Early last month, the Seth Golden crowd was summarily wiped out on a Monday afternoon when an already nervous market collided head on with the VIX ETP rebalance risk that multiple sellside desks had been warning about for at least a year.
Time and again, analysts cautioned that beyond a certain point, levered and inverse VIX ETPs would have to panic-buy VIX futs into a vol. spike, exacerbating the situation and, if it was acute enough, likely leading some of those products to be redeemed. You can trace the history of these warnings in our “doom loop” archive.
Over and over, the punditry dismissed those concerns and so did a lot of popular FinTwit personalities … right up until that Tuesday morning and suddenly all of those same people were bemoaning the injustice of the whole thing rather than simply stating the obvious which was this: “oops, turns out that VIX ETP rebalance risk was a real thing after all.”
Who knew?! I mean besides Deutsche Bank, and Goldman, and BofAML, and multiple boutique firms who had all been shouting from the rooftops about just that risk for months and months and months in report after report after report after report.
For about 18 hours, everyone demonstrated the same kind of perverse fascination with watching XIV and other retail short vol. products bleed out all over the pavement that causes traffic to come to a standstill on the highway after an accident even after the damaged vehicles have been moved to the shoulder – that is, markets demonstrated a propensity to rubberneck it while driving by the smoldering wreckage.
Once traffic started to move again, everyone started to ask the next logical question which was this: “ok, was that just the tip of the proverbial iceberg?” As Citi put it late last year (and as Chris Cole of Artemis Capital has been screaming about forever), “trades and strategies which explicitly or implicitly rely on the low-vol environment continuing are becoming more and more ubiquitous.”
“This is just an appetizer for what has yet to come,” Cole told The New York Times last month, adding that “the world won’t end tomorrow, but there has been such a massive bet on stability and low volatility that this could lead to a multiyear unwind.”
More simply: everyone was suddenly asking what would happen should the vol. spike in equities spill over and cause an unwind in the global, cross-asset bet on low vol. Things calmed down of course, but that question was left largely unanswered even as risks tied to Trump’s trade war and a coordinated hawkish shift from DM central banks loom large in the background.
Well BofAML is out with a timely new note that takes a look at vol. spillovers. Here’s the title:
The analysis is pretty tedious and it reads more like an academic journal article than it does a note, but nevertheless, we thought we’d highlight some of the color and visuals.
“In recent years, due to a low yield and low volatility environment, short volatility strategies have grown tremendously in popularity across different assets,” the bank writes, before flagging the obvious problem which is that “volatility across various asset classes can be at times highly correlated and hence the extraordinary growth of short volatility strategies might create risks.”
They go on to note that the X-asset correlation of short vol. strategies is high and hence a vol. shock in one asset “can potentially spread to the whole market, as we saw recently when equity market volatility spiked.” Here are some visuals that illustrate those points:
In order to get a handle on the situation, they build on their previous work by constructing a revised “spillover measure.” Trust me when I tell you that you probably aren’t going to be interested in the details of how they go about building this indicator and in the interest of keeping you engaged, I’ll just skip to the fun parts. Here’s the bank noting that their measure generally does a good job of tracking vol. spikes and contagion events:
Chart 3 shows that high volatility spillover is historically observable when major economic events occur: the Dot-com bubble burst in 2001, the Global Financial Crisis in 2008-2009, the European debt crisis in 2012, the “flash crash” in 2015 due to various economic reasons such as the Fed’s first rate hike in nine years, crude oil plummeting, and a weakening Chinese economic outlook. It also captures the recent spike in VIX. Furthermore, we can observe that a regime shift in volatility spillovers, to a new and higher level, took place during the Global Financial Crisis.
From there, they quantify “who” (i.e. what asset class) is the largest net “sender” of volatility shocks and which assets are the biggest net “receivers.”
“We can reaffirm that US equity is the biggest net sender of volatility shocks and UST is the biggest net receiver of volatility shocks, relative to their own respective vols,” the bank writes, before presenting the following charts:
They go on to explain how their analysis can help investors figure out how to go about allocating to short vol. strategies across assets (i.e. to see if there’s some predictive power here), and they do indeed suggest that they’re onto something.
While that’s certainly interesting, we’re frankly not in any kind of position to evaluate the extent to which the statistical methodology employed is robust (we assume it is) or to opine any further. Rather, the idea here is simply to hit the high points, which are that vol. spillover risk is high, it seems to have reset higher after the crisis, and this is particularly concerning in an environment where damn near everyone is short vol. – implicitly or explicitly.
Make of that what you will.
