So about that “doom loop.”
We’ve got an entire section here on HR dedicated to what we’ve variously described as the “nightmare scenario” for a market that we’ve argued is vulnerable to a technical selloff thanks to a kind of domino effect, where a nominally small VIX spike has the potential to echo through markets, culminating in a veritable disaster.
Our last warning about that came on January 11 in a piece called “‘The Biggest Risk Is A Quick SPX Selloff At The End Of The Day’: It’s Time For A ‘Doom Loop’ Update.” Here’s how that post started:
Ok, so it’s time to talk about VIX ETPs and the “doom loop” again.
Hopefully you don’t need a refresher on this, because if you do it likely means you haven’t been paying much attention to how shifts in market structure are creating systemic risks that no one understands, but just in case, the idea is that thanks to the low starting point on the VIX, a nominally small spike could force inverse and levered VIX ETPs to panic buy VIX futs into said spike, thus exacerbating the situation and ultimately forcing CTAs, vol. control funds, and risk parity to deleverage into a falling market.
We went on to note that according to Goldman’s Rocky Fishman (who used to track this risk when he was at Deutsche Bank), just a 3-point spike in VIX futures would force VIX ETP issuers to buy $110mm vega. That, Fishman said with some alarm, is “double the highest ever seen before 2017” and represents “~60% of daily 1st/2nd VIX futures volume, and around 30% of open interest.”
In case all of that wasn’t clear enough for you, we closed that post with this:
Unlikely? Of course. Possible? Also of course. And once the ball gets rolling, it will be hard to stop the self-feeding nightmare.
“Come play with us Danny…”
That last line is of course a reference to The Shining and we even included a video of Danny and “The Twins” to add a little humor and underscore the fact that this would be some scary shit were it to actually play out.
Well dammit it played out on Monday and from what everyone can tell, 3:00 p.m. was when the dominoes started to fall. Of course it was abundantly clear that something had snapped right there. That was when the Dow plunged 6% at the lows, USDJPY dove, gold, spiked, and 10Y yields plunged on a safe haven bid. Recall this from Bloomberg: “between 3pm-3:10pm ET, 266k TYH8 contracts traded in screens as 10Y yields reached 2.705% before rebounding to 2.75%, richer by 9bp on the day.”
The usual suspects were quick to note what likely happened. “Outflows resulted from index option gamma hedging, covering of short volatility trades, and volatility targeting strategies,” JPMorgan’s Marko Kolanovic wrote, adding that “these technical flows, in the absence of fundamental buyers, resulted in a flash crash at ~3:10pm [and] the large increase of market volatility will clearly contribute to further outflows from systematic strategies in the days ahead (volatility targeting, risk parity, CTAs, short volatility).”
“The ‘grey swan’ we all have spoken about for years—that being the absurd ‘tail wagging the dog’ potential of VIX ETN market structure (inverse and leveraged products) AND the massive growth in ‘negative convexity’ / ‘vol target’ / ‘vol rebalancing’ strategies to either generate extra income or ‘systematically allocate risk’ (looks good in the prospectus, right?!) –finally ‘broke’ the volatility market, and has now bled-through to the ‘underlying’ spot equities market…as the short vol trade went ‘lights out,'” RBC’s Charlie McElligott said, weighing in with his typical penchant for superfluous punctuation.
And here’s what we said, for anyone who missed it:
So what’s the outlook? Well, I’m not sure. For one thing, it’s as yet unclear what exactly is going on with those short vol. products and I for one wonder if there’s more programmatic selling in the cards if volatility remains elevated. We may have leap-frogged concerns about the bond rout and gone straight to the part of the show where some of the celebrated “miracles” of modern market structure break down.
So that brings us to this morning and the above-mentioned Rocky Fishman along with Goldman colleagues John Marshall and Katherine Fogertey are out with a new piece describing what went on with the “doom loop” on Monday. In case you were wondering, they want you to know that “there is no question that the move in the VIX was more extreme than other major markets [and] known rebalancing procedures of short-term VIX future-based products contributed to the sell-off at the end of the day through the 4:15 PM EST futures close.”
Here’s the breakdown via Fishman, Marshall, and Fogertey:
Technical buying likely furthered dramatic end-of-day movements in VIX futures. VIX futures, which had been barely up on the day as late as 2 PM NY time, rose quickly to the 4:00 PM cash equity market close, and then jumped significantly further between 4:00 PM and 4:15 PM NY time. We see VIX ETP rebalancing as a key component of these flows, as levered and inverse ETP issuers were economically driven to buy more VIX futures prior to the close to avoid unhedged overnight risk (ETN issuers) or excessive tracking error (ETF issuers). This buying of VIX futures, whether to reduce a now-oversized short futures position on a shrinking short VIX product or to grow the too-small long position of a much-larger levered product, could have pushed VIX futures prices up more, driving up their demand to buy more – a market feedback loop. By the end of the day, VIX ETP issuers had to buy $230mm vega (230k VIX futures) – 50% of the open interest of front-two futures – which was on top of around $80mm of vega VIX futures issuers likely would have bought on Friday. In a fast-moving, late-afternoon market, this supply was hard to find. By the time the 4:15 NY time futures close had arrived, the February VIX future was up over 100% on the day, and the March VIX future was up 87%. VIX futures fell quickly in overnight trading even though SPX futures were also down.
The doom loop was activated. It was not a myth. The demon under the bed was real. There really were monsters in the closet.
On the bright side, the flush means short VIX ETPs are “now quite small,” Goldman’s trio of strategists notes. Have a look at how yesterday’s dramatics cleared the proverbial deck in the space:
But we’re not completely out of the woods, because now comes the potentially larger problem: what happens to the systematic/programmatic crowd if the vol. spike proves any semblance of sustainable? Undoubtedly, there was some selling from those folks on Monday, but one wonders if we’ve just scratched the surface.
“Automatic flows, including selling from vol control funds (a strategy with a 12% vol target, 30% bond portfolio, and a variable amount of US equities would be selling equity futures totaling 15% of its AUM as a result of the sell-off) and CTAs may pressure equities in the coming days,” Goldman concludes, before adding that some of this may be offset by the corporate bid (i.e. buy backs) and “fundamental investors” (who definitely aren’t scared to fucking death right now – sarc.).
So there you go. For now, we’ll leave you with the twins…