Could betting on low volatility backfire? And do these inflation readings point to strength or weakness. Get our thoughts on these questions and more in this week’s edition of Steady Investor’s Week:
When Betting on Low Volatility Backfires – in a classic case of ‘chasing heat,’ many investors gravitated over the last year into risky securities that were designed to perform well in low volatility environments. Given the relative calm of the markets since early 2016, the Wall St. Journal reported this week that “pension funds, endowments and family offices often made big, unpublicized wagers seeking to benefit from what had been an unusually long period of low volatility, according to pension-fund consultants and others who deal with these institutions.” The basic premise of the investment tactic is that a portion of the portfolio could earn money selling “put” options, which is essentially a bet that markets would stay calm or rise. There were also a crop of low volatility ETFs that were designed to deliver returns so long as volatility remained subdued. That all changed when the onslaught of volatility in early February led many to unwind these positions or abandon them altogether, which arguably exacerbated the downside. The WSJ also reported that FINRA is scrutinizing whether traders placed bets on S&P 500 options to influence prices for VIX futures, which they could label as outright manipulation. Earlier in the week, a law firm sent a letter to U.S. regulators urging them to investigate VIX manipulation, claiming it has cost investors hundreds of millions of dollars in losses each month. Our question about of this is, are VIX bets really worth it?
Inflation Readings Point to Strength – in the UK, inflation readings in January soared to their highest levels in nearly six years, hitting an annual rate of 3%. The Bank of England somewhat surprised markets with their response, indicating that they wanted to return inflation back to a 2% range within two years instead of the previously disclosed three. That could potentially mean a faster rate of interest rate hikes, which may make UK stocks less attractive relative to other regions that are still easing or tightening more slowly. Inflation has risen considerably since Brexit. Here in the U.S., the consumer price index for all urban consumers (CPI-U) increased 0.5% in January on a seasonally adjusted basis, according to the U.S. Bureau of Labor Statistics. Over the last 12 months, the all items index rose 2.1% before seasonal adjustment, which brings it within the Federal Reserve’s target range.
Pressure on Interest Rates – we observe that higher inflation tends to put upward pressure on bond yields, as investors demand a higher yield to compensate for the potential erosion of purchasing power in the future. Anecdotally, we can already start to see signs of the effects in the consumer markets. The average rate for 30-year home loans climbed this week to 4.38%, the highest since April 2014, according to Freddie Mac data released last week. The 10-year Treasury yield has also been on the rise, and we’re seeing signs of buyers rushing to lock-in rates before they go even higher.
Is the U.S. Consumer Over-Leveraged? — Total household debt rose by $193B to an all-time high of $13.15 trillion at year-end 2017 from the previous quarter, according to the Federal Reserve Bank of New York’s Center for Microeconomic Data. The rise marks the 5th consecutive growth year for annual household debt, with increases across virtually every category: mortgage, student, auto and credit card. Borrowing standards have risen since the 2008 Financial Crisis, so arguably the new debt could be classified as having a different risk profile from mortgages originated in the early 2000s. But the nominal number is still worth eyeing.
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