The wild gyrations in capital markets in early February had a profound impact on investor sentiment. The spike in implied volatility, as measured by the CBOE Volatility Index, or VIX, roiled long-pacific markets, leading investors to question even now, almost a month later, whether a sustained sell-off might be looming.
According to signals from the options market, the answer is a definite no.
Options prices, which contain valuable near-term information about the market’s assessment of upside potential and downside risk, are showing average levels of risk for US equities. Rather than indicating rising risk of a substantial drawdown, options prices suggest more normal conditions ahead. That can be seen in the implied volatility of out-of-the-money puts on the S&P 500 Index, which reflect the price investors are willing to pay to protect against large losses.
At a recent 16.1, implied volatility was near the median level of 16.57 over the past 10 years.
A consensus trade over the past several months has been to bet on low volatility, otherwise known as shorting volatility, on the expectation that near-record-low market volatility — for both stocks and bonds — would continue unabated. This was a logical and rational response to ultra-accommodative monetary policies that drove real interest rates to abnormally low levels, likely leading pension funds, endowments and other institutional investors to find alternative ways to boost returns, such as by selling options and volatility.
These so-called short vol trades are mostly concentrated among institutional investors, with the banks taking the other side. That’s a crucial structural difference between today and 2008, when a key trigger for the credit crunch was the banks holding short vol positions through Special Investment Vehicles and other instruments in the shadow banking system.
Higher-than-expected US wage growth data for February sparked concern that faster-than-anticipated inflation would lead to faster-than-anticipated rate increases, particularly real rates. That led to the sell-off in equities, likely exacerbated by forced selling by commodity trading advisers and by delta hedging among those shorting options and volatility targeted strategies.
Volatility spiked higher than during the Lehman Brothers crisis, as investors rushed to cover their short vol positions, perhaps one of the most crowded trades ever.
Although there was initial fear last month that significant losses incurred by holders of short vol positions could lead to a greater sell-off, contagion was contained because banks were generally the counterparties to such trades, as opposed to bearing the exposure. This should remain the case, so long as short vol positions are in the hands of institutional investors and not banks.
While a crippled banking system can bring an economy to a standstill as the flow of money stops, a stable economy is more able to cope with the hit incurred by institutional investors who understand the risk and have the resources to absorb the losses from such trades.
It shouldn’t be forgotten that February’s sell-off was catalysed by a fundamental structural risk: a faster-than-expected rise in real rates. That kind of event that can push markets into a sustained correction and challenge real economic activity.
So the movement of real rates offers clues about the potential severity and permanence of a market drawdown. Even with recent upward moves, a US 10-year real yield at 75 basis points is artificially low and is a direct result of years of stimulative monetary policy. But if real rates continue to surge, the real economy may not be able to absorb a rapid increase in the real cost of capital, raising the possibility of a more significant drawdown.
Real rates are a key indicator of potential turbulence and could signal dangerous downdrafts if they rise too quickly. And if banks begin to pile onto the short volatility train, a derailment could also upend the economy.
The good news for now is that the options market does not see an epidemic unfolding, and, while the downside risk to US equities has increased, it has simply gone from abnormally low to more normal levels, which is all part of the normalisation that is now underway.