The markets are quiet. Too quiet?
The low level of a popular measure of volatility causes alarm
May 20th 2017
HAN SOLO, a hero from the Star Wars movies, has a habit of saying, at tense moments, “I have a bad feeling about this.” Many commentators are echoing this sentiment after a recent fall in the Volatility Index, or Vix, below ten. Their fears deepened on May 17th, when the Vix lurched above 15 and American stockmarkets had their worst day in eight months. Incessant turmoil in the White House at last seemed to take its toll.
A low Vix reading is usually seen as a sign of investor complacency. The previous two occasions on which the index fell below ten were in 1993 and early 2007 (see chart). One preceded the bond market sell-off of 1994 and the other occurred just before the first stages of the credit crisis.
The value of the Vix relates to the cost of insuring against asset-price movements via the options market. An option gives the purchaser the right, but not the obligation, to buy (a call) or sell (a put) an asset at a given price before a given date. In return, like anyone buying insurance, the purchaser pays a premium.
The price of this premium is set by supply and demand, reflecting the views of the purchaser and the person who sells, or writes, the option. A number of factors determines its size. One is the relationship between the market price and the exercise price; if the market price is $10, then the right to buy the asset at $5 must cost at least $5. Another is the length of the options contract; the longer the time period, the greater the chance that prices will move enough to make the option worth exercising and the higher the premium.
Volatility is also very important. If an asset is doubling and halving in price every other day, an option is much more likely to be exercised than if its price barely moves from one trading session to the next. No one knows what future volatility will be. But if investors are keen to insure against rapid market movements, then premiums will rise. This “implied volatility” is the number captured by the Vix.
As Eric Lonergan of M&G, a fund-management group, points out, the biggest influence on implied volatility tends to be how markets have behaved in the recent past (“realised” volatility). If the markets have been very quiet, then investors will not be willing to pay to insure against market movements, and implied volatility will be low. And markets have been very subdued of late. In early May the S&P 500 moved less than 0.2% in ten out of 11 trading days, the least volatile period since 1927.
Some see volatility as an asset class to be traded in its own right. You can buy or sell the Vix in the futures market or via an exchange-traded fund, or through a “variance swap” with a bank, in which one counterparty gets paid realised and the other implied volatility. There are also a couple of quirks that traders try to exploit. The first is that more people want to protect themselves against a big crash than against a small dip in prices. So the implied volatility of extreme options (covering, say, a 10% price fall) tends to be a lot higher than that of ones nearer the market price. Andrew Sheets of Morgan Stanley calls this a “risk premium” payable to option sellers who take the other side of the crash risk.
Another quirk is that the implied volatility tends to be higher than the realised volatility. So selling options tends to be profitable a lot of the time; you are selling fire insurance for $10 a year when claims are only $8. This sounds too good to be true and there is, of course, a catch. As the chart shows, volatility can suddenly spike; when it does, people exercise their options, leaving those who wrote them exposed to a big loss.
Has such a spike started? The temptation is to buy lots of options while the price is low. But this can be a frustrating strategy. Mr Sheets says that, when volatility was at such subdued levels in the past, it remained low for a further two or three months. Option buyers can lose a lot of money waiting for prices to rise.
Many are surprised that the stockmarket has been so quiet, given the tightening of monetary policy by the Federal Reserve, and the many political worries. Sushil Wadhwani, a fund manager, thinks that many investors were bearish before Donald Trump’s election in November and were caught out by the sudden rally in equities; they are reluctant to be wrong-footed again. They may also hope that, if the market wobbles, the Fed will help by not pushing up interest rates further.
Investors may also think that political worries come and go but the global economy and corporate profits are rebounding. If things do go wrong, and volatility continues to spike, somebody will be left with the bill. Unlike Mr Solo, traders cannot all escape in the Millennium Falcon.
America’s trade policy has a new face, Robert Lighthizer
The new US Trade representative plays by his own rules
May 18th 2017
AS IS well known, Donald Trump wants the press to focus not on what he calls “fake” news about himself, but on his administration’s achievements. On May 12th he helpfully tweeted an example: “China just agreed that the US will be allowed to sell beef, and other major products, into China once again. This is REAL news!”
His first trade deal was real, if short of the “Herculean accomplishment” touted by his commerce secretary, Wilbur Ross. It promised American credit-rating agencies, payment companies and beef exporters new access to the Chinese market, and set a deadline for progress, of July 16th.
Parts of the deal lack detail, so it may yet disappoint. China has been offering since 2006 to open its market to American beef, but with hefty restrictions. The World Trade Organisation (WTO) had already ruled that China’s restrictions on foreign payment-card companies broke its rules. And the Chinese incumbent is so entrenched that American cards may still struggle to compete.
Maybe Mr Trump picked the wrong “real” news. More important for his trade agenda was the Senate’s confirmation on May 11th of Robert Lighthizer as the new United States Trade Representative (USTR). He will matter much more for economic relations with China than a hasty mini-deal. And now that he is in place, renegotiation of the North American Free-Trade Agreement (NAFTA) can begin.
Even those who disagree with Mr Lighthizer admit that he is clever and charming. He has experience of bilateral trade negotiations from his time as Ronald Reagan’s deputy USTR. And, unusually within this administration, he knows how to work with other departments and Congress. “Everybody in the Washington trade bar wanted him confirmed because they wanted competence,” says Alan Wolff, of the National Foreign Trade Council, a business lobby.
For those alarmed by Mr Trump’s protectionist bent, Mr Lighthizer’s competence is scant comfort. His is the forensic version of Mr Trump’s economic nationalism, which sees China as a mercantilist military threat, enabled by America’s free-trade policies. His deep knowledge of the WTO, which codifies America’s trade relationship with China, means he knows the organisation’s weaknesses. He can see, for example, that it is poorly equipped to deal with China’s state-infused economy, which breeds industrial overcapacity.
Mr Lighthizer combines an encyclopedic knowledge of global trade rules with a willingness to flout them if they do not serve America’s interests. In 2010 he wrote that “an unthinking, simplistic and slavish dedication to the mantra of ‘WTO-consistency’…makes very little sense.”
At least he seems more interested in bending the existing rules to suit America than in blowing the whole system up. His success will depend on how others respond. He may need to reassure the many in the WTO suspicious of him, remembering for example a speech he gave in 2001, in which, admitting he had no evidence, he suggested that jurors on WTO panels might be “crooked”. But like his boss, Mr Lighthizer may be less interested in mending fences than in building walls.
The markets frustrate OPEC’s efforts to push up oil prices
The cartel is fighting not just shale producers but the futures market
May 18th 2017
BORROWING three words from Mario Draghi, the central banker who helped save the euro zone, Khalid al-Falih, Saudi Arabia’s energy minister, and his Russian counterpart, Alexander Novak, on May 15th promised to do “whatever it takes” to curb the glut in the global oil markets. Ahead of a May 25th meeting of OPEC, the oil producers’ cartel, they promised to extend cuts agreed last year by nine months, to March 2018, pushing oil prices up sharply, to around $50 a barrel. But to make the rally last, a more apt three-word phrase might be: “know thy enemy”.
In two and a half years of flip-flopping over how to deal with tumbling oil prices, OPEC has been consistent in one respect. It has underestimated the ability of shale-oil producers in America—its nemesis in the sheikhs-versus-shale battle—to use more efficient financial techniques to weather the storm of lower prices. A lifeline for American producers has been their ability to use capital markets to raise money, and to use futures and options markets to hedge against perilously low prices by selling future production at prices set by these markets. Only recently has the cartel woken up to the effectiveness of this strategy. It is not clear that it has found the solution.
The most obvious challenge shale producers have posed to OPEC this decade is the use of hydraulic fracturing, or fracking, to drill oil quickly and cheaply in places previously thought uneconomic. Once OPEC woke up to this in 2014, it started to flood the world with oil to drive high-cost competitors out of business (damaging its members’ own fortunes to boot).
But it overlooked a more subtle change. Fracking is a more predictable business than the old wildcatter model of pouring money into holes in the ground, hoping a gusher will generate a huge pay-off. As John Saucer of Mobius Risk Group, an advisory firm, says, shale has made oil production more like a manufacturing business than a high-rolling commodity one.
That has made it easier to secure financing to raise production, enabling producers to spend well in excess of their cashflows. Mr Saucer says the backers of the most efficient shale firms include private-equity and pension-fund investors who demand juicy but reliable returns. They are more likely to hedge production to protect those returns than to gamble on the “home run” of the oil price doubling to $100 a barrel. “Their hedging is very systematic and transparent,” he says. “They don’t mess around with commodity speculation.”
Data from America’s Commodity Futures Trading Commission, a regulatory body, bear out the shift. They show that energy and other non-financial firms trade the equivalent of more than 1bn barrels-worth of futures contracts in West Texas Intermediate (WTI), more than double the level of five years ago and representing almost a quarter of the market compared with 16% in 2012. Many of these are hedges, though Mr Saucer says the data only reflect part of the total, excluding bilateral deals with big banks and energy merchants.
OPEC and non-OPEC producers unwittingly exacerbated the hedging activity by inflating output late last year even as they decided to cut production from January 1st. The conflicting policies helped depress the spot price relative to the price of WTI futures, preserving an upwardly sloping futures curve known as “contango”. This made it more attractive for shale producers to sell forward their future production, enabling them to raise output.
That higher shale output will persist is borne out by a surge in the number of drilling rigs, which shows no signs of ebbing. The Energy Information Administration, an American government agency, reckons that by next year the United States will be producing 10m barrels of oil a day, above its recent high in April 2015. That would put it on a par with Russia and Saudi Arabia. Shale producers will have gained market share at their expense.
In response, the frustrated interventionists appear now to have set out to put the futures curve into “backwardation”, in which short-term prices are higher than long-term ones. The aim is to discourage the stockpiling of crude, as well as the habit of hedging. But success is not guaranteed.
The International Energy Agency, a forecasting body, said this week that, even if the OPEC/non-OPEC cuts are formally extended on May 25th, more work would need to be done in the second half of this year to cut inventories of crude to their five-year average, which is the stated goal of Messrs al-Falih and Novak. It also noted that Libya and Nigeria, two OPEC members not subject to the cuts because of difficult domestic circumstances, have sharply raised production recently, perhaps undercutting the efforts of their peers.
Moreover, global demand this year has been weaker than expected. In a report this week, Roland Berger, a consultancy, argued that rich-country oil demand has peaked, and that, as developing countries such as China and India industrialise, they will use oil more efficiently than did their developed-world counterparts (see chart). All this raises doubts about how far the oil price can climb.
Eventually, shale producers will have their comeuppance. Labour and equipment shortages will push up drilling costs. Higher interest rates will dampen investor enthusiasm. “Irrational exuberance” may lead them to produce so much that prices collapse. But for now, Saudi Arabia seems to be leading OPEC into a war it cannot win. As Pierre Lacaze, of LCMCommodities, a research firm, memorably puts it, it has taken “a knife to a gunfight”. Worse, it has wounded mostly itself.
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