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Will A Spike In Volatility Summon The “VaR Shock” Boogeyman?

in Equities by

It was just yesterday when we remarked that “if you short these bonds you’ll make a killing.”

We were of course referring to Japanese government bonds and German bunds, yields on which have been languishing in negative territory pretty much out the entire curve. But the ground appears to be shifting. Have a look: yieldscurve

The German 30Y experienced a five standard deviation move in the past two days:

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(Chart: RBS)

The worry here, of course, is that we get a repeat of the infamous taper tantrum, also known as a VaR shock. We’ve discussed this concept before. Here’s what we said back in June:

“Anyone remember what happened to Gross last spring after he called 10Y bunds the “short of a lifetime?” For those in need of a refresher, recall that shortly after his comments, bund yields did indeed spike, in what certainly looked like a rerun of the 2013 JGB VaR shock. The concept is pretty simple: global QE drives down volatility, so managers simply raise the size of their positions in tandem – and then things reverse. Here’s how JPMorgan put it last summer:

“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.”

Now you’d think central bankers would understand that rather self-evident concept, but they either don’t or don’t care.  To quote the film “Margin Call”, “when these things get moving in the wrong direction it can be huge.” Consider the following from JPMorgan’s head quant Marko Kolanovic – or, as we’re fond of calling him, “JPMerlin”:

Given the low levels of volatility, leverage in systematic strategies such as Volatility Targeting and Risk Parity is now near all-time highs. The same is true for CTA funds who run near-record levels of equity exposure. Our estimate of equity exposure for these strategies is shown in Figure 1.”

“Record leverage in these strategies and option hedging could push the market lower and volatility higher, if there is an initial catalyst to increase volatility. In fact, we may not even need a specific catalyst, apart from the seasonal increase in market volatility which is typical for September and October. Figure 2 above shows that equity volatility tends to increase by ~20-30% in September and October (September also tends to be the worst performing month, with an average -1% return). This seasonality is also present after removing prominent outliers (e.g. 2001, 2008, 2011, and 2015). When it comes to deleveraging of systematic strategies, even this seasonal increase in realized volatility would produce outflows of ~$100bn, which could push the market lower.”

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(Charts: JPMorgan)

We’ll close, for now, with the following chart from Deutsche Bank which shows you what can happen with these strategies during a surge in volatility:

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(Chart: Deutsche Bank)

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