Here Are The 4 Drivers Of The ‘Local Vol. Ceiling’

It’s been a wild-ish week – but that’s not saying a whole lot in 2019.

Central banks’ coordinated dovish pivot (spearheaded by the Fed’s “epic” relent and then iterated via the ECB’s announcement of new TLTROs, Japan’s forward guidance enhancement, the RBA’s pivot to neutral, the RBNZ’s eventual capitulatory cut, the Riksbank’s throwing of the towel, etc.) helped crush cross-asset vol., ushered back in “carry mania” and reinvigorated the global hunt for yield. 

That marks a stark contrast to 2018, which was defined by a QE-to-QT regime shift and, critically, episodic vol. spikes made worse by many of the dynamics which critics of modern market structure have been warning about for years. 

This week’s trade escalation brought those dynamics back to the fore, as documented extensively in these not-at-all-hallowed pages and crystalized on Thursday in “Is Negative Convexity Risk ‘Flashing Red’?” 

In what will presumably be his last note of the week (although don’t rule out another quick blast if things were to get dicey), Nomura’s Charlie McElligott summarizes things as follows:

Taking a step-back on the last week’s trading ‘post-mortem,’ the flow-shift deleveraging “canary” signal first showed-itself in VVIX last week (Weds into Thur, then leaping further this wk, as it indicated an impulse ‘grab’ for tails); after that, it bled into the VIX complex (systematic ‘yield enhancement-‘ / ‘roll-down-‘ unwind, now in the process of “cleaning-up”); thereafter, we have seen the “negative convexity” universe as the source of rolling de-risk (meaning “risk allocation” strategies which use historic “trailing” realized volatility measures as their leverage-, allocation- or sizing- “toggle”) and adjusting their exposures accordingly.

By the end of the week, volatility was looking tired as VIX and VVIX were flat despite Friday’s selloff in equities. McElligott notes there are several drivers of “this local ‘ceiling’ in vol.” He lists them as follows: 

1. Long vol / short delta positions are so far in the money that they ‘have to’ be monetized (e.g. VIX ETN “longs” sold, or dynamic Spooz short hedges are covered);
2. Similar, the unwind of systematic ‘short vol’ continues to be worked-through (which means the initial urgency to cover is relaxing);
3. It’s likely vol arbs too have pounced on the past few days of massive VIX OUTPERFORMANCE vs Stocks
4. Some strategies are now again back to selling still-elevated vol (e.g. yesterday’s large systematic seller of SPX Puts, whose flow coincided with the lows in Equities / highs in VIX on the day)

The upshot on that last point, Charlie says, is that the propensity (or, if you like, the temptation) to sell vol. on spikes can serve to calm things down. “Short vol’ strategies have the ability to act as a stabilizing ‘market buffer’ in times of shock”, McElligott writes, referencing Thursday’s apparent put selling. 

That said, the lagged effect still threatens to manifest itself in more mechanical de-risking from vol.-control, as documented in the linked post above. 

“Futures deleveraging flows continue to be ‘worked through’… with incremental ‘Vol Targeting’ flows now too piling on in the back part of the week, as trailing realized vol is pulled higher”, McElligott notes. As long as that incremental flow isn’t overwhelming (Barclays’ estimates another $25 billion in de-risking from vol.-control funds), things have an opportunity to perhaps stabilize. 

“Stable genius” permitting, of course.