Saturday, November 06, 2010

Simply put

The "price" of oil rises, the dollar falls. Any net difference for a dollar-based investor? Obviously, not much if any. But does the illusion distort other behaviour?

Apply that basic rule of thumb, now, to stock prices, and to an extent US Treasury bond prices, which is what these posts from the excellent FT Alphaville explains.

Bernanke’s genie released
The Bernanke put — aka that almost magical and metaphysical QE2 effect — appears to be having an impact on equity options skew already.

Simply explained: skew is what happens when the price of calls does not equal the price of puts exactly. That is to say when out out-of-the-money calls cost more or less than the equivalent puts.

So essentially, skew happens when the market is willing to pay more for protection on one particular direction in the underlying than the other.

Now here’s the interesting thing. Before Ben Bernanke’s Jackson Hole speech the skew in the S&P 500 had reached very high levels, with downside protection trading very expensive.

But as a second round of quantitative easing became increasingly expected by the market, that skew began to ease significantly.

This dynamic can be observed most directly by looking at the option market’s implied volatility skew, which measures the difference between the cost of puts and calls. As illustrated below, this declined significantly following the Fed’s hint at additional QE on September 21. Why buy downside protection when the Fed has done it for you?

Which is all well and good.

But there is another point that Curnutt makes, which is that the Fed may be unwittingly displacing all that volatility elsewhere:

…it looks like there’s a divergence between currency and equity volatility. The Fed may be compressing equity volatility but it’s incentivising currency volatility in its place.

He measures this divergence by looking at the correlation between the Vix index — which is derived from the implied volatility of the S&P 500 index — and the implied volatility of the UUP dollar index ETF [see the chart in the post].

All of which makes Curnutt conclude (our emphasis):

All in all, we are left thinking that there may be a derivatives market analogue to the “law of conservation of energy”. Perhaps it reads: “volatility cannot be created or destroyed, it can only change form”.

Which has to make you ask: will the granting of the market’s wish for liquidity actually lead to a much more sinister implication elsewhere?

Unwinding the US Treasury trade
there really is something perverse about the country undertaking the biggest bout of unconventional monetary policy ending up with the steepest curve.

Flattening yield curves are theoretically meant to stimulate the economy by lowering borrowing costs. (For those wondering, steep yield curves also have some benefits — like building banks’ balance sheets back up — more on which later).

this is from Bank of America Merrill Lynch:
The highlight of the Fed’s Treasury purchase program announced yesterday is the concentration of Treasury purchases in the 5y to 10y sector. This purchase program creates a negative supply of Treasuries to the private sector in 2011.

This will be most acutely felt in the belly of the curve, which is the preferred habitat of foreign institutions. The belly of the curve is also attractive because of favourable carry and roll down due to Fed hikes that are priced into the curve from 2013 onwards.

On the other hand, demand for the long end of the curve comes mostly from pension fund flows, which tends to be sporadic. This argues for a steep 5s-30s curve in the US.

In addition, the Fed is engaged in fighting disinflation and some pickup in inflation can be welcomed by the Fed … In this scenario, the long end will reflect an addition inflation risk premium, further steepening the US curve.
So $2,500bn worth of QEasing in the States has bought the Fed a steepening yield curve. Meanwhile, such a steep yield curve works to boost bank profits by upping the amount of money they can make borrowing short and lending long.

This was also one of the reasons why some commentators believed the Fed should actually be moving to flatten the curve. Suppressing the curve, it was thought, could decrease the attractiveness of the so-called US Treasury ‘curve trade’ and force banks to actually lend to the economy.

Flattening the yield curve to make banks lend to something other than the US Treasury is predicated on there actually being some private sector demand for loans (something which is still totally unclear), of course. But it might put a stop to some of the criticism currently being lobbed at the US central bank for its QE2 policy.

The below for example, is Reuters columnist Felix Salmon’s take on a 4,000-word piece by Shahien Nasiripour about winners and losers in the Fed’s monetary policy:

It’s truly outrageous that banks are lending more money to the U.S. government than they are to all commercial and industrial borrowers combined; well done to Nasiripour for connecting these dots and for providing a much-needed dose of outrage at the way in which
Bernanke’s monetary policy simply isn’t helping the broad mass of the U.S. population

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