June 20, 2013 / 2:18 PM / 4 years ago

Great volatility rotation takes hold

LONDON, June 20 (IFR) - Fixed income assets have become more volatile than equities over the past few weeks, turning an age-old market dynamic on its head and providing a further sign of investors re-balancing portfolios towards stocks and shares.

Fears that the US Federal Reserve may scale back its USD85bn monthly purchases of government and agency debt sparked a sell-off last month, hitting the main beneficiaries of quantitative easing such as high yield and emerging markets particularly hard.

But even as implied volatility on bond exchange-traded funds and EM currency pairs hit yearly highs on the back of the outflows, the VIX - CBOE's equity volatility index, often referred to as Wall Street's fear gauge - barely budged.

"We're observing a great volatility rotation between equity and fixed income," said Kokou Agbo-Bloua, head of European equity derivatives strategy at BNP Paribas.

"In past crises, equity has led the way in volatility because it sits at the bottom of the capital structure. But as QE has distorted fixed income assets more dramatically than equities, the senior part of the capital structure has become far more volatile on talk of a QE exit."

The VIX has failed to rise above 20 this year - a far cry from previous shocks, when it acted as a market bellwether.

As the US financial system teetered on the brink of collapse in October 2008, the VIX rocketed to just below 90, while in August 2011 it spiked to 48 on the back of the eurozone crisis.

Right now it is around 17, while the S&P500 looks resilient, up 14% so far this year.

In contrast, fixed income markets have become increasingly choppy over the past month.

BNP Paribas analysts calculate the iShares Barclays TIPs, Investment Grade and High Yield ETFs are currently the most volatile they've been in a year, and are all clocking in negative returns since the start of 2013.

"I can't remember the last time equities were less volatile than credit," said Peter Duenas-Brckovich, global co-head of flow credit trading at Nomura. "Equities have been incredibly stable, which suggests that money is slowly dribbling into the asset class. Perhaps investors will take note of this stability when they decide to put risk back on."

BONDS OUT, EQUITIES IN

There remains little doubt the so-called great rotation out of bonds into equities is well underway.

EPFR Global, a data provider, showed US bond mutual funds experienced outflows of almost USD10bn in the first week of June - their worst outflow in five years.

Other data suggest this is more than just a temporary blip. JP Morgan analysts noted US pension funds and insurance companies sold USD10bn of bonds and bought USD13bn of equities in Q1, pushing their equity weightings to 45% - their highest levels since 2007.

"If the economy improves and the Fed tapers, then money will flow in from fixed income; if the recovery stalls, QE will continue to support asset prices. Either outcome is good news for stocks," said Jakob Horder, global head of structured rates trading at Morgan Stanley.

Meanwhile, there is good reason to believe support for equities will continue. The equity risk premium - the excess return over risk-free rates required by investors to take equity exposure - is close to historical highs, said Agbo-Bloua, indicating equities are still under-owned.

At the same time, share prices are buoyed and volatility dampened by the USD35bn a month of equity buybacks in the US - the equity market's very own version of QE. Overall, many see equities as a safe bet.

"The great rotation has already started and the end is in sight for the hunt for yield theme. It's a matter of when, not if," said BNP's Agbo-Bloua.

Although bond outflows have been relatively small to-date, some fear it could be a taste of things to come for credit markets.

Fed data show corporate bond inventories at major dealers have fallen by around 75% since their 2007 peak as banks have trimmed balance sheets in response to more stringent capital requirements, and many doubt the market could take a large sell off in its stride.

"Banks simply don't have the balance sheet to absorb the amount of fixed income risk out there. In the absence of buyers, volatility in less liquid assets will creep up, as we've seen over the past few weeks," said one senior fixed income banker at a US house. (Reporting by Christopher Whittall, editing by Helen Bartholomew)

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