Setting the stage for current conditions
On Sept. 20, 2017, the Fed announced a balance sheet normalization program to reduce some of $4.5 trillion in holdings mainly acquired during quantitative easing programs from 2008 onward. The reduction of assets on the balance sheet is equivalent to a quantitative tightening (QT) policy that may accomplish many of the opposite results that three significant quantitative easing (QE) programs delivered throughout 2015.
A comprehensive discussion on the theory and the background of these policy effects is detailed in my prior article, VIX Trading Patterns to Watch Closely Through the Fed's Asset Unwind Into 2019. The purpose of this article is to provide additional updates on the anomaly with the most current information and demonstrate how accurate the technical forecasts continue to be.
The chart of the S&P 500 above combined with the overlay of the Fed's quantitative easing programs serves to illustrate how well these added liquidity and bank reserve policies contributed to very low volatility in the markets. By the time the Federal Reserve's balance sheet reached $1.8 trillion in U.S. Treasury securities at the end of QE-2, the number of daily (+/-) 2% moves in the S&P 500 had dropped off significantly. As the bar chart below illustrates, from 2012 through 2017, while the Federal Reserve increased its balance sheet to a record $4.5 trillion, the added liquidity served to stabilize markets to very low levels of volatility. In fact, no 2% or greater daily moves were recorded for all of 2017.
Volatility changed dramatically into 2018. As the Fed began draining liquidity through the new balance sheet normalization policy, the CBOE VIX volatility index began to spike to record levels in February this year. This also immediately ended the longest stretch of consecutive low volatility the S&P 500 has experienced in 25 years. The start of this dramatic shift is detailed in my first volatility report: What Is the VIX Telling Us From 3 Prior Events?
What I anticipate in my working theory of this QT activity is a steady increase in volatility as measured by 2%+ daily S&P 500 moves. Just as the three QE programs effectively reduced market volatility through additional liquidity, I anticipate the reduction in Fed assets will cause the volatility events to increase.
These increases in the frequency of volatility events will either occur gradually as the unwind progresses or will reach some threshold that creates a much larger volatility event than we have yet experienced in 2018.
Examining the VIX trade opportunity
From my last article, I forecasted another December bi-modal (two peak) event in the VIX volatility index. Specifically, I wrote and charted the following:
1. Forecasting VIX event patterns. Now that the QT has been capped at the maximum $50 billion per month and has begun showing bi-modal patterns in both October and November, there could be a strong basis for another bi-modal pattern in December. Watch for the two breakout events per month to recur in December and into next year as it has happened to occur in both October and November. Watch for changes in elevation of the trend as well as the number of large moves per month and how well they correlate with the published roll-off schedule.
Putting the trade to work involves either using options on the VIX, SPX, SPY or leveraging the VelocityShares Daily 2x VIX Short-Term ETN (TVIX) to trade the signals for maximum profitability. Additional volatility instruments include the iPath S&P 500 VIX Short-Term Futures ETN (VXX), the ProShares Short VIX Short-Term Futures ETF (SVXY), the ProShares Ultra VIX Short-Term Futures ETF (UVXY), the iPath Series B S&P 500 VIX Short-Term Futures ETN (VXXB), the ProShares VIX Short-Term Futures ETF (VIXY), among others.
The TVIX chart illustrates each monthly event with a (1) for the start of the month and a (2) for the mid-month event in a bi-modal recurring pattern. In each case, the second event mid-month has exceeded the height of the month-start event each time in the respective month. I anticipate that the (2) events will continue to increase along the forecasted trendline. So far, the reliability of this anomaly has been very high and is generating double-digit returns. In all likelihood, these effects could be arbitraged away as more traders participate.
October TVIX returns: 86.02%
The table of daily returns on the TVIX serves to illustrate the number of double-digit returns from the recurring volatility gains as the Fed drains at the maximum monthly level allowed by its policy. The largest of the gains from the volatility are realized from October 4th with the breakout of the month-start event.
This TVIX chart highlights the month-start events (1) that have lasted approximately 5 days each time. Also noteworthy is that each subsequent retracement from the high has fallen back to the midpoint of the prior run as shown in the technical chart. I anticipate that the current breakout event for the December will follow a very similar pattern until the effects are arbitraged away.
November TVIX returns: -18.53%
While the table of daily returns for November shows that a buy/hold strategy on the TVIX was not a profitable approach, the bi-modal events in November were again highly profitable. Each of the two breakouts for November made gains in excess of 20% without consideration for intraday gains not captured at the close.
Lastly, the TVIX chart highlighting the mid-month events shows a different price behavior where the retracement from higher highs returns to lower lows. That is, the second volatility events of the month show a higher downside risk along with higher highs.
December TVIX returns: +18.63%
The performance table for TVIX into December has already delivered better than 29% returns with a buy/hold strategy from the start of the month. Much better than that if you traded only when the month-start event broke out on December 4th.
Related trades for profitable returns
The charts below depict the high correlations with other sector funds that could also deliver significant profitability as this anomaly continues into 2019.
The charts show the strong correlation of the Direxion Daily Financial Bear 3X Shares ETF (FAZ) with the TVIX leveraged volatility fund. This is not surprising given that the banking and financial sector is likely to experience related effects as the Fed tightens liquidity through asset unwinds.
The bi-modal volatility anomaly is highlighted on the chart below with strong similarities to TVIX. A deeper dive into more volatile financial sector stocks may produce more profitable opportunities in this sector.
There are other studies I am conducting on this anomaly, and until the effects are collectively arbitraged away, I see highly profitable opportunities here for investors in the coming months.
Be sure to check out my many other free articles here.
All the very best and have a great week of trading!
JD Henning, PhD, MBA, CFE, CAMS
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Disclosure: I am/we are long TVIX. 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.