(Repeats Monday item without changes)
By Jamie McGeever
LONDON, Jan 22 (Reuters) - Even in a world of increasing political uncertainty, you could have set your 2017 financial market clock by three certainties: rising stocks, falling volatility and a flattening U.S. yield curve.
As 2018 gets underway, one of these trends is still in play. Wall Street continues to power on and is already up 5 percent, with the Dow breaching 26,000 points and printing new record highs in all but three of its 13 trading days so far this year.
But all of sudden, volatility and the yield curve aren’t playing ball. The VIX index of implied volatility on the S&P 500 leapt to its highest in over a month last week and the yield curve is steepening, albeit from an historically low base.
To be clear, it’s too early to say this presages the long-awaited market correction, far less a crash. In fact, it’s more likely it is signalling more volatility due to a tax-related quickening of growth, inflation expectations and acceleration of stock gains.
Whatever the implication, it suggests years of smooth sailing in debt and equity markets may be coming to an end and that volatility may be driven by more than a fear of a correction.
For the past three decades there has been a virtually unbroken inverse correlation between the VIX and S&P 500 — as stocks rose, volatility fell. For the majority of that time it’s been extremely strong at -0.75 or more — on a scale where one-for-one lockstep moves register -1.0. — on both daily and weekly measures.
This stands to reason as low implied volatility is the cornerstone of a buoyant market, both encouraging risk-taking as well as reflecting it, while higher implied volatility has typically been the mirror opposite. Breaking that link could be profound.
The weekly correlation is now -0.55, the weakest since April 2005. On a daily basis the correlation moved to -0.46 on Jan. 12, the weakest in a month and joint-weakest in almost a year.
Investors and traders are still naturally positioned for lower volatility. The most heavily traded VIX contract expiring on Feb. 14 has 411,283 open interest positions on “call” options on strike prices from 10.0 up to 13.0. The equivalent number of open interest “put” options on the same strikes is 811,738.
A call option is effectively a bet an asset will rise in price over a given period of time, and a put is a bet it will fall.
There’s also a heavier skew of puts to calls in the VIX contracts expiring on March 21 (295,175 vs 205,818) and April 18 (138,132 vs 89,611).
But a drill down into the March and April contracts shows that open interest on call options is larger than put options at the highest strike price. For March this is 84,601 calls vs 56,235 puts for a strike of 13.0, and for April it is 70,009 calls vs 49,541 puts on a strike of 15.0.
One interpretation is this is perfectly normal. Because these strike prices are “out of the money”, they offer investors cheap insurance against an increase in volatility.
But another interpretation is investors are positioning outright for a rise in volatility.
Meanwhile, the flattening yield curve was a major reason why financial conditions in the United States loosened so much last year despite the Federal Reserve raising interest rates. According to Goldman Sachs, the last time financial conditions were this loose was 2014.
It’s too premature to say the four-year curve flattening trend is over. Last year the curve steepened by 10 basis points or more six times, yet the gap between two and 10-year yields hit a decade-low of 49 basis points earlier this month.
Still, this month has already seen two bouts of rapid steepening, and on Monday the 10-year yield rose to 2.67 percent, its highest since July 2014. At the very least, yield curve flattening has paused.
A flattening yield curve is a classic warning sign of rockier economic times ahead. While this would appear to be a bearish signal for stocks, it suggests monetary policy will be kept loose or maybe even ease, thereby supporting equities as much as fixed income.
All else being equal then, a steepening yield curve is a sign of a healthier economy and is exactly what central bankers are trying to engineer. But it also reflects a tightening of financial conditions, which markets may not like.
Yet stocks have powered on and volatility has spiked higher. The VIX index rose to a seven-week high just below 13 percent on Wednesday last week, a day after the S&P 500 reached a record peak of 2,807 points.
Signs of fragmentation between these links and correlations suggest investors should be wary about taking for granted the benign conditions that have driven relentless gains in stocks and other assets over the past two years.
No investor wants to miss out. According to Bank of America Merrill Lynch, equity fund inflows of $58 billion over the past four weeks are the highest on record. A “super frothy” start to the year, it notes.
But if volatility and long-dated yields continue to rise, some of that froth could quickly some off.
Reporting by Jamie McGeever; Editing by Catherine Evans