Is it too quiet?

That question came up again and again over the past two weeks, a period during which equities’ ascent continued, but at a more deliberate rate following a raucous four-week rally.

The figure below, which regular readers may recognize from a December 3 article, is updated through Monday. Things have picked up a little, but not much. This is one of the calmer periods we’ve seen this year on a simple measure of outcome distributions.

That’s conducive to (indeed is in some sense synonymous with) subdued readings for realized vol, which became hostage to structural forces last month, something I’ve been over at length.

The VIX, meanwhile, is at pre-pandemic levels, and there’s no demand to speak of for downside protection. The only tail risk investors currently fear is the right-tail — which is to say a melt-up.

Naturally, this elicits concern in some corners to the extent it’s indicative of complacency. I’ve endeavored to show it’s probably a function of under-positioning. You don’t need downside hedges for longs you don’t have, but you do need upside protection in such a scenario.

According to some, the VIX now sits well below fair value. For their part, Goldman’s Kamakshya Trivedi and Dominic Wilson argue that the macro environment “is generally conducive to below-average volatility” and that in fact, equity vol was too high “through much of this cycle” based on the bank’s models.

And yet, that changed in recent days. “Those same models now show equity volatility screening lower than the macro backdrop implies,” Trivedi and Wilson wrote, adding that the cost of short-dated SPX puts recently reached the lowest levels in half a decade.

We’re in a pretty benign macro environment (assuming you ignore 4% core inflation), which raises questions regarding how swift the reset might be in the event the backdrop were to shift given current levels of vol are low even by the standards of kindly conditions.

But Goldman described low vol as “an opportunity, not yet an alarm bell.” “We would not push that conclusion too hard,” Trivedi and Wilson said, of the decline below model-implied levels. They noted that forward VIX pricing is “well above the levels that provided the warning signs of large volatility reversals in 2007 and 2018.”

Still, optionality is quite obviously cheap. That’s where the aforementioned opportunity comes in. “Given that our basic macro views are benign, and that the market may continue to press on the prospect of early rate cuts, we do not want to give up the upside tail on risk assets,” Goldman said. “Buying protection here can make it possible to maintain long positions at less comfortable valuations.”

Do note the point about the market’s proclivity to push the rate-cut issue. It certainly wouldn’t be surprising for rate-cut bets to be trimmed this week in the event of a warm CPI report and/or Fed pushback, but given where we (probably) are in the cycle, traders will be inclined to price those cuts right back in whenever the incoming data tips a slowdown. That’s particularly true in light of Chris Waller’s recent remarks around insurance cuts.

As the figure shows, 10-year reals track 2024 rate-cut pricing almost lockstep, and 10-year reals have a tendency to dictate equity multiples. So, if you “give up the upside tail on risk assets,” as Goldman implicitly advised against, you run the risk of missing a re-rating the next time traders decide to get excited about rate cuts.

Of course, if you’re outright bearish, the read-through of cheap optionality is straightforward. “Expressing downside views directly on equity and credit through options rarely gets cheaper,” Trivedi and Wilson remarked.

Meanwhile, over on the asset management side, Goldman’s Alexandra Wilson-Elizondo says this isn’t the time to press bearish bets. “If the market trades down, it is a good opportunity to rebalance or buy the dip” she told Bloomberg on Monday.