Early in the morning today (Eastern Standard Time at least) the German Supreme court ruled to allow the ESM to obtain a banking license. This had been largely priced into the market and any euphoria was further restricted by putting a cap on the German ESM participation at 190 billion euros. Before market open, the U.S. markets have been up as much as 0.5% and volatility futures down 2%.
The fact that the German courts ruled in favor of the ESM should shock no one. The rally that we saw on Thursday and Friday of last week was more than enough to convince me that Draghi had won the fight between the ECB and Germany and that the euro would see the printing party for which so many had been hoping. While some would think that a euro printing bonanza would lead to dollar strength and EUR weakness, you have to take into account the large short interest that had built up in the euro as many felt breakup or collapse to be around the corner. While the short covering rally will peter out eventually, the ESM decision will add more confidence to risk appetites in the short term and apply downward pressure to volatility.
Even Flatter Than Before
We go into today with an increasingly flat term structure.
- Spot VIX: 16.41
- September Futures: 16.60
- October Futures: 18.35
Spot VIX moved up slightly yesterday and the September contract rose with it. The October contract fell slightly and the spot/front month gap fell to 1.2% and front/next month gap fell to 10.5%. Since just two trading sessions ago the gaps were 33%+ higher in both cases, it appears the markets are getting closer to their decision points.
Since we are less than a week outside of September contract expiration, the volatility products are now mainly composed (75%+) of October contracts and any movements in the September contract will have a muted impact on VXX, UVXY and TVIX. Even if the futures go into backwardation slightly with spot above September, we won't get real fireworks until spot rises above the October contract. With the October contract sitting at 18.60, that is not out of the question, but the market will have to drop extremely quickly for that to occur. A Bernanke disappointment could easily send spot VIX to 18+ but I would expect the October contract to rise concurrently and front/next month backwardation to be avoided for now.
While today's ESM decision will cause a small dip in volatility as a level of certainty reenters the marketplace, we still have Bernanke and the FOMC meeting tomorrow that could change everything on a dime. The weakness in volatility that we are seeing the pre-market leads me to believe that we might have more downside until market participants decide to hedge again in front of tomorrow's FOMC decision.
Hopefully you were able to close out your volatility positions into the strength yesterday as we should see another intraday buying opportunity today. Yesterday we saw weakness until the close of the European markets and I would not be surprised if we saw the same playbook today.
Any long positions established today could be held overnight if you are willing to roll the dice as we should see continued hedging up until the FOMC announcement at 12:30 p.m. EST. If you have a profitable trade at the close today, taking half off the table and letting the remainder ride is likely a most prudent decision.