Market Volatility Bulletin: VIX Looks Beyond Some Warning Signs As SPX Touches 3000

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Includes: DIA, IEF, IWM, QQQ, SPY, SVXY, VXX, ZIV
by: The Balance of Trade
Summary

On the surface, stocks are at all-time highs, vol is low, and even Treasury yields are inching up.

There are some disquieting signals, such as falling liquidity and rising likelihood of a recession.

VXX Skew is getting pretty steep.

Market Intro

CNBC: 9:12AM EST

As markets prepare to open for Thursday trade, the SPX (SPY) looks primed to open above the 3000 mark. Spot VIX sports a 12 handle (a touch below 13), and the US 10Yr (IEF) is looking to distance itself a bit more from its recent foray into the "1's".

...Everything looks peachy from a financial markets standpoint (DIA, QQQ, IWM).

Thoughts on Volatility

There are a couple warning signs, however, as SPX launches over the 3000 mark.

I like the way that Pat Hennessy couches his argument. ES liquidity is quite low right now: that creates the possibility of more panic, proverbial dashes for the exits, rather than being a warning sign in its own right. Spot VIX is quite low here, but maybe there is room for a sudden jump higher (we'll revisit this below in the Term Structure segment).

What interests me here is how dramatically this indicator has flashed into warning mode; it has jumped from around 10% to now a tad north of 30%, and all since the turn of the year.

It should strike the reader that over virtually this identical time horizon (start of the year till now), the stock market has gone from its one-year lows to its all-time highs. Vol, of course, has been crushed along the way: spot VIX fell from just below 30 to its current level near 13.

The Fed has had no small role to play in this seeming contradiction between recession indicators clipping higher alongside prices of risk assets. In late December of '18, Powell made indications of the flinching from what was then a policy of steady tightening.

As atom&humber suggests, it really does seem as though the Fed is running its monetary policy less on the basis of actual economic indicators (though as the Tracy Alloway Tweet from above indicates, there may indeed be some cause for concern here) to more financial market signals. There is in my view some wisdom in this, with the important caveat that financial markets arguably respond more rapidly to Fed policy and forward guidance than does the Main Street economy. This is how feedback loops are created, and I argue that the Fed needs to distance itself from leaning too robustly on the whims of financial markets, as it could hamstring their long-term efforts at price stability and full employment.

Term Structure

The VX term structure plucked up a little over the last week from the lows of July 3rd, but unquestionably we're seeing a lowering - and a steepening - over the last month.

M1-M2 is now north of 11%, while HV10 is trading sub-seven. SPX is holding up at 3000, and there is all manner of reason to expect some continued drift higher as traders welcome the banner index level.

Not my favorite indicator (I wish that the implied correlation index didn't always exhibit a downward drift over the year due to index construction).

But the dip is nonetheless here, and falling correlation provides grist for falling volatility, further supporting the short-vol thesis (SVXY, ZIV) for a compelling way to get long risk assets at present. Lower correlations mathematically drive lower vol readings (for equal index maturities).

MarketChameleon.com: VXX Skew

Over the last week, implied vol on the VXX has fallen ATM, but the skew has gotten pretty stinking steep over that same time horizon. For those who trade options spreads on these products, take skew into consideration when assembling your structures.

In keeping with some of the warning signs we examined earlier, this pickup in skew (while vol itself falls) could be seen as a reasonable response to the flow of events, and the arguable separation between economic indicators vs. the current trend higher in the financial markets.

Wrap Up

If this is your first time reading Market Volatility Bulletin, thanks for giving it a try. If you're a regular, I thank you for your ongoing contributions in the comments section.

SilentSage and Alan had a productive set of comments in the most recent MVB. Topics covered term structure, seasonality, and long periods without meaningful drawdowns.

Thank you for reading.

Disclosure: I/we 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.

Additional disclosure: I actively trade the futures and options markets, potentially taking multiple positions on any given day, both long and short. I also hold a more traditional portfolio of stocks and bonds that I do not "trade". I do believe the S&P 500 is priced for poor forward-looking returns over a long time frame, and so my trading activity centers around a negative delta for hedging purposes.