Credit Signals European Stock Volatility Cheapening Further: Analysis

Equity volatility decline increases attractiveness as tail risks loom.

European equity volatility drops to one-year average after European Central Bank President Mario Draghi’s unconventional measures spur credit compression and cools short-tenor rates volatility. While the expansion of monetary stimulus will keep rates gamma anchored, spotlight may turn to relatively low stocks volatility to insure against global tail risks, Bloomberg strategist Tanvir Sandhu writes.

Swings in Euro Stoxx 50 Index, the region’s blue-chip index, tend to move in tandem with sub-investment grade credit index but a gap has emerged after ECB’s latest move, potentially pointing to further declines in equity volatility and an increase in its attractiveness.

iTraxx Xover has tightened about 60 basis points after the ECB decision to 321 basis points while SX5E 3-month at-the-money volatility has declined to 23 from 30.

Credit market performance has outpaced SX5E index, due to Draghi’s plan to include non-bank investment grade bonds to securities eligible for quantitative easing purchases.

The 21-day correlation between the two is now -0.67 vs year-to-date low of -0.93.

Investors, however, are awaiting details of the size and composition of the pool of eligible corporate bonds.

Risks facing investors include uncertainty over China deleveraging, global nominal growth, oil volatility, Brexit and U.S. elections.

Draghi’s change in focus away from rate cuts to more unconventional measures to improve borrowing conditions for the real economy has pared downside for front-end nominal and real yields, which may keep EUR rates short-tail gamma anchored.

Note: Tanvir Sandhu is a cross-asset derivatives market strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.

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