For wholesale investors in Australia

Things have changed: the options market suggests monetary tightening to moderate

Ashwin Alankar, PhD

Ashwin Alankar, PhD

Head of Global Asset Allocation | Portfolio Manager


25 Feb 2022

Key takeaways:

Signals from the options market about the near-term direction of asset classes indicate that investors are anticipating central banks will dial back their monetary tightening to support a global economy now dealing with a major geopolitical shock.

Key Takeaways

  • Option markets provide powerful signals on the near- to mid-term direction of several asset classes by measuring expected upside and downside volatility expectations.
  • Based in these readings, it appears the option market anticipates the pace of monetary tightening will be considerably curtailed in the wake of the Ukraine crisis.
  • Market segments such as U.S. equities and short-duration bonds that are vulnerable to rising rates could instead experience greater upside volatility, according to option signals.

As the Ukraine crisis has escalated from a battle of words to a battle on the field, we wanted to peer through the lens of the option market to determine whether it expects more upside or downside volatility. We found that while geopolitical risk leads to heighted market risk – which is bad – the aggressive monetary tightening that investors have feared in recent months now appears less likely to occur, which would be a welcome development for asset classes most vulnerable to rising rates. The option market sees the pendulum swinging toward upside volatility in regions like the U.S. where central banks laid out aggressive tightening plans. It now deduces that tightening will likely unfold at a much more moderate pace.

Unsurprisingly, option-based signals see higher volatility for equities. Interestingly, the market expects volatility to be biased toward the upside in U.S. stocks. This contrasts with non-U.S. equities, particularly Asia and emerging markets, as indicated in the charts below, which plot the ratio of expected upside-to-downside volatility within the context of historical levels. A greater upside for certain equity markets is likely due to an expected reversal of the monetary tightening priced in prior to the Ukraine crisis as central banks – among them the Federal Reserve (Fed) – must now move with greater caution. We have already witnessed the expected number rates hikes by the Fed at its March meeting fall from 1.8 two weeks ago to 1.2.

For the same reasons, global treasuries appear more attractive according to option markets. This is particularly the case in Europe. The risks of withdrawing liquidity too quickly in the current environment is simply too high. In the U.S., the option market views the volatility of shorter maturity Treasuries (under five years) to be biased toward the upside rather than the downside compared to 30-year Treasuries. A less-aggressive Fed should produce fewer rate hikes, benefiting shorter-maturity Treasuries most. Ultimately this may hurt longer-dated bonds as inflation expectations build. The option market is already telling us the attractiveness of the 5-year Treasury is above average while that of the 30-year is below.

The option market continues to see greater upside volatility to oil and improved attractiveness to gold. Gold – as a real asset – could potentially benefit from more moderate monetary tightening as that stands to limit the rise in real interest rates.

Both the “good” and the “bad” are at play today. War is terrible and lives will be upended. Central banks recognize this and will be much more measured in raising the cost of capital. While a horrible price to pay, moderated policy tightening could provide needed support for markets in otherwise uncertain times, especially in segments such as U.S. stocks and global bonds where aggressive tightening had been priced in.

The boxplots below display the “tail-based” Sharpe ratio, defined as the ratio of expected tail gains over expected tail losses for various assets. The grey shaded areas represent the inter-quartile range of this ratio over the last three years of daily observations. The line through the grey area represents the median value. The blue dot represents the tail-based Sharpe ratio from one month ago. And lastly, the red dot represents today's tail-based Sharpe ratio. The higher up the red dot lies on the boxplot, the more attractive the asset is.

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Global Equities

global equities

Source: Janus Henderson Investors, data as of 23 February 2022.

Fixed Income

fixed income

Source: Janus Henderson Investors, data as of 23 February 2022.

Fixed Income Yield Curve

fixed income yield curve

Source: Janus Henderson Investors, data as of 23 February 2022.

Commodities

commodities

Source: Janus Henderson Investors, data as of 23 February 2022.

Glossary

Duration measures a bond price’s sensitivity to changes in interest rates. The longer a bond’s duration, the higher its sensitivity to changes in interest rates and vice versa.
EURO STOXX 50® Index provides a blue-chip representation of supersector leaders in the euro zone. The index covers 50 stocks from 11 euro zone countries: Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain.
Nikkei 225 Index is a measure of Japanese economic and equity market performance. The Index includes 225 of the largest companies listed on the Tokyo Stock Exchange.
S&P 500® Index reflects U.S. large-cap equity performance and represents broad U.S. equity market performance.
Sharpe Ratio measures risk-adjusted performance using excess returns versus the "risk-free" rate and the volatility of those returns. A higher ratio means better return per unit of risk.
Volatility measures risk using the dispersion of returns for a given investment.

Equity securities are subject to risks including market risk. Returns will fluctuate in response to issuer, political and economic developments.
Fixed income securities are subject to interest rate, inflation, credit and default risk.  The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa.  The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
Emerging market investments have historically been subject to significant gains and/or losses. As such, returns may be subject to volatility.
Commodities (such as oil, metals and agricultural products) and commodity-linked securities are subject to greater volatility and risk and may not be appropriate for all investors. Commodities are speculative and may be affected by factors including market movements, economic and political developments, supply and demand disruptions, weather, disease and embargoes.

This information is issued by Janus Henderson Investors (Australia) Institutional Funds Management Limited (AFSL 444266, ABN 16 165 119 531). The information herein shall not in any way constitute advice or an invitation to invest. It is solely for information purposes and subject to change without notice. This information does not purport to be a comprehensive statement or description of any markets or securities referred to within. Any references to individual securities do not constitute a securities recommendation. Past performance is not indicative of future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

 

 

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