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Bank of America: The Hunt for Yield May Be Reaching an Inflection Point

Volatility could be set to make a major comeback.

No trade is safe from the great search for yield, not even volatility.

Research by Bank of America Merrill Lynch shows there's been a steep drop-off in exposure to securities that gauge expectations of volatility, as investors sell a VIX index that's already at depressed levels to enhance yield. The market is at its lowest VIX exposure as far back as their data goes, they say, meaning there's a brewing risk of a sharp correction.  

"Selling volatility to enhance yield is now at an extreme level, with net speculative VIX exposure at all-time shorts," the analysts, led by Christopher Xiao, write. To Bank of America, those record lows mean "the recent chase for yield has potentially reached an important inflection point." 

As the market hunts for yield across all assets, so too the risk of simultaneous corrections across multiple asset classes has increased. "Crowded short positioning across the volatilities of numerous assets worries us as we believe the next shock will likely lead to a volatility spike that is exacerbated by elevated cross-asset correlations," they write. 

There are a number of places that the said 'shock' could come from, the analysts say. These include a Federal Reserve that hikes faster than the market is anticipating, an uncertain election in the U.S., and market sentiment souring and over Italy's troubled banks

Calm tends to come before a volatility storm, according to Xiao et al. The last time cross-asset volatility was this low was in the summer of 2014, just before it spiked to recent highs as central banks across the globe began diverging in their monetary policies.

Selling volatility can be a profitable strategy when its price is elevated, they say, "but doing so at current levels exposes investors to highly asymmetric risks."

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