Volatility in decline - why the VIX index is so low

2023年4月19日

Having only recently traded through the most volatile (vol) environments in interest rates and bond markets since the GFC, we are now seeing far more subdued conditions in vol. Many have expressed disbelief at how the VIX index (S&P500 30-day implied volatility) is below 17% when the US is eyeing a possible recession this year, the credit crunch is yet to really bite, earnings estimates are likely due to be revised lower, and Treasury yields curves are still deeply inverted.

It’s not just the fact we haven’t seen the S&P500 close 1% lower since 22 March (18 sessions), but we also see the 5-day (exponential) moving average of the high-low trading range for S&P500 futures at a meagre 41-points. This is not far off the lowest levels since 2011, so traders are getting less and to work with intraday.

There isn’t one reason for the lower vol, so I have put some views on the considerations I see as causing these calmer conditions. I am sure there are others, but these jump out.

1. S&P500 realised volatility is impacting the VIX index – we see that S&P500 10-day realised vol is now 8.2%, with S&P500 20-day realised vol at 11.7%% - both are the lowest levels since Nov 21 – options market makers will typically look at how volatility is realising as the basis for pricing implied volatility. The fact the S&P500 just refuses to fall has also limited the demand for downside hedges- hedges cost money.

2. CTAs (trend-following funds) have been getting progressively longer and their estimated net exposure is ‘max long’ US S&P500 futures. Volatility-targeting hedge funds are adding equity exposure as equity realised vol falls – lower vol begets lower vol.

3. Why sell your equity longs? Funds are taking advantage of the grinding price action in stocks and selling S&P500 index calls and using the premium to buy OTM (out of the money) S&P puts – this means they can essentially hold their core equity holdings and utilise optionality with a cheap/free hedge.

4. Reduced interest rate risk – the Fed are now fully data dependent and the market prices a 25bp hike in May, with an extended pause through to November – with a far more normal distribution in the skew of expectations for bond price/yields (i.e. yields could go either way and not just higher), we’ve seen bond vol (we use the MOVE index) fall from the highs on 15 March. Probable lengthy inaction from the Fed has lowered volatility.

5. A weaker USD has helped lower broad market volatility - The USD index (DXY) fell 4.8% from 8 March to 14 April – in that time the VIX index fell 9 vols from 26% to 17%

6. The Fed’s response to managing instability risk through the rollout of emergency credit facilities was truly meaningful – the market is becoming comfortable that there will be consolidation in the US banking sector ahead of us, but the Fed has cut the systemic event risk.

7. Increased liquidity - Reserve balances held with the Fed are +12% since March. We also see that since January the TGA (Treasury General Account) has been drawn down by 450B to sit at 109B.

8. Corporate share buybacks authorisation hit a new record and nears 400b – companies are the biggest buyers of stocks, and this is suppressing vol.

9. BoJ gov Ueda said on 10 April that YCC is still the best policy for the current economy – the has reduced JGB and JPY implied vol, which again has spilt over into G10 FX volatility.

10. The Fed funds rate was hiked aggressively from 0.25% to 5% - Yet while the US real policy rate (fed funds adjusted for headline CPI) has moved from -8% to -0.2%, it is still negative and to some that are not restrictive enough.

11. The rise of 0DTE (days to expiry) options – fewer traders are trading 20–40-day expiries and the volume in ultra-short-term options means we see less volume in the strikes that feed the VIX calculation.

Trading Strategy – traders adapt their strategy to lower volatility and range compression. Recognising the market environment is pivotal for day traders – this means understanding if it’s a range/mean reverting session or more of a trending and possible momentum day. We can see that when the close-to-close percentage changes are low, and the trading ranges are compressing mean reversion strategies are preferred. Traders are selling strength intraday and buying weakness.

What changes this low-vol regime?

If we knew then everyone would be buying volatility – we can look at the known risks and anticipate, but we wait for the market to react and show it is now a factor – being early can hurt. To cause a material drawdown in risk and higher vol I think it must stem from liquidity. While we can’t rule out a renewed move to hike interest rates, I see the debt ceiling as a real risk – not because the US govt is going to miss a debt payment and technically default; the probability of that is incredibly low. But the actual negative event may come from once we see it resolved and the US Treasury aggressively rebuilds the TGA, and issues close to a 1T of short-term US Bills – this will act as a massive liquidity drain and QT on steroids. This comes at a time when the US could be moving into recession and the ECB balance sheet will be falling faster. A scenario many are starting to look at very closely now as liquidity is the oxygen in the market's lungs.