Market Volatility Bulletin: If The Economy Is Decelerating Dramatically, Then Why Is The VIX Falling?

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Market Intro

CNBC: 12:50PM

US stocks (SPY, DIA, QQQ, IWM) witnessed a decent rally heading into Thursday’s close. Futures dropped off in the overnight session, but the indexes have held their own since the opening bell on Friday.

Spot VIX is down modestly as we head into the weekend, toward the bottom of its recent range (15.25-17.00).

Thoughts on Volatility

CNBC

The Morgan Stanley Business Conditions slammed lower in the last month. Sentiment, however, is subject to mercurial change. The coupling of the weak jobs number for June with the ongoing trade disputes with China (and more reasonably Mexico) probably took their toll.

Time can only tell if this decline will rebound in short order, or whether perhaps more hemorrhaging is under way. Despite the salacious headline, vol markets are taking the report in stride.

Perhaps vol is capped with good reason. I think that ST’s comment in the previous MVB is pretty dead-on. Sure there are some warning signs. But there are always warning signs of some form or other. Holding rates makes sense, but to cut while the US economy seems to be hanging in there smacks of a Fed with an agenda to keep asset prices high and market volatility low.

The question at the end deserves to be taken quite seriously. Progress in rate increases should not be squandered at the first signs of danger, especially when no hikes occurred during a pretty good year for the US economy such as 2016; if anything, the Fed is a little behind where it ought to be on rate hikes.

Mr. Rosenberg brings up a good point, but we need to keep in mind that this trend has been going on for some time.

It is likely that larger dividend payouts and a desire to lever up corporate balance sheets have trimmed down corporate balance sheets.

As a side note, my Master’s degree was in financial engineering (University of Michigan, 2011), and it amuses me when folks use that term to essentially discuss share buybacks or policies that they dislike. FE has a lot to do with how derivatives are priced and does not concern itself much at all with issues of corporate capital structure.

Term Structure

I’ve included a smattering of VX term structures from the past three weeks or so. While last week’s jobs figure did not impress, it seems to have cemented the notion that help is on the way.

The term structure is most certainly at the low-end of its recent range. With the June VX contract expiring at this upcoming Wednesday open, July is soon to become the front month.

For trading purposes, this means that the front month may just not be very important to you. For instance, the ETPs (VXX, SVXY) are going to trade with much more weight to the M2 at this point.

For those who trade VX futures directly, likely you have a policy in place as to when you stop trading the M1. As such, we want to treat this low price level contract with some caution.

I do think there’s plenty of room for the M2 to follow suit shortly here, especially if SPX can get back over the 2,900 hurdle, which frankly seems pretty likely.

VVIX is trading at the lowest levels since the sucker-punch weekend announcement back in early May that the trade deal was off.

This is one reason that I think we could see some gradual downshifting to the M2 contract. If the supply/demand balance on VIX vols is targeting low volatility for the contracts, it will be difficult for the M2 to hold high above a falling HV20, spot VIX, VIX9D, etc.

MarketChameleon.com: USO IV (green) and HV (purple).

Now if you’re looking to trade some volatility on a product whose vol profile is cooking up, then I believe oil (USO) may be your cup of Texas tea. Both implied and HV are tracking up near the 40 level, with an upward-sloping trend and not a lot of divergence between the HV and IV; that narrow gap between the two suggests to me that past is pretty decent in terms of prologue for this market.

Wrap Up

If this is your first time reading Market Volatility Bulletin, thanks for giving it a try. If you’re a regular, I thank you for your ongoing contributions in the comments section.

Plenty of scope for another blow-up. The trouble is that while 2019 began with some notable vol levels, the overall market environment has in fact been one of sustained calm. Sure, there have been reversals, but that was true even back in 2013, which was a calm year by almost any standard other than perhaps 2017.

Cool stat, and I do think that even if 2019 is a laid back year on the whole, there are plenty of potential plot twists that pump VXX higher. This is especially true due to the relatively low roll yield paid by longs so far this year.

Thanks for reading.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I actively trade the futures and options markets, potentially taking multiple positions on any given day, both long and short. I also hold a more traditional portfolio of stocks and bonds that I do not “trade”. I do believe the S&P 500 is priced for poor forward-looking returns over a long time frame, and so my trading activity centers around a negative delta for hedging purposes.