Harmonic Tremor

|
Includes: CVOL, DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVOP, IVV, IWL, IWM, JHML, JKD, OTPIX, PPLC, PPSC, PSQ, QID-OLD, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL-OLD, RWM, RYARX, RYRSX, SBUS, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU-OLD, SPXV, SPY, SQQQ, SRTY, SSO, SVXY, SYE, TNA, TQQQ, TVIX, TVIZ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USSD, USWD, UVXY, UWM, VFINX, VIIX, VIIZ, VIXM, VIXY, VMAX, VMIN, VOO, VTWO, VV, VXX, VXZ, XIV, XVZ, XXV, ZIV
by: Macronomics

"Stupidity is an elemental force for which no earthquake is a match." - Karl Kraus, Austrian Writer

Watching with interest the tragedy unfold on the short gamma crowd through the demise of the short volatility ETN and ETF complex, sending markets into some tailspin and causing additional havocs in bond yields, when it came to choosing our title analogy for our post, we reminded ourselves of the meaning of "Harmonic tremor". A "Harmonic tremor is a sustained release of seismic and infrasonic energy typically associated with the underground movement of magma (rising term premiums), the venting of volcanic gases from magma, or both. It's a long-duration release of seismic energy (volatility), with distinct spectral lines, that often precedes or accompanies a volcanic eruption (the demise of some short vol ETNs). More generally, a volcanic tremor is a sustained signal that may or may not possess these harmonic spectral features. Being a long-duration continuous signal from a temporally extended source, a volcanic tremor contrasts distinctly with transient sources of seismic radiation, such as tremors that are typically associated with earthquakes and explosions. Harmonic tremor is part of the four major types of seismograms, the three others being tectonic like earthquakes, shallow volcanic earthquakes, and surface events.

In this week's conversation, we would like to look at the recent sell-off which in effect was triggered by the harmonic tremor coming from the uninterrupted rise of term premiums. This regime change in volatility and the effect of "Who's Afraid of the Big Bad Wolf?" aka "inflation expectations" thanks to rising wage inflation expectations have already claimed the small fishes such as some players in the short volatility leveraged and crowded complex. Like a new grain of sand U.S. Average Hourly Earnings triggered an avalanche as seen in complex systems such as financial markets.

Synopsis:

  • Macro and Credit - Rising term premium have already claimed small fishes, when are the whales going to show up?

  • Final chart - Increased inflation presents a potential threat to the purchasing power of consumers.

  • Macro and Credit - Rising term premium have already claimed small fishes, when are the whales going to show up?

We had hardly pressed the "publish" button for our previous post, that the events taking place in the volatility complex led to the already well publicized demise of some short volatility ETNs. This was bound to happen given the non-linearity aspect one can find in financial markets.

The events that took place were fascinating as it was indeed yet another confirmation of our musing from February 2016 conversation "The disappearance of MS München" when we were discussing the fascinating destructive effect of "Rogue waves" on man-made "structures". Those waves have a high amplitude and may appear from nowhere and disappear without a trace, or investors in some instances. Generally, rogues waves require longer time to form (like "harmonic tremors" led explosions), as their growth rate has a power law rather than an exponential one. While a 12-meter wave in the usual "linear" model has a breaking force of 6 metric tons per square meter (MT/m2), modern ships are designed to tolerate a breaking wave of 15 MT/m2, a rogue wave can dwarf both of these figures with a breaking force of 100 MT/m2. Remember this.

Once again, we would like to come back to our February post of 2016 and quote the book "Credit Crisis" authored by Dr Jochen Felsenheimer (which we quoted on numerous occasions on this very blog for good reasons) and Philip Gisdakis and steer you towards chapter 5 entitled "The Anatomy of a Credit Crisis" page 215 entitled "LTCM: The arbitrage saga" and the issue we have discussing extensively which is our great discomfort with rising positive correlations and large standard deviations move. This amounts to us as increasing rising instability and the potential for "Rogue Waves" to show up in earnest like the one experienced last Monday:

"LTCM's trading strategies generally showed no or almost very little correlation. In normal times or even in crises that are limited to a specific segment, LTCM benefited from this high degree of diversification. Nevertheless, the general flight to liquidity in 1998 caused a jump in global risk premiums, hitting the same direction. All (in normal times less-correlated) positions moved in the same direction. Finally, it is all about correlation! Rising correlations reduces the benefit from diversification, in the end hitting the fund's equity directly. This is similar with CDO investments (i.e., mezzanine pieces in CDOs), which also suffer from a high (default) correlation between the underlying assets. Consequently, a major lesson of the LTCM crisis was that the underlying Covariance matrix used in Value-at-Risk (VaR) analysis is not static but changes over time." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

You might probably understand by now from our previous sailing analogy (The Vasa ship) and wave analogy (The Ninth Wave) where it will eventually end: Another financial crisis.

Moving back to the LTCM VaR reference, the Variance-Covariance Method assumes that returns are normally distributed. In other words, it requires that we estimate only two factors - an expected (or average) return and a standard deviation. Value-at-Risk (VaR) calculates the maximum loss expected (or worst case scenario) on an investment, over a given time period and given a specified degree of confidence. This what we had to say about VaR in our May 2015 conversation "Cushing's syndrome" and ties up nicely to our world of rising positive correlations. Your VaR measure doesn't measure today your maximum loss, but could be only measuring your minimum loss on any given day.

Check the recent large standard deviation moves dear readers such as the one experienced on the VIX last Monday and ask yourself if we are anymore in a VaR assumed "normal market" conditions:

"On a side note while enjoying a lunch with a quant fund manager friend of ours, we mused around the ineptness of VaR as a risk model. When interviewing fellow quants for a position within his fund, he has always asked the same question: What does VaR measures? He always get the same answer, namely that VaR measures the maximum loss at any point during the period. VaR is like liquidity, it is a backward-looking yardstick. It does not measure your maximum loss at any point during the period but, in today "positively correlated markets" we think it measures your "minimum loss" at any point during the period as it assumes "normal" markets. We are not in "normal" markets anymore rest assured." - source Macronomics, May 2015

But, last Monday's move while surprising by its velocity, has not been as significant as the move seen in the VIX back in 1987. We are yet to see a spike to 173 seen on the VIX during the October 1987 crash and that was something, really something.

This is also what we argued in February 2016:

If you think diversification is a "solid defense" in a world of "positive correlations", think again, because here what the authors of "Credit Crisis" had to say about LTCM and tail events (Rogue Waves):
"Even if there are arbitrage opportunities in the sense that two positions that trade at different prices right now will definitely converge at a point in the future, there is a risk that the anomaly will become even bigger. However typically a high leverage is used for positions that have a skewed risk-return profile, or a high likelihood of a small profit but a very low risk of a large loss. This equals the risk-and-return profile of credit investments but also the risk that selling far-out-of-the-money puts on equities. In case of a tail event occurs, all risk parameters to manage the overall portfolio are probably worthless, as correlation patterns change dramatically during a crisis. That said, arbitrage trades are not under fire because the crisis has an impact on the long-term-risk-and-return profile of the position. However, a crisis might cause a short-term distortion of capital market leading to immense mark-to-market losses. If the capital adequacy is not strong enough to offset the mark-to-market losses, forced unwinding triggers significant losses in arbitrage portfolios. The same was true for many asset classes during the summer of 2007, when high-quality structures came under pressure, causing significant mark-to-market losses. Many of these structures did not bear default risk but a huge liquidity risk, and therefore many investors were forced to sell." - source Credit Crises, published in 2008, authored by Dr Jochen Felsenheimer and Philip Gisdakis

You probably understand by now why we have raised the "red flag" so many times on our fear in the rise of "positive correlations". They do scare us, because they entail, larger and larger standard deviation moves and potentially trigger "Rogue Waves" which can wipe out even the biggest and most reputable "Investment ships" à la MS München." - source Macronomics, February 2016

Obviously, for us, rising term premiums have been like a "harmonic tremor" leading to the buildup that ended with the explosion that occurred in the short volatility space. The catalyst has been rising inflation expectations coming from the latest U.S. Average Hourly Earnings rising 2.9% Y/Y, the most since 2009. This was the little grain of sand that triggered, we think Monday's avalanche.

If Short Vol ETNs could be compared to a piece of a CDO like structure for the financial markets complex, they could be seen as the "Equity tranche", or the first loss piece of this "capital structure" (The tranche that absorbs the first loss (and thus is the most risky tranche) is often called an equity tranche). Obviously, the next question one would like to have answered when looking at his portfolio is, am I "senior" enough in the capital structure and is my attachment point high enough to avoid the pain?

In relation to the issue of rising term premiums and additional potential pain and "de-risking" coming, we read with interest Nomura's Global Markets Navigator note from the 7th of February entitled "Rising term premium claims its first victim":

"According to the NY Fed, the 10yr UST term premium troughed in early December at -0.62bps. As of 5 February, the NY Fed estimates that it has risen 33bps to -0.29bps.

Over the same period, the MOVE Index of implied treasury volatility rose in sympathy from an all-time index low of 48 to today's 66. In previous reports we have linked low term premia to low implied interest volatility and in turn low implied volatilities in risk assets, e.g., equities.

Front-end VIX started to rise from the first day of 2018 trading, lagging behind the increase in the term premium. It was toward the end of January that both measures began to move faster. The recent few days of trading needs little rehashing.

And yet other risk assets and measures of risk aversion have not gone through similarly violent changes. Equity volatility in the euro area and Japan rose in tandem with the US but didn't reach the same intraday highs. High yield spreads widened too, but not in a disorderly manner. Investment grade spreads didn't move much. Indeed a simple model of daily VIX changes vs. daily S&P changes would have implied that US equities should have been down nearer 11% on 5 February rather than 4%. In other words, implied has move significantly higher than realised.

There are two interpretations of these facts. First, the VIX is sending us a serious message about the outlook for short-term US equity returns that the market needs to pay attention too. Second, US equity volatility products are an asset class in their own right. The existence of levered short-vol carry positions in those markets makes them more exposed to relatively small changes in other asset classes, e.g., rates vol.

To the extent interpretation one is correct, we should see a large increase in long rates hedges and selling pressure in credit and EM. To the extent the second interpretation is correct we should expect, when the affected positions are removed, a return to the status quo ex ante. Feedback from discussions with market participants suggests most people are putting faith in the second interpretation; this was an isolated incident in an important derivatives market.

The evidence supports that case. But there's a problem. And it's the term premium.

As we wrote last time, the cyclical growth outlook points to higher policy rates and flatter curves, tight spreads and strong equity performance. The secular improvement scenario calls for higher rates too but is ambiguous about the shape of the nominal and real curve. The ambiguity stems from uncertainty about the natural rate and inflation. This makes it hard to anchor long-end rates (without even taking into account net net issuance) - ergo higher realised rates volatilities. This uncertainty is unlikely to go away for some time if we remain in an above-trend positive output gap world.

Thus normalisation - whether cyclical or structural - means a higher term premium and higher rates volatility. Even while the absolute level of yields remains low the past few days tells us two important things: investment strategies habituated to low term premia are likely to struggle in this environment; and higher beta assets can rally as government yields rise so long as their risk premia fall faster than rates increase. If rates rise too quickly, all bets are off.

The speed and breadth of the recent recovery has left central banks with a communication problem - it is tough to forward guide a nervous bond market if inflation is rising and growth is well above trend. If a rising term premia has claimed its first victim, will there be others?

Given the low absolute level of yields there's little case for a growth driven risk sell off. But it is the speed of the adjustment to normal that will now be critical. Perversely, the best thing for markets now would be more modest growth and comforting downside inflation miss. - source Nomura

There lies the crux of the situation. Too much good news could lead to more bad news for risky assets such as the dreaded CPI number coming out soon in the US. This is a very important number for bond yields in particular and asset prices in general.

As we stated in our previous conversation prior to the VIX bloodbath that ensued, positive correlations matter and matter a lot. On this subject, we read with interest Deutsche Bank' Special Report from the 7th of February entitled "The bond risk premium and the equity/yield correlation":

"A few months ago, we noted that the combination of low yields and high equities raised concerns that a sudden rise in bond yields could lead to a material repricing of equities. A week ago, we had a glimpse of a potential shift in the equity/yield correlation (higher yields/lower equities) that has been mainly positive since the late 90s. The risk-off environment of the last couple of days has reasserted the positive correlation between bond yields and equities. How can we explain such shift in correlation?

Our analysis suggests that the equity/yield correlation is related to the bond risk premium. A high bond risk premium coincides with a negative correlation between yields and equities. In the post Volker period, 10Y UST ~3% above r* corresponds to a yield/equity correlation close to zero (on a 12m backward looking basis). Current estimates of r* are between 0 and 50bp, but are expected to rise to 50-75bp in the quarters ahead.

On this basis, assuming that inflation expectations remain broadly anchored, a persistent shift in correlation is likely to occur when 10Y UST is somewhere between 3 and 3.5%. Clearly, the market will notice a shift in correlation on a much shorter time frame: a few days of negative correlation between yields and equities have been enough to generate significant attention. Thus, one would expect the shift in correlation to be felt at lower level of rates.

The relative perception of the risk of high vs. low inflation regimes - i.e. 70s stagflation vs. Japanese deflation - is likely to be the underlying driver of the equity/yield correlation. When higher inflation is negative for growth (e.g. the 70s), one would expect bond yields and equities to be negatively correlated. A positive shock to inflation would coincide with a negative shock to growth, leading to higher bond yields and lower equities. Moreover, as higher inflation will coincide with lower growth, bonds will not be a good hedge for an equity portfolio. As a result, they should command a higher risk premium. We would therefore observe a higher risk premium in bond markets and a negative correlation between bond yields and equities.

Conversely, if low inflation is negative for growth (e.g. Japan), then one would expect bond yields and equities to be positively correlated. A negative shock to inflation would coincide with a negative shock to growth. It would lead to lower bond yields and lower equities. Moreover, as lower inflation will coincide with lower growth, bonds will be a good hedge for an equity portfolio, commanding a lower risk premium. We would therefore observe a lower risk premium in bond markets and a positive correlation between bond yields and equities.

From a historical perspective, higher productivity coupled with cheap supply of labour reduced the risk of high inflation since the late 1990s. Technological advances and globalization have therefore likely been instrumental in establishing the low bond risk premium regime in place since the late 1990s.

This enabled central banks to establish their inflation targeting credentials and to be more predictable, thereby reducing interest rate volatility and the bond risk premium. Moreover, the FX regime in place in key EM economies led to a significant increase in excess savings, which in turn depressed the bond risk premium (the bond market conundrum).

Looking ahead, the focus on inequalities in DM economies coupled with the desire of China in particular to shift towards a more consumption based economy suggest the current political economy trend is conducive to some reversal of the regime in place since the 90s, pointing towards the potential for a higher bond risk premium.

Indeed, these trends should result in (a) greater risk of trade barriers, (b) greater fiscal deficits in DM and (c) reduced current account surpluses in EM. Taken together, this should reduce the savings/investment imbalance and the disinflationary pressures from globalization. The resulting rise in the bond risk premium would put downward pressure on the yield/equity correlation.

The bond risk premium and the equities/yields correlation: the evidence

The bond risk premium (defined as the 10Y yield minus long-term growth and inflation expectations) has proven to be a good indicator of the correlation between equities and yields (defined as the rolling 12m correlation of weekly changes in the S&P and weekly changes in the 10Y yield). In the early 1990s, the bond risk premium was high and the correlation between yields and equities was negative.

Since the late 1990s, the correlation has been mostly positive with temporary exceptions around the end of tightening cycles (early 2000s and 2006) and the taper tantrum (see graphs below, note that the correlation scale is inverted on the left graph).

The focus on the post 1990s period is driven by the data availability: there are no long term growth and inflation surveys prior to this date. This period has been one of relatively stable inflation (especially relative to the 1970s), and as a result a significant portion of the move in yields can be associated to changes in the bond risk premium or a decline in the neutral real rate rather than changes in inflation. Thus, over this period, using the gap between UST10Y and the neutral real rate (as estimated by Holston, Laubach and Williams) is also a good indicator of the correlation between bond yields and equities (see graphs).

By focusing on 10Y UST - r* we can extend the sample to the early 60s. The correlation observed since the 1990s, extends over the whole lower inflation era (1986-2017). During the post Bretton Woods/high inflation/Volker periods, the correlation is weaker which could be ascribe to the fact that the 10Y rates are more impacted by inflation. Also the yield/equity correlation is always negative, which is consistent with the intuition discussed above.

In the 60s, the correlation is somewhat stronger again (see graph below).

In short, the bond risk premium is a decent indicator of the correlation between equities and bond yields. When it is high, the correlation becomes negative, pointing to high bond risk premium weighing on equities.

Assuming that inflation does not vary significantly, the gap between 10Y UST and r* can be used as a reference. Looking at the most recent samples (charts below), a spread between 10Y UST and r* of 3% would be consistent with the bond equity correlation persistently changing sign.

As well as representing a gauge of bond risk premium, the equity/yields correlation can be also used to confirm the evolution of credit risk in the euro area. Indeed, the correlation between the various European bond yields and equity markets was the same pre-crisis. In 2009, Italy switched to a persistently negative correlation which increased back towards zero following the "whatever it takes" statement from Draghi. The correlation between the CAC40 and OAT briefly turned negative when French spreads where widening substantially in 2011/2012. The shift in correlation can be interpreted as the result of a tightening of credit conditions due to a widening of credit spreads." - source Deutsche Bank

If indeed the shift in correlation from positive to negative marks a regime change in the narrative, given how loose financial conditions have been, it also indicates as per Deutsche Bank a tightening of credit conditions. To illustrate further, the impact changes in cross-asset volatility, thanks to change in correlations, we think the below chart from Bank of America Merrill Lynch Cross-Asset Hedging note from the 7th of February entitled "Few signs of X-asset contagion as equity vol bubble finally pops" illustrates even further the "harmonic tremor":

- source Bank of America Merrill Lynch

For us, the most important piece of the puzzle for additional pain would be from the "Big Bad Wolf" aka inflation. This would generate additional pressure on risk premiums and bond yields. What matters as Nomura puts it in its note is the speed of the adjustment, and also from the Fed should it fall, it is behind the curve thanks to faster than expected rise in inflation expectations. The risk obviously is on the upside particularly when it comes to rising concerns with inflation expectations. Some see the current situation with the latest US fiscal profligacy as similar to what the US experienced in the 1960s. This is the case for Deutsche Bank which sees similarities as per its Global Fixed Income note from the 9th of February entitled "A structural repricing of bond markets":

"There are some striking similarities between the new policy mix discussed above and the conditions that led to a shift upward in inflation expectations in 1966. In the first half of the 1960s, unemployment was declining rapidly but core inflation remained low and the Phillips Curve was "dead" (right graph below).

In 1966, the US administration significantly increased its fiscal spending on the back of (a) the Vietnam war and (b) the introduction of Medicare and Medicaid. This denoted a turning point in core inflation, which began to rise markedly (graph above). There are competing interpretations as to what drove the pickup in inflation: (a) fiscal stimulus, (b) non-linearities in the Phillips curve as the unemployment rate dipped below 4%, (c) rising healthcare inflation and (d) a Fed that was (ex-post) behind the curve.

Irrespective of the precise drivers, there are some similarities with current conditions. As the US economy is approaching full employment, the US government is implementing a significant fiscal stimulus. The potential introduction of trade barriers creates upside risks to inflation. Finally, the Fed may not intend to be behind the curve today, but if r* rises, as the Fed and our economists expect, current market pricing of the Fed policy will be overly accommodative." - source Deutsche Bank

There are many upside risks we commented in recent conversation, one being the start of a trade war through the implementation of trade barriers (that 30s feeling) which would put indeed some pressure on prices no doubt. This setup of both US profligacy and trade war would obviously reinforce further the bullish case for gold that led, at the end of the Vietnam to the Nixon shock in August 1971 and the direct international convertibility of the United States dollar to gold. Could the sudden rise in positive correlations be yet another sign of the buildup in "harmonic tremor" that would led to a regime shift in inflation? We wonder.

Given as we pointed out again recently in our conversation "Bracket creep" that bear markets for US equities generally coincide with a significant tick up in core inflation, this is the biggest near term concern of markets right now, we think. When it comes to the relation between inflation and stock markets, we read with interest Nomura's take from its Inflation Insights note from the 6th of February:

"A lesson for the near future

We think the correction in stock prices is connected to the likelihood of a return of wage inflation. We look at the traditional Gordon growth model to find that a scenario of higher wage inflation, higher inflation, higher inflation valuations, higher nominal rates and higher equity prices are very unlikely unless expectations of trend real growth substantially increase from current levels. We note that the US corporate tax cut did not manage to lift these expectations. We also note that the correction in stock prices may be a signal that US monetary policy is maybe being tightened in real terms more rapidly than what profit growth can actually sustain.

A simple framework and a reminder

According to James Bullard, President of the Federal Reserve Bank of Saint Louis, "inflation scare triggered some of the (equity) market sell-off". There is indeed a very strong theoretical linkage between inflation and equity markets, which is best illustrated in the simple framework provided by the Gordon growth model, also referred to as the Dividend Discount Model. In this very simple model of stock prices, stock prices are discounted dividend expectations so that:

Where P is the stock price, D is future dividends and y is the nominal discount factor. Assuming a constant rate of growth for dividend g, this equation can be re-written so
that:

Yet beyond this simple formula there are various assumptions that connect stock prices to the inflation market. First, y is the discount factor for stock prices, so it is the nominal risk-free rate plus the equity premium (y=r+ep). G is the growth rate for dividends, so it is in fact the nominal growth rate of the economy multiplied by the share of economic growth that goes to profits rather than wages (g=k*gdp, with gdp the growth rate of nominal GDP). Economists call it the sharing of national income.

A key factor affecting the sharing of national income is wage inflation. Average hourly earnings increased to 2.9% year-on-year in the US nonfarm payrolls report for January - their highest growth rate since 2009. This high number was perceived as heralding the return of wage inflation in the US and therefore altering the sharing of national income towards a larger share for wages and a lower share for profits.

Clearly, this framework from 1962 does not capture some other key financial aspects of the determination of stock prices. For example, it is likely that there is some linkage between the sharing of national income and the level of the risk-free rate (k and r). If wage inflation returns, the path of nominal interest rates is likely to be higher: that was also the case recently, resulting in a higher discount factor for dividends negatively affecting stock prices. With the equity premium term already minimal (implied volatility is low), there were few reasons for investors to expect higher risk-free rates to be offset by a lower equity premium.

We view this framework as a good reminder that a scenario of higher wage inflation, higher inflation, higher inflation valuations, higher nominal rates and higher equity prices are very unlikely unless expectations of trend real growth substantially increase from current levels. It is also intriguing that the US corporate tax cut was so promptly followed by the stock price correction - which suggests at least some skepticism about its effectiveness.

A minor caveat

And there is of course a minor caveat to this framework: the risk of an inflation overshoot remains noticeably absent from inflation valuations despite the increase in wages in January. Figure 1 shows that despite an increase in the 5yr inflation swap rate, the price of a hedge against inflation much higher than 2% is not historically high. We are only cautiously long 5yr breakeven rates in the US, it is worth recalling.

Too high, too fast?

Maybe the correction in stock prices - despite the tax cut - is a sign that real rates are getting close to "neutral" levels, for example the level of the natural real rate estimated by Williams and all, is likely to exert a negative effect on growth that may go beyond what inflation conditions currently imply. In other words, absent the risk of an inflation overshoot, real rates may normalise too fast, too soon - which would have an adverse impact on the real risk-free rate, but also on real dividend growth.

- source Nomura

When it comes to inflation "expectations", the above reminds us it is all about "implied" and "realized". In similar fashion, implied volatility is more simply what the market is expecting (VIX), whereas realized volatility is sometimes deemed more tangible because it reflects the actual daily movement of the S&P 500 Index. The true outlying year in history was 2008 (before 2018's sucker punch), when realized volatility was actually higher than implied volatility - the only such instance over recent years. Even in 2017, the relationship between implied volatility and realized volatility was pretty much "normal". The issue of course is that when central banks are meddling with interest rates and financial repression leads to volatility being subdued for too long, then like a coiled spring, profiting, primarily, from the "volatility premium" (the difference between implied volatility (investors' forecast of market volatility reflected in options pricing) and realized (actual) market volatility) seems like a "sure bet" for the likes of LJM Fund Management that got beaten up big time with the VIX blowing out à la 2008 (that infamous rogue waves we talk about with a breaking force of 100 MT/m2). Believing that the spread between implied and realized volatility would persist has indeed been a dangerous proposal with rising positive correlations. In similar fashion, believing that "implied inflation" could persist remaining below "realized inflation" could become hazardous in the coming months, particularly with growing geopolitical exogenous risks around. Whereas QE was deflationary, QT could prove to be inflationary, but we ramble again...

Make no mistake, inflation is the "Boogeyman" for financial markets. A sharp pickup in inflation is likely to entail a significant re-pricing, and as per our final chart below, it represents a serious headwind for the US consumers (Bracket creep aside).

  • Final chart - Increased inflation presents a potential threat to the purchasing power of consumers.

The "Big Bad Wolf" aka inflation would force the hand of central banks and lead to a more rapid pace in rate hikes leading to some significant additional repricing on the way. Inflation is our concern numero uno. Our final chart comes from Wells Fargo Economics Group note from the 8th of February entitled "Is the US Consumer Running on Fumes?" and highlights the relationship between PCE Deflator and Disposable Income:

"The Threat of Higher Inflation and Higher Interest Rates

In general, higher inflation reduces the growth rate of real disposable personal income and vice versa, which is clearly demonstrated in Figure 8.

As income and wealth are affected by fluctuations in inflation, one of the biggest threats over the next several years has to do with the rate of inflation. Markets recently seem to have been spooked by the relatively, and surprisingly, strong report on average hourly earnings, which could be indicating some pressure on prices for the U.S. economy. Higher inflation means higher interest rates, and both factors are clearly negative for the U.S. consumer. Higher inflation reduces the purchasing power of income, while higher interest rates make purchases of durable goods, which are typically financed, more expensive over time. While for those that have fixed-rate mortgages, it is music to their ears, it is bad news for those that have adjustable rate mortgages.

Although inflation has remained low in this cycle compared to its historical trend, if prices were to accelerate, Americans' real DPI growth will, once again, slow down and could also lead to a slowing of growth in real PCE, all else equal. Therefore, if we were to see an uptick in inflation, real DPI growth will slow and consumers' purchasing power, or the amount they could consume based on their current income, would be negatively affected. Although this effect is clearly demonstrated in Figure 8, it is also evident that DPI experiences fluctuations with rather lackluster inflation growth. That is, although higher inflation can directly decrease disposable income growth, it is not the only factor that causes reductions in the rate of growth of income.

Furthermore, increases in interest rates could contribute to a slowdown in real PCE, as consumer purchases might diminish based on increased expense, such as what we have previously mentioned associated with durable goods financing. Another sector of risk for the consumer as well as for the credit market is the tax reform's change in second mortgages or equity lines of credit. Americans, in some circumstances, can no longer take a credit on their taxes for interest on equity lines of credit and this together with the still-high, relative to the past, delinquency rate for these lines of credit could be signaling problems ahead for the U.S. consumer, as well as for the overall credit market." - source Wells Fargo

One could argue that the only "easing" day was yesterday. Have we seen "peak consumer confidence" in the US? It certainly looks like it, so beware of the Big Bad Wolf aka "inflation" because he has already blown apart the "short vol" pig's house made of straw...

"Worry is the interest paid by those who borrow trouble." - George Washington