Buy Volatility Ahead of a Jam-Packed 'Policy Month,' Says BofAML

The central bank calendar is about to get heavy.
Photographer: Chris Ratcliffe/Bloomberg

It's time to position for the end of that peaceful, easy feeling that's enveloped markets this summer ahead of a month fraught with event risk, says Bank of America Merrill Lynch.

"We remain 'cynically bullish' on financial asset prices," writes a team led by Chief Investment Strategist Michael Hartnett. "Tactically, the 3P’s (Positioning, Policy, Profits) still argue for upside; but with risk assets up 15-20 percent since Feb, and Sep a big 'policy month' we once again recommend buying volatility."

Federal Reserve Chair Janet Yellen's speech at Jackson Hole on Friday will usher in a period in which central bankers dominate headlines, with the Reserve Bank of Australia, Bank of Canada, European Central Bank, Bank of England, Bank of Japan, Bank of Mexico, and the Fed all slated to deliver interest rate announcements in September — all against the backdrop of the U.S. elections creeping closer.

Hartnett concludes that investors aren't positioned for a firming macroeconomic environment coupled with a Federal Reserve that's more aggressive with rate hikes than is currently priced in. This combination could produce a "bond shock" that has the potential to roil equity markets, as well:

Expectations for a dovish Fed are coinciding with macro strength in the U.S. (most obviously in housing & consumer spending) as well as highest level of wage inflation since Jan’10. If average hourly earnings push above 3 percent YoY, it will be hard for bond yields to remain so low. But the biggest catalyst for higher yields would be stronger economic data in Europe and Japan, reversing the DM demand for Treasuries.

In a separate note,  Head of U.S. Equity and Quantitative Strategy Savita Subramanian pointed to seasonality — that September is typically the worst month for U.S. stocks — as one of ten reasons to expect a pullback in equities.

Bank of America joins strategists at UBS Securities LLC in warning investors to prepare for a mean reversion in volatility.

Volatility has had seemingly nowhere to go but up for the vast majority of the past four years, with the CBOE Volatility Index (VIX) averaging 15.34 since 2013, relative to its long-term average of 19.75. In fact, this index hasn't risen by a full point in a single session since the U.K. referendum in June.

VIX Index (Chicago Board Options 2016-08-25 06-42-34
Source: Bloomberg

And it's been hard to make money betting on higher volatility even when the spot levels of the VIX move higher. That's because investors aren't able to simply buy the VIX index to take a long volatility position. With the curve in relatively steep contango in the front end, the negative roll-down costs of a long position weigh heavily on the performance of exchange-traded products that hold short-term VIX futures.

Macro Risk Advisors Head Derivatives Strategist Pravit Chintawongvanich observed that 57 percent of the decline in the iPath S&P 500 VIX short-term futures ETN from June 30 (in the wake of the Brexit vote) until August 22 has been attributable to this rolldown, and less than half to the actual drop in implied volatility.

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