Tuesday, April 19, 2011

How Low Can the VIX Go?

What's going on with market volatility? You'd think with Standard and Poor's putting the US government on notice that it risks losing its AAA credit rating and Greece teetering on the abyss, markets would be going haywire waiting for the next shoe to drop.

David Berman of the Globe and Mail asks, Why did stock market panic?:

Here’s yet another theory why U.S. government bonds are failing to react much to the Standard & Poor’s cut to the U.S. credit rating outlook: The bond market had already priced it in.

From Jan Hatzius at Goldman Sachs: “Clearly, the U.S. fiscal situation is unsustainable unless a large, multi-year fiscal tightening is implemented. However, there is no information in today’s report about the fiscal situation that was not already known. Academic research has generally found that rating agency actions lag market pricing, rather than lead it.” [Double SIGH!!]

This sounds reasonable, though it raises the question why the stock market was so quick to panic. The Dow Jones industrial average was down nearly 250 points at its low point during the day. Even though the Dow recovered about 100 points in afternoon trading, the stock market nonetheless stood out for its hysterical reaction to the S&P report.

The CBOE volatility index, or VIX – which is considered a fear gauge of the market – had jumped in early trading. But the gains were still slight: The index hit an intraday high of 19 before settling back to 17 in the afternoon, which is exceptionally low.

Last spring, during the stock market correction that followed the European debt crisis, the VIX had shot above 40. And during the initial reports of the Japanese earthquake and tsunami in mid-March, it rose close to 30. By comparison, Monday’s blip looks like nothing.

True, after surging as much as 23% Monday, the VIX dropped 7% closing at 15.83 on Tuesday, just above the 15.32 close of last Friday, its lowest finish since July 2007. So what's going on? Why are markets so complacent? Isn't the world coming to an end?

Perhaps the VIX isn't the right gauge of fear. At Zero Hedge, Tyler Durden posted a comment late Monday afternoon that the SKEW does not paint a remotely as rosy picture as does the VIX. Moreover, Tyler noted that the Credit Suisse Fear Barometer, another measure the "pros" look at is exploding up, suggesting that smart money is very scared right now.

I read the comment and then asked one of the best TAA pension fund managers I know to share his thoughts:
With vol at 15..it is reasonable for skew to be so steep. This market is a very low vol market, point in fact is 100 day realized vol on spx is below 12. However, it is prudent risk management to buy short term vol or gamma at these low levels because you benefit if a you have a big move in the markets. But the biggest anomaly is still long term volatility, which is sitting at 30. The past 5 years realized vol on spx is at 28. Unless you think we will have another banking crisis it will be very difficult for vol to realize this level. Interest rate curves are steep and the Fed hasn’t yet increased short term interest rate.
He added:
"...that is why I am moderately bullish..hedge funds are quick to short and real money is hedged.... We are climbing a wall of worry!"
We talked about the S&P debt warning on US debt and both quickly dismissed it as "bullshit". I want you all to repeat this sentence a trillion times: The US will never default on its debt -- EVER! Get that silly thought out of your head. It's beyond stupid and I'm sick and tired of the media fueling this nonsense.

Some lady on CNN tonight was painting a "nightmare scenario" where the Chinese "woke up one morning and stopped funding US debt". I was rolling my eyes as I listened to this nonsense. The Chinese need the US consumer and they're still an export-led economy. China's middle class is growing by leaps and bounds but they're nowhere near the point where they can wake up tomorrow and tell the US to screw off.

I'm also sick and tired of hearing about how Bill Gross is selling US bonds (yeah right!) and how the US is the next Greece. Total rubbish! When a possible Greek restructuring hit the newswires, investors fled to the safety of US Treasuries.

On the subject of Greece, that TAA manager sold his 2-year Greek government bonds last week and made a nice profit. On Monday, the yield on those 2-year Greek bonds rose to 20%. On Tuesday, risk appetite was buoyed after Greek debt sale:
Athens sold €1.625bn of 13-week notes and although the yield demanded by investors was 4.1 per cent – up from the 3.85 per cent paid at its last sale of these notes in February – there was healthy demand with orders for 3.5 times the bonds on offer.
I asked another sharp pension fund manager his thoughts on 2-year Greek bonds and here is what he had to share:

I’d want to buy ones with lower prices (discount to face); the assumption being that restructuring could take the form of a haircut off of face value. However, you don’t want to get too long a maturity, so you end up looking at 5- to 10-years. With short maturities, you’re playing the game of guessing how long they can delay any restructuring event, which we have no expertise in.

It looks reasonable from a risk-return standpoint even under the assumption that they will restructure; and if for some insane reason they don’t restructure, you make out like a bandit.

Even though Greece is forced to pay sky-high rates to borrow, and restructuring looks more likely than ever, I have a feeling some large hedge funds and asset managers are going to "make out like bandits" snapping up Greek debt at these levels.

As far as how low the VIX can go, it's anyone's guess, but it can go much lower and stay low for a very long time as the market continues to climb the wall of worry, which I predicted back in January in my Outlook 2011. There is a tremendous amount of liquidity which will propel all risk assets higher. Don't say you weren't warned.

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