Why is the VIX dropping going into the Fed meeting?

Traders work on the floor of the New York Stock Exchange.
Lucas Jackson | Reuters
Traders work on the floor of the New York Stock Exchange.

Why is volatility dropping going into the Fed meeting?

It's happening again—the CBOE Volatility Index, a measure of how panicked investors are about the stock market—is down again today. It's been mostly in a downtrend for three weeks, ever since briefly spiking over 50.

Those fears have not gone away. Yet the VIX has been dropping. What does this mean? It is implying that traders believe the Fed decision this week is not going to create a lot of volatility…whether they raise rates or not.

That seems a bit strange, given this is one of the biggest Fed meetings in years, and a rate hike is still very much on the table, and no one is quite sure what the market reaction will be if they do raise rates.

What's going on? The short answer is that on a longer term basis, the VIX is elevated—it's been trading mostly between 13 and 16 for the past couple years, with occasional spikes over 20.

Still, it's not elevated much. At 22, the VIX is implying a move of roughly 2 percent up or down in the S&P 500 in the near-term.

That's not much; many think given the uncertainty about the implications of a rate hike, the VIX should be in the 30s.

Why aren't investors panicking and buying more protection? Volatility traders I have spoken with in the past couple days offer several explanations:

1) Many traders DID panic and buy protection: worries over the Fed raising rates, along with concerns about China imploding, is precisely why the market suddenly turned south three weeks ago and the VIX briefly spiked over 50.

Traders who bet on a spike in volatility won: they sold their positions and made a bunch of money.

2) The majority of traders are taking their cues from the Fed Funds market, which is assigning the probability of a hike to only roughly 30 percent. Because buying protection has become more expensive, many traders have concluded it is not worth the price.

3) even if the Fed raises, most traders believe it is "one and done" (for a while), and that the beginning of hiking cycles has been very strong for the markets.

One final point: there's not a lot of panic about the coming months either. VIX futures contracts for October, November, and December are all in the low 20s as well.

So does all this mean that the markets are free and clear? I don't think so. Global growth—not the Fed—is the issue that is clearly the most concern for the markets.

You can see this in oil, which many consider a proxy for global growth. Big daily moves in oil definitely have translated into moves in equities, particularly energy, basic materials, and industrials. According to Credit Suisse, 70 percent of the volatility in oil on a daily basis is transferred into U.S. equities.

That's a sign that global growth is the big story to watch.

  • Bob Pisani

    A CNBC reporter since 1990, Bob Pisani covers Wall Street from the floor of the New York Stock Exchange.

Wall Street