Catching inflection points is the holy grail of trading. It’s what makes investing lore. From shorting the 2005 housing boom or skyrocketing technology stocks in 2000, to classic value investing, taking contrarian positions can create large profits and legendary reputations. While seductive, it’s a difficult way to trade over the long term. I’ve tried to deemphasize catching market turns in my evolving investing framework. However, I still wonder if today’s volatility is creating future opportunities, especially since I believe there are two identifiable factors at play.
Many investment markets are off to a rough start this year. U.S. 10-year treasury yields (the benchmark) increased by ~27% year-to-date while the S&P 500 and NASDAQ stock market indices have declined by ~9% and ~13%, respectively. Familiar volatility measures like the VIX and MOVE indices are skyrocketing. While many will blame the Federal Reserve (Fed) or inflation, I see other, more concrete culprits producing these conditions: leverage and volatility.
Many investment markets have experienced declines this year. Source: Koyfin
It’s not the Fed, per se
The Fed catches lots of flak. It’s commonly blamed for many of society’s ills from stoking inflation, to inflating stock market valuations, to perpetuating income inequality. To be sure, I’m opposed to central planning of any sort, including central banking. However, I find the Fed’s influence to be mostly exaggerated.
While undoubtedly large, the Fed plays a much smaller role in today’s monetary system. It’s taken a backseat to the shadow banks. The Great Financial Crisis illustrated this clearly. Fractures within their network produced the largest financial crisis in human history and brought the global economy to its knees. The central banks (the Fed included) helplessly watched events—that they had no hand in (at least from a monetary policy perspective)—unfold.
In my view, today’s market volatility stems from rising interest rates. Bondholders are demanding higher yields in response to rising inflation (rightly or wrongly so). To be sure, markets expect the Fed to also react and begin hiking its policy rate. However, bond markets moved well ahead of the Fed’s pivot. Besides, the Fed concerns itself more with other matters. I believe investors are (rightly) worried about the fallout that higher interest rates create for carry trades.
Rising interest rate volatility (MOVE Index) preceded rising equity market volatility (VIX Index). Source: TradingView
Unwinding carry trades produce selling pressure
Over the years, I’ve reconceptualized financial markets as carry trades. A carry trade is an investment made with borrowed money. The financial system is merely a network of interconnected banks and service companies. They borrow money to lend and/or invest it at higher rates of return. These lenders and investors employ leverage, which is their productive economic contribution. Thus, the financial system can be mentally modeled as a carry trade.
Carry trades can be fantastically profitable so long as investment yields remain higher than borrowing costs (and liquidity is expertly managed). As a result of their leverage, carry trades are very sensitive to changes in yields. Small rises in borrowing costs and/or falling investment returns can force them to unwind. Thus, carry trades are procyclical. They buy more when markets rise and sell when they fall.
Banks, for example, can operate with ~10x financial leverage (defined here as tangible assets divided by equity). Insurance company leverage can be even higher. Trading strategies, such as risk parity, also invest with borrowed money. In fact, the financial system consists of a diverse ecosystem of leveraged investment vehicles: finance companies, hedge funds, mutual funds, individual margin accounts, derivative transactions, and more. Rising interest rates are a concern for all (to varying degrees, of course). The higher and faster they go, the more forced-selling must be occurring.
Irrespective of their reasons, interest rates have been rising. Thus, systematic selling and deleveraging must be increasing due to carry trade dynamics. This could be adding to asset price declines.
Volatility’s adding fuel to the fire
Dramatic price swings produce higher (realized) volatility. Volatility in the investment markets describes price movements. It is frequently discussed in two contexts: implied volatility and realized volatility. Implied volatility is an option-pricing concept. It describes how much an asset’s price needs to fluctuate in order for an option to be “in the money.” Realized volatility is the standard deviation of an asset’s return. The more an asset moves, the higher its realized volatility.
Realized volatility is a common investment management risk metric. The greater an asset’s volatility the risker it’s deemed. Thus, many strategies will use volatility to scale position sizes and, more importantly, employ leverage. According to modern portfolio theory, investors can purchase low-yielding, low-volatility assets with leverage to generate a superior return stream. Thus, low volatility assets can make up large portions of portfolios and facilitate higher amounts of leverage. For example, risk parity portfolios have historically been leveraged more than 2-times using this logic.
Leverage in S&P’s Risk Parity Index has ranged between 2.3x and 2.8x. Source: S&P Global
Many strategies from variable annuity investment options to Commodity Trading Advisors (CTA), to ETFs and mutual funds, utilize volatility in similar ways. As a result, volatility has become both an output of investment returns (i.e. a description) and an input. Thus, these strategies become procyclical, buying more when volatility is low and selling when volatility rises.
Rising rates and volatility may be creating oversold conditions
In my view, rising interest rates are causing selloffs in other markets as leveraged carry trades unwind. As a result, volatility is increasing. Due to its risk management usage, this higher volatility is prompting other strategies to systematically sell, thus adding to the market declines. I refer to this as a volatility deleveraging cycle. However, it can’t go on forever. As strategies sell and de-risk, their footprints and market influences shrink.
Thus, today’s forced-selling could represent a future buying opportunity should markets get “oversold.” However, identifying oversold conditions is no easy feat. Valuation is one commonly used framework. Assets get “too cheap” such that buyers eventually step in. Others use technical factors, like trend, to inform them. To be sure, these techniques can work; however, they are heuristics. Oversold is a function of who’s selling and why. It can only occur when the sellers stop—for whatever their reasons—thus allowing more balanced conditions to return.
Hence, my interest in volatility targeting strategies. While markets are big oceans with many participants acting on different motives, volatility is one known (and large) factor. For example, variable annuity assets surpassed $2.3 trillion at year-end 2020. Many employ volatility-targeting strategies. Estimates for assets managed by risk parity funds—another established user of volatility—range from $150 to $350 billion. These are considerable market participants and just two examples!
Variable annuities assets surpassed $2.3 trillion at year-end 2020. Source: Insurance Information Institute
To be sure, it’s hard to accurately estimate the extent to which volatility impacts investment markets. However, some profited by betting against volatility strategies in previous cycles. Whether or not today’s selloffs represent a similar opportunity remains to be seen. Regardless, identifying the prerequisite conditions is required. Since I believe interest rates are the primary cause of today’s volatility, I remained focused on their direction.
Monitoring for oversold conditions
Many investment markets have sold off year-to-date. While the Fed and inflation will catch most of the blame, I see rising interest rates (more generally) and volatility as the main drivers. Both play critical roles in how investment portfolios are managed. I see today’s selloffs as the result of their procyclical uses.
The financial system is a network of interacting banks, finance companies, insurers, and a diverse set of other investment vehicles. It’s a leveraged system that can be mentally modeled as a carry trade. Rising interest rates—irrespective of their reasons—create imbalances in carry trades and may be forcing some to unwind (i.e. sell down exposures) thereby compounding the market declines.
Modern portfolio theory has turned volatility into a risk management input. As it increases, portfolios de-risk by selling assets (and vice versa). Thus, strategies that incorporate volatility into their investing process are also procyclical. While it’s difficult to estimate their impacts, many popular investment products, like variable annuities, utilize these tactics.
Thus, today’s rising interest rates and volatility may be prompting systematic selling. They could create oversold conditions and, as a result, future buying opportunities. Since oversold is a function of who’s selling and why, I remain keenly focused on interest rates given the framework discussed herein. To be sure, this article hardly constitutes a thorough analysis. It does, however, present a lens through which I am viewing today’s market moves; I am keenly looking.
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