I Like My Term Structures Kinky

I’ve talked quite a bit about how the US equity market is grossly mispricing political risk.

As a friendly reminder, last month was the third calmest January in history as measured by average VIX level and realized volatility was the fifth lowest on record.

Essentially, US stocks are pricing in no near-term risk from elections in the Netherlands, France, and Germany and seem entirely blind to policy implementation risk here at home.

The discrepancy in how the VSTOXX is pricing French election risk versus how the VIX is pricing political turmoil is instructive, to say the least. Here’s an up to date version of what I think is one of the most critical charts in finance:

(Goldman)

Note the highly visible “kink” in the VSTOXX term structure versus the relatively smooth slope on the VIX. From Goldman:

The equity volatility term structure is starting to price more event risk for April. In Exhibit 3 we show VSTOXX term structure moves from two weeks ago. Term structure is showing the kink in April expiry has become more extreme in the last two weeks.

I highlighted that chart elsewhere earlier today, but I wanted to ensure it got the attention it most certainly deserves. Similarly, consider the following chart which essentially depicts how April VSTOXX futs are discounting French election risk relative to how VIX futs are pricing that same risk:

(Goldman)

As Goldman goes on to note, “the ratio of VSTOXX vs. VIX April futures is now already comparable to preBrexit and Euro area crisis levels.”

Once again, the point is that US markets seem to be priced as though there would be no knock-on effect from an adverse outcome in European elections. Needless to say, I think that’s a mistake.