Equity hedges are priced for a growth shock while the market keeps delivering a rate shock

The most expensive mistake available in this market costs almost nothing to make. Three month at the money implied volatility on the S&P 500 closed the week at 14.8, near the bottom decile of the past five years, and a portfolio manager who wants downside protection can buy it for less than at any point since spring. The protection is cheap for a reason that has nothing to do with complacency. It is cheap because the index it references has stopped responding to the risk that is actually moving portfolios.

Set that against the rates market. The Norwood Quay rates volatility index, which measures implied volatility across the swaption surface, closed at 112. Its five year average is 84. The two markets are describing different worlds, and the one describing the world investors are living in is the rates market.

Why the index does not carry the shock

Eleven companies account for 71 per cent of the index return this year, and those eleven share a balance sheet characteristic that matters more than anything they sell. They hold net cash. They fund capital expenditure from operating cash flow. Their weighted average cost of capital barely moves when the credit market reprices. When term premium rises 73 basis points over a quarter, as the Bellweather Macro estimate says it has since June, the discount rate applied to those eleven moves by a fraction of that, because most of their value sits in cash flows already being generated rather than in cash flows a decade out that need financing to reach.

The other 450 members are the opposite construction. They carry net debt, a meaningful share of it floating rate, and they refinance on a schedule the market sets. A term premium shock lands on them at full force. The equal weighted version of the index has returned 0.9 per cent this year against 15.1 for the capitalisation weighted version, a gap of 14.2 percentage points, and almost all of it opened after July.

The last row is the one that should unsettle a traditional allocation. A ten-year Treasury has lost 4.1 per cent over a period in which equities were flat to lower. The asset held specifically to offset equity drawdowns has added to them for three consecutive months, because the correlation between the two flipped sign in July and has not flipped back. Anyone running a risk model calibrated on the past decade is carrying a hedge ratio that assumes the opposite.

The index put is not mispriced. It is correctly priced for a risk that is not the one in front of us, and clients keep buying it because it is the instrument they have documentation for.

Stellan Roux, head of derivatives strategy at Norwood Quay

What the rates market is charging for

Swaption volatility at 112 is not pricing a recession. It is pricing dispersion in where the long end settles, which is a different thing, and the dispersion is real. The two-year yield fell 9 basis points across the four sessions after the September 10 reinvestment decision while the ten-year rose 34. Two ends of the same curve moved in opposite directions by a combined 43 basis points on a single piece of news, and the news itself was a technical annex about where maturing proceeds get reinvested.

What clients are actually buying

• Relative value structures long the index and short small caps, which cost financing rather than premium and have returned 9.4 per cent since July.
• Curve steepeners in two-year against thirty-year swaps, which carry negatively but have been the single best expression of the underlying shock.
• Downside on the Russell 2000 rather than the S&P 500, which costs more than twice as much in premium and has actually paid.
• Outright gold, which has risen 14.8 per cent over three months and now carries a positive correlation to the ten-year yield.
• Shortening credit exposure rather than hedging it, on the reasoning that a spread hedge on an index that is only 68 basis points wider is a poor use of capital.

None of these is a clever trade. Each of them is the obvious response to observing which risk factor is moving and hedging that one instead of the one with the deepest options market. The reason they remain underused is structural. Investment committees approve index puts because the mandate language describes equity risk, and the paperwork to add a swaption or a listed steepener takes a quarter to clear, by which time the regime being hedged has often changed.

The correlation between duration and equities turned positive in July. Every multi-asset portfolio in the market is built on the assumption that it will turn back, and nobody has written down what happens if it does not.

Ines Marchetti, head of rates strategy at Harrow Lane Capital

The thirty-year auction on Thursday is the cleanest available test. If real money steps in at 5.2 per cent, the long end caps out, term premium compresses, the discount rate on the 450 eases and breadth improves without the index leaders giving anything back. If the auction tails, the pattern of the past fourteen months extends, and a portfolio hedged with cheap index puts will discover for the fourth quarter running that it bought insurance against the wrong event.