Low market volatility now, but when it comes it could be huge

On 1 August we saw S&P 500 10-day realised volatility hit an all-time low, while a strong focus has been placed on the fact that S&P 500 futures have not traded in a 1% range in 25 straight trading sessions.

Market data
Source: Bloomberg

The streak that last occurred in 1995. In fact, it has been 75 trading sessions since we saw a rally of 1% in the S&P 500.

Financial markets, outside of crypto-currencies have simply lacked anything that even resembles a pulse.

Traders have been eyeing the US volatility index (also known as the 'VIX'), which is the options markets pricing of implied volatility in the S&P 500 over the next 30 days and again this has been at such subdued levels. Culminating in the index closing under 10% for 10 consecutive days through late July.

We can also look at the net position held by speculative funds in VIX futures and see this is currently net short 152,000 contracts. This is a record and the market has never been more bearish on volatility or calm about the near-term outlook for US equities. In effect, a 3.5% sell-off in the S&P 500 could result in a 15 percentage point spike in the VIX index, which in turn would set off a wave of panic through financial markets.

Another consideration is that many of the market participants that are holding these huge short volatility positions are systematic trending following hedge funds. Systemic funds trade utilising a rules-based approach, which would largely be dictated to by the underlying market trend. If the VIX is trending lower and the S&P 500 higher, then they need to trade this move accordingly. The concern here is that an event that causes a strong pickup in market angst and risk aversion could, in theory, see the many of the rules dictating a reversal of these positions in a very short space of time, which could exasperate the move.

The question then, of course, is what causes a genuine protracted shock to the financial system and a move lower in the S&P 500 and higher in the VIX?

The answer to this is naturally impossible to answer, because if we knew, the markets would already be reacting. What is important is that there are a few red flags that suggest the market is starting to become concerned and they are well worth watching. High yield corporate bonds (credit) are finding sellers, so put the HYG ETF (iShare High Yield credit ETF) on the radar, as the S&P 500 would historically follow high yield and investment-grade credit.

Despite a move lower in the HYG since 26 July, the S&P 500 has held close to the record high. NYSE and S&P 500 market breadth is deteriorating, with the percentage of companies above their 20- and 50-day moving average headed lower, while the number of companies at 52-week lows is rising.

We can also see a strong performance from the ‘funding’ currencies, such as the CHF and JPY, while in fixed income we are seeing ‘real’ (on inflation-adjusted) bond yields heading sharply lower. This move in ‘real’ bond yields is clearly boosting the investment case for gold, especially when traders hedge their USD exposure into NZD, EUR or

IG’s Volatility index (September contract) has attracted buyers through August, off what looks like a solid floor of 12.3. However, the volatility bulls have been burnt before and there is just no conviction to push the index higher, at this stage.

Three variables to consider

For me three issues that are known to the market as a genuine threat, clearly include the conflict between North Korea and the US, a policy mistake from the Federal Reserve or a sudden deterioration in global economic data trends that in turn could impact earnings.

Clearly, geo-politics is the most immediate threat, although US Secretary of State Rex Tillerson has calmed some nerves insisting there is 'no imminent threat of war'. Still, there is little doubt that we have entered a new phase in relations here and strategists continue to ask if this can escalate from what the market sees as a rhetorical battle at this stage. North Korea’s threats against Guam have clearly got a backbone and we have heard quite specific timelines.

The two other variables I have mentioned would take some time to play out, especially with global growth being somewhat inspiring for the equity bulls in 2017. However, the idea that the Fed hike the Fed funds rate above the estimated neutral Fed funds rate (the rate that is neither stimulatory nor restrictive for growth and inflation), which currently sits at 1.28%, is certainly something to consider. The last two times we saw this factor materialise was in 2001 and 2008 and in both cases we saw the US head into a recession shortly after. So unless we see US core PCE (personal consumption expenditure) heading higher in the next few months, then a rate hike in December would push the fed funds rate above the neutral rate and this could make market participants very nervous.

Of course, there are a number of other variables which could become a volatility event, but they haven’t garnered as much attention of late. Either way, the big consideration is that when (or if) they present themselves the dynamics from positioning could result in chaos for markets.   

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