After 12 consecutive days in risk-off mode, our long-only multi-asset model went risk-on again last night. Its long/short equivalent has been risk-on since Aug 25th after a one-day lapse.
So we are back to “risk-on” for both long-only and long/short models. The question is how sustainable is this?
On the one hand, there are plenty of reasons for volatility and uncertainty to remain high. Mohamed El-Erian makes an excellent case for this in his recent FT article.
On the other hand, there is a powerful market force acting to bring volatility down, and that is low interest rates. Even after the next Fed hike, whenever it ends up happening, interest rates in the US and around the world will remain low, making volatility stick out as a rare source of yield in a yield-starved world. Since investors can easily convert volatility into yield, implied volatility is not only a measure of expected future volatility, it is also measure of the yield one can get by selling optionality. The following graph puts this in perspective – it shows the ratio of VIX to the 5y US Swap rate, which stood last night at 15.5 versus an average of 6.2 over the last 25.5 years. For this ratio to revert towards its long-term trend, volatility has to fall relative to interest rates.
Simply put, for this picture to normalise, volatility has to fall, interest rates have to rise, or both.
Time will tell, but in the meantime, we are building our platform so clients can decide to include risk on/off triggers to their strategies as they see fit.
Data source: ALPIMA Ltd, Bloomberg