Cross Asset Volatility.
Is the VIX at 15 really Cheap?
April 2023
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Not that Cheap
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Correlations Fall
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Buyer Beware
April proved to be a cruel month if you were long volatility. The VIX closed at 15.8, the lowest level since November 2021 when the equity market was on fire. Chart 1 shows the ferocity of the decline despite anxiety about the banks, the Fed, the economy, and the debt ceiling.
Chart 1
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
Not that Cheap. Some folks think that the VIX is headed back to the mid-20s or higher, given the array of potential problems in commercial real estate, bank runs, lagging impact of rate hikes, and so on. Two weeks ago, an investor bought a very large number (~100,000 contracts) of the June 26 strike calls – a big bet on a big volatility spike.
Before we get too excited about buying volatility, we need to understand why the VIX has been trading lower. First, realized volatility, the actual changes in the SPX, not forward- looking volatility (VIX), has been declining dramatically (Chart 2).
Second, the VIX looks at the realized volatility of the SPX, and then, in effect, incorporates a forecast of future volatility. The VIX typically trades at a premium to realized volatility (20-day). In Chart 3, we see that the spread of the VIX to realized volatility is currently around 4 points. The average premium for April was nearly 5 points. A 4-point premium is in the top 30% of all readings over the past year. With that in mind, it is hard to argue that the VIX is cheap. Said another way, you must believe that realized volatility is going to rise rapidly, in the next few weeks, for a long VIX bet to pay off. Further, VIX futures, the instrument that you can trade, typically trades at levels higher than the VIX spot. As VIX futures contracts approach expiration, the price moderates to spot value.
Third, the average value of the VIX, going back to 1990 is ~20. More important than the modal value, is the median value at which the VIX closes, ~13, well below the lifetime average. The modal value is excessively high, because the VIX spikes for short periods and then moderates. We caution investors as our view is that the current VIX level seems rich.
Chart 2
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
Chart 3
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
Correlations Fall. An important reason behind the VIX and realized volatility dropping is that correlations among stocks within the SPX are falling, a lot. Generally, the VIX spikes when correlations spike, and vice versa. When market conditions are constructive, investors can buy or sell the stocks based on how individual stocks perform. Conversely, selling is less methodical and often related to liquidity, therefore stocks are more often sold collectively increasing correlations. In Chart 4, we see that 1 month realized correlations are more volatile than the 3 month realized correlations. Both metrics retreated to levels last seen in 2021.
Chart 4
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
Buyer Beware. To buy the VIX right now means you must believe in a catalyst, or a series of catalysts that cannot be addressed by the Fed. If you believe in the catalysts, then you must believe that correlations will align.
In our view, catalysts are starting to dwindle. Roughly half the companies in the S&P 500 have reported Q1 earnings better than expected. The Fed is nearing its terminal rate. We are certainly not dismissing the aftereffects of the Fed’s rate hikes or continued risks among regional banks, but, at this point, economic data has been reasonably good and well received. There are risks associated with banks having still more deposit problems, and a presumed tightening of credit standards. However, these factors, and any weakness in the economy and anticipated earnings outlook will likely be a slower moving process. A slow and predictable path is much easier for the market to digest.
The Bank Bear Feeds
The Big Tech Bull
March 2023
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MOVE keeps moving but the VIX doesn’t care
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Big Tech or Cyclicals and Value
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Earnings best keep up with P/E expansion or look out below
The abrupt collapse of Silicon Valley Bank (“SVB”), the forced acquisition of Credit Suisse by UBS, and the mandatory restructuring of a handful of other banks, caught the market, which was anticipating a 50-basis point hike and substantially bearishly positioned, by surprise. The market reaction was to reprice the 2-year Treasury yield as a result of a flight to quality directed at the shorter end of the curve. In two days of trading, the 2-year yield fell from 5% to 4% (Chart 1).
Chart 1
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
As noted in our February Commentary, Treasury volatility is tied to strong economic data. With this repricing, Treasury volatility hit record levels. Chart 2 shows the surge in the MOVE index. It has since tapered but remains well above its historical mean. Interestingly, the VIX did not share in the excitement. It briefly hit 30 on the SVB news, then reverted to finish the month at 18.7, its lowest point of the past year.
The muted VIX can be attributed to renewed interest in the Nasdaq (“NDX”). Expectations that tighter lending standards would dampen earnings for cyclical stocks, and the Fed’s continued tightening cycle would lead to increased demand for big tech names. These names typically have less credit dependency and perform better in weaker economic conditions. To illustrate, the NDX rallied 8%, since the collapse of SVB, and now sits above 20% year-to-date.
The NDX rally has been driven, almost exclusively, by P/E expansion. Since the start of 2023, the NDX P/E is up more than 4 points, to 24.4x forward earnings, according to Bloomberg consensus estimates. We believe that we will need to see strong Q1 earnings from big tech, at month end, to validate the current bull trend. Chart 3 shows NDX month-end equity risk premium, illustrated by the spread between NDX earnings yield and the 10-year Treasury yield, at 60 basis points. If the 10-year Treasury yield climbs and big tech earnings disappoint, we expect to see more equity volatility.
To that end, we are also watching the spread between NDX and SPX volatility as this spread is still very low compared to its long-term mean. To our eye, it appears that the risk of the NDX is not properly priced.
Chart 2
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
Chart 3
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
Another curious development, which has arisen from the banking crisis, is the spread between NDX and value and cyclical stocks. Chart 4 shows the spread of the NDX earnings yield (the inverse of the P/E ratio) relative to the SPX Equal Weight (a proxy for value and cyclical stocks). This spread reached record levels at the end of March - top 1% of all readings over the past decade. If the bull trend continues, we expect to see a rotation into cyclical and value stocks. Said another way, it is hard to imagine the broader market appreciating without value and cyclical stocks outperforming.
We are now at a point where fundamentals (earnings) need to deliver, particularly if rates start climbing again. If rates rise and earnings are weak, it will be difficult for the U.S. market to continue higher. If you expect earnings will expand as quickly as P/E, then stay the course. If you do not believe that, then we think it is time to get more defensive.
Chart 4
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
MOVE-ing on up!
February 2023
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MOVE rises to over 100
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Push-up the Terminal Rate
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Pushback the Date we reach the Terminal Rate
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VIX/MOVE relationship
We think rate volatility will continue to come in from the record levels, and as this happens, equity volatility will continue to edge into a lower range. However, we caution that there are new inflationary forces on the horizon which might create new challenges for the Fed, and the markets.
Chart 1
Push-up the Terminal Rate
So why is the MOVE heading higher? Look no further than the January jobs report. While it is not the only reason, it is the most important one for now. The jobs report was released on February 3rd, a day after the Terminal Rate and MOVE reached its recent low. Chart 2 shows the MOVE with the Terminal Rate - both inflecting higher since this jobs report.
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
Pushback the Date for the Terminal Rate
Between November and January, Fed Funds Futures were pricing in the last rate hike to occur at the May or June meeting. After the January jobs report, the timing of Terminal Rate has been pushed back as far as the September meeting. In Chart 3, we see that the number of months expected to reach the Terminal Rate has pushed higher since early February, in concert with interest rate volatility moving higher.
This might be a subtle and nuanced concept, but it stands to reason, if there are more Fed meetings with which policy can shift, Treasury option traders have more opportunities to play outcomes, which can lead to higher volatility. More broadly, there will be more economic data and Fed messaging to consider over the next eight months.
Chart 2
Chart 3
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
VIX MOVE relationship is hitting a rough patch
As we have discussed, the VIX and the MOVE are highly correlated. What is interesting, however, is that this relationship has just made fresh lows (Chart 4). The current price ratio of the VIX to the MOVE is the lowest it has been since 2004. Generally, these ratios tend to mean revert – meaning either equity volatility must move higher or Treasury volatility must move lower, or a bit of both. We believe that there is a good chance that the VIX will continue to edge lower, but this probably won’t happen until Treasury volatility returns to January levels.
Chart 4
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
So, What Does This Mean for The Markets?
The Treasury sell-off has more to go. The VIX will continue lower until Treasury volatility subsides. For the time-being, equity markets will remain rangebound.
MOVE the VIX, part Deux!
January 2023
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The MOVE will lead the VIX lower
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Four obvious reasons
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Lower but not back to ‘normal’
We think rate volatility will continue to come in from the record levels, and as this happens, equity volatility will continue to edge into a lower range. However, we caution that there are new inflationary forces on the horizon which might create new challenges for the Fed, and the markets.
The VIX for Interest Rates.
The MOVE is an index which captures near dated implied volatility across the key maturities. As highlighted in our November commentary, the MOVE index soared to its highest level since the Financial Crises in 2008 (Chart 1). As we can see in Chart 2, the MOVE index has fallen since the October 2022 peak, but remains above recent historical levels.
Why Is Treasury Volatility Coming In?
Typically, extreme levels of volatility are difficult to maintain. There are four key reasons why we believe Treasury volatility is contracting:
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Components within the overall measure of inflation are coming in.
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Inflation forecasting is becoming clearer.
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SOFR futures have been stable for several months (Chart 3), indicating the market believes that we are at or very near the terminal rate.
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Chart 4 indicates that historically as the Fed reaches a “plateau” in their hiking cycle, the MOVE index contracts.
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
Lower Rate Volatility Drives Equity Volatility Lower.
Rate volatility is a key factor impacting equity volatility. Uncertainty in the risk free rate leads to uncertainty in valuing equities. Uncertainty in valuing equities leads to wider price swings.
Let Us Not Be Too Clever.
While we believe that the trend is lower in both rate and equity volatility, we don’t think that it will fall back to decade-long lows. Inflation is lingering with stickier than expected wage growth, tight commodity supply driving energy and metals prices higher, and the re-localization of the economy. As long as the markets think that they are smarter than the Fed, there will continue to be elevated volatility.
When I get knocked down,
I get up … again.
December 2022
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Gold was negatively correlated to real rates and the U.S. Dollar for the better part of 2022
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Gold volatility is relatively low and has not caught up with its price
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We expect Gold to rally this year and drag gold volatility with it
In 2022, gold was a perfect sideways trade. It started the year at $1,829/oz. and finished the year, $3 lower, at $1,826/oz. We think gold volatility is attractively priced and both its price and volatility will move considerably higher in 2023.
Gold, Real Rates, and the U.S. Dollar.
To answer the above question, we need to address what drove gold down, and then back up again, over the course of last year. In Chart 1, we see that gold reached its high of $2,043/oz. in March, when real rates (measured using the 10-year TIPS/Treasury break even inflation rate) were trading close to its low. Then, as real rates began to rise, gold sold off to its 2022 lows in September ($1,624/oz.). As real rates stabilized and the traded lower in the fourth quarter, gold prices climbed higher into the end the year.
If we measure gold price against the dollar’s relative strength to other major currencies, we see a very similar pattern. Chart 2 shows that gold sold off from the peak in March in lockstep with a steady rise in the dollar. It also bottomed in September as the dollar began to weaken. The dollar’s rise and fall against key currencies is typically influenced by a currency’s real rate (the carry trade). The correlation between these two charts is therefore not surprising. In short, when both U.S. real rates and the dollar trend lower, gold should do so as well.
In 2023, real rate, dollar, and gold trends will be defined by the Fed. Amongst the major central banks, the Fed was the most aggressive and earliest to start hiking, and they are also likely to be the first to take their foot off the brake. As the Fed approaches the terminal rate (expected sometime this spring or early summer), we expect the Euro and Yen to strengthen and the price of gold to increase.
Gold Volatility Has Not Caught Up With Its Price.
While gold is off its September lows, gold volatility has continued to remain low (Chart 3). This is unusual, especially considering that, unlike equity volatility, gold’s volatility tends to expand when it rallies. As gold moves higher through key technical levels, short covering and trend following will likely create an explosive bid for gold call options.
Gold Volatility Is Low Relative to Other Asset Volatility Levels.
If we zoom out, and consider gold’s volatility relative to other asset classes, we can see that, on a relative basis, it is much lower than other major asset classes. Chart 4 compares certain major asset classes current implied volatility levels and their respective percentile rankings with 10-, 5-, 3- and 1-year look backs. With that, we can see that while asset volatility levels are elevated, gold volatility has underperformed – gold’s current implied volatility relative to its 10-year history is in the top 40%, whereas all the other implied volatility levels, particularly Treasury and FX volatility, are in the top 12% or 5%.
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
Gold Volatility and Rate Volatility Divergence.
The divergence between rate volatility and gold volatility is striking - for the simple reason that gold volatility tends to move higher or lower with Treasury volatility. Chart 5 provides a long-term view of the MOVE Index (VIX equivalent for the Treasury curve), the GVZ (VIX equivalent for gold implied volatility), and then the ratio of the GVZ/MOVE index in the lower panel going back to inception of the GVZ, 2008. We see that this ratio is at its all-time low and thus we expect some mean reversion in this ratio in 2023. Even if this mean reversion is driven in large part by Treasury volatility coming in, as a result of approaching/arriving at the Fed’s terminal rate. It also appears likely that some expansion in gold volatility will occur as arriving at the Fed’s terminal rate should also push gold and its implied volatility higher.
The China Call Option.
November 2022
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Don't forget about China
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Muted inflation in China
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Korean Won risk reversal is a window into Chinese economic health
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Inflation may continue outside the U.S.
Understandably, investors have been focused on the Fed and U.S. economic inflation data. We would like to draw attention to the impact of China’s zero-COVID policy resulting in unusually weak inflation in China. The chart below (“Chart 1”) shows that Chinese inflation has been loosely correlated to U.S. inflation until the onset of COVID. This is when U.S. inflation began to rise as Chinese inflation began to fall.
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
It is difficult to say whether the widespread protests or a weakening economy are the catalyst for change in China. Either way, it has raised important outcomes from supply chain shocks for U.S. companies/consumers to the risk of political upheaval. China has made the decision to loosen COVID restrictions and the Yuan has strengthened, and Chinese equities have rallied (“Chart 2”).
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
As we look across assets, specifically the options market, we identify an important relationship between the Chinese economy and Korean Won risk reversal, the spread between calls and puts. Korea has a sophisticated open capital markets system with substantial exposure to the Chinese economy. Historically, when the Won risk reversal surges (Won protection), it coincides with a downturn in the Chinese economy. This was never clearer in the Chinese Yuan devaluation in August of 2015. Today, the lower Won risk reversal spread points to less regional stress and a healthier economic outlook for China. In “Chart 3,” we observe a stable Won during the recent Chinese protest.
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
Finally, in “Chart 4,” we overlayed the dollar (DXY) with the Won. This chart shows periods of correlation with a spike at the dollar peak in late September 2022. Since that time, the weakening dollar has led to further Won spread compression. Said another way, the U.S. dollar has had a greater impact on Asian markets than China’s unrest. Take away: China growth coming back online could be a spark to reignite global growth. This could lead to improving EM equities and increasing commodity prices which could impact the Fed’s terminal rate. How fast will this all play out, patience my good friend.
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
MOVE the VIX.
October 2022
The VIX reached a higher peak in October than it did in September. Interestingly, in the second half of October, the VIX then steadily decreased as the U.S. equity market rallied more than 8%. For its part, Treasury volatility also came in during the latter part of the month, but for all practical purposes, the MOVE index (a VIX for the Treasury curve) did not come in as much as the VIX (Chart 1).
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
If we look at the long-term relationship between Treasury volatility and equity volatility (Chart 2), we can see how unusual the last two and a half years have been. In the aftermath of the Fed’s emergency response in the spring of 2020, the MOVE index fell to record low levels and remained there throughout 2020. In 2021, the MOVE index normalized to pre-COVID ranges, and this year, the MOVE has surged to record high levels. The VIX, on the other hand, remained elevated throughout 2020 and 2021, and while it remained in the higher range this year, it has not exploded even higher with the bear market. The MOVE/VIX ratio, shown in the bottom panel of Chart 2, has oscillated between record lows to the current record highs.
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
Why is Treasury volatility expanding so quickly in 2022? An obvious reason, the Fed has undergone an extreme pivot in monetary policy over the past year. Currently the futures market is pricing in eight more hikes (an incremental 125 basis points after the just announced 75 basis points) to a “terminal rate” of about 5% which is anticipated to be reached in May of next year. If this plays out as currently priced, this hiking cycle will be the second most aggressive on record in terms of both the number of rate increases and the speed of those rate increases. The fact that this hiking cycle started at an incredibly accommodative level underscores how strong a policy shift this has been, and why the rate volatility has been so high.
There is another dimension to this sustained rate volatility. Chart 3 shows the market pricing of the terminal rate increasing steadily this year (the blue line) alongside the number of months that the terminal rate is expected to reach. Since June, the timing of the terminal rate keeps getting pushed back. With no clear end in sight to the end of the hiking cycle, we think it is intuitive that rate volatility will remain at these extremely elevated levels until the Fed sends a signal to the market as to when the rate hikes will end or at least be paused.
Source: Tallbacken Capital Advisors L.L.C., Bloomberg L.P.
Clearly, when the Fed decides to stop raising, we should see a reduction in both rates and rate volatility. There is another scenario to consider: the Fed hikes toward market expectations and then “sits on” the terminal rate for a long period of time. That would presumably bring down inflation and rate volatility. Once we see lower rate volatility, then we believe the equity market will be able to sustain a less choppy condition.