How volatility eats itself Part 3

Well well well. Just a year ago, in Part 1, lower volatility begat ever lower volatility, with any sniff of a spike in vols immediately snuffed out. WSJ’s Hilsenrath commented at the time that ‘Fed officials are starting to wonder whether a tranquility that has descended on financial markets is a sign that investors have become unafraid of the type of risk that could lead to bubbles and volatility’.

Thus the recent oscillations should provide reassurance, not concern, for central banks. The Reserve Bank of Australia, arguably even more exposed to China, didn’t feel the need to make any changes in their meeting overnight, either to interest rates or much to their statement. Volatility in and of itself is not now a reason for action. This is a shift from the Pavlovian lesson we have learnt since the financial crisis, where central banks were needed because the markets entirely seized up. To be fair to Mr. Market, the behaviour of central banks since last autumn has reinforced the view, with one after another falling overthemselves to ease policy in response to a dramatic fall in the oil price. But this wasn’t actually a response to the sharp plunge itself, in terms of its potential for contagious volatility; rather it was to do with its impact on inflation expectations, which has always been a legitimate area for central bank policy.

Hence why the Greenspan Put appears to be dead. A smart Blondemoney reader from New York flagged up that it was still alive, but the strike was no longer at the money. For the non-derivatives geeks out there (and that particular reader is certainly one of those), this means the following. The Fed aren’t just going to step in because of a sudden equity market drop. It would depend on the speed, magnitude, and potential reversal. A flash crash of 5 or even 10% at this stage just looks like an overdue correction. Several weeks that take you down 25%, and that would be another matter. For good reason, too, as that might indicate an underlying issue in the economy, or might hamper economic activity in the future. But the point is that volatility in and of itself is not a reason for intervention.

Hang on a second, you might argue. The Vix hit 50 last week. 50! We haven’t seen those levels since the financial crisis! You may squawk. Surely that means something more dreadful is afoot?

Yes, on Monday the VIX did indeed have its biggest intra-day move ever. The week before it had its biggest weekly increase ever. Smashing through those kinds of records isn’t to be ignored. Surely the central banks will come to their senses?

Well, no. This price action is a sign of a different market structure. Ever since the financial crisis and then the Eurozone sovereign debt crisis, the Vix has become a tail hedge of choice. Knowing that, the systematic volatility funds then snaffled up all those people who would buy the first contract as a portfolio hedge, and then bought longer-dated contracts, a kind of volatility curve carry trade. Putting these together means that volumes traded in the Vix have exploded. Here’s Open Interest on the 1st contract, up from 20,000 in 2008 to 150,000 now:

Vix open interest

Added to that, there has been an explosion in Exchange Traded Funds over the past 5 years. One of the most popular is the VXX, which tracks the performance of the Vix. Check out the explosion in volume traded on this bad boy (as another loyal BM reader might say):

VXX Volume

Bloomberg has an excellent story on how volatility ETFs now hold $4.3bn in assets. That article also contains some very telling quotes on the psychology of this market. The Head of Research for the CBOE, the exchange where the VIX trades, said: “The idea that VIX futures are driving volatility in the market just seems unlikely to me,” Speth said. “Yes, we traded a lot of VIX futures on Monday, but it was in response to market moves. It didn’t cause market moves.”

Either this is disingenuous or it misses the point. If a lot of people want to trade a lot, chances are that they are all trading in the same direction. If this causes a trading halt, as happened to the Vix for half an hour before its big spike, then once it’s back online, a lot of people are piling through a narrow exit door. Does that cause the price to spike? Of course it does!

You think its over? Check this chart from BAML, which showed their retail clients buying US stocks in the largest inflow for that segment since their data began in 2008. If they can hedge it with a simple volatility product that profits when vol spikes on an equity downturn, what do they have to worry about?

Buyers of equities

All of these bets to protect oneself against volatility are in fact causing volatility. And the central banks are not only happy to sit back and watch it, they actively encourage it.

 

 

 

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