Today’s briefing is dedicated to the recent market volatility that comes as a result of the blow out in the VIX and the near complete unwind of some of the highest profile vol products, such as XIV and SVXY. From a market risk standpoint, Macro Risk Advisors say these two products have covered 96% of their risk and essentially no longer will have any market impact on VIX futures, despite the fact that CRedit Suisse have only announced this morning that there has been an event acceleration of XIV ETNs. But there is more to come, say analysts. Jarrod Dillian of the DailyDirtNap writes that “short vol” isn’t just XIV. There’s an explicit short vol trade (XIV, short VXX, futures, roll down, var swaps, etc.) and there’s an implicit short vol trade, which includes risk parity and a bunch of other stuff. The implicit short vol trade is much larger than the explicit short vol trade, he fears—which is why the unwind could continue, says Dillian.
Substantive's Top Themes - Best of the Broker Notes
1. Short Vol Unwinds: Snake Eats it’s Tail
There’s a huge amount of complexity involved in the explosion of volatility as an asset class and what the ramifications of that might be should this be unwound, especially in a disorderly one. One of the leading experts in this field is Chris Cole, CIO of Artemis Capital. Last year he gave two incredible interviews to RealVision TV about this market and the growing dangers of the short vol trade. Cole describes this as a self-reflexive cycle where you have accommodating central banks, keeping liquidity flowing, doing preemptive strikes on financial risk, leading to massive amount of share buybacks, which are a vol compressing. This becomes a massive self-reflexive, self-reinforcing spiral, says Cole. As far as analogies go, Cole references the concept of Ouroboros, which is this idea of a snake eating its own tail - which typified what was happening last year - in the sense of the stock market was buying itself back, the only vol market in history with lower and lower volumes ever. But when a snake becomes confused and sick, (As the vol market has become in recent days) it will look at its own tail and think of it like food, and it'll begin to eat itself and self-cannibalize. Click below to take a free trial to RealVision to listen this this fascinating interview and understand what some of the major risks may be in the days and weeks ahead.
2. Vol Rises; Now What?
The increase in volatility experienced in recent days is unlikely to subside short-term, says Ed Clissold, Chief US Strategist at Ned Davis Research. History suggests volatility should increase, but it does not declare the cyclical bull market has to end. Most major peaks form via a topping process - failed rallies where the popular averages may or may not make new highs but fewer and fewer stocks participate. Many corrections resolve themselves. NDR does not rule out a topping process is starting, but rather points out their models are not providing enough evidence to support that conclusion. Click below to request access to the full note.
3. Negative Gamma
In reference to yesterday’s vol product liquidation, MI2 Partner’s Julian Brigden says such events typically create opportunities and, short term, this has created some interesting price divergences, he writes in this note published late yesterday. For example, the spread between VXN (Nasdaq volatility) and the VIX, which typically trades at a premium, is trading at over a 4 vol discount, the most extreme in 15 years. Brigden first highlighted this spread in December, in a piece entitled “US Equity Rotation at 30,000 Feet”. In it, he outlined the fundamental vulnerability of the equity market, that whenever the spread of the VXN over the VIX hit 6.5-7.5% either the VXN needed to move lower, or we risked a broader push higher in market volatility. With yesterday’s move, it appears that we have ended up with the latter, says Brigden.The other extraordinary price event has been the speed of the VIX’s rise, which over the last few days has exploded. It’s 14-day RSI, which never sustains moves above 82, closed at 91, i.e. the highest close since 1991. Extreme moves like this are typically associated with blow-offs, but this time it’s different. The problem is that, in marked contrast to 2013 or 2015, when bond weakness triggered equity wobbles and higher vol with inflation pressures building, it is going to be far harder for central banks to put Humpty Dumpty back together again. If that is the case, yesterday’s liquidation move may, if we are lucky, set a short-term base in stocks. But higher volatility is going to gradually eat away at the risk-taking abilities of all leveraged players from hedge funds to risk parity funds. MI2 maintain an Ammo Index, which measures the ability of leveraged players to absorb a VaR shock, before they have to liquidate their underlying portfolios. It’s already through the lows of 2000, Brigden shows in the report. Clock below to request trial access to read the full piece here.
4. A New Macro Environment; Easy Money No More
However one cuts it, writes Louis Gave from Gavekal Dragonomics, the investment environment has changed. A year ago, oil was falling, the US dollar was rising and US bond yields were low. Today, these three important prices have changed direction by 180 degrees. Market participants should therefore not be surprised that the market’s momentum is shifting. The assets that did so well when oil and interest rates were falling and the US dollar was strong, are unlikely to welcome the about-turn in these three key prices. In this light, gave says the current sell-off can perhaps be seen simply as the markets adapting to a very different macro environment—an environment in which making money will become more challenging now that the world’s central banks are no longer printing it hand over fist. In this report Gave addresses some key questions amid this market sell off. 1) Are equity and bond markets “cheap” enough to warrant deploying more capital? 2) Could this dip trigger forced selling from leveraged market participants or other “weak hands”? Gave reckons this is probably not a buy the dip scenario and many participants will unlikely want to increase risk (Pension funds, and hedge funds (for different reasons)). Gave suggests that markets most likley to receive a bid are those US. Click below to request trial access from Gavekal to read this full note.
5. VIX: The Day of Reckoning Finally Came
Back in mid December we highlighted this piece from Macro Risk Advisors that explained the inherent dangers of short vol products like XIV and SVXY and their potential to ‘’blow up’’ causing large market disruption in the process. In this note, written at the close of US trading yesterday, MRA write that the day of reakoning came yesterday. They explain how XIV and SVXY have effectively been wiped out, and are down ~95% in a single day. MRA explain that the weighted 1-month VIX futures basket tracked by these products (weighted roughly to 35% Feb VIX futures and 65% March VIX futures) went from 15.24 on Friday 2/2, to close at 29.81 on Monday 2/5 – a 96% single-day increase. What was the market impact of XIV and SVXY liquidating their risk? According to MRA, XIV and SVXY were both short approx. 200,000 VIX futures (or 200 million vega). 95% of that short volatility risk was covered yesterday, most likely in the minutes leading up to the 4:15 futures close, the report says. This was likely the primary driver of the massive move higher in VIX futures from 4 to 4:15, and potentially a significant contributor to the S&P futures selloff in this time period, MRA conclude. Has the major ‘’blow up’’ event happened? MRA say given that the short vol products have covered 95% of their risk, the “VIX blowup” event has effectively already happened. If the upward pressure on VIX (and to a lesser extent, downward pressure on S&P futures) was driven mostly by the VIX ETPs, that source of pressure is now gone. The report then goes on to discuss 1) Did XIV and SVXY officially liquidate? 2) What are XIV and SVXY worth now, and why are they still trading above NAV? MRA are the ‘’go-to’’ firm on this market, and have an extensive knowledge base. Click below to request trial access to their research to keep abreast of market developments.