The VIX Index - More Trouble Ahead for Markets?

Despite the US equity market’s rally, the VIX Index, a measure of expected volatility based on S&P 500 index options, continues to hover around the 28 mark. Not only is this a very rare pattern, but a strong sign that there may be more trouble ahead for markets.

Mehdi Sagid

  • 6 min Read

From a low of 2,191 in March to an intraday all-time high of 3,588 in September, the S&P 500’s staggering 63.7% rally in record time “officially” propelled the index into a new bull market amid one of the worst economic crises the world has ever faced.

What can explain such a dramatic gap between an insolent equity market, indifferent to macro figures, and a reality where a devastating recession is looming?

One might argue that the equity market is forward-looking – representing a forecast of the economy based on expectations – meaning that investor optimism over a strong economic recovery in the medium term is helping to sustain the market rally despite a slew of negative economic data.

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Yet, the risks have not subsided, and the market still faces serious challenges for the rest of the year among which include another wave of lockdowns from increased infection rates to a disorderly U.S presidential election.

Are investors once again underestimating the risks and getting too complacent, or merely relying on the central bank omnipotence?    

Indeed, following the 2008 subprime crisis, the world biggest central banks intervened with unprecedented accommodative monetary policies, introducing quantitative easing, rock-bottom rates for an extended period and strong forward guidance. The Fed injected trillions of dollars in the monetary system to mitigate the economic shock and sustain the recovery. Today, they are even going further by including non-investment grade corporate bonds, the so-called “junk-rated bond”, in their asset purchase scheme.

In other words, what this arguably tells us is that investors can legitimately assume there are few limits to the lengths that the Fed may go to in order to provide aid to the economy should the situation worsen. This includes cash injections into the financial system, cash which will reach the equity market much faster than the real economy. Hence, a sustained equity rally, and low inflation, especially in Europe with soaring savings and the decline in spending, and investments.

In an era where the almighty central banks (the Fed and ECB at the forefront) are only too willing to inflate and fix asset prices, and given limited attractive alternative investments to the equity market, it seems investors are showing a worrying lack of consideration for the risk/reward ratio choosing to base investment decisions on momentum.

But what about volatility? Can central banks control it?

Since 2008, an ample degree of monetary policy combined with tougher regulations on capital requirements brought more financial stability and considerably reduced systemic risk. Volatility across all asset classes was reduced by the willingness of central banks to put forth strong forward guidance and a readiness to act and provide liquidity if needed.

This year’s crisis, however, has exposed market vulnerability; a pandemic was never a parameter of the equation. In fact, the risks associated with the virus threat were so severely underestimated by central banks and governments, that the VIX surged from an average value of 15 at beginning of 2020 to an intraday all-time high of 95 in March.

Is the VIX index warning there is a storm coming?

 

A sustained rise in the US equity market, such as the one we have been experiencing over the last several months, is normally followed by a decline in the VIX. Since May, however, this negative correlation between both appears to be vanishing, and the VIX is now carrying one of the largest risk premiums ever, pointing towards a high demand for downside protection. The spread between the VIX and the 10-day realized volatility has also widened considerably, hitting a peak of 18 during the second half of August – a level not seen since December 2018 crash. A major difference is that it was very short-lived back then.

Ultimately, we are witnessing one of the longest episodes of high-risk premia for the VIX – a reflection of the options market’s skeptical response to what has been a staggering stock market rally. But most importantly, a clear warning signal September correction may be the beginning of a market meltdown

 

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