Equity Markets Will Be Increasingly Accident Prone In 2016

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December 29, 2015 5:10pm NYSE:DIA NYSE:SPY

wall-street-etfTyler Durden:  BofAML’s Economics of Volatility framework has been anticipating the 2015 starting point to a turn in volatility for the last two years. 

From here on we expect to see a rising trend in equity volatility levels, a trend that could last 1-2 years, transporting us from the low volatility regime of the last 3 years towards a sustained high volatility regime.

The Economics of Volatility framework – a quick refresher

The framework attempts to forecast the transitions from low volatility environments to high volatility ones, and vice versa. These periods can last a few years at a time, as do the transitions themselves.The ends of peak and trough periods in interest rates lead declines and rises in mean volatility levels by around 2 years.

During low volatility environments, the inevitable volatility spikes that occur as new information hits the market will get washed over with plentiful risk capital, such that the spike is quickly suppressed. In high volatility environments, higher mean volatility levels can be sustained due to a reduced supply of risk capital.

The global equity derivative team’s expectation for a turn in the volatility cycle follows from a clear turn higher in 5Yr real rates in 2013, and allows for a 2-year lag (Chart 6). High volatility regimes may resemble periods like 1998-2003 or 2008-2011, as two examples. Transition periods can also take various forms.

Unlike the 1996-1998 transition period which was gradual and well behaved, the 2008-2009 transition was short and violent, as a suppressed and overdue re-pricing of risk finally manifested itself.

It’s hard to predict the exact form the next transition will take. While our base case is for an orderly transition, we are wary of the possibility of unpleasant surprises resulting from an unwinding of the highly unusual monetary policy of the last 7 years.

Unwinding extreme easy monetary policy is a tightening

The monetary tightening cycle which started with the 2013 taper has continued its progress, reflected in rising 5yr real rates. This in turn has driven a significant tightening in global liquidity as capital flows from developed to emerging markets start to reverse, evidenced in a slowdown and reversal of FX reserve accumulation.

Tightening liquidity combined with fragility: equity markets are accident prone

Chart 7 shows a measure of global US$ liquidity derived from the momentum of the Fed’s balance sheet. Historically we see that tightening cycles have typically started at high liquidity levels. The current cycle in fact started in anticipation of the tapering of the open-ended QE3 program in 2013, with the impact evident in the sharp turn in the 5Yr TIPs rate (Chart 6), and the subsequent fall in US$ liquidity.

Given how far liquidity has already dropped, it is going to be interesting to watch the impact of the more traditional part of the tightening cycle – actual rate hikes – which are expected to start imminently.

Combined with our view of an increased likelihood of local shocks due to deteriorating trading liquidity, we may find the markets more accident prone in 2016 than they have been in some time.

This article is brought to you courtesy of Tyler Durden From Zero Hedge.

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