Macro traders are a miserable lot these days. Extremely low volatility means financial markets are in snooze mode, leaving hedge funds and other macro-oriented players with fewer opportunities to employ trend-following trading strategies and upending some traditional fundamental market patterns.
With traders putting much of the blame on the lack of movement in official interest rates, it feels almost like uncharted territory. Well, maybe not.
John Hopkinson, an FX strategist at Bank of America Merrill Lynch, offers the chart above in a bid to show that recent price action and volatility across U.S. equities, interest rates, commodities and the dollar has evolved in a way “remarkably similar” to what happened in 2005 – 2006. The most obvious similarity is apparent in forex volatility, which has already slumped near the low from 2006, Hopkinson said in a note.
Not everything is the same, however, and Hopkinson says an understanding of the differences and similarities between now and 2006 offers a useful framework for understanding markets in 2014. For one, a flattening yield curve indicates markets are pricing in the end of the Fed’s tightening cycle, even though rate hikes are far from imminent. If so, that means market participants should be paying more attention to what happened in 2006. He elaborates:
The flattening of the US rates curve since December is consistent with the premise that tapering marked the beginning of a tightening cycle. Our hypothesis that the market is pricing a lower terminal rate essentially means that the market is currently pricing the end of the hiking cycle. This means markets are at a similar point in the cycle to 2006. The idea that the tightening cycle is nearing completion seems absurd, but in an era of extreme transparency from the Fed, it is not unreasonable that the market can try to price Fed policy years in advance. Ultimately it is what the market is pricing that matters, in our view.
There has been some debate as to whether 2014 will be more like 1994, with higher rates volatility and inflation, or 2004 with subdued inflation and lower volatility. If the answer is actually 2006, then evidently the rates curve should continue to flatten, and indeed considerable flattening is now priced. The short term outlook for the dollar is less clear, with the path of inflation being a crucial factor.
As for the differences, Hopkinson says that while the level of forex volatility in 2014 is similar to 2006, the drivers are quite different:
Convergent economic fundamentals and monetary policy (both actual and forecast) are key factors at present. In 2006, longer dated volatilities were suppressed by retail structured product flow, creating deep liquidity. Liquidity was reflected in an increase in leverage utilization in 2006. Post-crisis consolidation together with more stringent capital regulations on banks means that this deep liquidity may remain elusive. This justifies a term premium that can keep FX volatility curves very steep without creating expectations of significantly higher volatility.
Hopkinson says that’s good news in that it should soothe fears that “if we are currently in 2006, what comes next might be like 2007-2008.”
A short hiking cycle accompanied by low volatility and leverage suggests markets might evolve more like 1996-1997, he says.
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