed market credit spreads are some way off the tights of 2018, yet we are focused on maturities inside 5 years to limit spread sensitivity
  • European additional tier one banks present value
  • Hold hard currency investment grade emerging market sovereigns

When we skim across research pieces that relate to this low-volatility feedback loop, we glean a sense of confirmation bias from both sides: those hoping for risk assets to grind higher argue there is no end in sight, limiting their reasoning to ‘cui bono’ style political reasoning; and those wishing for volatility to spike calculate the size and sensitivity of gamma risks, often using subjective implied values of OTC market positions and open interests that cannot be entirely quantified.

The current narrative by some market participants—of this year being a repeat of 2017’s Goldilocks year—suggests an early sign that complacency has crept into risk taking. What can go wrong? Central banks have rolled over, a US or global recession is not imminent and trade war negotiations are coming along nicely. ‘Everybody knows that,’ as Jim Rogers famously tells us. Lower volatility has the powerful force to suck people into trades not only at less attractive entry points, but also in larger size. This “Minsky” moment where risk-seeking behaviour suddenly reverses is impossible to forecast. A general observation over the years has been that only a small challenge to prevalent market beliefs is required for sentiments to change; and a sentiment change in 2019 when central banks have little to no crisis retardants could be enough to lead to systemic changes, without the requirement of a smoking gun like 2008’s subprime culprit.

The first few days of May have arguably served investors with precisely this quantum of change – more to think about than the month of April had in its entirety. Two of the big actors in 2018 market volatility, the Fed and President Trump, have shaken two of the perceived pillars of market stability in a matter of days, being lower rates and a diffused trade war. The Fed took a non-dovish (more accurate than “hawkish”) tone in its meeting, pouring cold water on cries to signal for a rate cut soon. Suggesting that inflation around current levels (slightly under target) was good enough for now, FOMC members sat firmly on the fence over which direction would come next for rates. The probability of a rate cut for 2019 has subsequently fallen back below 40%.

A few days after the Fed meeting, President Trump, no doubt bolstered by the recovery in US equity markets, launched a new round of twitter tirades at China, threatening new tariffs and bringing the existing trade negotiations back out into the public sphere. The Chinese response was measured if not conciliatory, but the immediate market reaction demonstrated the belief that this theme was on course to be resolved, or at least buried out of sight and out of mind.

Despite the lustre of corporate bonds among those on the hunt for yield—evidenced by a lack of selling and plenty of competition for buying in the secondary market—primary issuers are not taking advantage of the favourable borrower landscape like they have in the past. Combined with the well-documented inflows into the asset class, we remain in a market where select opportunities lie with the smaller and more esoteric issuers that are not being hoovered up by the index trackers. As interest rate arbitrage opportunities fade in chorus with lower returns on risk generally, we see this as a hint to central banks and governments that favourable rate environments are not enough to conjure up a perpetual appetite for corporate debt from prospective issuers.

With this combination of inflows, a lack of primary supply and flattish spread performance in March, something had to give; and it did – we saw around 30bps of tightening globally across high yield and 10bps across investment grade markets in April. European bonds rallied harder than those in the US and European investment grade spreads are now sitting inside those of the US for the first time in a year, with high yield European year-to-date spreads—upon a backdrop of the Q4 sell-off, of course—tightening around 150bps.

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