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Wall Street Fears Volatility Trap as Fed Kills Price Swings

Central Banks Kill Volatility. Now Wall Street Fears a Trap

(Bloomberg) -- Wall Street’s volatility complex is roaring back to life as dovish central banks beat recession fears into submission, spurring the fastest return to market calm since 2012.

How long the serenity can last is the vexed question.

For now, hedge funds are amassing short wagers on equity price swings, while the Cboe Volatility Index sits close to a five-month low. Thanks to lowflation, interest-rate moves in the U.S. have fallen to a record as tranquility takes hold of global currencies.

Traders are in a bind: Bets on lower price swings offer diminishing rewards for the risk, but money managers banking on gyrations face a world of pain if a Goldilocks-lite economy keeps volatility at bay. Already this year, Argentiere Capital is said to have returned capital to investors after misfiring wagers on rising turmoil in its flagship $940 million fund.

As the likes of JPMorgan Chase & Co. see shadows of the cross-asset calm that preceded 2013’s Taper Tantrum, speculators riding the monetary put in the aging business cycle are in soul-searching mode.

Wall Street Fears Volatility Trap as Fed Kills Price Swings

“Why would an investor incur the risk associated with short-volatility strategies only to be compensated with a return comparable to a three-month Treasury bill?” said Pat Hennessy, head trader at IPS Strategic Capital in Denver, Colorado.

The Federal Reserve’s dovish tilt has driven all fear out of Treasuries, sending the MOVE Index to 43.7 as of 1:56 p.m. in New York. That has boosted equity-investor confidence in the earnings yield and the discount rate for cash flows to suppress stock swings along the way.

Those punting on short-volatility trades “really need to be right” that monetary authorities will live up to their label as volatility killers, according to Benn Eifert, chief investment officer of QVR Advisors.

“Longer-term fixed income, currency and commodity implied volatility are mostly at or near their post-crisis lows,” he said. “The risk/reward of betting that they go even lower is poor.”

Wall Street Fears Volatility Trap as Fed Kills Price Swings

The link between the business cycle and the volatility market is far from straight-forward.

Short-vol equity strategies can deliver returns even as economies hurtle toward recession -- but the journey is famously bumpy. In 11 Fed easing cycles since 1972, the realized volatility of the S&P 500 rose “reliably’’ in the months preceding the first rate cut, according to Bank of America Corp.

With some Wall Street recession signals still flashing, hedging for an end-of-cycle uptick in volatility has a clear appeal. But trading with conviction is a challenge given the relative stability of the macro climate.

“As long as fundamental data -- the volatility of inflation etc. -- is very low we would avoid any strategic trades and only tactically examine periodic opportunities,” said Yannis Couletsis, director at Credence Capital Management Ltd.

Wall Street Fears Volatility Trap as Fed Kills Price Swings

If short-vol trades famed for their dependable income are offering thinner returns while long bets look risky, it may be a case of being nimble.

QVR’s Eifert is pursuing relative-value trades that “isolate specific market dislocations, as well as cheap, low-carry-cost long volatility positions.” He points to strategies across the volatility surface of the S&P 500 as an example. Long-term interest-rate swaptions are a potentially cheap way to bet on rising volatility, he said.

For Hennessy at IPS, the relatively low premium available from shorting VIX futures makes options contracts more attractive given the subdued volatility of volatility itself.

Meanwhile, some hedge funds in the becalmed $5.1 trillion-a-day foreign exchange market are snapping up riskier instruments from managed futures to gold.

Hedging Trades

There’s an upside to all this for real-money investors: Hedges are looking cheap. At a unit of Allianz, one of Europe’s biggest insurers, low price swings are offering the chance to load up on U.S. interest-rate derivatives.

“We are taking advantage of very low volatility to manage very actively the complexity of our portfolios,’’ said Franck Dixmier, global head of fixed income at Allianz Global Investors. “We were able to play some downward momentum on rates in buying calls and then playing a correction buying puts.”

All told, step back and the killer question continues to haunt traders of all stripes: At what point will market confidence in the ability of central banks to prolong the cycle give way?

“It is unappealing to be outright short vol at the current historically low levels,” Societe Generale SA rates strategists led by Michael Chang wrote. But “it is also difficult to be outright long vol when market participants are demonstrating willingness to sell implied vols on any bounce,” they said.

--With assistance from Anooja Debnath.

To contact the reporter on this story: Yakob Peterseil in London at ypeterseil@bloomberg.net

To contact the editors responsible for this story: Samuel Potter at spotter33@bloomberg.net, Sid Verma

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