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Signals from the options market about the near-term direction of asset classes indicate that investors are anticipating central banks will dial back their monetary tightening to support a global economy now dealing with a major geopolitical shock.
As the Ukraine crisis has escalated from a battle of words to a battle on the field, we wanted to peer through the lens of the option market to determine whether it expects more upside or downside volatility. We found that while geopolitical risk leads to heighted market risk – which is bad – the aggressive monetary tightening that investors have feared in recent months now appears less likely to occur, which would be a welcome development for asset classes most vulnerable to rising rates. The option market sees the pendulum swinging toward upside volatility in regions like the U.S. where central banks laid out aggressive tightening plans. It now deduces that tightening will likely unfold at a much more moderate pace.
Unsurprisingly, option-based signals see higher volatility for equities. Interestingly, the market expects volatility to be biased toward the upside in U.S. stocks. This contrasts with non-U.S. equities, particularly Asia and emerging markets, as indicated in the charts below, which plot the ratio of expected upside-to-downside volatility within the context of historical levels. A greater upside for certain equity markets is likely due to an expected reversal of the monetary tightening priced in prior to the Ukraine crisis as central banks – among them the Federal Reserve (Fed) – must now move with greater caution. We have already witnessed the expected number rates hikes by the Fed at its March meeting fall from 1.8 two weeks ago to 1.2.
For the same reasons, global treasuries appear more attractive according to option markets. This is particularly the case in Europe. The risks of withdrawing liquidity too quickly in the current environment is simply too high. In the U.S., the option market views the volatility of shorter maturity Treasuries (under five years) to be biased toward the upside rather than the downside compared to 30-year Treasuries. A less-aggressive Fed should produce fewer rate hikes, benefiting shorter-maturity Treasuries most. Ultimately this may hurt longer-dated bonds as inflation expectations build. The option market is already telling us the attractiveness of the 5-year Treasury is above average while that of the 30-year is below.
The option market continues to see greater upside volatility to oil and improved attractiveness to gold. Gold – as a real asset – could potentially benefit from more moderate monetary tightening as that stands to limit the rise in real interest rates.
Both the “good” and the “bad” are at play today. War is terrible and lives will be upended. Central banks recognize this and will be much more measured in raising the cost of capital. While a horrible price to pay, moderated policy tightening could provide needed support for markets in otherwise uncertain times, especially in segments such as U.S. stocks and global bonds where aggressive tightening had been priced in.
The boxplots below display the “tail-based” Sharpe ratio, defined as the ratio of expected tail gains over expected tail losses for various assets. The grey shaded areas represent the inter-quartile range of this ratio over the last three years of daily observations. The line through the grey area represents the median value. The blue dot represents the tail-based Sharpe ratio from one month ago. And lastly, the red dot represents today’s tail-based Sharpe ratio. The higher up the red dot lies on the boxplot, the more attractive the asset is.
Source: Janus Henderson Investors, data as of 23 February 2022.
Source: Janus Henderson Investors, data as of 23 February 2022.
Source: Janus Henderson Investors, data as of 23 February 2022.
Source: Janus Henderson Investors, data as of 23 February 2022.
Duration measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.