As the government lurches toward a shutdown tomorrow and the October 17 deadline for a debt ceiling deal approaches, volatility traders appear surprisingly complacent. Writing this article midday on Monday, the VIX is a little south of 17, lower than its historical average of about 20. According to the latest commitments of traders data from the CFTC, "leveraged funds", a category that includes hedge funds and other money managers, are heavily net short VIX Futures: 33,327 contracts long, 163,413 short and 37,361 spreading.
The "smart money" is betting that these issues will be resolved without much ado. And traders have good reason for thinking this: shorting the VIX through ProShares Short VIX Short-Term Futures ETF (SVXY) or VelocityShares Daily Inverse VIX Short-Term ETN (XIV) has been a winning strategy during the last several episodes of government squabbling, from last December's budget battles to the Cyprus bailout and the sequester. Even after it became clear this morning that a shutdown is likely, front-month VIX futures have hardly budged. At a current price of 16.15, the front month contract is now selling below the spot VIX price, a somewhat unusual phenomenon known as backwardation. What this means is that market participants believe the VIX will decline from current levels when the October 15 contract expires in fifteen days. VIX shorts are so optimistic that they are willing to pay a premium in the form of time decay to VIX longs for the right to bet on this decline. This does not usually happen, because shorts typically demand a premium from the longs in order to take on the risk of a sudden sharp spike in expected volatility or "black swan".
I believe that shorts are making a bad bet. Even if the government shutdown is averted or only lasts a few days, October 17 is still the key date on the upcoming risk calendar. Both sides of the aisle seem intransigent and willing to play chicken with the economy for the sake of scoring political points. On the left, the Affordable Care Act is non-negotiable and Obama's key domestic policy achievement. On the right, the Affordable Care Act threatens the economy and represents worrisome government overreach. I will not comment on the merits of the legislation here, but only note that both sides are itching for a fight and risk alienating their bases if they back down. In the end, political survival depends upon votes, and many voters appear to prefer confrontation to compromise.
So if the government shutdown is avoided by a last-minute compromise or only lasts a few days, both sides will be left unsatisfied. They will seek to appear tough during the debt ceiling fight, which will likely consume the news during the first half of October. VIX shorts appear to think that while there may be some posturing, the debt ceiling debate will be concluded by October 15th. I'm not so sure. Even if there is only a 20% chance of the debt ceiling debate going to the last hour and only 1% chance of a technical default or constitutional crisis, the risk-return seems asymmetrical to me. A debt default or constitutional crisis poses a much greater threat to the global financial system than some federal government workers getting furloughed.
John Kenneth Galbraith once quipped that the financial memory is very short, and VIX shorts appear to have forgotten about 2008, 2010, and 2011 already. The short trade has been the path to riches since the beginning of 2012, but now the trade is getting crowded and traders are complacent. Every few years, volatility suddenly spikes and short VIX positions lose 50% or more. Complacency is replaced by fear as VIX shorts and other leveraged "risk-on" players scramble for the exits in the face of margin calls and evaporating portfolios. October may become another episode of VIX shorts getting pulled out to sea.
Personally, I'm waiting on the sidelines for a washout of the shorts to initiate a short position myself. It is only when traders are reminded that VIX futures are extremely risky and the shorts capitulate to fear that the short trade really pays off.