Late last week, I noted that war risk became real for markets. Briefly. It became briefly real for markets.
Iran’s aerial barrage against Israel was, as I put it, an early candidate for worst-kept military secret of the century. Mainstream media outlets all around the world began reporting on the likely timeline for the attack early last week.
Markets largely ignored that reporting until April 12. Why? Why ignore it until a Friday? Because holding risk — let alone adding it — into and over the weekend was a perilous proposition. In the event one of Iran’s missiles or drones veered off course and slammed into an Israeli suburb, you wouldn’t be able to get out of your positions. Come Sunday evening, you’d be staring at a pretty significant gap.
So, on April 12, markets went ahead and sold off, not necessarily because anyone thought Iran was determined to fire the shot that starts World War III, but rather because they worried Iran might do so accidentally, and in the event they did, best to have your positions squared.
At the same time, recent hedging set the stage for any downside move to be amplified. As I wrote in the linked article above while editorializing around the biggest VIX spike in six months, “investors have demonstrated demand for downside protection of late.” Dealers are short that protection. So in a spot selloff (or a vol expansion), their hedging activity had the potential to exacerbate the situation.
The figures above (skew, put skew and ATM vol) all include Friday’s theatrics, but note that skew was already steepening prior to the war selloff. Again: That steepening was indicative of the first real demand for downside protection in months, and on the other side of it are dealers who’d need to hedge in the event of a selloff. A selloff like April 12’s.
On Monday, Nomura’s Charlie McElligott walked through the mechanics in a brief postmortem of the market’s fleeting war “freakout.”
“The incalculable ‘full-blown Middle East war escalation’ risk” came atop an “already murky” macro picture, Charlie wrote, noting that depending on how things played out, there were serious “implications for the global economy via the energy complex.”
Between the US CPI overshoot and the hawkish implications for the Fed of a “no landing” macro scenario, it was all “too much for even this bull market,” McElligott went on, before noting that the April 12 “forced-hedging exercise” saw the 11th highest VIX call volume on record and the “12th busiest day ever” for US equity options. Here’s Charlie with the play-by-play:
By this past Friday midday, we saw the US equities index vol space going into pretty legit ‘freakout’ mode, with term structure actually inverting in the very front of SPX iVol, and VVIX blowing out to 113, levels last experienced during the late-October US rates term premium panic in the long-end, particularly as the size VIX calls which dealers have been short to customers pick[ed] up a bunch of delta on the equities selloff and VIX actually moved higher on the spot / vol / beta to S&P pickup over multiple time horizons — so VIX dealers had to go out and buy VIX futures / S&P downside / short Spooz the higher VIX went and the lower that Spooz went.
That feedback loop — the selling begets more selling via dealer short gamma dynamics — will be familiar to most readers.
As ever, you have to take account of the read-through for systematics. Spot downdrafts and vol spikes can elicit mechanical selling from CTAs and vol control strats, and when you consider the implications of suddenly higher vol for liquidity/market depth, you’re left with a recipe for a magnified drawdown. Nomura’s estimates suggest vol control shed more than $8 billion of equities exposure across Thursday and Friday last week.
So, what now? Well, it looks like things are set to calm down. Knock on wood. Reports suggested the Biden White House talked Israel out of an immediate military response (“an eye for an eye” not being especially conducive to good outcomes and all), which means last week’s vol spike may be viewed as an opportunity.
“We got a small taste Friday of what it could feel like when market conditions allow us to ‘move’ again, but per my tag line, vol tends to mean revert lower unless it’s fed with sustained large moves,” McElligott wrote.
Equities did ultimately sell off further on Monday. The two-session decline counted as the largest in six months.
