Yesterday, as the VIX was setting up for one of its biggest one day jumps in history, we reminded readers just how massive the short-vol overhang was courtesy of the following chart from JPMorgan showing that the net Vega on VIX-related ETFs was at an all time high, suggesting that the risk of a vol-buying feedback loop was significant, because as VIX rose and markets fell, it would prompt more vol-shorters to cover, selling more risk assets in the process, leading to an even higher VIX, and so on...
So what happens next to the VIX, and the vol-complex in general? Below we share the latest thoughts from RBC's head of cross-asset strategy, Charlie McElligott, who notes;
# WITH THIS MUCH NEGATIVE CONVEXITY FROM A LOW ABSOLUTE LEVEL, IT SURE DIDN’T TAKE MUCH TO ‘SET IT OFF’: So this is awkward: the hedges pushed last week ‘hit’…but with the ‘wrong’ event-risk catalyst.
Yesterday was pure ‘comeuppance’ for the ‘short vol’ / ‘negative convexity’ crowd, off of the crescendo-ing cacophony of self-fulfilling expectations for a market ‘volatility event.’ I know this sounds ‘chicken or the egg,’ but I truly believe that it was this volatility positioning which was the core of the issue yesterday, and not wholesale buyside de-risking of underlying core portfolio longs as the catalyst.
Yes, crowded trades and themes came off sharply in some cases--but relatively-speaking, the index move was rather small (from a ratio of index % move vs move in vols), especially considering the nose-bleed levels of index returns YTD. And client conversations certainly weren’t indicative of ‘panic’ or liquidation. In fact, shorts were pressed and performed very well…this wasn’t ‘gross down’ stuff.
Under the hood, stretched positioning in SPX leading ‘Tech’ sector / ‘Growth’ factor was the ‘right’ place to look for asymmetry (S&P Tech’s worst day since the June 9th ‘Momentum Unwind,’ while 12m Growth market-neutral experienced its worst day since January 31st).
China Internet, Biotech, Internet, Semiconductors / Equip/ Semicaps, SMID Cap Software, Cloud were all areas which saw outsized underperformance, but of course coming from very strong YTD levels. The impact of this ‘crowding’ (as I have been highlighting risk of ‘tipping’) was seen in my model equity L/S hedge fund model, which not surprisingly generated its 3rd worst drawdown of the year (following the May 17th and June 9th unwinds), but really just from longs due to still-high net exposure levels (shorts were pressed and did travel lower, offsetting the long losses).
But in this case, the ‘butterfly flapping its wings’ moment, beyond the aforementioned market ‘anticipation’ / almost ‘willing’ of a vol event, as ‘short volatility’ had crowded itself into a tight corner, actually came via the mounting geopolitical discomfort in the Korean Penninsula and not an ‘interest rate volatility’ blast which I had predicated my thesis around. Instead / conversely, the still relatively-tame FTQ-bid in fixed income has seen 10s push through 2.20 with bull-flattening in curves.
# WHERE TO FROM HERE ON VOL TRICKLE-DOWN:
After the crazy move around the US equities open in VIX, it looked as if VIX hedges were likely later being monetized in the US session afternoon yesterday. This makes sense, as we’ve become conditioned to shorter-and-shorter ‘half-lives’ of these ‘negative gamma’ bursts in recent years, because the Pavlovian response of ‘selling more vol into the squeezes’ has been rewarded with very handsome returns.
But the final hour and a half in the US cash equities trade again saw an acceleration of short convexity ‘stop-ins’ likely generated from the VIX ETP universe (leveraged and inverse VIX ETFs, in addition to dealer gamma), which had to buy a ton of futures to rebalance on account of the massive percentage change in spot. It’s painfully clear that these products have contributed to a huge amount of ‘vega’ in the marketplace (driving large ‘feedback’ in both VIX futures AND SPX index options). As mentioned earlier, VIX has again continued higher this morning.
*) Indeed it did when this note was sent out. However, following another disappointing CPI miss, the 5th in a row, the VIX has plunged as expectations of a December rate hike now been firmly off the table, sending the VIX sharply lower and futures in the green...
*) McElligott's conclusion:
It should be noted however that from a ‘vol control’ fund deleveraging perspective, we still aren’t likely to have seen heavy de-risking flows from the masses yet (many targets at 8 or 10), as SPX realized vol, even of the short-term 20d varietal, remains painfully low at 6.5. So, in order to ‘trigger’ it would either require another violent jump in vol, or a few more days further in this 15-16-17 vols level to ‘drag up’ the trailing number.
# Which, of course, won't happen if the Swiss National Bank, BOJ or Fed, ECB, and BOE for that matter, have anything to say about it....