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Volatility in the US Risk-limited alpha in a “collared” market: SPX ITM KO puts US equities vulnerable...to a summer range-trade The Federal Reserve last week appeared more emboldened to normalize monetary policy, not only raising interest rates by 25bps but also reiterating its intention to hike four more times by the end of 2018 and stating that it “expects to begin implementing a balance sheet normalization program this year” - all despite recent softness in inflation data. Breakeven rates of inflation narrowed following the Fed communications due to tighter monetary conditions in the face of slowing US economic data, and risk asset bears responded in force, suggesting that Janet Yellen had “broken up” with investors and that it would be prudent to sell “before it’s too late”. We agree that the changing reaction function of the Fed is likely not supportive of further substantial US equity upside and may be viewed as the Fed now providing a short call option on the S&P 500. However, in our view, it is premature to conclude from last week’s developments that the “Yellen put” is dead. We see its strike as declining but would not underestimate Yellen’s dovish inclinations in a shock or the capacity for the Fed to still remain credibly on hold as long as the US economy is not “running hot”. In short, we see monetary policy as now providing a “collar” (long put / short call} on a US equity market that has already shown a propensity over the past year for getting trapped in record tight trading ranges.' Other factors may also conspire to create a summer range-trade for US equities, namely (i) fiscal policy, where gridlock likely caps equity upside but lingering policy hope floors the downside, and (ii) positioning, where the risk of continued “fragility events” (potentially exacerbated by stretched quant fund/short vol positioning) meets cashed-up investors still accustomed to buying dips. Tug of war between fragile market/stretched positioning and cashed-up dip-buyers As we have noted recently, US equities have displayed a historically unusual tendency to jump rapidly from calm to stress and back (“fragility”), with the recent Tech sell-off and rebound the latest example. For example, in the past year, the S&P 500 has seen 5sigma declines (3 in total—Brexit, Sep-16, May-17) occur 20x more frequently than over the prior 90 years or so. The increased frequency of these “fragility events” is in part due to vol failing to remain high post a spike as equity market participants continue to aggressively “buy the dip” and in the process reset vol lower. Historically low vol alongside consistently upward trending equity markets and low cross asset correlations could be creating stretched positioning across markets. For example, upward trending equities on historically low vol may be pushing CTA equity positioning to near record levels (Chart 7). Risk parity portfolios could be increasing their leverage due to low vol as well as low cross asset correlation (Chart 8). And lastly, inverse VIX ETPs have seen increased open interest as performance has swelled on the back of continued declines in vol and attractive term structure risk premia (Chart 9). Should vol spike again alongside a reversal in equity price momentum and a rise in cross asset correlations, then unwinds from these strategies could exacerbate market fragility. However, this must be weighed against an investor base that has plenty of cash on hand (Chart 10) and their potentially fickle but still-intact tendency to view any equity market dip as an alpha opportunity. ' For example, the Dow Jones Industrial Average traded in its tightest trading range in over 110 years in Jan-17; this followed a record in the S&P 500 ending Sep-16 for the longest stretch of trading within a range of 1.77% since 1928. Bankof America 4 Global Equity Volatility Insights | 20 June 2017 Merrill Lynch HOUSE_OVERSIGHT_014975