Jitters about a possible earlier-than-expected tapering of QE have temporarily stopped the ongoing rally of stock prices. Interestingly enough, this comes at a time when the VIX and some associated option-linked indicators are showing some interesting patterns.
Even though the VIX continues to post an inverted relationship with the S&P 500 (higher stock prices/lower VIX), the curve of the VIX Futures (6-month vs. spot) has disconnected. As can be seen below, the VIX curve used to steepen during equity bull markets: a sharp steepness of the VIX futures curve used to provide an early signal of overbought markets and imminent correction. This is no longer the case, as can be seen below.
As it was mostly driven by the short end, there is a natural limit to the where the VIX curve can steepen when it is hovering close to its historical lows. The VIX has not reached its lowest level while the S&P 500 broke new highs - a reminder that the directionality of volatility is not always certain.
It is also explained by the fact that, barring risk aversion episodes, the VIX is generally floored by the historical volatility of the S&P 500. The decline in prices recorded in April could explain why the VIX is "stubbornly high."
Lastly, and most importantly, the spread between the VIX and the historical volatility of the S&P 500 should be much higher given the 10% return of the S&P 500 registered over the last 3-months. This kind of disconnect is very rare and could be considered as a cause for concern.
The long end the future curve has fallen as optimistic investors expect the rally to go on, which is not unusual.
The smile/skew (implied volatilities curve) might provide some further information. The S&P 500 skew is generally negative as stock indexes face negative fat fail risk (the return distribution is not log normal and its "skew" is negative). The skew of the S&P 500 is a complement of the VIX. To simplify, the VIX provides an indication of how far away from the current mean the market might go (+/-) while the skew captures the additional risk on the downside (see http://www.cboe.com/default.aspx for more).
The Skew index is built so that an increase in the perception of a fat tail risk comes along with higher risk aversion (see below). Whatever the measure of skew (here I use the CBOE index), the link exists but remains weak.
In conclusion, the flatness of the VIX curve during the recent stock rally is at odds with the historical relationship between the S&P 500 and the VIX futures curve. We cannot extract an early signal for stock returns from the steepness of the VIX curve. On the contrary, the 3-month return of the S&P 500 suggests that the spread between the VIX and the historical volatility of the S&P 500 is too low.
Lastly, in spite of the Fed tapering threat, the skew and the VIX curve have proven quite resilient: a signal of complacency or robustness of the current rally? At this stage I would say both.