Suddenly, Everyone’s Talking About VaR Shocks Again

We’ve talked quite a bit lately about systematic strategies and about the dangers they pose to markets.

We’re talking here about CTAs (trend followers), risk-parity, and vol. targeting.

We dodged a bullet around Brexit when it came to CTAs. Here’s why:

(Chart: BofAML)

What that shows is that CTAs weren’t forced to liquidate as aggressively as they might have during the turmoil that followed the yuan devaluation. Why? Because short-term moving averages stayed about long-term moving averages.

Another mitigating factor post-Brexit was that thanks to relative bond strength, risk-party wasn’t cornered into rebalancing which is a good thing, because this is what happened to short gamma funds when the VIX spiked after the referendum:

(Chart: BofAML)

So why does this matter now? Well for a number of reasons. First of all we’re in the midst of what is, for now anyway, a min-VaR shock.

The last one we saw was in May of 2015 with German bunds. The problem is that when central banks suppress volatility, it allows vol targeting funds to lever up. Here’s a simple explanation from JPMorgan that we’ve used before:

“What is causing VaR shocks and why are they happening often? We argued before that one of the unintended consequences of QE is a higher frequency of volatility episodes or VaR shocks: investors who target a stable Value-at-Risk, which is the size of their positions times volatility, tend to take larger positions as volatility collapses. The same investors are forced to cut their positions when hit by a shock, triggering self- reinforcing volatility-induced selling. This, we note, is how QE increases the likelihood of VaR shocks.”

Right. So consider that and then consider the back up in yields shown above. Here’s a bit of color from Citi:

“Non-US CB withdrawal fears are driving the govvie sell-off. To what extent this transmits to risk asset depends on the pace of any further yield increase. We think the rise in UST yields will be less like the 2013 taper tantrum but, if anything, more similar in magnitude to 2015. Look to add duration around 2%.”

And here’s a great chart that demonstrates where we are with 10Y versus where we were with bunds when things went haywire last year:

(Chart: Citi)

JPMorgan is out with some similar commentary:

“We would argue that at least some of the break to higher yields over the past week has been driven by a disappointing outcome at last week’s ECB meeting. As we mentioned earlier, the outcome of next week’s BoJ meeting will be key in determining the direction of US rates. Our colleagues in Tokyo have noted risks are skewed toward disappointment relative to our baseline forecast and recommend 5s/20s bear steepeners to position for this (see Japan, Global Fixed Income Markets Weekly, Takafumi Yamawaki, 9/2/16). Accordingly, the recent steepening in the JGB yield curve suggests markets are pricing in increased odds of some shifts in their policies around JGB purchases.”

“Exhibit 2: Treasury yields have thus far followed the same pattern that was observed around the 2013 US and 2015 Euro tantrum episodes, which suggests they could rise further from here.”

“Cumulative change in 10-year Treasury yields around local lows observed ahead of tantrum episodes; bp”

(Chart: JPMorgan)

But here’s the good part: modest rises in yields are associated with higher stock prices, but so-called “shock” rises in yields can be detrimental. Let’s go to Citi one more time:

“As Figure 6 shows, for contained four week UST moves, historically we have seen equities rise more often than fall. But notice the upwards trend on the blue bars – around the 40bp threshold, the historic equity response becomes 50:50 and beyond that equities always sell-off more often than they appreciate. Put differently, a mild UST sell-off, induced by positive data say, is usually equity positive. A sharp or fast sell-off, especially if not triggered by growth positive events, likely means risk assets come off too.”

(Chart: Citi)

And that folks, means there’s nowhere to hide which is when funds like Ray Dalio’s famous “All Weather” get caught out without an umbrella.

Much more on this to come.