Volatility Trade Has A Catch-22 Feel To It These Days, Analysts Say

Who wants to be a vol. trader?!

Why, everyone, of course! Because volatility is an asset class!

(“I’m an asset!”)

Or at least everyone wanted to trade volatility right up until February, when the Seth Golden crowd was summarily wiped out in spectacular fashion by the implosion of short VIX products.

February 5 is a day that will live in market infamy and the hilarious thing about that episode (well, it wasn’t “hilarious” if you were sitting in one or more of those products) was that a bevy of ostensibly “smart” people were convinced the rebalance risk inherent in inverse and levered VIX ETPs would never be realized.

Late last year, I gave up on arguing the point, because for whatever reason, the danger inherent in the structure of those products seemed completely lost on a lot folks who really should have known better.

Even if, for whatever reason, they didn’t know better, multiple analysts spent the better part of 2017 pounding the table, on the way to warning that eventually, the chickens would come home to roost. There was Rocky Fishman, for instance, who penned note after note after note last year on the subject for Deutsche Bank (he’s since moved on to Goldman). You can read multiple excerpts from those notes in our “doom loop” archive.

There was also BofAML’s Michael Hartnett, who variously warned that “short vol.” was one of the most crowded trades on the planet. In January, he flagged the risk one final time for anyone who still wasn’t convinced. The bottom fell out just weeks later.

And there was of course Marko Kolanovic, who explained the problem in the simplest possible terms midway through last year:

Given the low starting point of the VIX, these strategies are at risk of catastrophic losses. For some strategies, this would happen if the VIX increases from ~10 to only ~20 (not far from the historical average level for VIX). While historically such an increase never happened, we think that this time may be different and sudden increases of that magnitude are possible. One scenario would be of e.g. VIX increasing from ~10 to ~15, followed by a collapse in liquidity given the market’s knowledge that certain structures need to cover short positions.

That played out almost to the letter on February 5 and those strategies did indeed suffer “catastrophic losses”.

As SocGen mused two days later when everyone was trying to pick up the pieces and figure out what exactly went wrong, the theoretical flow from the rebalancing of leveraged ETPs on February 5 amounted to a 23-standard deviation event. I’m not sure what color swan that is — maybe psychedelic?

That cleaned out the armchair vol. sellers, but it didn’t necessarily deter all the pros and while the dislocations from that event still linger (more on that here), things have calmed down considerably. The VIX is now back to a 12-handle, despite myriad geopolitical risks and a preponderance of “shocks” including, but not limited to, the Q1 dollar funding crunch, the BTP meltdown, and the collapse of the Turkish lira.

Well, as Bloomberg’s Dani Burger writes on Wednesday, the end result through August as been a “heads you lose, tails you lose” scenario when it comes to picking a side: long vol. or short vol.

“This year for the first time, trading strategies betting on a jump in equity market volatility and those wagering for calm are both losing”, Burger writes, adding that “February’s ‘volmageddon’ blow out did enough to sink short-volatility strategies but not enough to protect long-vol trades from the tranquility that’s enveloped stocks on their way to new peaks.”

As you’re probably aware, the various bouts of volatility that have popped up in connection with this year’s “non-stop risk cabaret” (to quote BofAML’s Barnaby Martin) have remained largely isolated to relevant markets. Or, more simply, spillover has been minimal.

“The S&P 500 has broken through all-time highs and recent volatility in EM, and in particular assets in Turkey, had little lasting impact on a supportive backdrop for risky assets and cross-asset volatility has generally been anchored in the summer”, Goldman writes, in a note dated Tuesday, adding that outside of EM FX and sterling, “cross-asset vol is quite depressed, with the increases related to the February VIX spike largely having faded — i.e., the market does not seem to be pricing much risk premia around any broad spillovers, for example, as S&P 500 1-month realized vol has drifted below 8% again, and implied vol and the VIX have followed.” Here’s a heatmap:

(Goldman)

The durability of suppressed vol. still depends on the same factors that drove 2017’s historic low vol. regime – namely, a supportive global growth backdrop and still-subdued inflation in developed markets. While inflation is indeed anchored, it’s picking up stateside thanks to the combination of late-cycle fiscal stimulus and the prospect that U.S. trade policy will lead to higher prices for consumer goods.

Those two factors (America’s fiscal expansion and the Trump administration’s confrontational trade strategy) are also leading to divergent growth outcomes, with the U.S. economy chugging along, while question marks pop up in other economies. That divergence appears to be reversing of late, or at least according to Citi’s economic surprise indices, but the overarching, U.S.-centric narrative remains intact. The stronger the U.S. economy, the more prone Jerome Powell’s Fed will be to hiking, increasing the policy divergence between the U.S. and the rest of the world.

It is, to quote another recent BofAML note, the “end of synchronized everything“.

Here’s some additional color from Goldman on the likelihood of either a low vol. regime or a sustained spike in volatility:

A high vol regime remains unlikely until the macro data turns worse — right now the ISM manufacturing index is still at high levels and unemployment is low, with the Fed hiking. Of course, our model relies primarily on US data rather than on global data, which has been less strong, but so far we see little spillover and global growth, while slower, remains above trend and should stabilise based on our leading CAI.

While another low vol regime is not impossible — based on our model this probability remains well above the unconditional average — the drivers that give a reduced probability of a low vol regime are unlikely to reverse, in our view. As the macro backdrop is gradually getting less strong, with the growth/inflation mix worsening, uncertainty about growth, inflation and economic policy is picking up.