Observation Deck: Volatility makes a comeback

 |  March 08, 2018

SVB Asset Management's monthly Observation Deck newsletter covers current topics on portfolio management, credit considerations and market events that influence investment strategy. 

Volatility makes a comeback

Steve Johnson , Portfolio Manager

There was an awful lot for investors to digest in the year’s shortest month. Volatility made an unexpected but robust comeback in February as jitters rippled throughout markets, disrupting the relative calm participants have come to expect.

At the beginning of the month, Janet Yellen’s final Federal Open Market Committee (FOMC) meeting set the stage with a statement highlighting the committee’s belief that target inflation would return this year, as opposed to remaining “below the 2 percent objective on a 12 month-basis.” They also referenced ‘further gradual adjustments’ to monetary policy, explicitly telegraphing a hawkish trajectory for Fed Funds in 2018. The FOMC communication was not the only factor that prompted this bout of volatility. Elevated average hourly earnings came in at 2.9 percent, the highest level since 2009. Next, headline CPI surprised to the upside on a month-over-month basis, adding more fuel to the market’s fear of accelerating inflation. Suddenly, investors were wondering if the Fed might have to more aggressively raise rates to slow the building price pressures in the economy.

The combination of rising inflation fears, potential for faster monetary tightening and a rise in nominal interest rates motivated participants to quickly reconsider risk asset valuations. Near-term equity and bond market equilibriums were hard to justify and equity indexes plummeted to near correction territory as markets digested the uncertainties.

Indeed, volatility was back. The S&P 500 sold off 4.1 percent on February 5th, part of a broader sell-off in risk assets. As equities wobbled and bond yields moved higher, the CBOE Volatility Index (VIX) shot up to levels not seen in nearly two years. In fact, the 20-point spike in the VIX from an already elevated level of 17 to 37 was the largest one-day move on record. This jump in volatility had dramatic ramifications, especially among investors who had allocated to a nuanced and popular strategy – shorting volatility – that had grown more common over the past 18 months. In other words, those investors (including some notable university endowment and state retirement plans) were betting on continued placid markets or even declining volatility. Unfortunately, they were caught on the wrong side of a crowded trade and suffered large losses. In fact, the derivatives used by some of these short volatility wagers and inverse-VIX products resulted in catastrophic losses and prompted the sponsors of several of these exchange-traded products into forced liquidation. No surprise, this has triggered SEC investigations and lawsuits will likely to follow. The calm that had characterized the equity markets has vanished.

By comparison, fixed income markets felt insulated throughout the equity turmoil even as nominal Treasury yields moved directionally higher and investment grade credit spreads widened modestly. The Bloomberg Barclays U.S. Aggregate Credit OAS sold off from +82 to +91 over the month, while the short duration Bloomberg Barclays 1-3yr U.S. Corporate OAS widened from +46 to +57. The Merrill Lynch MOVE index, a measure of Treasury option volatility, also moved higher along with the VIX, but much less on a percentage basis compared to its equity counterpart. Notably, with the inflationary data pointing higher in February, the 2-Year/10-Year Treasury curve steepened during the month, reversing the recent flattening trend.

By mid-month, equities had stabilized. The VIX returned to more customary readings and bond yields became more range-bound. Participants seemed to refocus on strong US corporate earnings, positive implications of tax reform and synchronized global growth. At month end, new Fed Chair Jerome Powell’s first testimony to Congress confirmed his belief in the strong footing of the US economy. With higher yields and lower equity valuations, some investors viewed the early February price dip and increased turbulence as a buying opportunity. Despite February’s bout of extreme volatility, the quick rebound in valuations seems to suggest that the aging bull market could have room to run.

Treasury Rates  
Total Returns:  
3-Month 1.63%
ML 3-Month Treasury 0.10%
6-Month 1.84%
ML 6-Month Treasury 0.07%
1-Year 2.04%
ML 12-Month Treasury 0.05%
2-Year 2.23%
S&P 500 -3.64%
3-Year 2.39%
Nasdaq -1.39%
5-Year 2.63%


7-Year 2.79%


10-Year 2.86%



Source: Bloomberg, Silicon Valley Bank as of 2/28/18

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Credit Vista: Slumber party

Tim Lee, CFA, Senior Credit Risk & Research Officer

While jarring moves in equities and interest rates are waking up financial markets, credit card asset-backed securities (CC ABS) are snoozing through a noisy beginning to 2018. In contrast to this year’s 11 percent swing from the high to the low in the S&P 500 and a 39 basis-point jump in the 2-year Treasury yield, AAA-rated CC ABS spreads have edged wider by just four basis points for fixed rate bonds and is unchanged for floating rate bonds.

Credit card graph  

Source: J.P. Morgan Securities LLC  

The relative stability reflects the solid performance of the underlying credit card accounts that collateralize the CC ABS. Our research of CC ABS trusts reveals that charge-offs are roughly only 67 percent of rating agency expectations. Meanwhile, delinquencies are near the lowest levels seen in the past seven years.

There are four key attributes contributing to these sound fundamentals:

First, the average credit card account has an appreciable track record, and these cardholders have proven to be reliable and many have successfully managed credit through the last recession.

Second, the expansion of reward programs, online transactions and consumer preferences for electronic payments have turned credit cards into synthetic cash. The growth of convenience usage has led to higher payment rates as more monthly bills are paid in full.

Third, cardholders that do carry balances are currently in tip-top shape from a robust job market, escalating wages and a lower aggregate debt servicing burden. Interestingly, in a February 2018 report J.P. Morgan Securities insinuates credit card debt could be more fundamentally stable than unsecured corporate debt because household leverage is now lower than corporate leverage.

Fourth, AAA-rated CC ABS appear well fortified against losses. Based on our research, average excess spread can absorb more than five times the average current default amount. In addition, average subordination can handle more than eight times the average number of current delinquencies. The high protection levels are one reason there has been no rating agency downgrades of AAA-rated U.S. CC ABS for more than a decade.

CC ABS are well positioned to calmly sleep through further market turbulence this year. Though rising rates will increase interest costs for borrowers, both robust labor conditions and generally good consumer balance sheets provide bandwidth to handle higher payments. More importantly, lower income tax rates should provide consumers with more cash to not only manage higher rates, but also to strengthen their repayment capabilities and keep delinquencies from moving materially higher.

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Economic Vista: The revival of inflation?

Renuka Kumar, CFA, Director, Portfolio Management

It was hard to miss the fact that inflation data took center stage this month. The growth in wages witnessed in early February, through the average hourly earnings report, reverberated through global markets as concerns grew over the prospect of rising prices and the possibility of accelerated rate hikes by the Fed in order to combat rising inflation.

Average hourly earnings surpassed market expectations, rising 0.3 percent on a month-over-month basis in January and 2.9 percent on a year-over-year basis – the most in almost a decade. Rather than the gains being broad-based, the majority of gains came from highly skilled industries. Additional inflation readings – such as CPI and PPI – also reflected a pickup. All CPI readings came in above market expectations with headline CPI for January at 0.50 percent month-over-month and 2.10 percent year-over-year. Headline PPI for the same period rose 0.40 percent month-over-month and 2.70 percent year-over-year.

Inflation aside, the economy continued to grow at a measured pace. The second estimate of fourth quarter GDP came in at a healthy rate of 2.5 percent driven by robust consumption of 3.8 percent. Nonfarm payrolls rose by a better-than-expected 200,000 the prior month while the unemployment rate hovered at a cyclical low of 4.1 percent. However, a weak spot in the monthly data was retail sales. Overall retail sales fell 0.3 percent the prior month, which was the largest decline in a year.

The higher-than-expected inflation readings may have contributed to near-term market volatility, but we don’t believe that the beginning signs of inflation will dampen growth expectations. Rather, the economy remains on track for continued growth given the already healthy labor market and potential stimulative effect of tax reform. Moreover, the Fed has already been under the assumption that inflation would pick up in the near term and we believe it will continue their measured pace of rate hikes in order to fulfill its dual mandate of price stability and job growth.

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Trading Vista: Buyer's market

Jason Graveley, Fixed Income Trader

My, how quickly the script can flip. In January, we touched on how the domestic economy was benefiting from strong corporate earnings, tax reform and rising wages. In turn, markets were responding to soaring demand for investment grade assets, grinding credit spreads to their tightest levels in over ten years. But that was then. In February, we witnessed a complete reversal. Investors stepped back from the market as volatility spiked early in the month and global equity markets plunged. Although equities have largely recovered, the tumult was not lost on investors. The supply-demand dynamics that we had seen throughout much of the bull market shifted abruptly, with dealer balance sheets swelling to capacity as a result. The VIX, the most popular measure of near-term equity volatility and often referred to as Wall Street’s fear gauge, surged to record highs. At one point, investors offering to sell securities outnumbered those buying by a whopping 6:1 ratio.

Despite the spike in volatility, we welcomed the changing dynamics and increased supply. Prudent duration management has left our client portfolios positioned to take advantage of any short-term price dislocations. The widening credit spreads, coupled with rising benchmark yields, caused all-in yields to spike. In turn, the securities within our focus area cheapened by up to 25 basis points, which we believe is more a reflection of panicked investors opposed to any fundamental deterioration in investment grade credit. The shift allowed us to add some of the highest-rated investment grade names at what we believe are discounted prices, a reprieve from the trend we’ve seen over recent years. During that spike in volatility in early February, it was a buyer’s market, briefly. It remains to be seen if elevated volatility returns and presents additional buying opportunities in the coming months.

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The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decisions. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction.

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SVB Asset Management, a registered investment advisor, is a non-bank affiliate of Silicon Valley Bank and member of SVB Financial Group.

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