“The Loss Of Central Bank Credibility Is The Biggest Tail Risk” BofA Warns Brexit Threat Remains

Despite the rapid central-bank-inspired decline in short-term risk momentum, there is no doubt in BofA's mind that the world is a riskier place following the UK’s decision to leave the EU. Hence, they warn, the chances for additional critical stress events as Brexit unfolds remain high, and given the critical role of central banks in supporting markets in recent years, a loss of credibility remains the biggest visible tail risk.

Global Financial Stress (GFSI) remains high… but, as BofA's Abhinandan Deb exclaims, the decline in some stress measures within GFSI (particularly short-term risks) has been remarkably fast following the UK’s vote to leave the EU.

In fact, short-term volatility in both European and US equities fell at speeds only expected if the UK had voted to "Remain."

However, several factors help explain this unusual decline, in our view:

1) The political nature of Brexit risk has led to high uncertainty over its timeline. The potential for volatility to be kicked down the road with pending negotiations has helped short-term risk measures understandably decline.

2) The fact this risk was self-inflicted has led to speculation that it may be just as easily reversed, though we see this as unlikely,

3) Bearish investor positioning ahead of the referendum, has likely helped squeeze risk-assets higher, and

4) the anticipation of central bank support – the key to reversing every major stress event since 2013 – has been strong in recent days.

However, long-term risks are clearly higher post the vote

Despite the rapid decline in short-term risk momentum, there is no doubt the world is a riskier place following the UK’s decision to leave the EU. Hence, the chances for additional critical stress events as Brexit unfolds remain high, in our view. Brexit risk is also not the only concern expressed by GFSI today.

Japan remains the most at-risk region globally, as stress has risen materially following the BoJ’s decision to move to negative rates in February.

Given the critical role of central banks in supporting markets in recent years, a loss of credibility remains the biggest visible tail risk, in our view, and is why Japanese stress should be carefully monitored.

Positioning for Brexit; own longer-dated EU volatility

The recent strong rally in risk assets despite longer-term risks rising demonstrates the challenges in timing markets in the short-term around Brexit threats. The fact that we expect to see more volatility, but with unknown timing, argues for efficient systematic hedging overlays. For those able to trade volatility directly, we believe one of the best ways to profit from this unique risk is owning longer-dated European realized volatility,
particularly vs. US volatility as

1) we expect Europe to lead volatility higher and

2) US markets have shown a strong tendency to downplay European risks until they become concrete and acute.

And it appears professionals remain of the same concerned opinion…