Risky Business

by: The Heisenberg


Investing and trading is risky business.

Your performance will depend largely on your ability to determine where and to what extent risk is mispriced.

The biggest risks you face going forward are political in nature.

Here's a comprehensive summary (is that an oxymoron?) of how political risk is being priced across assets.

I'll confess that I'm starting to get sick of writing about French election risk.

That might sound strange given my affinity for reminding readers that macro matters and that going forward, geopolitics will be the primary driver of asset prices.

The problem though, is that when you become hyper-focused on something, there's a tendency to tunnel. Before you know it, everything to do with that something seems important and therefore worth writing about. Small-ish events become magnified in your own mind. Short posts turn into 2,000 word diatribes about esoteric things no one but you cares about.

This is why I backed off of the China money market posts that I penned on a near daily basis in December. The Chinese bond market selloff was indeed important, but I found myself drilling down further and further. Before long, it was abundantly clear to me that a large percentage of readers had absolutely no idea what I was talking about. Normally, that's a good thing.

It makes people work to understand the concepts. But I'll confess that no matter how important it is to track Beijing's efforts to tighten policy via repo rates (as opposed to policy rates), it's probably not necessary for average readers to monitor daily moves in every onshore and offshore money market rate.

I vividly recall losing my cool during the Greek bailout drama that unfolded in the summer of 2015. It got to the point where I was being forced to incorporate every single Bloomberg headline into our models no matter how insignificant. Before long, we were scouring random blog posts penned by disgruntled Greeks for any little kernel of information that might give us a leg up. It was entirely absurd - not to mention horribly exhausting.

This week we've seen a fair amount of French political drama and it's moved markets. On Wednesday, following reports that centrist François Bayrou was set to "take one for the team" by proposing an alliance with Emmanuel Macron, we saw OATs rally and as I outlined earlier today, that rally spilled over into Thursday as French 10Y yields touched their lowest levels in a month.

It's probably fair to say that we've reached a point with the French elections beyond which it will be well nigh impossible for anyone other than perhaps AFP or Reuters to stay completely current on the most recent developments. Indeed I'd wager that by the time this post is published, something else "notable" will have happened.

So rather than try and document whatever is supposedly "news," I thought that instead, I'd simply revisit one of my favorite topics: the pricing of risk. Or, more specifically, the extent to which markets are pricing in risk around the French elections.

Obviously, market pricing changes with the news. So you can't really divorce an effort to track how the market is pricing event risk from tracking the latest news on that particular event.

But what you can do is take a snapshot in time and evaluate how risk was priced at that particular moment. Indeed that's the best anyone can do. Can you imagine how frustrating it is for analysts to try and track evolving political risk when every piece of research has to be run up the compliance flag pole before it's released?

Anyway, let's look at some interesting excerpts from a couple of new pieces out Wednesday and Thursday. Note that the following analysis builds on concepts I discussed in "Pricing Politics," "Free Money," and "This Makes Absolutely No Sense."

In those posts, I documented, in order, the extent to which European equities (NYSEARCA:FEZ) are perhaps more efficient than US markets in pricing event risk, the fact that the ISDA basis between 2003 and 2014 French sovereign CDS wasn't nearly wide enough to account for the fact that the 2003 "protection" will likely never pay no matter what happens, and the comically ridiculous fact that although € IG synthetic credit and OAT-bund spreads have become increasingly correlated, € IG spreads haven't blown out as much as they should given sovereign risk.

Let's revisit how European equities are pricing political risk. Here are some excerpts from a great Barclays note out on Wednesday (my highlights):

In line with the credit and FX risk pricing, nervousness in volatility markets appears to be driven mostly by the French elections as Mrs. Le Pen's popularity is growing. Figure 7 plots the SX5E and DAX variance spot and forward term structures as well as the corresponding V2X futures levels. Both markets are pricing a growing risk premium for the French elections as per the kink in the variance term structure and the high April V2X future.

In fact, since 7 February, the V2X April futures took 3 vol points. Likewise, the SX5E implied excess volatility in Figure 8 moved up to 6.4% from 5.3% two weeks ago while the DAX implied excess move is 5.6% for the same maturity, up from 4.9%.

German elections are captured by the September VSTOXX futures. Although the Sep Dec 17 implied excess move priced by both the DAX and SX5E term structures moved up (3.6% vs. 3.3% for the DAX and 2.7% vs. 1.6% for the SX5E), Figure 7 shows that the September V2X future is not particularly high. This means that the volatility futures market is not pricing a risk premium for the German elections yet. However, please bear in mind that the September future is not very liquid at the moment. It only represents an open interest of 7K contracts, which compares to 100K contracts for the April future.

Okay, so as usual, don't get bogged down in the jargon.

It's probably a little late to say that. That is, you probably got bogged down in the jargon. So go back and read it again.

What you're looking at - primarily - is the kink in the term structures in Figure 7. You'll recall that in one of the posts linked above ("Pricing Politics"), we looked at the S&P implied volatility term structure, which admitted of no such kinks. The simple takeaway: That's one way to gauge how markets are pricing event risk. I argue that in the US, markets aren't doing a very good job in that regard. Now consider that and apply it to the bolded passages about the September V2X future and German elections. See? This is actually not as complicated as it sounds.

Moving on to revisit the point made about French CDS and the extent to which is does or doesn't protect against a potential redenomination event or other catastrophe (sorry for the hyperbole, but that's what such an event would constitute), let's look at some new commentary from Morgan Stanley (note: I'm revisiting and expanding on the points made in the second post linked above - "Free Money"). To wit:

2003 versus 2014 sovereign CDS: The sovereign CDS market implications from redenomination risk are also twofold. There are two sovereign CDS contracts trading in parallel since 2014, the 2003 ISDA CDS versus the 2014 ISDA CDS. The key contractual differences between the two in regarding to restructuring event are:

  • Asset package delivery: Under the 2014 contract, if certain Deliverable Obligations are converted into an Asset Package in the course of a Restructuring, the Asset Package can be delivered in lieu of the Obligation, while it would not be deliverable under the 2003 contract. It is rare to find examples in sovereigns for such an event.
  • Currency redenomination: The 2003 contract classifies a currency redenomination to a Permitted Currency (G7 or OECD AAA rated currency) as acceptable, i.e., not a trigger for a credit event for France as it's G7. However, the 2014 contract removed the Permitted Currency exception. A new trigger mechanism has been introduced: where a redenomination to a currency other than CAD, JPY, CHF, GBP, USD or EUR represents a trigger, provided that the redenomination is the result of a deterioration in the creditworthiness of the Reference Entity. If the redenomination occurs from EUR to another currency as a result of governmental action, which is applicable to the entire jurisdiction of the relevant state, the redenomination has to lead to a reduction of principal or interest for a trigger to occur.

In other words, the 2014 contracts are far more likely to trigger. To let Citi tell it, the 2003s will almost surely never trigger. The implication there (and this is another one of those cases where something that sounds complicated actually isn't - at all) is that the 2003 "protection" is worthless compared to the 2014 protection.

What do you think that should mean for the spread between the 2003 and 2014 contracts? Here's a visual hint courtesy of Marine Le Pen:

Well it's not that wide, it's only this wide...

(Chart: Morgan Stanley)

... and as Morgan Stanley correctly points out, that wide probably isn't wide enough (my highlights):

Exhibit 51 shows that the 2014 contracts trade at a spread over the 2003contract since the launch, which captures the differences in contractual definition we highlighted. But French and Italian spreads between these two contracts have widened out in isolation from other eurozone sovereigns recently, which shows there is some currency redenomination risk being priced in by the CDS market, but not to a large degree.

Finally, let's reconsider the point I made in the third post linked above ("This Makes Absolutely No Sense").

Recall what exactly it was that "made no sense." The correlation between iTraxx Main and OAT-bund spreads clearly indicates that € credit is, to quote Citi, "becoming more attuned" to sovereign risk. But for whatever reason (e.g. sleeping corporate credit markets), that hasn't translated into wider corporate spreads. Here's what Morgan Stanley has to say on exactly that point (my highlights):

European credit is yet to price in the risks of a Le Pen win scenario, which adds to our cautious outlook. Our economists' realistic bear case - a rise in volatility and growth headwinds - is not particularly bad for credit, but we remain wary of the tails.

The European credit market has thus far been measured in its response to the rise in political concerns. Despite weak cues from the rates market, we see few signs of weakness outside specific French and Italian bank credits. The net result is that BBB corporate bond yields are well inside 10-year BTPs and are only 18bp off 10-year OATs. iTraxx Main (the primary CDS index) is trading in line with the 10-year OAT spread (over Bunds). Credit trading through peripheral government bonds is not new. In fact, it was the norm during the sovereign debt crisis. When the lines between core and periphery are getting blurred and rates are reacting to political risks, we see reason to stay selective in credit as it continues to trade rich versus fair value. We are also wary that there is little tiering between peripheral or French corporates and the broader market.

Or, put differently, "Heisenberg was exactly right."

Look at the chart in the left pane there. 10Y French yields are now on par (bond market pun fully intended) with € IG yields. In other words: BBB corporates are no more risky than French government debt. Remember: According to BofAML, nearly a quarter of the € IG market is comprised of French corporate debt. The market would thus appear to be mispricing the overlapping exposure to a possible French redenomination.

What you just read is a pretty comprehensive survey of how political risk is being priced across Europe. Someone will invariably ask for a Cliffs Notes version and someone else will invariably complain that they can't act on any of the above. That's unfortunate because frankly there are all kinds of trades in there that are actionable for everyone from average investors all the way up to those who "sit at the big boy table" - so to speak.

But beyond that, the more important takeaway is that what's presented above is a survey of risk pricing in everything from equities, to sovereign debt markets, to corporate credit. You should compare and contrast and draw conclusions about which markets are more efficient when it comes to accounting for event risk. I've already drawn those conclusions for you throughout, but I encourage you to internalize everything said above and develop your own point of view.

Finally, everything said above has applications for how you think about US markets and the extent to which they're pricing in the American political landscape.

In the end, investing and trading is by definition "risky business" and if you don't understand how that risk is priced, you're going to be perpetually... well... perpetually at risk.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.