Big move for vol of vol

Staying with the volatility theme, the latest jump in VIX was clearly dwarfed by what we saw in 2008 or even in 2011. However that's not true for the volatility of VIX - the so-called "vol of vol". The CBOE's VVIX Index, "an indicator of the expected volatility of the 30-day forward price of the VIX" (see description), has been comparable to or higher than what we saw during those high stress periods. The possibility of VIX doubling or even tripling ("tail" risk) does not seem outside of the realm of possibilities these days - even from the current elevated levels. And traders are willing to pay a relatively high premium to be able to take advantage of such moves.

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From our sponsor:

As Janet Yellen talks about low risk premium in the markets, risk premium declines further

It was quite strange listening to Janet Yellen's press conference this afternoon. She clearly expressed concerns about declining volatility in the markets, saying that “volatility both actual and expected in markets is at low levels”. She proceeded to say that we have plenty of uncertainty associated with the trajectory of the Fed's monetary policy and market participants should take that into account when making their decisions. The message is: investors are not pricing in enough risk premium. She was echoing comments made by the Fed's William Dudley, who recently expressed concerns about declining volatility across multiple asset classes, saying it "makes me a little nervous".

Similarly, Janet Yellen proceeded to point out - once again - how the Fed is concerned with the lofty valuations in US corporate high yield markets. As she was talking however, implied volatility (VIX) declined sharply and high yield bonds rallied.

Intraday movements in VIX and HY bond ETF in reaction to Janet Yellen's press conference

The Fed officials continue to be surprised and even annoyed by the diminishing risk premium in the markets. By striking a rather dovish tone however, the Fed is directly creating the issues that Janet Yellen is uneasy about. The irony is that we saw risk premium decline further today - while she was speaking about these concerns.

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From our sponsor:

Yield curve inversion moves beyond one month as fiscal negotiations progress remains elusive

It took a while for the public to begin to care about the debt ceiling fiasco, but the realization is sinking in that this is not just "fun and games".  Google search frequency for the term "government default" has moved way past the spike in 2011 to hit a new record.

Google search frequency for the term "government default"

Equity investors have pinned their hopes on a potential breakthrough in negotiations, with Paul Ryan suddenly stepping into a leadership role (see post). VIX dropped some 24% (relative move) in a couple of days in response and indices rose sharply.

VIX implied volatility index (source: Barchart)

Expectations have risen that the Republican leadership will attempt to find a face-saving solution that will reduce the ongoing bleeding of popular support for the GOP. The party is in trouble and is facing potential losses of seats in the House. What's even more concerning for some is the prospect of a Democrat in the White House for another 8 years. If anything, this should be enough of an impetus to find a speedy resolution.

Bond investors however are not taking any chances. The yield curve inversion has now moved beyond 1-month bills, with maturities out to three months are feeling the impact. Rumors persist that institutions are continuing to move out of treasury money market accounts in fear of having their funds frozen.

Today much of the action has moved to the Senate, with hopes that something positive could happen this weekend. The news so far is not encouraging.

POLITICO: - It’s now the Harry and Mitch show.

After Senate Democratic leaders rejected a proposal Saturday by Sen. Susan Collins (R-Maine) to end the budget impasse, the burden to find a solution now falls squarely on Majority Leader Harry Reid and Minority Leader Mitch McConnell — two shrewd tacticians who have a long, complicated and contentious personal and political history with each other.

Republican senators, eager for a way out of a shutdown fight that has roiled their party’s brand, reacted to the leadership discussions positively, believing that the two crafty dealmakers could concoct a proposal to reopen the government and avert the nation’s first-ever default as soon as next week.

Reid, however, was notably more dour.

When asked if he is confident he could reach a deal with McConnell, Reid told POLITICO: “No.”

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From our sponsor:

What's driving VIX futures spread higher?

The focus is on the FOMC meeting this coming week. Market participants, economists, the public  - all want to know if the "taper" is coming. The Google Trends search frequency for "Fed taper" has spiked in recent weeks.

Google Trends phrase "Fed taper" (search frequency over time)

The reduction in securities purchases is however already priced into the market, with the expectations varying between $10bn and $15bn per month. The markets are prepared and are now looking beyond the FOMC meeting. And things are not looking too certain in the next couple of months. The spread between the November and the October (post FOMC period) VIX futures has risen, pointing to expectations of higher volatility ahead.

Where will the markets begin to focus after the FOMC meeting? The situation in Syria of course still runs the risk of causing market havoc globally. But judging by Israel's sovereign CDS spread, it seems that the probability of a US-led military conflict has receded. Prospects for a diplomatic solution or a status quo situation have improved.

And while crude oil prices remain elevated, a great deal of that premium is not due to Syria any more. Instead it is the reduced output from Libya that is keeping prices relatively high (see NYT story, which demonstrates that getting rid of a ruthless dictator does not necessarily improve stability or prosperity).

So if the Middle East is not expected to flare up, why has the VIX futures spread increased so much? Clearly there are a number of other macro risks, but markets are beginning to pay attention to the upcoming budget fight in Washington. And this one has the potential of becoming quite ugly.

CBSNews: - If Congress doesn't send Mr. Obama a spending bill by Sept. 30, the federal government would partially shut down. Quickly after that, Congress will have to raise the nation's debt limit or risk letting the government default on its loans. As these deadlines approach, Democrats and Republicans remain deadlocked over federal spending levels -- lawmakers either want to restore the spending slashed as part of sequestration, or replace the sequester with "smarter" spending cuts.

What could make the debate particularly contentious is the fact that President Obama's approval ratings have slumped recently. House Republicans are running less political risk - and in fact could gain more support from constituents - if they dig in for a fight against what they perceive as a weakened administration. Remembering a similar situation in late summer of 2011, the uncertainty around possible outcomes of such a confrontation certainly has the potential to roil US markets.

Source: Gallup

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From our sponsor:

A steeper VIX futures curve

One helpful risk indicator worth tracking is the steepness of the VIX futures curve (see description). In particular the spread between the December and the September futures provides a measure of risk premium that should in theory encompass both the Fed action and the budget/debt ceiling fight in Washington. Based on the recent spread movements, the market seems to be mostly just concerned with the Fed right now. Will the curve steepen further once the risk of this potential government shutdown becomes more real?

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From our sponsor:

Is VIX "exuberance" premature?

VIX has been hovering near multi-year lows as investors become comfortable selling volatility. With the Fed being an implicit seller of volatility via MBS purchases (see discussion), some view it as an easy trade. In fact some traders are positioned for a "carry trade" (given how difficult it is to get carry in other markets with rates at the lows), as options decay works in the volatility sellers' favor. Market participants have discounted the impact of near-term uncertainty, particularly the impending debt ceiling negotiations. But with Washington gearing up for a fight (and Mitch McConnell actively pushing for major entitlement cuts) is this "exuberance" premature?

Market Watch: - “I would expect [the VIX] to rise over the next two months until the next deadline and resolution date” in Washington are reached, said Ron Rowland, president of Capital Cities Asset Management. “It may be just barely trending, as opposed to rallying, but I think it’s general direction will be upward.”

Frederick foresees low volatility in the VIX, within the 13 to 16 range, until late February or early March, then a pick up just ahead of the debt-ceiling deadline. “If [lawmakers] look like they are going to push it right down to the wire, and I’ll be shocked if they don’t, [the VIX] is going to run up again just like it did in the two or three days before the fiscal cliff occurred.”

At this stage it is difficult to see VIX moving materially lower and the risk seems to be to the up-side.

VIX Index

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From our sponsor:

Washington forcing investors into the options market

Back in July we discussed the mispricing of equity risk that was visible in the low levels of the VIX (implied volatility) index (see post). Making money by shorting equity options and riding the decay became fashionable after Draghi put in a backstop for the Eurozone periphery and the Fed started taking volatility out of the market (see discussion). But those shorting options got punished today. Demand for short-term equity options spiked, driven by the dysfunction in Washington. VIX (and VIX futures) jumped some 17% in a single day.

Source: Investing.com

WSJ: - Late-day fiscal cliff news out of Washington Friday provoked the biggest one-day percentage gain in the market’s so-called fear since gauge November 2011.

With just three days remaining to reach a budget agreement to advert the year-end tax increases and spending cuts known as the fiscal cliff and no solution in sight, the Chicago Board Options Exchange’s Volatility Index Thursday jumped to the highest level since June.

Investors don't trust Washington to get a resolution any time soon and are willing to pay a high premium to protect themselves. The risk-on trade is on.

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From our sponsor:

Is QE3 justified? Comparing current conditions with 2010

As the financial markets widely anticipate an aggressive easing action from the Fed (to be announced on 9/13), it is once again worth making a comparison between the conditions that lead to QE2 in 2010 and the current financial/economic conditions. The goal is to focus on the factors that central bank asset purchases can actually impact as opposed to those that the FOMC wishes to influence. Here they are:

1. Central bank balance sheet expansion can reduce financial stress in the system (similar to what happened in 2008). Here we compare the Westpac US Financial Stress Index as well as the VIX index for the the past couple of months with the same period in 2010. The current period basically has no financial stress at all (the more negative number for the stress index indicates lower stress).

2. Quantitative easing can also lower rates (both consumer and corporate) via fixed income asset purchases. The long-term treasury rates are already negative when adjusted for inflation expectations (see post) which wasn't the case in 2010. Both mortgage rates and corporate HY bond yields are near their historic lows. It's not clear if the Fed can push these rates much lower, and even if it could, we may be at the point of diminishing returns. A 3.5% or a 3.25% mortgage rate will not make a difference in most people's decision to buy a home. Much below that and the real rate approaches zero - not something many lenders/investors will be interested in particularly when they are asked to take risk.

3. By increasing bank reserves the Fed could encourage more bank lending. Here is an updated chart on US bank lending now and in 2010 during the same period. Many US banks are already near their limit with respect to how fast they can execute due diligence and close on loans. Adding reserves is not going to make them move any faster (unless credit officers are asked to take on more risk than banks are comfortable with - and we all know how that movie ends.)

Source: FRB

4. Quantitative easing will also increase prices of "risk" assets, particularly if valuations are near distressed levels. Both equity and commodity prices are already appreciably higher than in 2010. That has increased consumer net worth, yet has had little impact on consumer sentiment (see discussion).

Job creation, which is what Ben Bernanke focused on at Jackson Hole, can supposedly be improved via the mechanisms above. However financial stress conditions, corporate and retail interest rates, and bank lending are all in decent shape already, while risk asset valuations are not anywhere near "distressed levels". "Improving" these further may prove far more difficult than in 2010 as the Fed tries to squeeze the last few basis points out of rates (and push VIX down to 13?). As discussed earlier, it will certainly not generate a great deal more in payrolls. The "unintended consequences" however may pose further risks to the economy (discussed here).

Even if QE was justified in 2010 (some would argue it wasn't), additional monetary expansion certainly can not be justified in the current environment.

SoberLook.com

September risk calendar

For those shorting equity index options because (as someone pointed out) "volatility is dead", consider the following events coming up during September. Also consider the fact that with VIX at current levels, much of the "good news" has already been priced in.

Source: CS

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VIX futures curve steepens again

Early in the year we discussed the steepness of the VIX futures curve as the spread between the 7th VIX futures contract and VIX hit a record. This steepening is taking place again. Investors are shorting 1-2 month equity options in hopes these options will expire worthless. The thinking is that Draghi's latest action should hold the markets stable in the short-term while the US government is unlikely to do anything meaningful on the budget until after the elections. Corporate earnings won't be known for a couple of months. Even the German court decision on ESM is not expected until mid September.

This selling of short-term options brought VIX down to a multi-year low.

VIX futures curve: Blue = Now, Green = 1 month ago (source: Bloomberg)

The longer dated vol however has not moved much. The steepness of the curve is approaching the highs reached earlier this year.

7th VIX futures contract minus VIX

This is telling us that in spite of the drop in VIX, there is no confidence that the recent market stability is sustainable over the longer term.

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All is well with the world

The VIX index hit a multi-year low today (it went below 14.1 this morning).

VIX

With interest rates at historical lows, investors are shorting options to become long "theta". Option decay seems to be the only way to generate income. The bet is that no major fiscal decisions will be made in the US until after the elections, the Fed will announce QE3 soon, the next set of corporate earnings is not out for a while, and Draghi has Europe under control. All the macro risks have been resolved for now and we should not expect more near-term volatility.

Right.

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VIX near lows shows mispricing of equity risk

Take a look at this chart of the VIX index (the S&P500 implied volatility index). This is not your standard "stochastic" process. In the last 5 years the index has maintained a definite floor somewhere around 15. VIX is currently at 15.45. Risk pricing in US equities is once again showing lack of caution.

VIX

To put it another way let's compare VIX to IG CDX (investment grade CDS index). Unlike VIX which is measuring implied volatilities of options, CDX is an indicator of CDS protection premium (spreads) on the bonds of many of the same US companies. This in effect compares the risk pricing for equities with that of credit. The scatter plot below shows VIX vs. IG CDX levels since 2009. Based on this dislocation, equity implied volatility looks cheap. Certainly being short volatility in this environment could be a serious mistake.

VIX vs IG CDX

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A flatter VIX futures curve

A few months back we discussed the record steepness of the VIX futures curve. Equity options traders did not trust the rally in stocks, bidding up the longer dated vol. Of course they happened to be right. In fact the futures curve turned out to be a reasonably good predictor for VIX and the VIX curve.

VIX futures curve now and 3 months ago

The curve is now considerably flatter, with expectations of volatility persisting near current elevated levels for some time.

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Economic surprise index eerily reminiscent of last year

The Citigroup economic surprise index is now clearly in the negative territory in a trend reminiscent of last year's decline.

Citi Economic Surprise Index

BW/Bloomberg: - The Citigroup Economic Surprise Index for the U.S., a gauge of how much reports differ from economists’ estimates in Bloomberg surveys, turned negative on April 25 and fell May 3 to the lowest level since September. Last year, the gauge sank below zero for the first time in five months on May 2, the day when the S&P 500 began a 19 percent drop.

Given the rising concerns out of Europe today, there is a strong possibility we may be looking at sharply higher market volatility. As discussed back in March, the VIX futures curve steepness earlier in the year seemed to be a good predictor of uncertainties in the post-LTRO environment.

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Spain's spreads breaking away from other risk indicators

As the sell-off in Spanish government bonds continued today, Spain's spreads broke away from other global macro risk indicators. Typically Spain's bond and CDS spreads move in tandem with risk measures such as VIX or SovX WE (MarkIT Western European index of sovereign CDS), etc. But this time around, the widening has outpaced these other measures. As an example consider the relationship between Spain's 10yr bond spread (to Germany) and SovX WE (chart below). The red asterisk indicates the current levels.

Spain to Germany 10y Gov. spread vs. SovX WE spread (last 2 years; source: Bloomberg)

One can run the same comparison against VIX or swap spreads and get a similar result. Using Spain's CDS spreads rather than bond spreads also shows that we are in an uncharted territory with respect to this widening. Consider for example that the last time Spain's 10-year spread was at current levels (4.3%), VIX was around 30 (it's 21 today) and the USD 2-year swap spread was over 50bp (31bp today) - see chart below.

Spain to Germany 10y Gov. spread vs. USD 2 year swap spread

Clearly there is plenty of room for the other risk indicators to "catch up" with Spain. But for now it stands on its own with respect to the relative amount of risk that is being priced in. More Spanish and Italian debt auctions loom and it is uncertain just how much more room the periphery banks still have to absorb the extra debt. In the mean time foreigners continue to sell.

Reuters: Spain has found itself the focal point of those concerns after relaxing budget targets earlier this year and with subsequent budget-cutting plans winning little investor support - culminating in weak demand at an auction last week.

Spanish 10-year yields jumped 22 bps on the day to a four-month high of 5.99 percent before finding resistance at the psychological 6 percent barrier - though few in the market believed that level would halt the selling.

"We're going to see Spain develop as the story this week as hedge funds look to short it," a London-based trader at an investment bank said.

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With a 50% drop TVIX snaps back to NAV

Shorting equity volatility has been an amazing trade in recent months. For example here is a chart of VXX, the VIX futures ETF, collapsing below the pre-2011-crisis levels. ETFs like VXX roll the nearby futures contracts, and as the VIX futures curve steepened, the cost of this roll (the "negative carry") rose. The increased cost of the roll was on top of the general collapse in the VIX index, sharply lowering the value of the ETF. A great deal of money has been made on this short.

VXX share price (Bloomberg)

But as discussed a few days back, why settle for the 1x VIX futures when you can short 2x via TVIX. Except TVIX is not an ETF - it's an exchange traded note (ETN). The manager does not have to issue new shares if the security trades at a premium to NAV (see this post for the ETF mechanics). With the number of participants taking short positions rising, a short squeeze ensued last week.

TVIX short interest

The press and apparently the SEC (though this has not been verified) gave the manager a wake-up call.

WSJ: Credit Suisse AG (CS) on Friday reopened issuance of a leveraged exchange-traded note tied to the market's fear gauge, a month after the bank suspended new issues following a rush of demand.

The reissuance of shares follows a month of unusual market performance in the VelocityShares Daily 2x VIX Short-Term ETNs (TVIX), capped by a two-session decline during which time the ETN hemorrhaged half its market value.

Friday, TVIX fell 30% to close at an all-time low of $7.16.

Credit Suisse said in a news release late Thursday it will resume issuance Friday on "on a limited basis," after the bank suspended new issues on Feb. 21, citing "internal limits on the size of the ETNs."

TVIX shares outstanding

Under pressure, CS issued more shares, which hit the market all at once, collapsing the premium to NAV - price dropping by some 50% in a couple of days.

TVIX price vs. NAV

It is likely the SEC will have a few things to say about this. Arbitrarily changing or holding constant the number of shares outstanding, no matter what the reason is, causes tremendous market distortions. Products like these may be deemed inappropriate for retail investors, particularly when the manager can effectively manipulate the price.

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The TVIX short squeeze - welcome to the "safety" of exchange traded derivatives

Retail investors are pressing for stricter derivatives regulation in the financial services industry. Yet many of the same investors engage in derivatives trades that would make even an institutional structured products specialist uncomfortable.

Here is a good example - a product known by its ticker symbol as TVIX. It's issued by VelocityShares and is actually an exchange traded note traded on NYSE Arca. TVIX targets to replicate 2x the VIX futures performance (it's a leveraged note on futures contracts on options implied volatility - a "double" derivative). Here is the description:

VelocityShares Daily 2x VIX Short Term ETN is an exchange-traded note issued in the USA. The Note will provide investors with a cash payment at the scheduled maturity or early redemption based on 2X the performance of the underlying index, the SP 500 VIX Short-Term Futures Index less the Investor Fee.

As VIX came crashing down this year, people thought it may be a good idea to be short vol. It wasn't enough just being short though - they wanted to be 2x long US equity implied vol via TVIX. As more people kept piling in, it became what's known as a "crowded trade". Some people were short the ETN and long the VIX futures against it, trying to arb out the discrepancies between TVIX price and NAV. But before the weekend, someone decided to cover their short. And that's when the ETN began to rally, while VIX futures went lower. This continued into today.

In the last 5 days the VIX futures are down about 3%. According to the description above, TVIX should be down 2x or 6%. Yet TVIX is up over 7%.

TVIX vs VIX futures (Bloomberg)

The short squeeze has pushed the price up so much that TVIX now trades at over 36% above its net asset value.

TVIX premium to NAV

It is now nearly impossible to short TVIX since there are none to borrow - thus limited ability to arbitrage out the dislocation. By lunch time today TVIX is up over 1% for the day, while VIX futures are down 5%. So the next time you feel like shorting some vol, try using futures directly, or stick with SPY options. This is not for the faint-hearted and the fact that it is exchange traded (vs. OTC) doesn't make it a whole lot "safer".

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The slope of VIX futures curve hits record

As discussed earlier, the VIX (implied volatility index) futures curve has become extremely steep.

VIX futures curve 

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In fact the slope of the VIX futures curves has hit a historical record last week. The 7th nearby futures contract (UX7) is now almost 13 vol points higher than spot (VIX). The reason for using the 7th contract is that it takes us just over 6 months out - the 6th nearby contract yields the same result. The chart below shows the difference between the two since 2005. The record low of just below -40 was reached during the 08 crisis when the nearby implied volatility was bid up so much, the curve was at a record inversion (negatively sloping).

UX7 - VIX

Where as in 2008 and in 2011 the highly inverted curve indicated an immediate threat to the markets, the current steepness is implying risks further out in time. The market is not buying the sustainability of the current equity rally and is pricing in risks of a material correction later on. This is consistent with other indicators such as the cyclicals underperformance. The record steepness points to the fact that central banks have been successful in suppressing current volatility, but the market is fully expecting it to show up again a few months down the road.

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Implied volatility curve is inconsistent with credit spreads

This is the VIX (S&P500 implied volatility) futures curve a year ago showing the implied volatility term structure as it was on 3/8/11.

This is the VIX futures curve now:

See the difference? While the front contract for implied volatility futures is roughly where it was a year ago, the curve is far steeper now. The contracts 6-8 months out have VIX at close to 30%. The markets are pricing in a material spike in volatility by the mid of 2012. The market is basically saying "the world is OK for now, but just wait until late summer". That makes some sense given all the uncertainty, but it is not at all consistent with movements in credit spreads.

The scatter plot below compares the levels of VIX futures six months out (the far end of the curve) with the 5-year Investment Grade (IG) CDX (index of investment grade corporate CDS) spread. The current pricing is a clear outlier. If the credit markets are right, the implied volatility curve is way too steep (by 2-3 "vol points"). If the medium term equity options markets (that determine the implied volatility curve) are right, the IG CDX spread should be closer to 120 basis points vs. 96 bp where it is today.

Buying IG CDX protection and shorting longer-term equity index options would be a trade that takes advantage of this apparent disconnect between the two markets.

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Technical indicators point to need for caution

Investors Intelligence is reporting the highest reading of bullish oriented news writers since May of 2011. Those writing articles with a bullish sentiment now make up 52%, while bearish views are down slightly from prior week at 29%. Many who have been predicting a correction have become bullish, with those in the "corrections camp" now at 19%, the lowest in 4 weeks.

With VIX at July-2011 levels and the CS Risk Appetite Index clearly in the neutral zone, this may be time to become more cautious on the equity markets. While fundamentals remain strong, one needs to watch the technicals more closely. 

CS Risk Appetite Index (source: CS)

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