The Wall Street Journal is worried about volatility.
Actually, WSJ is worried that maybe the whole “you too can be a vol. seller” marketing pitch that’s implicit in vehicles like XIV may be a siren song.
The problem, of course, is that by the time something ends up in the Journal, it’s probably too late.
In a piece dated Monday called “Does a 263% Profit Mean Markets Are Efficient?,” WSJ essentially parrots the warnings that have emanated from the desks of folks like Deutsche Bank’s Rocky Fishman and JPMorgan’s Marko Kolanovic.
There’s also a mention of the market’s fabulous collapsing vol. act, which BofAML so poignantly illustrated earlier this year in the following chart that tends to pop up anytime this subject is broached which, in the current environment, is just about every day:
As noted there, vol. is “mean reverting” at an increasingly rapid rate on any spike.
The market is now so conditioned to buy every dip, that vol. spikes are becoming more fleeting with each passing episode. Here’s another way to visualize the same dynamic:
And here it is again:
“Complacency still rules, with ‘buy the dip’ firmly embedded in investor psychology after an eight-year bull market,” the Journal notes, in a nod to the dynamic illustrated above.
Indeed, that was readily apparent last week when, to quote the Journal again, “the VIX had its fourth-biggest ever rise of 55% from open to peak [on Thursday], before recording its eighth-biggest fall from peak to close. By its low on Friday it was back in the lowest 1% of VIX readings ever.”
That kind of thing lulls people to sleep and makes idiots look like geniuses for buying inverse VIX products on spikes.
The worry is that these folks are going to get run the fuck over one day. More specifically, if volatility spikes enough to force inverse and levered VIX ETPs to buy VIX futs into said spike, it will exacerbate the problem and could spiral quickly out of control – especially if that kind of action can’t be easily absorbed. Think of it as selling into a falling market.
And ironically, given the presence of vol.-sensitive programmatic strats, an exaggerated vol. spike could well cause a mechanical deleveraging event that would… wait for it… trigger systematic selling into a falling market. That, in turn, could drive vol. still higher, and around we go in a self-feeding loop.
For those who missed it, here’s Deutsche Bank’s feedback loop dashboard (more here):
The Journal article doesn’t get that granular with it, but whether they know it or not, that’s what they’re warning about when they say things like this:
When low-volatility regimes have ended in the past, they have typically trended higher before turning really nasty, giving investors time to get out. If volatility is no longer predictable, the “short-vol” strategies used by hedge funds, pension funds and institutional investors–and available through exchange-traded products, too–are riskier than their advocates suggest.
Just how risky was evident last week. The VelocityShares Daily Inverse VIX exchange-traded note, known by its ticker XIV, tumbled 15% intraday on Thursday. Investors must decide if this is advance warning of danger ahead, or merely a move to be expected after gains of 263% in the previous 12 months.
The August 2015 panic meant those who had continued selling volatility–despite a warning from a smaller VIX rise earlier that summer–lost more than half their money. The XIV exchange-traded note took until January 2017 to recover all its losses.
There are two causal stories to tell behind these concerns. One is that explicit bets against volatility are crowded, so when volatility starts rising, the rush for the exit drives it up further.
The second story is that implicit bets against volatility such as equities or emerging-market debt are crowded. Investors who have been persuaded by calm markets to move out of their comfort zone to buy riskier assets are very sensitive to any sign that the market or economic cycles might be ending.
Again, the explicit bets can turn into a feedback loop that catalyzes unwinds in the implicit bets and before you know it, it’s an avalanche. Indeed, we recently penned a post on this citing Deutsche’s Aleksandar Kocic, titled, appropriately enough, “The Avalanche.”
The Journal also suggests that markets shouldn’t be as sensitive as they are to subtle shifts in central bank rhetoric:
Some dates deserve a place in market history. Black Monday 1987 and Black Thursday 1929 occurred before the VIX fear gauge was created, but the volatility index’s three biggest intraday rises also resonate: August 2015’s China fears. May 2010’s flash crash. February 2007’s subprime concerns mixed with another China panic.
Last Thursday shouldn’t merit being on the list. Central bankers kind of maybe indicated that just possibly they might do what they previously said they would do, and tighten monetary policy if the economy improves.
Duly noted, but at the same time, that assessment fails to take into account the extent to which the central bank liquidity backstop is part and parcel of the vol. seller’s/carry trader’s paradise in which we currently exist.
When you consider how correlated central bank liquidity flow is with risk assets and credit spreads, you can see why people have a tendency to freak the fuck out when the messaging turns too hawkish. Does that make it a healthy dynamic? No. But it does make sense.
In any event, consider this yet another warning to those who are busy picking pennies in front of steamrollers.