With the “smart” money (as defined by Don Hays) exiting the stock market in droves, yield curves collapsing (now with extra help from a “Twisting” ECB), extreme speculative positioning in bonds, and a dramatically diverging economic reality from market market narratives, the possibility of a crash – Fed triggered or not – is rising. Do ‘they’ know something the “dumb money” does not?
And with everyone still the same side of the rates boat…
… while Bank of America is warning that the current market feels ominously similar to that right before the 1998 Asia Crisis and LTCM blow up…
… the question is – what’s the cheapest way to hedge against a crash scenario?
Bank of America’s Jason Galazidis has some answers for traders looking for some protection. The screen below shows that the hedges, ranked by the average, which are most underpricing historical drawdowns are Gold calls, EUR 10y receivers and TLT (US 20y+ Treasury) calls:
EUR 10y receivers and TLT calls screen as the best value hedges after Gold calls. Interestingly, USD 10y receivers screen materially richer owing to increased demand on heightened US trade tensions.
HSCEI puts are the second best screening equity hedge after RDXUSD (Russia) puts despite the HSCEI being the worst performing equity index in our screen (YTD peak vs. current levels).
EU Credit payers have richened remarkably over the last few months, particularly in IG, following the extreme widening in EU-periphery bond spreads in May. Our credit derivatives strategists note that the richening of downside tails in credit (payer skew) reached 8y extremes driven by heavy hedging demand.
As a reference, the table below shows the largest drops (or gains in the case of GLD, gold, Euro and US 10Y and TLT as designated with **) within 3 month in each asset class between ‘06 and ‘17, ranked in the same order as the assets in the chart above. The table shows that gold not only has a high vol delta but is consistently one of the best performing assets during crisis times.
And so – once again – the precious metal regains ‘most-favored-nation’ status as the world’s emerging markets collapse and economic reality washes ashore on the banks of the river-of-excess-debt.
Since the middle of January, gold’s implied vol has been notably, systemically lower than stocks:
And US equity vol has “normalized”, catching back up to Europe over the past month:
Cross asset risk is once more in benign territory relative to history as vols and credit spreads are all in their 1st quartile, although recently cross asset risk rose across the board led by credit spreads, while commodity volatility has emerged as a notable exception after declining MoM – largely thanks to the recent surge in the price of oil – and is now the 2nd least elevated risk metric vs. its own history.
Meanwhile, another indicator that further vol breakouts are coming is the 12M cross-asset-class correlation, which has continued its climb since the Feb-18 equity-led sell-off, and is now at 5y highs.
Historically there have been 3 distinct cross asset correlation regimes since 1995. Interestingly, we see a broadly upward trend since Oct-03, well before the Lehman bankruptcy in Sep-08. This is related to the liquidity driven crush in asset risk-premia that helped drive investment leverage higher. Long-term correlation established a new regime since 3Q13, similar to the ’03 to ‘08 correlation environment.
Which brings us to the punchline chart: these are the two-month-forward historical stress peaks observed during turbulent market shocks in 2008, 2009 and 2011, and compared to current levels. This is BofA’s way of hinting where vol is most underpriced assuming, of course, that a crash should occur in 2 months:
The chart illustrates why it is useful to consider the relative pricing of options across asset classes to hedge against tail events: option markets often underestimate the severity of market shocks, and to different degrees. In 2008, currency, equity and sovereign risk vols were the most optimistic ahead of the Lehman crisis and the most surprised after (rose to the highest levels).