Posted by on August 24, 2017 4:02 pm
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Categories: Alpha bank of america Bond China Debt Ceiling Economy Finance Financial risk Leverage Market Crash Mathematical finance money north korea Options Risk parity Risk Premium S&P S&P 500 Skew Technical Analysis US government VIX Volatility

With the VIX surging, and then quickly getting pummeled on two occasions in the past three weeks, dizzy traders could be forgiven to assume that any latent “risk off” threat, whether from North Korea or the US political front, has been taken off the table. However, a deeper look inside the vol surface reveals something very different: with increasingly more analysts and traders warning that volatility is set for a sharp return this fall, equities have already been adjusting to the increased probability of a “tail event.” However, instead of buying VIX futures, call or ETPs, they have been doing so by bidding up the price of OTM equity put options, or equivalently, by steepening the S&P 500 put skew and.

As a reminder, a put skew shows how much more expensive it is to buy deep OTM puts vs puts that are in the money or in other words, a levered bet on (or hedge against) a market crash.

 And as the following chart from Bank of America shows, the S&P put skew is now at the highest level on record, making the relative price of tail hedges the highest in 13 years as traders are quietly bracing for a sharp market crash.

While not new, Bank of America again underscored the potential risk in the coming months to actively managed portfolios from a possible volatility flaring event, primarily impacting risk-parity portfolios. This is what the team of BofA Benjamin Bowler wrote in an overnight note:

Both equity and bond valuations are high. In a report from last week, our equity strategists pointed out that the S&P 500 forward P/E expanded in July and hit its loftiest level since the Tech Bubble. Even at these elevated levels, equities look attractive relative to bonds whose risk premium is more than 50% above its long-term average. This is clearly a concern for portfolios that invest in both classes (risk parity). A significant risk for multi-asset managers going forward is a breakdown in the diversification between stocks and bonds in which we see simultaneous declines in both asset classes similar to the ‘Taper Tantrum’ in May/Jun-13 or to a slightly lesser extent the risk-off event from Aug-15 two years ago. It may be surprising to an equity investor, but for a multi-asset manager these two declines were the largest since 2008 and equal to 50% of the drawdowns from the GFC. With multi-asset vol so low, for those managers who use leverage, the leverage levels may be high and therefore their portfolios may be more sensitive to a breakdown in correlation.

Bank of America then writes that with both rates and equity volatility at historically low levels, however with correlations between the two rising, going into the fall – even if equities and rates remain range-bound – an uptick in volatility could lead to outsized jumps in a cross-asset vol pair trade.

Interestingly, for most of this year an increase in equity volatility has tended to coincide with an increase of rates volatility. The payout is dependent on rates going higher and equities falling from current levels, so it is implicitly short equity/rates correlation. This correlation has had an increase over the past month and provides for an attractive entry point (Chart 11).”

Indeed, while many traders point out that intra-equity correlation has dropped to near all time lows, traditionally a welcome sign for active investors as it provides return dispersion and alpha creation abilities that are detached from broader macro conditions, looking at cross-asset vol shows a very different picture. As the following two charts show, correlation between rates and equity volatility, or MOVE and VIX, shows a sharp spike in recent weeks. In fact, as Chart 10 shows, the correlation is now the third highest on record. Confirming this troubling observation, Chart 11 shows that the correlation between the underlying asset classes has also soared in recent weeks, after plumbing near record lows just weeks ago.

To explain the surge in put skew, below we present several observations from BofA on why the recent period of record low volatility appears to be coming to an abrupt end.

1. The S&P recorded three moves of at least +/- 1% within a six days span, the first time this has occurred since September 2016. In fact, prior to the 1.48% loss on 10-Aug, SPX hasn’t moved morethan +/- 0.3% in a single day since 19-Jul.

“These larger one-day moves are evidence that the record-low vol we’ve seen throughout the summer may be starting to come to an end. As we’ve noted recently, seasonal trends and a fall which encompasses numerous catalysts (including the debt ceiling deadline, the September FOMC meeting, and political reform negotiations) suggest that the extreme quiet may not last much longer.”

2. Last week, the VIX recorded +30% spikes twice in a six day period (10-Aug, when the VIX jumped 44.37% and 17-Aug, when the VIX jumped 32.45%). This is only the third time ever that we’ve seen two such drastic moves occur in that short a period of time.

“Notably, the only other two times this has occurred were early August 2011, immediately following S&P’s downgrade of US government debt, and August 2015, when markets were rattled over fear of slowing growth in China. The seasonally low vol environment typically seen during late summer may be a contributing factor to these occurrences as each has happened during August.”

3. On 8-Aug-17, the total number of VIX call options (including all strikes and all expiration dates) was 1,994,418, an all-time high, as investors piled into long call options amid the rising tensions with North Korea. The amount of options traded surpassed other notable highs on 3-Feb-2014 and 13-July-2015, when 1.85mn and 1.93mn call options were traded, respectively. “The former period saw investors buying VIX calls due to a global selloff sparked by concerns over Asia and EM, and the latter period saw purchases on the back of Grexit fears.”

4. On 17-Aug SPX fell 1.5%, the second largest decline YTD since the 17-May 1.8% drop and similar to the 1.4% sell-off on 10- Aug. However, in one regard this sell-off was remarkably different.

“Specifically, markets this time around appeared to have made little distinction between different pockets of the market. For instance, the underperformance of cyclical sectors vs. defensives was less pronounced in the latest sell-off. Consequently, also the relative moves in volatility were not as significant as in the past two largest sell-offs YTD. This could signal the beginning of a new narrative whereby market participants are more skeptical about the prospective of a pro-business agenda being pushed forward in Washington; as such they stop differentiating between potential losers and winners from the aforementioned agenda.”

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