A Positive Risk (Lower VIX) Scenario For Q2

I am bearish volatility based on the feasibility of restarting economies without rekindling the epidemic and on the policy response.  This suggests buying investment grade credit and equities in the US and UK as well as EM carry.  Based on the Fed balance sheet plans, the USD could be about to embark on a multi-year down trend.

 

Chart 1: Cases and Slope of Epidemic Curve

Source: Macro Hive, Johns Hopkins university

 

There are two key reasons to expect the Vix index to fall further from here.  First is increasing evidence that quasi economic normalcy can be maintained without rekindling the epidemic.  With many countries entering lockdowns and effectively shutting down their economies, last month’s Vix spike largely reflected fears that either mass mortality could not be avoided or, if it was avoided, the cost would be economic collapse.

Since then, countries’ lockdowns have started to show results.  In addition, countries that were able to avoid lockdowns have still managed to contain their epidemic.  Hong Kong, Singapore and Taiwan have contained an early March renewed increase in cases.  Singapore has recently entered a lockdown, but its case count of around 260 per mn population remains well below, for instance, Denmark’s 1000 per mn population, which is one of the lowest in Europe (Chart 1).

Sweden remains the global outlier.  It has not gone into lockdown and has implemented looser social distancing than other European countries.  Yet it one of the lowest case counts in Europe as well as a flatter epidemic curve than France, the US or the UK.  Its 8% mortality rate is high but could reflect measurement issues.

European countries are now considering reopening strategies, and Austria and Denmark have already announced specific plans.  Successful reopening will require testing of the general population for infections as well as for immunity, which every advanced economy is currently setting up.  It will also require extensive contact tracing, which can be achieved by repurposing the extensive personal information already collected by the private sector.  In addition, precautionary business and personal practices will have to remain in place.  But businesses will be gradually allowed to reopen, which will end the economic collapse.

The second reason to be bearish volatility from here on out is the policy response, which has been much more proactive and aggressive than in 2008.  In 2008, the policy response took place after large-scale households and financial sector insolvencies were already underway.

 

Table 1: Policy Support

NA = Not Applicable

Source: Macro Hive, IMF

 

By contrast, this time around the policy response is attempting to pre-empt an illiquidity crisis from turning into an insolvency crisis (Table 1).  In developed markets, central banks have therefore been at the forefront of policy support through the provision of liquidity, asset purchases, the provision of credit to the private sector, and through rate cuts.  They have gone to extraordinary lengths to ensure that liquidity is flowing to where it is needed.  For instance, the Fed Commercial Paper Credit Facility involves a grandfathering of the rating eligibility to before 17 March, and  the ECB has relaxed its collateral requirements.  Additional policy options include debt holidays already implemented by countries such as Italy and Brazil.

Fiscal policy has also been eased, though to different extents.  Fiscal easing has been strongest in the US, Japan, Germany and the UK and more limited in France, Italy and Spain, as well as in EMs.

It is still early in the process but on balance I expect the policy response to be more successful in the US and UK than in the Euro area and Japan.  In the US, elections are due to take place in November, which suggests the economy will be back before then.  And while the UK has just gone through an election, its government has also embarked on aggressive policy easing.

In the Euro area, by contrast, fast agreement on common policy response, including issuance of “coronavirus bonds”, is hampered by the governance structure: 19 sovereign states with divergent economic structures and policy objectives.  In Japan, liquidity provision, especially to SMEs, has been limited. And while the fiscal stimulus looks impressive, historically, actual Japanese deficits have tended to undershoot the announced government target.

These considerations suggest the following Vix scenario, i.e. a framework to organize incoming information around four key themes: market functioning, US epidemic, US policy support, and US economic performance.

 

Table 2: VIX Scenario

Source: Macro Hive

 

Chart 2: VIX Index

Source: Macro Hive, Haver

 

This scenario suggests buying equities and investment grade bonds in the US and UK and carry EM currencies such as MXN, RUB, TRY, ZAR, IDR.  In addition, the scale of the Fed balance sheet expansion relative to other central banks suggests that the multi-year trend of USD strength could be about to reverse.  With the US exiting the GFC earlier than other countries and with higher yields, the USD went through a 40% real, trade-weighted appreciation during 2011-17.  This time around, the Fed may well have decided it did not want a repeat (Chart 3).

 

Chart 3: USD Trade Weighted Indices

Source: Macro Hive, Haver