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Summary

  • A sudden drop in the S&P 500 accompanies an outsized surge in volatility off 7-year lows.
  • The bearish surge in volatility is greatly tempered by a lack of response in (spot) currency markets.
  • In particular, strength in the Australian dollar and a lack of strength in the Japanese yen suggest a shallow sell-off for now.

Thursday, July 17 was a tough news day that pressured the market in several ways. The S&P 500 (NYSEARCA:SPY) dropped 1.2% and returned to where it traded at the end of June.

The primary uptrend for the S&P 500 ends with a decisive blow.

Although the drop in the S&P 500 was not particularly large - it experienced larger one-day losses during two separate bouts of selling earlier this year - the volatility index, the VIX, surged a tremendous 32.2%. This is larger than the 31% surge on January 24th, when the S&P 500 dropped 2.1%.

The VIX surges… and amazingly manages to stop cold at the old 15.35 pivot (you just can't make this stuff up!)

As the media hashes through all the headlines and connecting dots, there should be discussion on why "this time" is different than so many other occasions when the market shook off bad news headlines. Perhaps it is the still fresh memories of the Federal Reserve posturing about high valuations in small cap stocks. Perhaps the strong surge in volatility is a natural reaction of traders who rush for options protection while it is still so cheap. In January and now, the VIX is coming off extreme lows. In January, it was a low level that held as an approximate bottom throughout 2013. This time, the VIX is leaping off levels last seen in 2007.

Despite the tremendous surge in volatility, "risk-on" moves were notably absent in the forex market. This collective yawn makes me think that this sell-off will stay shallow and not last long (which would be fortuitously consistent with "buy in July").

I began this year noting that the Australian dollar (NYSEARCA:FXA) versus the Japanese yen (NYSEARCA:FXY) should provide key indicators or points of confirmation for bullish and bearish moves in the broader stock market. In January's stock market sell-off, AUD/JPY simultaneously plunged. The abrupt end to the drop in the currency pair helped me to ascertain that the S&P 500's sell-off would not last much longer. Fast-forward to today, and AUD/JPY is not confirming Thursday's sell-off one bit. In fact, not only is the currency pair still marginally in the middle of a breakout, but also at the time of writing, the currency pair is rallying, with the Australian dollar jumping against all major currencies.

The tell-tale Australian dollar versus Japanese yen currency pair has all but ignored the sell-off in the S&P 500

I think there was plenty of reason for traders to take Thursday's angst as an excuse to sell off risk and the Australian dollar, given the return to jawboning by the Reserve Bank of Australia against its currency.

Adding to the sense of a non-event in forex is that the Japanese yen also failed to break down through a trading range that has neatly held up for most of 2014 against the U.S. dollar.

The U.S. dollar continues to hold the line against the Japanese yen

The Swiss franc (NYSEARCA:FXF) also kept its cool against the euro (NYSEARCA:FXE). Note that the franc has been gaining strength slowly but surely all year as the European Central Bank (ECB) has loosened monetary policy without any firm moves from the Swiss National Bank (SNB) to counter the exporting of deflation across Swiss borders.

The Swiss franc continues to strengthen against the euro, but it has yet to make new lows for the year.

Source for charts: FreeStockCharts.com

None of this is to say that the situation cannot dramatically change in favor of the bears. I am merely pointing out that the fresh bearishness in the S&P 500 lacks some key confirmation from the currency markets in the typical risk-on/risk-off currencies. The implication is that under current conditions, this sell-off will transform into another shallow episode. However, given the S&P 500 DID break its primary uptrend, I am much more confident in an imminent fade of volatility than an imminent resurgence in the S&P 500. Accordingly, I took a tentative position in fresh puts on the ProShares Ultra VIX Short-Term Futures (NYSEARCA:UVXY), which jumped 19.2% on the day.

The bears got my attention, but not my heart.

Source: Forex Mainly Yawns As Stock Market Volatility Finally Surges Off Lows

Additional disclosure: In forex, I am net short the Australian dollar, short the euro, long the U.S. dollar, and net short the Japanese yen (the Australian dollar positioning is the only one that is "longer-term").