Sleepy summer markets could be getting ready to give way to something more violent this fall.
While the ultra-low VIX may be reflecting a calm stock market, futures on the VIX show investors fear there increasingly could be trouble brewing down the road.
The VIX futures curve is at the steepest level since before the financial crisis began, with each progressing month at a higher and higher level with longer term volatility at a much higher premium than short-term volatility.
The VIX, itself, is the market’s fear meter and it is also trading at a pre-financial crisis level, hitting a low of 13.71 last week. On Thursday, it was at 14.40, down slightly on the day, but down 24 percent since the beginning of August. The VIX is based on a weighted average of the implied volatility of options on the S&P 500 that trade on the Chicago Board of Options Exchange. The falling VIX has added to the steepness, but traders say the steep levels are unusual.
“You’re looking at a 30 percent September premium over cash. That is big,” said Daniel Deming, managing director and VIX trader at Stutland Equities.
“It’s basically telling you over the next six months, the market could have some form of volatility spike,” said Deming. He said investors appear to be hedging against a whole stream of major events, starting with the Jackson Hole speech by Fed Chairman Ben Bernanke on Aug. 31, the Fed meeting in September, Europe’s handling of its debt crisis, and the November elections. There is also the pending “fiscal cliff” when the Bush-era tax cuts expire Dec. 31 and automatic spending cuts take hold Jan. 1 if Congress does not act.
“There’s a lot between now and October and November that could change the volatility landscape,” he said.
The VIX’s current low level reflects a sense of complacency that has permeated the stock market and helped drive it higher Thursday, after German Chancellor Angela Merkel indicated support for the euro zone. Deming said a rule of thumb is that a VIX of 16 reflects a one percent move in the S&P 500, and the VIX currently is reflecting less than that now.
“The markets basically have come to the sense, right or wrong, that the central banks are going to do what they have to do to keep the market afloat, and it’s almost put a floor under the market for the time being, and with that you’re seeing volatility come out of the market because people aren’t willing to pay for a lot of protection right now,” Deming said.
Jordan Beck of BTIG said the cash VIX, by definition, reflects shorter-dated options prices. “Because there may be these things in the future that investors are looking at, that is one of the reasons for a very steep VIX futures curve, the steepest in years. Those things that are looming don’t really have a great effect on short-term volatility prices,” he said
“Among the things that are depressing volatility these days are the expectation that you have an accommodative central bank policy globally in the largest markets, such as China and the United States,” he said.
Beck said another reason why the August VIX futures, trading at 15.90, are depressed compared to later months is because the popular VXX ETN, whose shares outstanding ballooned to an all-time high this week, is still rolling into the September contract form the August contract. “That puts extra pressure on the August futures,” he said. The August contract expires Wednesday.
In recent years, a VIX front month futures contract below 16 has not been a good sign for stocks. Beck points out that each of the five times the front month contract closed at or below 16 since 2008, it coincided with a sell-off in the S&P over the next one to two months. Of the five times it happened, the selloff average 8 percent over 40 trading days.
Volatility for the euro, which is closely correlated to the S&P 500, is at a similar low level, said Marc Chandler, chief currency strategist at Brown Brothers Harriman.
“Below 10 percent, the benchmark 3-month implied volatility is near the lower end of the range it has been in since Lehman's collapse. Together these two observations are suggestive of a spring coiling awaiting the decisive developments and events that are looming in the weeks ahead,” he wrote in a note today.
Chandler said, in an interview, that the VIX and implied volatility for the euro are showing a similar complacency. “The lower the VIX goes, the more you’re going to be paying back with these gains,” he said.
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