Impact of Quantitative Easing - US vs Europe

I found interesting to compare the impact of Quantitative Easing / Operation Twist / Bailout / EFSF / SMP / Mario Draghi's Bazooka on the Equity Markets, in US and Europe on a timeline. 

In the US, the market is very responsive to QE. As a consequence, the S&P Index is back to April 08 level. In Europe, well ... I am still trying to find a pattern. It looks like a mess to me. Good news is bad news, but sometimes not, while bad news is bad news but sometimes good. And vice-versa... Something like that.

Steepness in the Forward Volatility Term Structure

I was looking at the steepness in the forward implied volatility and found something interesting. Currently, in the wonderful VIX world, the 1 month forward volatility term structure is the steepest ever (99th percentile) over the last 7 years, when looking at the difference between the 7 month and 4 month forward contracts (UX7 Index and UX4 Index in Bloomberg). The difference is 4 vols.

The trade here, is to sell the 7 month and to buy the 4 month contract in order to benefit from the convergence between the two volatilities. So the position is paying decay. In order to figure out how much decay the position is inflicting, I had a look at the 1 month / 3 month contracts spread in order to assess the cost of carry. The difference is 5 vols, which means that, provided we hold the position until maturity, the cost of holding the spread is 1 vol.

Looking at the risk/reward, I believe that the maximum steepness between the two contracts will be 5 to 6 vols (losing 1 to 2), while the possible gain is of 4 to 6 vols. the risk/reward ratio seems appealing, while the cost of carrying the positing is one of the smallest since 2005.

Why is the forward term structure so steep? 

I think that at the moment, we are in a world of financial repression where equity and bond markets are wherever central banks want them to be. The greater the level of monetary expansion, the calmer the VIX and the higher the gains in the S&P Index.

So, as realised volatility is poor and the equity market is rallying, implied volatilities are drifting lower and lower (even to truly absurd levels given the state of our economies), especially in the front end of the term structure. However, market participants still expect volatility to pick up in the future. 

So in a certain way, we go back to the same question, which is how long our politicians and central bankers can kick the can down the road and avoid confronting the real issues.

Yeeehaaa! Let's Save The Euro, The World and The Princess!

Bearish Trading Strategy - with a twist

If you are bearish on an underlying, on low implied volatility names, you can:

-        Buy a naked put spread

-        Buy a put (hedged)

-        Buy an upside call (hedged)

Let's talk about the last trading strategy. It sounds counterintuitive, however, let's have a closer look. 

The interesting part is that, on a low implied volatility / high convexity underlying, the return is higher than on a hedged long put. See the detailed analysis below, for an instantaneous 5% down move.

Notes:

-         As the spot moves down by 5%, implied volatility follows the skew and is readjusted. Lets imagine (and this is purely fictive) that implied volatility moves up by 1% (fixed strike). Also, as we move away from our call, its implied volatility increases more (convexity). So we considered that for the call, the adjustment is 2 vols (This is an rough estimate - no science behind)

-        Being long the call, we end up with 9% delta, so we are still a bit short shares. Being long the put creates a larger delta position, so we are more and more long shares of a crashing underlying.

-        The highest performance is from the put spread strategy, we left it as a benchmark.

Greece Exit Contingency Plans On The Way ...

While in Europe we are still quite casual about Greece leaving the Eurozone, talking about it as a possible outcome without putting numbers on it (probably no one knows how broad the shock waves will be - think about the Lehman bankruptcy), American banks and consulting firms are advising their corporate clients on how to prepare for a splintering of the euro zone, something that was once unthinkable.

- Bank of America Merrill Lynch has looked into filling trucks with cash and sending them over the Greek border so clients can continue to pay local employees and suppliers in the event money is unavailable.
- Ford has configured its computer systems so they will be able to immediately handle a new Greek currency.
- JPMorgan Chase has already created new accounts for a handful of American companies that are reserved for a new drachma in Greece (or whatever currency)

Almost all of that has come in the last 90 days..
In a survey this summer, 80% of clients of an American consulting firm polled expected Greece to leave the euro zone, and a fifth of those expected more countries to follow. This morning, a FT poll found that 25% of Germans think Greece should stay in the Eurozone or get more help from other countries in the currency union.

Clearly, banks and consulting firms are making money from the fear of the Euro break-up. So should we be sceptical? Or start running around the house like mad?
On Thursday, the European Central Bank will consider measures that would ease pressure on Europe's cash-starved countries...

Just below, you can find the calendar of events for the Euro-zone.