Since becoming a Seeking Alpha contributor in November 2011, I have written 7 negative articles about VIX related products. My most recent piece was published in August 2012. The chart below shows some of the most popular VIX products, iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX), iPath S&P 500 Mid-Term Futures ETN (NYSEARCA:VXZ), Velocity Shares Daily 2x VIX Short-Term ETN (NASDAQ:TVIX), and Pro Shares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY) performance since November 2011.
So far, my negative view on these products has been correct. I have already said enough about the structure flaw within these products, so I am not going to comment on that in this piece. (If you have not already done so, please consider reviewing my previous articles on the topic) Instead, I am going to comment more broadly on why I think it is a good time to sell volatility itself (think spot VIX), not just the related products.
Why Has Volatility Spiked?
As shown by the chart below, the VIX has spiked more than 41% over the past month. VIX products have also moved higher during this period. The primary reason for the spike in the VIX is related to the spike in interest rates associated with recent talk of the Fed's decision to begin discussion of tapering its bond buying program. Of course, discussion of Fed tapering has not only led to a spike higher in interest rates but also a sharp sell-off in stocks.
Fed Tapering Because Of Strong Economy
In my opinion, market participants, and especially those bidding volatility, are overlooking the simple fact that the Fed is tapering because the economy is improving. In other words, the Fed is discussing scaling back its asset purchase program because it sees the risks facing the U.S. economy as diminishing. To me, this is not a reason for volatility to spike. Perhaps, if the Fed was tapering purchases because of rising inflation, then investors would have something to worry about. However, that is simply not the case.
If there is one thing that is clear, it is that the Fed will adjust its asset purchase program based on current conditions. The Fed's press release stated:
The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.
If volatility remains at the current level, then there will likely also be negative effects on the economic outlook. Given this, the Fed would likely reverse course and decide to continue asset purchases at the current level or increase them. This change in Fed policy would likely lead to lower VIX levels. Simply stated, if the Fed has caused the recent spike in volatility, then the Fed can change policy leading to a drop in volatility.
No Systemic Event
Often, when the VIX spikes, it is because market participants are worried about a systemic event such as the banking crisis in 2008, or more recently the Eurozone crisis. In both cases, an argument could be made that the problems faced would lead to a major global recession. Fed tapering is not a systemic event. When looking at events such as the banking problems in 2008, or more recently, the Eurozone issue, the market was at times uncertain that a solution was possible. Is there anything that EU leaders can do to prevent a self-fulfilling crisis? For now, the answer appears to be yes. However, the market has not always taken this view. When it comes to the current issue, the solution seems rather simple: either the markets will learn to live with higher rates or the Fed will need to change course in order to keep rates down.
Risk To My View
The major risk to my view here is that the Fed loses the ability to control interest rates. Specifically, here is what would have to happen for me to change my view on the Fed tapering issue:
1. Interest rates continue to surge higher.
2. Stock prices continue to fall.
3. Fed announces change to policy, asset purchases to continue at $85 billion.
4. Interest rate markets fail to respond to change in Fed policy.
5. Fed decides to increase asset purchases in an attempt to pressure interest rates lower.
6. In response to increased Fed bond buying, interest rates rise instead of fall as investors worry about inflationary impact.
This scenario would be problematic because the Fed will essentially lose the ability to control the interest rate market. There is little evidence to suggest this series of events has been set in motion. However, interest rate markets should be watched closely if the Fed changes its rhetoric. If rates continue to surge higher despite a pivot in Fed rhetoric then the issue may become systemic and one would likely want to be long volatility.
In my opinion, Fed tapering is not a good reason to buy volatility. The recent rise in the VIX and VIX related products should be viewed as a chance to exit these products. This is not to say that it is impossible for a continued move higher in volatility to occur. One thing to keep an eye on would be any change in Fed rhetoric due to rising interest rates. In particular, if the Fed decides to walk back some of its recent talk how will interest rates respond? If interest rates fail to move lower, then, in my opinion, market participants may want to consider being long volatility.
Disclosure: I 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.