By Kevin Muir of “The Macro Tourist” fame; reposted here with permission
Everyone loves to talk about VIX. I guess it’s because VIX is relatively easy to trade, and even more importantly, during the 2008 Great Financial Crisis, long positions were monstrous winners.
Hedge fund managers made their careers with that move. It was an amazing opportunity to make money.
During the summer of 2008, the VIX was flopping around between 15 and 25. But then September hit. In an unprecedented development, the VIX rallied from 25 to 90 in less than three months. This was supposed to never happen. The index was implying a level of volatility for stocks that had never been seen in the history of financial markets.
Since that fateful once-in-a-lifetime explosion, VIX has never been far from investors’ minds. For the longest time, everyone wanted to buy volatility. VIX futures and other products traded rich relative to realized volatility. This, in turn, created an even more popular trade as some shrewder traders took advantage of the relative ‘fatness’ of stock index options to short volatility.
As with all things Wall Street, a good idea was taken too far and this trade gained widespread popularity. So much so, that its overwhelming adoration resulted in the disastrous short-volatility ETN blow-up this past winter.
Volatility used to only be for geeks
But I remember a time in the 1990s when only derivative geeks would talk about implied volatility. Back then, when I would let out a loud whoop after writing a 20%+ vol sale, the traders on the main equity desk would ask me what I was so excited about. I would explain the trade. Instead of joining me in my celebration, they would stare at me with a blank look in their eyes (as they wondered who let the geek on the trading floor).
Today, no self-respecting equity trader doesn’t understand option index pricing and what it might mean for their index. Yet for all the attention the VIX index gets, there is still precious little attention given to other volatility markets.
And that’s a shame.
The last financial crisis was caused by a build-up of overextended leverage in the banking system. I doubt the next one will be the same.
I contend that severely stretched government balance sheets will be the root cause of the next market dislocation. If that forecast is correct, then the equity volatility market will not be the asset class that shows the first signs of stress. The real panic will start in fixed-income. It will probably spread to foreign exchange and only then will VIX come along for the ride.
Yet so far, that call has been completely off-base.
The past six months have been terrible for government bond investors. But even with that awful performance, bond volatility has slumped.
And foreign-exchange volatility has been even worse.
Contrast this to the moves in VIX over the same time period.
So what’s going on?
I would argue that February’s VIX spike was the result of extremes in positioning rather than underlying fundamentals. The short volatility trade became outrageously overcrowded and there was simply a rush for the exit. It wasn’t so much the market making a prediction regarding future volatility as it was the prediction market influencing the underlying market.
It was interesting to see how quickly the tide could turn though. VIX had drifted lower for years, and then suddenly, out of the blue, it exploded from 10 to 50 in the space of less than a week.
An actual regime shift resulting from a change in fundamentals could be devastating. Investors have assumed that central bankers will be able to maintain control of financial markets indefinitely.As central bankers’ influence has grown, volatility has slumped. Yet, artificial pegging of rates (whether they be interest rates or foreign exchange rates) does not eliminate volatility, but merely postpones the eventual adjustment. As the imbalances that accompany the pegging grow, the magnitude of the move needed to restore market equilibrium expands. Volatility cannot simply be wished away through central bank market intervention. And given the enormous amount of central bank intervention since the Great Financial Crisis, the eventual adjustment will be a doozy.
New volatility index
Instead of mindlessly staring at the VIX to get a sense of the market’s volatility worries, I have created a new index. I have included the VIX, but also incorporated normalized amount of Merrill Lynch’s MOVE Index – which measure fixed-income implied volatility, along with JP Morgan’s G7 Foreign-Exchange Implied volatility index.
Even with the recent elevated VIX, this macro implied volatility index is still sitting a near record lows.
This is just further proof as to the absolute bargain basement levels for fixed-income and foreign-exchange volatility. In fact, if you compare MOVE to VIX, we are sitting at levels that we rarely stayed below in the past.
I know everyone loves to own VIX. Trump is dropping trade-war tape bombs on a fairly regularly basis. And these come at a time with a relatively consensus view that the stock market is over-priced and due for a big correction. Owning VIX would be a natural hedge to offset these worries.
I, on the other hand, would much rather be selling stock-market volatility and buying fixed-income and foreign-exchange volatility. It’s harder to do because there aren’t easily traded listed futures and ETFs, but then again, I am that geek. You know the one.
The kind that would rather be dynamically hedging a long bond vol strategy than just buying VIX. Come ‘on. Whoop it up with me!
