With polls showing Presidential candidate Donald Trump creeping ever closer to rival Hillary Clinton, who appears to be taking a defensive wait out the clock keep head down strategy, a Bank of America Merrill Lynch report says Clinton’s lead will continue to narrow. In fact, there will come a point for market where political concern, benign for most of the summer, will revert to volatility. This won’t look pretty for risk parity strategies, the report projects, breaking the calm during a relatively strong year for the strategy.

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BAML Trump volatiltiy risk parity

Risk parity - Markets are pricing in perfection, a Clinton victory with Republican control of Congress

Last Friday's sharp loss for the risk parity strategy, a rarity in a world of calm, is not a one off event. For those who watch algorithmic market environments, get ready because the short volatility environment is likely to give way to political concern before the election.

The bank report didn't address algorithmic market environments but did note an NBC News poll out Tuesday that noted the new and improved Trump chipping away at Clinton's assumed insurmountable lead. After a series of historic gaffes and a change in campaign management, Trump closed the gap by two points overall. With Clinton still leading 48% to 42% -- some polls even show a closer gap -- and yet the prediction markets pointing to an overwhelming 88% chance of the corporate-backed Clinton winning, BAML's FX and Global Rates Strategist David Woo likes the mean reversion trade.

"History tells us to expect Clinton’s lead to narrow and volatility to rise in the final stretch of the elections," Woo writes in an August 26 Cause and Effect report titled "Pricing in a perfect gridlock."

Markets are right now pricing in perfection: Clinton will sweep to victory but Republican control of Congress remains. The inability to change the status quo remains and this will result in market reaction, is the consensus. But the electorate is upset at control over the entire process. This is a political trade against the consensus which is most interesting particularly when their is an identifiable floor, making for a short-term mean reversion wet dream.

Note the gamma, or rate of change, as elections approach
Note the gamma, or rate of change, as elections approach

If there is a clean sweep, watch for fiscal stimulus and government cooperation to ensue

With this divided political environment comes trepidation over government fiscal stimulus in the form of infrastructure spending. The important behind the scenes consideration was over the central bank's role in potentially being a financial backer of "helicopter money" seems to have faded or gone deep under cover. What's left is for government to start doing some economically stimulative work without relying solely on central banks.

Under a divided government scenario, the likelihood of a partisan political process to agree on what is economically best for the country is unlikely. The status quo is the real winner. In this environment long risk parity and short volatility will likely reign -- that is, of course, until the market environment changes.

Those who know how a CTA short volatility strategy works mostly recognize that size of loss is a more significant risk factor than win percentage. It is the point of mean reversion where the strategy can get harsh particularly when surprise quickly pushes volatility to extremes. Likewise for risk parity, risk does not find parity and volatility targeting becomes an oxymoron when a storm front of volatility rolls in. BAML, for its part, has previously provided sophisticated investors with the risk parity heads up that might be most appropriate now that markets are heading into the election.

BAML Trump volatiltiy risk parity Implied vol

Mean reversion trades do not require ultimate victory to be successful

For a mean reversion trade to be successful it does not require ultimate victory. Woo's projection is that election uncertainty will continue to creep into the market until it hits the mainstream, then volatility will ensue. Sell the mainstream, buy volatility.Woo's projection doesn't have to result in a Trump election victory and the analysis is not measured in political terms, but rather market terms.

Mean reversion trades are actually best when most stretched. This is when the negative news is full priced and the natural floor might be reasonably close. The key to the trade is selecting assets that have a high probability of mean reversion and don't go into bankruptcy.

For this, Woo likes the currency markets.

In the age of fiat currency, there is a potential for extended relative value price disruptions when one sovereign region is engaged in something significantly damaging economically while the others remain untouched -- the harmful effects of negative interest rates, for instance. Even given the risks, currencies in the past have exhibited strong mean reversion tendencies, even though commodities have a more robust value duration proposition.

From Woo's standpoint, this is a moment in time, day it be said history?

We cannot remember the last time the FX and the rates markets have so much at stake in a US election. While gridlock probably means lower rates and a weaker USD, a clean sweep would likely lead to both higher USD and higher rates over the medium-term, in our view. We believe the volatility market is underpricing the bi-modal nature of the outcome of the election for US fiscal policy outlook.

If one is looking at volatility and thinking a step or two ahead to how this portends to risk parity, Woo recommends the 3-month AUD/USD digital put to position for a possible unwinding.

While most explanations of risk parity focus on the assets traded and look at the world from an equity and economic point of view, algorithmic analysts often look at the world differently. From this perspective, just look only at how the formula components are constructed. Volatility is often used as a trigger to wind up and down the strategy. The problem, in part, is that volatility by itself is not always a leading indicator. Certain strategies use volatility correlated with other indicators as identification when the mainstream has it wrong, but seldom is volatility by itself a measure of volatility to come.

Due to the systematic nature of risk parity's unwinding mechanism, negatively correlated with surprise at times, trades resulting from the strategy "can become self-fulfilling." In other words, as volatility increases the risk parity strategy unwinds and creates more volatility -- the topic of a heated debate, one that has pitted the likes of Bridgewater Associates against some of the most well-known algorithmic strategists in the industry on opposite sides of a divide.

For now the fascinating algorithmic debate doesn't matter as much as the trade recommendation, which is pointing to a market environment change involving Trump volatility. Get ready investors, you have been given a heads up.